Vale SA (VALE 0.33%) is a diversified miner, but it still gets roughly 70% of its sales from iron ore. That's been a tough market of late with falling commodity prices taking Vale's shares down roughly 60% since 2011. Now, however, the stock trades at historically low multiples of book value. It could be time for more aggressive investors to reconsider Vale.
That was then, this is now
In the first decade of the new millennium, China grew robustly. The world became accustomed to seeing double digit GDP growth out of its largest country. But growing at 10%-plus a year requires a lot of investment, which in turn requires a lot of natural resources. Building everything from roads to power plants can't be done without iron ore for steel.
No wonder Vale and the other large miners saw demand and prices rocket upward. For example, in 2011 Vale was getting $126 a tonne for its iron ore and $181 a tonne for pellets. The company's shares topped $37.
It's been all downhill since. In the second quarter, Vale got just $81 a tonne for iron ore and $136 a tonne for pellets. Declines of 36% and 25%, respectively. The company's shares, meanwhile, are trading around $13, a drop of more than 60%. Ouch! The big reason for all of this is a significant slowdown in China's growth coupled with additional iron ore production coming online -- at just the wrong time.
Stepping back
And that additional production doesn't look likely to slow down any from here. Vale, for example, is planning on increasing its iron production by a massive 40% over the next three years or so. And it isn't the only one looking to expand.
Fellow mining giant BHP Billiton (BHP 0.43%) exceeded its iron ore production targets in Australia in fiscal 2014 (years end June), hitting an all-time record. It's looking to increase iron ore production by 11% in fiscal 2015. And Rio Tinto (RIO 1.59%) increased its iron ore production 5% last year and has internal projects that could lead to a further 20% production increase by 2017.
On the surface, that should lead investors to run screaming from iron ore miners. Supply is already an issue and it only looks like it will get worse. However, Vale points out the positive aspect of major, low-cost miners, like Vale, Rio, and BHP, expanding production: it pushes out higher cost mines. In other words, the invisible hand will guide supply into balance with demand. According to Citigroup, iron ore prices in the $90 range would put roughly 25% of China's mines underwater. Meanwhile, JP Morgan projects China ore production of around 280 million tons next year--down 15%. That should, in time, lead to stronger commodity prices and higher earnings for Vale.
Value in the ground
Meanwhile, it's important not to lose sight of what makes Vale a valuable company. It isn't just the mining operations, it's also what Vale has in the ground waiting to be dug up. While commodity prices will swing the value of unmined iron ore up and down and ultimately changes the company's book value along with it, the value doesn't disappear because investors are down on the iron ore industry -- even if that assessment is justified in the near term.
For example, Vale's price to book value ratio is hovering around 1.5 times. That's the low end of the company's historical range over the past decade. The company's five-year average is 2.6 times and the industry as a whole is currently at around 2.4 times. So Vale looks relatively cheap compared to its own history and its peers based on book value. And while that might be pricing in the roughly 30% drop in iron ore prices this year, but if iron ore prices go up, which isn't unreasonable to expect based on the fact that global steel demand is still increasing despite an oversupply situation, the value of the company's unmined ore would head back up again.
That isn't to suggest that Vale is perfect, it isn't. For example, it mines for iron ore largely in South America, which results in a much longer, and more expensive, boat ride to major Asian customers. BHP and Rio have big operations in Australia, closer to key buyers. However, that doesn't negate the value of what Vale has amassed above ground (low cost operations) and below (iron ore reserves).
Change will come
Right now, Vale looks like it's in the eye of the storm. It could get worse from here, but eventually supply and demand will even out; in fact the seeds of that process are being planted right now. There's no way to time the perfect entry point, but it's probably better to start looking early than miss the ride. For more aggressive investors, now would be a good time to start considering Vale -- particularly since it looks relatively cheap.
