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Vale S.A. Stock Upgraded and Downgraded: What You Need to Know

Rich Smith, The Motley Fool

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

China is making things difficult for stock market investors.

Last week, I described how JPMorgan had decided to recommend investing in mining concern Rio Tinto, on the theory that a new surge in Chinese infrastructure investment will drive demand for iron ore in the Middle Kingdom -- helping exporters like Rio Tinto.

This week, that theory is gaining both support -- and critics -- as shares of Rio Tinto rival Vale S.A. (NYSE: VALE) win both upgrades and a downgrade on Wall Street.

Here's what you need to know.

Cargo ship offloading iron ore

Consensus on Vale stock arrives via slow boat from China. Image source: Getty Images.

Downgrading Vale stock

Let's get the bad news out of the way first. Yesterday, analysts at RBC Capital announced they're cutting their recommendation on Vale S.A. stock to underperform, reports TheFly.com. The reason: Although Vale management is to be commended for "stabilizing the company, reducing capex and de-gearing the balance sheet," RBC is worried about what the outcome of Brazil's elections next month will mean for Vale.

Even more important than that, RBC isn't certain that Chinese demand for iron ore is going up next year. And given that iron ore accounts for about 74% of Vale's annual revenue stream (according to data from S&P Global Market Intelligence), growing demand from China is essential to any buy thesis for Vale stock. For this reason, RBC is recommending that investors stay away from Vale for the time being.

Upgrading Vale stock

And yet, here's something surprising: Although RBC isn't certain whether China is about to increase iron ore imports, the analyst says its "base case expectation" is that iron ore demand will rise -- which makes the decision to downgrade Vale stock on the chance that it's wrong about that a strange one for RBC.

Much more logical, I think, is how analysts at French investment banker Exane BNP Paribas are looking at the iron ore story. Contradicting RBC's move, this morning, Paribas announced that it is upgrading shares of Vale to neutral on "revised" expectations for iron ore demand. According to Paribas, the "iron ore price deck does leave upside in the shares" -- which translated into English, basically means Paribas is forecasting greater demand, and consequently higher prices for iron ore going forward -- thus making Vale stock more valuable.

Why could demand rise?

As I mentioned last week, the South China Morning Post reports that after taking "a 12-month pause" on national infrastructure-building projects, the Chinese government now plans "a series of major urban infrastructure projects" to spur growth in its economy. Such projects, as a rule, require steel to undergird them -- and making that steel requires iron.

Final word

And so we have one analyst downgrading Vale, but another upgrading the stock. (Technically, it's more like two versus one. There was a second upgrade this week -- to outperform -- from Brazilian banker Bradesco BBI.)

One thing that both RBC and BNP Paribas both agree on, though, is this: From a free cash flow perspective, Vale stock is looking a whole lot more attractive right now than it once was. RBC noted yesterday that Vale has done a "tremendous job" in "reducing capex" from levels in excess of $12 billion a year five years ago to less than $2.7 billion over the past 12 months. With less cash being siphoned away into capital investments, Vale is currently generating cash profits at the rate of $7.5 billion per year -- nearly twice the company's reported GAAP profit of $3.9 billion.

For its part, Paribas likes the fact that Vale is using these cash profits to buy back $1 billion worth of stock and pay down debt -- and I like that, too. Here's why:

With a market capitalization of $69.3 billion, Vale stock currently sells for just 9.2 times annual free cash flow. But Vale also carries $14 billion in net debt. That debt pushes Vale's enterprise value-to-free-cash-flow ratio up to 11.1 -- which still isn't unreasonable, but is certainly less attractive than the valuation would be without all the debt.

The more iron ore demand Vale enjoys in China, the more cash it will generate, and the more debt it can pay down. And they more debt Vale pays down, the better a bargain it will be -- and the more it will deserve additional upgrades in the future.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.