2023-07-10 16:56:20 ET
Summary
- Vale, the world's largest iron ore producer, is trading at a 30% discount from its peak in June 2021, indicating potential undervaluation given its strong cash generation in recent years.
- Despite uncertainties surrounding China's economic growth, Vale is expected to provide an attractive dividend yield to shareholders and benefit from share buybacks, enhancing investment returns.
- Vale has shown resilience in challenging periods within the iron ore market, and I expect the company to generate a 7-9% yield by 2023.
Vale ( VALE ) is the world's largest iron ore producer and the second largest nickel producer and is also responsible for producing several other metal groups. The company operates globally, but its iron ore mines are most concentrated in Brazil. Vale has integrated iron ore operations, including railroads, terminals, and ports. As an exporter, most of Vale's revenues come from selling iron ore internationally.
With Vale's current shares trading at approximately a 30% discount from their peak in June 2021, the company shows indications of being undervalued, especially when considering its robust cash generation in recent quarters, despite the fluctuations in iron ore prices.
While uncertainties surrounding the growth of the Chinese economy persist, it is expected that Vale's annual results for 2023 may be lower compared to previous periods.
Nonetheless, given Vale's ability to generate cash even during uncertain periods for the iron ore market, the Brazilian mining giant is poised to provide an attractive dividend yield to shareholders. Additionally, shareholders may benefit from buybacks, enhancing their investment returns.
Vale's recent performance
Throughout this year, Vale and other significant players in the industry, such as Rio Tinto ( RIO ), BHP Group ( BHP ), and Anglo American ( AAUKF ), have experienced significant losses primarily due to the fluctuating macroeconomic data related to iron ore in China. As the world's second-largest economy and the largest consumer of iron ore, China has played a crucial role in this market.
Last year, iron ore prices exceeded $150/ton, but they have since declined to approximately $110 per ton. This decrease can be attributed to economic downturns, particularly in China.
In the first half of this year, there was a deceleration in economic growth within China's consumer and private sectors. This slowdown signaled weak demand as the country reopened its economy following stringent Covid-19 measures. Furthermore, market expectations were revised to reflect a less robust economic stimulus than the initial projections.
However, a couple of months ago, the picture slightly changed as rising iron ore prices gave signs of a resumption of confidence. China's Premier Li Qiang suggests that the country's economic growth in the second quarter will likely be more robust than in the preceding three months, projecting an annual expansion rate of around 5%.
Moreover, the Chinese government has indicated its intention to limit crude steel production to curb speculation on iron ore prices. This measure is positive for Vale and other mining companies as it helps maintain price stability.
Additionally, it is worth considering the impact of seasonality on iron ore prices in the short term. Towards the end of the year, as the rainy season in Brazil and the cyclone season in Australia ends, there is a tendency for ore shipments to increase. This seasonal pattern is expected to bolster the supply of the commodity, potentially influencing its market dynamics.
If we reflect on the past, a significant portion of the notable increase in Vale's shares from November 2021 to April 2022 can be attributed to a unique combination of factors. These factors include the devaluation of the Brazilian Real against the dollar, driven by financial pressures and heightened political risk within the country, coinciding with rising commodity prices.
Metallic commodities, such as iron ore, are the ones that tend to suffer most in times of crisis for being very dependent on more elastic sectors, such as civil construction, automobiles, and household appliances.
Thus, iron ore dropped drastically throughout 2022 with the expectation of economic recession in developed countries due to increased interest rates, inflation, energy crisis, and logistics. But the main culprit was the crisis in the Chinese housing construction sector, a massive consumer of steel. Large construction companies like Evergrande, showing a fragile balance sheet and tight liquidity, also weighed deeply on the performance of iron ore, primarily until late 2022.
Typically, commodity prices rise when there is a weaker dollar scenario. And in fact, this happened mainly until April of this year. Since the beginning of this year, there has been a significant appreciation of the Brazilian Real against the dollar and a performance of the November 2022 iron ore rising 61% from $80/ton to $130/ton in March.
In any case, monitoring various factors related to iron ore is essential. The general principle states that if the largest economies in the world show signs of acceleration, iron ore prices will likely rise.
Undervaluation and resilient cash generation
Even with many macroeconomic uncertainties still hanging over the global economies and skepticism over China's consumer demand rebound, Vale should continue with good prospects for cash flow generation, even in a hypothetical scenario if the current iron ore price nearly halves.
Vale's iron ore prices break even today between $61/ton, the minimum iron ore price at which Vale generates cash. With iron ore currently around at $110/ton, I forecast Vale generating roughly R$ 108.9 million in EBITDA for 2023, which suggests a forward EV/EBITDA of 3.1 times.
Considering hypothetical scenarios of iron ore downside and upside considering the volatile macroeconomic scenario, these are my assumptions:
Iron Ore Price | EBITDA (in R$ millions) | EV/EBITDA |
$55/ton | 87.495 | 4.106 |
$80/ton | 112.491 | 3 |
$90/ton | 119.988 | 2.666 |
$100/ton | 124.991 | 2.400 |
$110/ton | 128.492 | 2.181 |
$120/ton | 130.491 | 1.994 |
$150/ton | 137.489 | 1.613 |
As Vale shares have already devalued about 21% by 2023 as of the time of writing this paragraph, currently with Vale trading at an EV/EBITDA of 3.7 times, this implies a discount relative to the sector of 53% versus a historical value of 20% - which points to an asymmetry.
Thus, I see Vale trading even in extreme scenarios at still solid levels, which guarantees a considerable safety margin to consider that cash generation at least remains robust.
Leverage and dividends distribution
During the first decade of the 2000s, Vale went through a massive investment spree that enabled it to triple its iron ore production, eventually yielding enormous profits for the company, resulting in sizable dividend distributions extending into 2016.
Between 2014 and 2019, the iron ore market experienced a substantial decline, with prices plummeting to as low as $40 per ton and hitting their lowest point at the end of 2015. The challenging period was further compounded by the tragic events of Mariana in 2015 and Brumadinho in 2019, which profoundly impacted Vale's financial performance. Consequently, the company began distributing relatively low dividends during this period.
However, from 2019 onwards, there has been a remarkable turnaround in the price of iron ore. It has witnessed a significant surge, reaching a peak of $220/ton in 2021. This positive price trend has been favorable for Vale, contributing to the recovery of its bottom line and potentially creating new opportunities for increased dividend distribution.
Thus, Vale brought in a very high profit in this recent period and was able to invest in security and retain more capital to reduce its indebtedness. From 2020 onwards, Vale began distributing much of its profit to its shareholders. Vale's payout was 132% in 2020, followed by 54% and 28% in 2020 and 2021, respectively.
But as Vale reported in its most recent quarterly results, although there is a natural drop compared to 2021 levels, there are reasonable indications that the payout distribution for this year tends to remain relevant due to low leverage.
In the first quarter of this year, Vale reported financial results that showed significant free cash flow generation, totaling $2.28 billion. This increase represents the conversion of approximately 62% of EBITDA into cash. Reduced capital expenditures drove this considerable cash generation and the positive variation in the company's working capital during this period.
Although Vale distributed about $1.8 billion in dividends in March, if it confirmed that the company has no other significant investments this year, I still see room for further dividend distributions during the year. The consensus predicts a consistent yield of 8.3% for this year, which I believe should likely be achieved.
Vale's share repurchasing
Vale has also been expanding its share buyback program , seeking to maximize shareholder return, which started in April 2022 and is expected to be completed by October 2023. The logic is that the company's shareholding increases without buying back more shares. Similarly, as Vale distributes more profit, investors receive more dividends.
Vale has made substantial progress in its share repurchase program, having already repurchased 500 million shares, which accounts for an impressive 10% of the free float, reaching 47% completion of the overall program. In addition to benefiting shareholders through concentrated dividends, Vale suggests that its share prices are currently at a relative discount, presenting an exciting investment opportunity with potentially attractive returns.
While there is a risk that Vale may overvalue its shares and pay too much, it is essential to note that Vale's current share prices are significantly below its historical average, which in my view, is likely to yield favorable returns over time.
Risks to be aware of
China's economic landscape has emerged as a paramount concern in shaping Vale's investment thesis, warranting a closer examination of the risks.
With a substantial 54% of the company's revenues reliant on the Chinese market, shifts in steel and iron ore demand stemming from China's evolving economic priorities and the slowdown in the real estate sector loom as sizable risks for Vale's stakeholders.
Nevertheless, recent positive developments in China offer a glimmer of optimism. The Chinese Central Bank's decision to lower lending rates and the government's implementation of measures to stimulate the beleaguered real estate sector hint at a more favorable outlook. These actions can support the sector and alleviate concerns about diminished iron ore prices for Vale.
Notably, iron ore stockpiles at Chinese ports have dwindled to their lowest levels since July of the previous year, displaying a modest 0.5% year-on-year decline. Although the decrease is relatively modest, it suggests that steel mills have ample room to sustain solid imports and maintain comfortable inventory levels.
However, China's recovery from the strict anti-COVID-19 measures has been irregular, evidenced by lackluster economic data despite positive signs in iron ore demand. The conversion of the Chinese government's stimulus measures into tangible steel demand in the upcoming months is pivotal to ensure a sustained increase. This transformation will bolster investor sentiment toward iron ore as expectations for additional stimulus measures remain high.
Positive signs have already emerged from the Chinese government's stimulus measures, as reflected by Moody's creditworthiness upgrade in the sector for the first time in two years. However, it is essential to underscore that weak data can also impact Vale, underscoring the need for diligent monitoring of the measures' effectiveness.
The bottom line
Vale has displayed impressive resilience in navigating challenging periods within the iron ore market, consistently generating cash flow despite turbulence. However, a careful analysis of the risks tied to the global economic panorama, particularly the influence of Chinese demand on Vale's performance, is warranted. The slowdown in China's real estate sector and the possibility of declining iron ore prices pose significant challenges for the company.
Yet, Vale's competitive advantage lies in its relatively low breakeven point, affording it a favorable position even during iron ore downturn cycles. Vale has also implemented prudent measures, including share buyback programs and dividend distributions to shareholders, bolstering its financial position.
While dividend levels are expected to moderate compared to previous years, the enticing prospect of generating a 7-9% yield by 2023 remains compelling.
Considering these factors, I consider Vale a promising investment opportunity, particularly with a focus on dividends and the potential for robust cash generation, providing a notable margin of safety. However, monitoring economic developments and iron ore demand, particularly in China, is essential to detect potential shifts in the bullish thesis.
For further details see:
Vale: Moderately Discounted, Compelling Dividends And Buybacks