On May 6th /08 Citigroup analyst Alexander Hacking initiated coverage on Vale/CVRD’s common (ordinary) shares with a US$48/sh target.
Company Profile (from Reuters)
Companhia Vale do Rio Doce (Vale) is a diversified metals and mining company. The Company is a producer and exporter of iron ore and pellets and a producer of nickel. It also produces copper, manganese, ferroalloys, bauxite, precious metals, cobalt, kaolin, potash and other products. Directly and through affiliates and joint ventures, the Company has investments in the aluminum, coal, energy and steel businesses. Vale operates, among others, eight hydroelectric power plants in Brazil and two in Indonesia. The Company is headquartered in Rio de Janeiro, Brazil.
Takeaways From The Event
Is it the end of Commodity Super Cycle? No – says Hacking!
Hacking writes “Metals stocks continue to trade at a deep discount to the broader market. This is typical for “peak” conditions (i.e. when earnings are at their highest level for the cycle). Multiples have inched up in recent years – suggesting that the market thinks we are “close but not at the top.” This is a reasonable outlook in our view and is supported by Citi’s “commodity super cycle” thesis. The super-cycle suggests that high metals prices are sustainable for another 5-10 years based on 1. continued Chinese industrialization/infrastructure investment; 2. supply-side consolidation; 3. rising capex costs and 4. shortages of high-quality, low-cost reserves. On balance we think current valuation multiples are fair, and expect strong earnings growth to be the key driver of share-price appreciation.
In providing his investment thesis for Vale, Hacking writes “1) Vale secured a 65% increase for 2008 iron ore prices, and we foresee another 30% increase in 2009. Vale would have to increase fob prices by 100% to reach parity with current China/India spot. 2) We forecast EBITDA growth of 56% in 2008 and 43% in 2009. The main driver will be higher iron ore prices but we also expect 5-10% volume growth in both iron ore and nickel. 3) Citi forecasts maybe too conservative – particularly in Nickel where we expect $10/lb in 2009 – well below the futures curve. 4) The second leg to Vale’s near-term growth story is a bold set of organic growth plans. The company is targeting over 50% volume growth in both iron ore and nickel by the end of 2012. 5) We view the current boom in commodity prices as a secular phenomenon driven by a potent combination of Chinese industrialization, supply-side consolidation and rising investment costs. 6) Vale trades at 12x 2008E EPS and 8.0x 2009E. These multiples are low compared to our view that current earnings are sustainable – and may even continue to grow beyond 2009.”
Buy the Common shares or Preferreds?
Hacking has a slight preference for the preferreds and writes “1) The Ordinary (common shares) premium is currently at the top end of the historical range (23% vs a recent range of 10-24%). 2) Preferreds may be granted additional shareholder rights (tag-alongs) if Vale uses equity as currency for a major acquisition. 3) Dividend yield – Preferreds pay the same dividend for a lower share price. 4) A takeover of Vale is exceptionally unlikely and so we see no big downside risk from the Preferreds relative to the Ordinaries.
So why do the Common (ordinary) shares trade at premium of 23% to the preferreds (US$41 vs. US$33)?
Hacking answers “There are two key differences between the two share classes: 1. Ordinary shareholders can vote on the Board of Directors, while Preferred shareholders cannot; 2. In the event of a takeover, Ordinary shareholders are guaranteed at least 80% “tag-along” (i.e. at least 80% of the value given to the controlling shareholders), while Preferred shareholders have no minimum rights. Ordinary shares are more heavily traded (56% of liquidity). Ordinaries are also the dominant share class for the NYSE ADR (89% of trading). US investors have shown a preference for the Ordinaries – and our conversations with investors suggest that there is some significant confusion in the marketplace as to what exactly the Preferred shares represent.”
Catalysts
According to Hacking, the following could act as catalysts: “1) Vale may award tag-along rights to Preferred shareholders to sweeten the price of an equity-based acquisition. Vale was considering this option in its talks with Xstrata, according to multiple news reports. Thus anticipation of another big M&A deal could spur investors to close the gap again. 2) An increase in the % of shares traded through the NYSE ADR could increase the Ordinary premium. The recent S&P upgrade to Brazil may encourage more overseas investors in Vale. Further US dollar weakness might encourage US-based investors to seek out companies with overseas earnings power (like Vale). 3) A decrease in the % of shares traded through the NYSE ADR could similarly shrink the Ordinary premium. US dollar strength may be a catalyst to decrease demand for the ADR shares. 4) Vale could conceivably merge its two share-classes, although it seems extremely unlikely that Valepar would allow this to happen. The Brazilian government would also be extremely nervous about control of the company shifting to foreign investors. Also any merger would not be done on a 1:1 basis. 5) This would strongly favor the Ordinary shares – but we think it is very unlikely that Brazil’s government would allow Vale to be acquired in any foreseeable timeframe.”
Valuation
Hacking bases his target of US$48 for Vale’s common (ordinary shares) on “a 50:50 weighting of NAV and market multiples." His target multiples for the Ordinary shares are 13x P/E and 7x EBITDA (applied to 2008 and 2009 earnings estimates). These multiples are close to where Vale is currently trading on 2008 estimates, and he expects these conditions to persist into 2009. Hacking also raises his price target on the preferred shares to US$41 from US$37. He raises this target based on a new lower Brazil risk-free rate in his DCF (to take account of S&P’s upgrade of Brazil to investment grade). He also increased his target P/E multiple to 13x from 12x on recent improved sentiment in the mining sector. He discounts multiples by 15% for the Preferred shares – equivalent to an 18% premium (the average of the recent band).
My Take: I quite like this idea of purchasing the preferred shares of Vale and being paid to wait. The company offers a large-cap diversified base metals play with an expected 3% dividend yield (Hacking's report) to cushion some of the downside when commodity prices have sharp short term pullbacks. Keep in mind, that the common (ordinary) shares recently broke above the $37 area (support) to all time highs.
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