Vale: The Best Play In Mining?

Bill is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There is a mining boom based largely on wildly-oversized construction spending in the People's Republic of China. Investors should be careful not to pay high valuations for mining companies that supply raw materials for building projects. Instead, they should require low valuations that do not assume continuous, high growth.

Some Mining Companies Understand

Vale (NYSE: VALE), the world's biggest iron-ore company, reported $4.28 billion in EBITDA (earnings before interest, taxes, depreciation and amortization) for the third quarter 2012. Vale has been able to surprise analysts since its sales beat lowered expectations based on declining global demand for mineral exports.

Vale's Chief Executive Officer Murilo Ferreira said that the company is postponing some of the it's heavy projects. A Vale statement read, "We will conclude projects already under execution, while research and development expenditures are being cut to give rise in the future to a smaller and more select portfolio of project. 2012 is very likely to be the peak year for capital expenditures in the foreseeable future."

This change in strategy is appropriate in response to dropping commodity prices. China and Europe are the biggest markets for the company's mineral and metal products, but have become sore spots in the global economy. So, the decision to cut production was inevitable.

According to the company's Chief Financial Officer, Luciano Siani, Vale is looking to sell stakes in two of its heavy projects: its potash project in Argentina, and Moatize coal project in Mozambique. He said, "The decision has been made but we are still exploring the market to see what's the possibility to realize value on the sale as well, we are not going to fire sale any asset." Siani hopes that the company will be very selective to find the best new partners for these projects.

Mining is Cooling

Australia's economy has benefited from the China-induced mining boom more than Brazil's. Unfortunately, this means that Australia's economy has slowed as the China-Australia relationship seems to be weakening.

The prospect of recession has prompted Australia's Reserve Bank, its central monetary agency, to consider slashing borrowing costs. The economic slowdown has provided impetus for looser monetary policy. By the end of 2012 investors in the country anticipate a cut of 0.25 points in the central bank's key rate, down to 3%.

In contrast, the Australian dollar remains strong. The Australian dollar is above parity with the U.S. Dollar but used to weigh in at $0.73 U.S. The country's growth is expected to slow down to three percent in 2013.

The mining industry is Australia's principal economic driver. But with an uncertain business atmosphere worldwide and a strong currency, the export-driven mining industry has lost steam and is posting lower revenues. High exchange rates and lower commodity prices have pushed the mining companies BHP Billiton (NYSE: BHP) and Fortescue Metals to initiate layoffs.

Profit Protection

Investors who want excess returns must find the most compelling stocks, either in good industries or gloomy ones. The mining industry is no exception, and the price appreciation of mining stocks tends to lag behind commodity price appreciation.

There is nothing magic about mining companies. They become profitable by controlling costs and negotiating higher prices, just like other businesses. Industries whose firms have more bargaining power with suppliers, more bargaining power with customers, high barriers to entry, low rivalry between firms, and few substitutes for their goods tend to be more profitable. These five factors are called Porter's Five Forces, and they characterize an industry's profitability.

Despite the logic of this model that underpins profitability, many professional investors crave mining and other commodity firms. They don't seem to care that commodity producers are rivalrous because their products are fungible, or that new competitors are free to spring up without proprietary barriers to entry. These overzealous investors don't mind that suppliers to these firms like land-owners and union laborers have the bargaining power to demand high prices.

With these considerations in mind, investors must be selective and require that commodity companies are trading at compelling valuations before buying.

Valuation

Since commodity producers offer fungible goods and compete on price, investors should demand low valuations for such brutal competition.

The current market prices for BHP Billiton are not attractive at $72 per share. Investors can buy more revenues per dollar from the S&P 500, since this index has a price-to-sales ratio of 1.32 while BHP has a much higher 2.64 ratio. The price-to-book multiple of this stock is 2.90, higher than the 2.07 S&P 500 average. BHP shares are trading at a 12.38 price-to-earnings ratio, lower than the 14.23 average of the S&P 500 index. This is not much of a discount.

Worse yet, Rio Tinto (NYSE: RIO) is too expensive, at a price of roughly $52, a price level which seems rich given a cooling demand for commodities. Rio Tinto shares are trading at a pricey 23.57 price-to-earnings ratio, a value that is almost double the S&P 500 average. The firm's 1.67 price-to-sales ratio is in line with today's prevailing market multiples. The price-to-book multiple of this stock is 1.70, somewhat cheaper than the 2.07 S&P 500 average. Taken as a whole these valuation multiples are not significantly lower than the broader market and do not justify the risks taken by investing in the mining industry.

Fortunately, shares of Teck Resources (NYSE: TCK) are more reasonably priced. At prices near $33 per share the firm's 1.83 price-to-sales ratio is a touch higher than today's prevailing market multiples. Teck shares trade at a lower 14.71 price-to-earnings ratio, a value which is near the 14.23 average of the S&P 500. The 1.08 price-to-book multiple of this stock is also attractive, much cheaper than the 2.07 S&P 500 average. The firm's reasonable 0.42 debt-to-equity ratio demonstrates that the company is not over-leveraged.

Shares offer a dividend yield of 2.40%, which is much higher than the 1.82% yield of the 10-year treasury bond. Future dividend payments are likely because the company pays out 0.24 of earnings as dividends, so earnings could drop considerably before dividends must be cut.

Vale is clearly a better investment prospect at $19 per share. The firm's 2.08 price-to-sales ratio is a touch higher than today's prevailing market multiples. Vale shares are trading at a low 8.15 price-to-earnings ratio and a low 1.21 price-to-book multiple, less than the S&P 500 index. The firm's reasonable 0.38 debt-to-equity ratio demonstrates that it's not over-leveraged.

The shareholders of this large cap industrial metals and minerals stock enjoy a 3.60% dividend yield. Its dividend payout is likely sustainable because the firm's 0.52 payout ratio is below the 0.6 rule of thumb for maximum sustainable dividend payouts.

Conclusion

After drilling miners for value, it is clear that Vale is the best bet in this industry. Management is trying to get ahead of demand contraction, and the company trades at cheaper multiples than its peers.


BillEdson11 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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