Brazil: Currency Is Key for Vale

by Tim Seymour | January 27, 2012 12:19 pm

Brazil: Currency Is Key for Vale

Dealing with exchange rates is one of the things that makes trading in foreign stocks both exciting and complex. Last year Brazil led the way in complexity — and now the excitement may have a chance to catch up.

It’s best to think of any non-dollar investment as a two-for-one trade. In theory, buying into the right currency magnifies your upside and can even hedge your downside if it turns out you picked the wrong stock or ETF.

On the flip side, riding a weakening currency ensures that once the trade translates back into dollars, you’re earning less than the paper return that domestic investors receive.

Knowing the forex trend can also help you gauge the fundamentals of a major exporter and even predict the big exchange rate “adjustments” that come as a surprise to other traders.

Let’s take Vale (NYSE:VALE[1]) as an example. This iron miner is the biggest in the world and one of the largest companies in Latin America — digging more than 300 million tons of ore a year.

Vale exports a lot of that ore, and every bit of it is priced in U.S. dollars. So when the dollar gets stronger, the value of the company’s assets — and ultimately, Vale’s revenue — climbs with it.

Meanwhile, Vale’s accountants pay the bills in the local currency, the Brazilian real. When the real gets weaker, those costs decline on a currency-adjusted basis. (Anywhere but Brazil, we’d say “on a real basis,” but that gets confusing.)

So strong dollar/weak local currency normally means wider margins for commodity exporters. Weak dollar/strong local currency has the opposite effect, squeezing profits.

Dollar Debt Bites Into an Otherwise Bullish Scenario

Putting this into practice, we would have expected to see Vale’s margins expand in the third quarter of 2011, a period in which the real plunged 16.5% against the dollar.

What actually happened is that Vale’s operating margins stayed the same — an otherwise impressive 51% — but the company booked a $2.1 billion charge for “foreign exchange and indexation losses.”

What went wrong? Foreign-denominated debt.

With Brazil’s interest rates among the highest in the world, Vale was happy to borrow $970 million, promising to repay the loans in dollars.

That was great when the real was surging out of control in early 2011, but once the dollar swung back on the offensive, every dollar Vale owed effectively ballooned 16.5% on a local-currency basis.

Like anyone who inadvertently took out a variable-rate mortgage, the company saw its payments soar, which took a much deeper bite out of otherwise robust profits and disappointed Wall Street.

Given Past Performance, Forecasts Seem Overly Pessimistic

Now here’s where it all comes together: Vale is expected to report its fourth-quarter results around Feb. 15. The Brazilian currency declined an additional 2% over that time, so traders should expect to see the company’s financing costs edge up again.

However, the consensus is for Vale’s operating margins to collapse by a full 4 percentage points. Is that realistic in a weak-real scenario?

If you say “yes,” then maybe the analysts are on target. After all, it took a 16.5% currency headwind just to float Vale’s margins in the previous quarter.

But all it takes is evidence of a slight uptick in China’s demand for iron to give the numbers what they need to deliver quite the upside surprise.

And while the real has already turned around — up 5% so far this year — the estimates may be baking in too much compression in the current quarter as well.

Wall Street currently thinks Vale’s margins will tighten an additional 5 percentage points in the current quarter. That’s close to twice the compression we saw in the second quarter of 2011, when the real soared 16%.

All else being equal, the dollar would have to plunge an additional 15% over the next nine weeks for Vale to deliver the disappointing results analysts expect. That could happen, but if it does, we’ll probably have other things to worry about.

Endnotes:
  1. VALE: http://studio-5.financialcontent.com/investplace/quote?Symbol=VALE

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