This 6.5% Yielder has 40% Total Return Potential!

By Peter Epstein - August 22, 2012 | Tickers: AAL, BHP, VALE, RIO, XTA | 0 Comments

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Vale (NYSE: VALE) screens cheap, has a 6.5% dividend yield, is the largest iron ore producer in the world, has a forecast 2013 EBITDA margin of 45% and has deployed the most growth capital of its peers. I wrote an article 2 weeks ago, in which I stated that there are multiple ways to win with an investment in Vale.

"Reduced CAPEX in 2013-14 will free up significant cash flow to make acquisitions, increase dividends, pay special dividends or buy back shares. With Vale's margins, cash flow and balance sheet, it should be trading at a higher multiple. Either that, or the excess cash driving the EV lower will be returned to shareholders."

Last week 2 news items caught my attention, here's the first.

"RIO DE JANEIRO--International iron-ore prices are set to recover in September, Murilo Ferreira, CEO of Brazilian mining company Vale SA said Thursday. Prices are set to rise because inventories in China have fallen to 20 days from a level of 30 days in June, Mr. Ferreira told reporters in Rio de Janeiro."                             

The other news story comes from an interview of Vale's CEO.

"Vale SA (VALE3) will postpone a $3 billion fertilizer project in Canada and may delay other investments as it seeks to contain spending, Chief Executive Officer Murilo Ferreira said. The world’s largest iron-ore producer is committed to“cost austerity,”

This second news item demonstrates what I discussed in my other article, namely that curtailments of CAPEX could be used for shareholder friendly purposes.  In today's update, I look at Vale vs. its global diversified peers. See the following chart compiled from recent Deutsche Bank reports.

Vale has the highest forecast EBITDA margin, edging out BHP, (NYSE: BHP) and Rio Tinto, (NYSE: RIO). Vale has the second largest Enterprise Value, "EV" in the group. The company's Net Debt to EBITDA ratio is slightly elevated, but still strong. Vale's Cash Flow from Operations, "CFO" divided by its EV is the second highest at 18.7%. This measure of cash flow is BEFORE cap-ex. 

The chart speaks for itself, Vale is right in-line with Rio and Anglo American, (LSE: AAL), but it yields roughly double that of peers. BHP screens rich, but I believe BHP is in a different risk bucket because of its giant size and significantly more diversified operations. BHP should be good for upside of 20% with limited downside. 

Less clear in the chart are the last 2 columns. I looked at cumulative net cap-ex deployed in the 2009-2012e period. I divided each total cap-ex figure in half and subtracted that number from the respective company's EV. I did this to capture capital spent for growth that's largely not generating EBITDA yet. Therefore an adjusted EV/EBITDA ratio is found in the last column. With this adjustment, Vale, Rio and Anglo are ALL trading extraordinary cheap at below 3.5x next year's expected EBITDA.

While I like Rio, Vale is my favorite due to its compelling yield. Rio is my second favorite as it derives about 70% of its EBITDA from one od the best iron ore franchises in the world. I like that Rio is expanding into copper/gold via a massive project in Mongolia. Anglo has strong copper and coal assets. Anglo's company-wide EBITDA margin is currently depressed by the coal segment, but I consider coal a longer-term winner. 

Foolish investors may recall that Xstrata, (LSE: XTA) wanted Anglo's coal and copper assets back in 2009 when it proposed a merger of equals. See this for commentary on Xstrata and Glencore. Based on Glencore's earnings conference call, the company's acquisition of Xstrata is highly uncertain.

For a safe, sleep at night 20% return, Foolish investors can look to BHP. For more upside, but still fairly limited downside, investors can shoot for 40% total return in Vale.  

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