The Perilous China-Driven Commodity Boom: Vale Has Spent $50 Billion On CapEx Since 2008 And The Iron Ore Glut Is Just Beginning

By Andres Allende At Seeking Alpha

I admit that I have a bias against commonly accepted views. I sort of feel that at that point, when everybody thinks alike, things start to be taken for granted and skepticism, "the chastity of the intellect" as Santayana called it, is forsaken. And that's when bad things happen to investors.....

Vale is one company that many people follow and many seem to like once again for a number of fair reasons (low cost producer, volume growth potential, solid balance sheet, has fallen a lot, tax blow behind us, asset write downs over?, already impacted by Brazil outflows…), but I feel investment odds aren't good enough yet. We live in a wide World and there are plenty of alternative contrarian investments out there with a more favourable starting point.

I could be missing out on Vale but there are a number of points that still make me quite wary, especially when so many seem to be pushing the name and few mention the following:

1.- Iron Ore price downside

Who dares forecast commodity prices? Prediction is VERY difficult, especially about the future (Niels Bohr). That is why what investors should care about is profit margins, which invariably mean revert. It is rather well understood that commodities prices eventually revert to the 90th percentile production cost level. We have already seen this for most metals/commodities already (link).

Iron ore and copper are the main ones lagging still. Consequently the potential for profit margin compression is a major overhang for Vale (80% EBITDA from iron ore). It is worth to note that China is slowing down iron ore consumption growth while the iron ore majors continue to increase production volumes. Industry players expect c. 700MM Mt additional iron ore volumes by 2020. As most investors know China accounts for 67% of the seaborne iron ore market (and 99% of the growth for the period 2005-13). Going forward many people forecast oversupply every year even though they keep some China growth (c. 300MM Mt or 35% by 2018) and they throw in some growth in Japan, US and EU, which haven't had growth in decades…I am not sure I would bet big on that.

(click to enlarge)

Iron ore majors are mostly responsible for additional capacity. And they will bring it in any case as they sit at the low end of the cost curve and expansion projects are ongoing already. By 2020 current global volumes could be fulfilled at c.-$40/Mt vs. today 90th percentile.

The combination of all the above suggests downside risk to prices/margins. Anyone making a buy case for Vale on the back of iron ore prices today has a difficult point to prove given the very unfavourable odds. I would be much more comfortable to buy if I saw sell side forecasting long term iron ore some 20-30% lower from here.

2.- China Iron Ore/Copper based funding schemes

For me this is a worrying known unknown. And how many times have the "fathers" of investment recommended not to invest in what one doesn't understand? China NPLs risk and the (related) bouts of credit tightness have led many to innovate with funding schemes based on various commodities. This could explain the build-up in iron ore inventories (zerohedge). But now the local authorities are clamping down on it and the end of the one-way RMB forex trade is pressuring too. Many argue that the potential unwind of these deals could wreak havoc in prices. For me this is not about risk but rather uncertainty (i.e. I have no clue about the probabilities and the damage!). Nobel laureate Thomas J. Sargent very interestingly explained how he and Lars Peter Hansen showed that a little uncertainty can be worse for valuations than a lot of risk… (Rational Expectations and Ambiguity).

(click to enlarge)

3.- Volumes growth

Vale has very ambitious volumes growth plans in iron ore (+100MM Mt), copper (+180k Mt), coal (+11MM Mt) and nickel (+30k Mt) by 2018. However there are two main issues with these plans.

The first issue has to do with their track record, which has been rather appalling for the last few years. They have delivered so little after having spent so much.

Management haven't done a great job really, and on top of poor volumes there have been large write downs plus a huge tax liability charge (-$9bn) which they had always deemed as unlikely as not to make provisions for it.

(click to enlarge) Source 20-F

But even if we gave them the benefit of the doubt and believed they will deliver at long last (similar to Petrobras' case for example) the problem is in Vale's case volumes are no guarantee of profits. In fact so far they haven't been able to make almost any money in Copper, Nickel and Coal despite the favourable price levels during the super-cycle years. More volumes could mean wilder profit swings (losses even) given the larger base of poor executing commodities. Vale is a good operator for iron ore while the rest is questionable.

Meanwhile more Iron Ore and Copper volumes would add to the two commodities with the highest pricing risk (see points 1 and 2 above).

4.- Regulation/Tax overhang

Over the last few years government (Dilma Roussef) has increased the interference within the private sector in Brazil (electric utilities concessions changes, toll road concessions noises, back tax liabilities charges (including Vale), potential banking deposits charges…). Meanwhile this same government has failed to undertake much needed structural reforms (like the prior president Lula). It remains a heavy government and they are keen on new sources of revenue.

This is all very relevant for Vale as changes to the mining code are still pending. Mining royalties are very possible (2% mining tax at the moment only). A 6% royalty for example (vs. common global ranges 10-20%...) would cost Vale to c. 10% of operating profit. We are not talking about risk but uncertainty here again; there is no odds and damage can be anything. Perhaps for this reason very little of this is in sell side forecasts yet.

Additionally the above could be compounded if the company transitioned to paying the Statutory corporate tax (34%) vs. their paying 20% at the moment. This is just one more piece of the puzzle to be aware of although there is no indication/time frame for it (perhaps 2020…).

5.- Valuation

Valuation is touted by most to justify a contrarian investment in Vale. Normalized PE13 c. 10x, and perhaps 8-10x PE14, PBV 1x with c. 11% ROE seems about fair to me though. Unless you expect much, much more from the future that is. Dividend at c. 6% is juicy, but it hinges on iron ore prices at the end of the day. If Vale executed well and made say $10bn net income in 2014, or in 2015 (vs. $5bn in 2012 and c. $7bn "recurring" ($0.5bn effective) in 2013), they would be making the c. 2007 run rate of profits. Only that the "commodity super-cycle fever" isn't on anymore.

Global peers (Rio, Bhp, Anglo, Glencore…), with their differences in commodity exposures (but similar cycle) do not trade too far away and cluster around 10-12x PE trailing, 1.5-2x PBV and dividend at 3-5%. Pure iron ore Fortescue and Kumba (Vale is virtually a pure player profit wise…) trade at 5x and 8x PE respectively, 1.7x and 5x PBV make 40 and 60% ROE and pay 5 and 10% dividend.

The bottom line for me is that there is certainly upside for Vale already (one can easily get 30% if Vale makes $10bn a year and then take a terminal book value at 1x). However there is potentially about the same downside, spiced with global commodity headwinds (sell side still holding on to highly profitable long term prices) and a number of uncertain, difficult to assess events. Vale is certainly not a contrarian bargain vs. its global peers.

Despite so much water under the bridge already (tax settlement -$9bn 2013, write down -$2.5bn in 2013, -$6bn in 2012) it seems a bit early to me for fundamental contrarianism. Sentiment contrarianism would actually be to avoid/sell the name, given that almost all analysts seem to have a buy on the name (perhaps because it's a large part of the index (fear of missing out), or a relative call to their local universe etc.)

So, Vale… Ya? I'd rather not. I could miss out, but investment odds suggest a most difficult action: just sit on your hands.

Summary

  • Vale isn't a good contrarian yet, now it's a fear-of-missing-out name.
  • Risks (margins, volumes) and uncertainty (China funding deals, mining code).
  • Valuation not even extreme yet.

I admit that I have a bias against commonly accepted views. I sort of feel that at that point, when everybody thinks alike, things start to be taken for granted and skepticism, "the chastity of the intellect" as Santayana called it, is forsaken. And that's when bad things happen to investors.

When fundamentals seems intractable or when sentiment sounds one sided, or both, it is good to look at the key pieces of the investment puzzle, one by one, and think about damage and odds. I don't try to catch every salmon, but rather I try to make sure that I catch some good ones with the least risk of drowning. Fear of missing out is less than fear of losing out for me! Luckily there is so much ground to cover that opportunities abound.

Vale is one company that many people follow and many seem to like once again for a number of fair reasons (low cost producer, volume growth potential, solid balance sheet, has fallen a lot, tax blow behind us, asset write downs over?, already impacted by Brazil outflows…), but I feel investment odds aren't good enough yet. We live in a wide World and there are plenty of alternative contrarian investments out there (check out Petrobras, ITMG - Indonesia Coal notes for some ideas) with a more favourable starting point.

I could be missing out on Vale but there are a number of points that still make me quite wary, especially when so many seem to be pushing the name and few mention the following:

1.- Iron Ore price downside

Who dares forecast commodity prices? Prediction is VERY difficult, especially about the future (Niels Bohr). That is why what investors should care about is profit margins, which invariably mean revert. It is rather well understood that commodities prices eventually revert to the 90th percentile production cost level. We have already seen this for most metals/commodities already (link).

Iron ore and copper are the main ones lagging still. Consequently the potential for profit margin compression is a major overhang for Vale (80% EBITDA from iron ore). It is worth to note that China is slowing down iron ore consumption growth while the iron ore majors continue to increase production volumes. Industry players expect c. 700MM Mt additional iron ore volumes by 2020. As most investors know China accounts for 67% of the seaborne iron ore market (and 99% of the growth for the period 2005-13). Going forward many people forecast oversupply every year even though they keep some China growth (c. 300MM Mt or 35% by 2018) and they throw in some growth in Japan, US and EU, which haven't had growth in decades…I am not sure I would bet big on that.

(click to enlarge)

Iron ore majors are mostly responsible for additional capacity. And they will bring it in any case as they sit at the low end of the cost curve and expansion projects are ongoing already. By 2020 current global volumes could be fulfilled at c.-$40/Mt vs. today 90th percentile.

The combination of all the above suggests downside risk to prices/margins. Anyone making a buy case for Vale on the back of iron ore prices today has a difficult point to prove given the very unfavourable odds. I would be much more comfortable to buy if I saw sell side forecasting long term iron ore some 20-30% lower from here.

2.- China Iron Ore/Copper based funding schemes

For me this is a worrying known unknown. And how many times have the "fathers" of investment recommended not to invest in what one doesn't understand? China NPLs risk and the (related) bouts of credit tightness have led many to innovate with funding schemes based on various commodities. This could explain the build-up in iron ore inventories (zerohedge). But now the local authorities are clamping down on it and the end of the one-way RMB forex trade is pressuring too. Many argue that the potential unwind of these deals could wreak havoc in prices. For me this is not about risk but rather uncertainty (i.e. I have no clue about the probabilities and the damage!). Nobel laureate Thomas J. Sargent very interestingly explained how he and Lars Peter Hansen showed that a little uncertainty can be worse for valuations than a lot of risk… (Rational Expectations and Ambiguity).

(click to enlarge)

3.- Volumes growth

Vale has very ambitious volumes growth plans in iron ore (+100MM Mt), copper (+180k Mt), coal (+11MM Mt) and nickel (+30k Mt) by 2018. However there are two main issues with these plans.

The first issue has to do with their track record, which has been rather appalling for the last few years. They have delivered so little after having spent so much.

Management haven't done a great job really, and on top of poor volumes there have been large write downs plus a huge tax liability charge (-$9bn) which they had always deemed as unlikely as not to make provisions for it.

(click to enlarge) Source 20-F

But even if we gave them the benefit of the doubt and believed they will deliver at long last (similar to Petrobras' case for example) the problem is in Vale's case volumes are no guarantee of profits. In fact so far they haven't been able to make almost any money in Copper, Nickel and Coal despite the favourable price levels during the super-cycle years. More volumes could mean wilder profit swings (losses even) given the larger base of poor executing commodities. Vale is a good operator for iron ore while the rest is questionable.

Meanwhile more Iron Ore and Copper volumes would add to the two commodities with the highest pricing risk (see points 1 and 2 above).

4.- Regulation/Tax overhang

Over the last few years government (Dilma Roussef) has increased the interference within the private sector in Brazil (electric utilities concessions changes, toll road concessions noises, back tax liabilities charges (including Vale), potential banking deposits charges…). Meanwhile this same government has failed to undertake much needed structural reforms (like the prior president Lula). It remains a heavy government and they are keen on new sources of revenue.

This is all very relevant for Vale as changes to the mining code are still pending. Mining royalties are very possible (2% mining tax at the moment only). A 6% royalty for example (vs. common global ranges 10-20%...) would cost Vale to c. 10% of operating profit. We are not talking about risk but uncertainty here again; there is no odds and damage can be anything. Perhaps for this reason very little of this is in sell side forecasts yet.

Additionally the above could be compounded if the company transitioned to paying the Statutory corporate tax (34%) vs. their paying 20% at the moment. This is just one more piece of the puzzle to be aware of although there is no indication/time frame for it (perhaps 2020…).

5.- Valuation

Valuation is touted by most to justify a contrarian investment in Vale. Normalized PE13 c. 10x, and perhaps 8-10x PE14, PBV 1x with c. 11% ROE seems about fair to me though. Unless you expect much, much more from the future that is. Dividend at c. 6% is juicy, but it hinges on iron ore prices at the end of the day. If Vale executed well and made say $10bn net income in 2014, or in 2015 (vs. $5bn in 2012 and c. $7bn "recurring" ($0.5bn effective) in 2013), they would be making the c. 2007 run rate of profits. Only that the "commodity super-cycle fever" isn't on anymore.

Global peers (Rio, Bhp, Anglo, Glencore…), with their differences in commodity exposures (but similar cycle) do not trade too far away and cluster around 10-12x PE trailing, 1.5-2x PBV and dividend at 3-5%. Pure iron ore Fortescue and Kumba (Vale is virtually a pure player profit wise…) trade at 5x and 8x PE respectively, 1.7x and 5x PBV make 40 and 60% ROE and pay 5 and 10% dividend.

The bottom line for me is that there is certainly upside for Vale already (one can easily get 30% if Vale makes $10bn a year and then take a terminal book value at 1x). However there is potentially about the same downside, spiced with global commodity headwinds (sell side still holding on to highly profitable long term prices) and a number of uncertain, difficult to assess events. Vale is certainly not a contrarian bargain vs. its global peers.

Despite so much water under the bridge already (tax settlement -$9bn 2013, write down -$2.5bn in 2013, -$6bn in 2012) it seems a bit early to me for fundamental contrarianism. Sentiment contrarianism would actually be to avoid/sell the name, given that almost all analysts seem to have a buy on the name (perhaps because it's a large part of the index (fear of missing out), or a relative call to their local universe etc.)

So, Vale… Ya? I'd rather not. I could miss out, but investment odds suggest a most difficult action: just sit on your hands.

Published at Seeking Alfpha. View original post. 

David Stockman's Contra Corner is the only place where mainstream delusions and cant about the Warfare State, the Bailout State, Bubble Finance and Beltway Banditry are ripped, refuted and rebuked. Subscribe now to receive David Stockman’s latest posts by email each day as well as his model portfolio, Lee Adler’s Daily Data Dive and David’s personally curated insights and analysis from leading contrarian thinkers.

Get Access