Is Rio Tinto a steel?

Commodity prices are crashing. From oil, gold and coal to nickel, copper and iron ore, the demise of China’s investment-led growth model has been crushingly brutal on both commodities and equity prices. We’ve responded to the carnage by selectively upgrading a few stocks in the sector but what of Rio Tinto, the second largest miner on the market? Is it also worth buying?

It is certainly a fine business with outstatnding operating credentials. Yet it has changed enormously over the recent boom and bust and stands apart from its peers today. To see how, we must peer into its fabled iron ore division. 

Rio's iron ore business has grown from a small dusty outpost to a hub of 15 separate mines connected by 1,700km of railways and four port terminals. The scale is immense: Rio moves enough earth to fill the MCG to its brim every two days. Each day, ore will travel the distance of the Trans-Siberian railway to get from mine to port. This is more than just a business, it is an engineering marvel and a financial colossus.

Despite low iron ore prices, Rio still generated EBITDA margins of more than 60% last year and a return on assets (ROA) of 40%. Ten years ago, when iron ore prices were less than $30 a tonne, Rio generated ROA of 24%. This is perhaps the finest mining asset anywhere. Yet it is this very quality that has changed the business and what worries us today.

Rio was the first miner to embrace the diversified mining model. It bought together far-flung commodities – coal, iron ore, copper, diamonds – and housed them under one business arguing that diversification would limit volatility.

And, for years, it did. However, the company reinvested cash flows where it was making the best return – in iron ore. As a result of the great boom, the business has morphed from a diversified miner to one dominated by iron ore.

Ten years ago, iron ore accounted for about 35% of earnings; last year it accounted for 80%. The diversified miner is dead. Rio is largely an iron ore business now.

We were among the first to warn about an implosion in iron ore markets way back in 2010 but remain concerned. Although prices have collapsed from a peak of over $180 a tonne, supply continues to expand. The iron ore price will go as low as it must to force excess capacity out. In our view, that means a price with a 2 or a 3 in front of it.

At those prices, Rio has the asset quality and experience to continue to generate decent returns. Rio collects the highest price for its blended ore and reports the lowest costs. In order to cut costs, it has pioneered the use of autonomous drill rigs and trucks; it saved $16m last year just by managing the tyres on its trucks a little better. All up, the cash cost of production has fallen from US$24 a tonne in 2012 down to under US$15 today, the lowest in the industry.

Quality, however, cannot offset lower Chinese demand. Although Rio forecasts Chinese steel output to surpass 1bn tonnes – it is currently 800m tonnes per annum – we are far more bearish and expect Chinese steel output to shrink dramatically, triggering further iron ore weakness.

Although higher cost iron ore supply is exiting the industry that volume is being displaced by lower cost output. As the industry cost curve flattens, so do producer returns.

We expect Rio’s iron ore ROA to fall from a ten-year average of 52% to 35% as a result of lower prices. That is still high but it means earnings from iron ore will halve from about $13bn to about $6bn. Iron ore will still remain an outstanding business but the rest of the empire could face a tougher future.

Aluminium accounts for 40% of Rio’s assets but just 10% of profits. Over the past decade, Rio generated median ROA of just 3% from aluminium. Even after writing off US$30bn, it struggles to generate meaningful returns.

Whereas BHP’s oil business (ex-shale, anyway) generates excellent returns and remains a counter-cyclical buffer, Rio’s aluminium business is a dead weight.. Things could change, of course, but it’s hard to see how aluminium might offset the expected decline in iron ore.

The copper business is also high quality, but only generates about 10% of earnings. This is a weakness of Rio: next to its dominant iron ore business, its other assets struggle for relevance. Without sustained higher prices, copper is unlikely to rescue profits either. Much the same goes for the coal division.

In terms of net profit, we expect Rio to generate earnings per share of about US$1.60, rising to about US$2.40 by 2017 as it cuts costs and conditions improve. Again, this is a fair outcome but doesn't justify a buy at current prices.

What would change our mind? A cheaper share price, for a start. We would consider an upgrade around $38 which implies an expected free cash flow yield of over 5%. If enough supply exited the industry, we would also consider changing our recommendation from the current HOLD.