Vale: Attractive Valuation, But Major Chinese Housing Headwinds Remain (NYSE:VALE)

Large open cut iron ore mine

BeyondImages

Thesis

I’m starting to compile a watchlist of stocks I would buy if the equity market crashed.

I’m bearish on equities and bullish on the dollar over the next year, but do think that we’ll eventually have a FED pivot in a severe recession. Also, I believe that very few market participants are paying attention to a potential zero-COVID pivot in China in mid-2023 which would significantly lift commodity prices.

Vale S.A. (NYSE:VALE) is a company that is already undervalued and should get more undervalued during an equity crash and dollar melt-up, so a short-term downturn provides a great opportunity to get long.

Vale Background

Most reading this article will be familiar with Vale, but for those who aren’t I’ll give a quick synopsis. The company is the world’s largest producer of iron ore, pellets, nickel, copper, and other commodities, with iron ore making up a majority of its revenue; the operations cover 30 countries, but most operations are centered in Brazil. They also focus on vertical integration by owning logistics such as railways, ports, terminals, etc. where the produced commodities are transported, and by self-generating their energy needs.

Lower Demand for Iron Ore due to the Chinese Housing Bust

With China’s housing market in a bust period, which should get worse, key industrial commodities such as iron ore should continue to go down. Many SA authors have already made countless articles on the Chinese housing bubble, so I would check those for more in-depth theses.

The bust in China’s housing bubble won’t just impact the real estate market, as it will likely have a contagion effect on the rest of the Chinese industrial economy similar to the GFC in the U.S.

To get an understanding of how a lack of Chinese demand would impact the iron ore price, we need to have a good view of what percentage of demand comes from China and how much that would lower the price.

Below is Iron Ore production by country:

2020 Global Iron Ore Production
Country Production Share
Australia 900 million tons 37.5%
Brazil 400 million tons 16.7%
China 340 million tons 14.2%
India 230 million tons 9.6%
Russia 95 million tons 4.0%
South Africa 71 million tons 3.0%
World Total 2.4 billion tons 100%

Source: U.S. Geological Survey.

According to the South China Morning Post, it’s estimated that China imports 80% of its iron ore. Using this figure, we can presume that China’s total consumption of iron ore is 5x that of its production, making for total consumption of 1.7 billion tons, which is 70% of world production.

Even though 70% of the consumption is from China, we do have to keep in mind that they will still consume a large amount even in a deep recession for essential purposes; to get a better view of what the drop in prices is likely to be I like to look at previous recessionary periods such as 2008 (GFC) and 2014-2016 (slowdown in China and emerging markets along with increasing supply causing a supply glut).

Below is a chart of Iron Ore prices:

https://tradingeconomics.com/china/imports-of-iron-ores-concentrate

Trading Economics

This is the Tianjin delivery contract on a rolling basis.

We don’t have as good of a view of how much iron ore prices went down in 2008-2009, since there weren’t any iron ore futures till 2009. It wasn’t till 2014 that Singapore’s SGX (main exchange to speculate on China and SE Asia) started trading iron ore futures, so we’d have to rely on OTC pricing, which significantly varies.

At the time of writing, the current price is $91.5 USD per tonne. Back in 2016, which was the worst slowdown since 2008 along with a bad supply glut, the price went down to $39 USD per tonne. If this were to repeat in a worst-case scenario, it would be a drop of over 50% in prices from here. I don’t believe that we’d see the same price drop this time around since we have a tighter supply side now.

The price chart below gives a view of iron ore prices prior to the current futures market. When looking at this chart, we see that even during the GFC iron ore prices didn’t get as low as they did in 2016. The last time we saw prices that low was in 2003.

Iron Ore Prices

Macro Business

This is why I use the 2016 slowdown and supply glut as the worst-case scenario price for iron ore. If we were to see a significant contraction in China (a peak-to-trough GDP contraction of more than 20%), I still expect the 2016 lows to stay. Of course, if prices were to drop to the 2016 lows, most companies would pause production eventually, sending the price higher to a more economical level for the producers.

Breakeven Prices

It’s extremely difficult to get exact breakeven prices, but we can get a back-of-the-envelope calculation for the breakeven price by looking at how low gross profits would have to go for the net income to get to zero.

Below is how revenue, gross profit, and net income looked in 2021:

Revenue (in millions of USD) $52,654.3 Margin
Gross Profit (in millions of USD) $31,612.8 60%
Net Income (in millions of USD) $21,743 41%

The gross profit would have to go down 67% for the net income to go to zero. Hence, the underlying commodity prices would have to go down 67% to get to breakeven.

There are, of course, a lot of assumptions here, which is why I call it a back-of-the-envelope calculation. The first assumption is that the gross margins continue to stay the same because the COGS stay the same. The second is that operating expenses continue where they are. Also, not all revenue comes from iron ore production, so that has to be factored in.

With that said, though, it would take a significant drop in commodity prices down to two-decade lows for Vale to lose its current profitability, as it still continued to stay profitable in 2016, with a lower, but still positive, EPS of $0.77.

Long-Term Reasons to Be Bullish

The Xi Jinping Pivot

While I hear many market participants consistently talking about the FED pivot, I hear very little about a pivot that matters even more, which is the Xi Jinping pivot. Since China is the biggest manufacturing base in the world, a reopening in China would cause commodity prices to spike, which then in turn would have broader secondary impacts.

While no one truly knows why extreme Zero-Covid policies were implemented in the first place, there are a lot of creditable hypotheses as to what got us to this point and where things will go from here.

The first, and most simple to understand, hypothesis is that the Chinese government needed to save face after it became obvious that Covid-19 originated in China. Little was done to stop the spread out of the country even though local officials in Wuhan knew about it as early as November 2019. To show that the government was taking the risk seriously, especially as more eyes were being put on China due to the Beijing Winter Olympics, China took a full 180-degree shift in policy.

The second hypothesis is that Xi Jinping is focused on consolidating power. Ever since the death of Mao Zedong, the CCP has had multiple different factions within it that would try to balance the party power so as to not keep it a monolith with absolute power. The party was largely split into two wings, an elitist faction often referred to as the Shanghai Clique, and a populist faction referred to as the Communist Youth League. The Shanghai Clique was run by wealthy businessmen in Shanghai who had the goal of industrializing China; the main CCP leader in this faction was Jiang Zemin. The CYL had the goal of spreading the wealth out to the more impoverished regions of China; this faction was led by Hu Jintao. Xi Jinping was originally part of the Shanghai Clique in his rise to power, but in his bid to consolidate power and return the CCP to a monolith like it was under Mao, he had to take drastic steps to limit the powers of both these factions. It is believed that to suppress the power of the Shanghai Clique he started the Shanghai lockdowns; since Shanghai is the wealthiest city in China and home to many businessmen who are CCP influencers, it has normally gotten off the hook on many nationwide restrictions, but this time around it is likely that Xi Jinping purposefully orders a harsh lockdown in Shanghai to clamp down on any competition from the faction. He also has clamped down on the CYL; this was recently shown when Hu Jintao was publicly removed from the party congress. Since then, the CCP has removed term limits at the 20th Party Congress, making Xi Jinping the first president since Mao to be allowed to have a third term. This means that Xi Jinping has likely finished his consolidation of power and is now willing to open up by removing Zero-Covid policies.

Regardless of which hypotheses one believes in, it’s clear that Zero-Covid policies can’t continue both because the economy can’t handle it and because there is increasing defiance from the citizens of China, which over the last few days has led to the biggest protest since the Tiananmen Square Massacre in 1989.

While it’s evident that they need to reverse this policy, the question becomes how they’ll pivot. The CCP has put itself between a rock and a hard place; if they shift now, it makes their policy look like it was a failure and it shows the people of China that they get their way when they’re protesting against the government; also, since people in China don’t have access to Western vaccines which have high efficacy, nor do they have natural immunity since they haven’t been exposed to the virus due to these policies, as soon as they open up it will likely cause the virus to spread rapidly. If they don’t pivot, then it might be the end for the CCP. This means that the government will have to open up but do it in a slow manner to stop the spread of the virus, and they will simultaneously have to spin zero-covid as a success.

Demand in other parts of the world due to infrastructure spending

Brazil Equity and Currency Play

The biggest tailwind to Vale is a thematic play on Brazil. Brazil currently has one of the cheapest equity markets on a P/E basis and a currency that is outperforming the USD even when it is strong. It also has an economy primarily tied to commodity prices. This means that if commodity prices do well over the next decade, earnings will go up, causing their already low P/E ratios to go even lower. With a strong currency, it makes Brazilian equities outperform in USD terms. Low valuations, a strong currency, and GDP growth due to commodity price upside should all create a long-term bull market in Brazilian equities.

Below is the P/E ratio over time for the iBovespa Index (IBOV) Index:

Date Price P/E (TTM) Ratio EPS (TTM) * Forward P/E Ratio
6/30/2022 98,541.95 5.48 291.45 5.93
12/31/2021 104,822.44 6.80 249.59 7.51
6/30/2021 126,801.66 13.50 152.11 9.02
12/31/2020 119,017.20 33.09 58.27 12.55
6/30/2020 95,055.82 18.48 83.33 16.50
12/31/2019 115,645.30 18.73 100.00 12.95

*EPS (earnings per share) in the table above has been indexed to start from the base value of “100.” Data: Siblis Research.

As can be seen, P/E ratios are low across the Brazilian markets. This is primarily because there’s been very little price appreciation over the last few years, combined with rapidly growing earnings. This is why large-cap Brazilian companies like Vale and PBR trade at a low multiple. Until just two years ago, Latin American equities were seen negatively by most investors due to worries about a strong dollar and weak commodity markets; this is why these markets continued to trade at low multiples with little appetite from foreign capital. Recently, though, commodities and LATAM currencies have been doing better than expected even with a rising dollar, so investors are likely to rethink the decision to not allocate to Brazilian equities. If foreign capital finds these valuations attractive with significantly less risk than before, then multiples are likely to expand for Brazilian equities.

Another major strong suit for Brazil has been its currency, which is up against the dollar over the last 2.5 years not including the carry made from being long. The main reason for this is the central bank’s hawkish attitude towards inflation. Currently, inflation in Brazil is 7.71% YOY, which is certainly higher than it should be, but similar to that of the U.S. and EU. The high for inflation was 12% YOY, but it has substantially pulled back from there as the central bank has been aggressively fighting it. Since Brazil has a history of hyperinflation, they take the risk very seriously, so when inflation started to go higher, they raised rates from the previous 2% now to 13.75%. They say that they will keep them here but are ready to raise if inflation starts to spike again. I believe this hawkish attitude is the reason why the Brazilian Rial has been strong against the USD, and if the central bank continues this hawkish attitude the currency will continue to be strong, encouraging foreign capital to invest in Brazil.

Below I’ve linked where I got the inflation and interest rate information.

Trading Economics- Brazil Central Bank Rate

Trading Economics- Brazil Inflation Rate.

Summary

The main short-term headwind that should stop Vale from outperforming is the crash in the Chinese housing market. This should suppress iron ore prices over the next 12-18 months and cause a shrink in margins for Vale. Longer term, though, low prices are the solution to low prices, so we will likely see the supply decline in that environment. The main benefit that Vale has is its low breakeven price, which will allow it to still be profitable in a downturn. China opening up will likely raise demand for commodities, which will suppress some of the demand destruction caused by the burst in the Chinese housing market.

In the long term, Brazilian equities are significantly undervalued and Vale is a way to play the strong currency and multiple expansion.

Ultimately this is why believe that Vale is likely to go lower in the short term. However, I am a long-term bull; hence, I’m putting a hold on Vale S.A. for now.

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