A rethink on Rio

The mining giant is heavily exposed to iron ore … but all the numbers add up to growth.

Summary: Rio Tinto has been labelled as a “one-trick pony” because of its massive exposure to iron ore. But the mining company’s management is increasing production, and is set to deliver big financial gains, irrespective of what the iron ore price does over the shorter term.
Key take-out: The company has forecast a product cost target of $US35 per tonne, well down on the current market spot price of around $US130. That means Rio has plenty of buffer against a falling ore price.
Key beneficiaries: General investors. Category: Shares.
Recommendation: Outperform (under review).

Iron ore prices have fallen 7% over the past six weeks, while Rio Tinto’s share price has risen 9% over the same time.

This is the first clue that investors are taking a different look at a mining company which is heavily dependent on its iron ore division.

Rather than treat Rio Tinto as a simple proxy for the iron ore price, a premium is being paid for the profit margin per tonne which, in the case of Australia’s biggest iron ore miner, is the best available and is likely to get better.

The key to analysing Rio Tinto today is to look through the raw commodity prices to see a management team that is defying the wishes of some of its biggest shareholders to win a future prize as the biggest and lowest-cost producer able to withstand any price correction.

In effect, Rio Tinto is a buy on financial and executive competence, which is not something often said about any mining company, and even less often about a business which has been a serial disappointment for the past decade.

There is a risk that buying today at close to $63 a share will produce a short-term capital loss, and that better buying opportunities will occur as the seasonal slowdown in China’s steel industry further depresses the iron ore price.

Fellow Eureka Report writer, John Abernethy, was a seller of Rio Tinto last month (August 14; Tipping out Rio) on the grounds of its poor half-year profit result and excessive exposure to iron ore. He made his exit at $62.62 after deciding that the stock offered little growth potential over the next 18 months.

Abernethy could be right, but at some point all Australian investors should add Rio Tinto to their portfolios, or consider increasing their exposure, because of the potential for the lessons being learned in iron ore flowing through to weaker copper, coal, aluminium and other operations.

Analysing the Rio numbers

A few numbers picked up by analysts during last week’s four-day tour of Rio Tinto’s iron ore division tell the story of a company exposed earlier this year to management shortcomings that led to the sudden departure of its chief executive, Tom Albanese, and his replacement by the former head of the iron ore division, Sam Walsh.

  1. The most important is the figure $US35, because that is the forecast future cost per tonne of iron ore produced at Rio Tinto’s WA mines, down 30% on the current $US50/t as the mines head for an expansion target of 290 million tonnes a year, and then up to a planned 360 million tonnes.

Whatever happens to the notoriously cyclical iron ore price, Rio Tinto will be the low-cost producer and profit leader. Even if the price falls to a forecast of between $US100/t-and-$US80/t, Rio Tinto will still be on a gross profit margin of more than 100%, while some smaller (and higher-cost) rivals will be at risk of closing.

  1. The second critical number is four, because that’s the number of months by which Rio Tinto has beaten its infrastructure construction schedule to be in position to hit its 290m/t target. This is a remarkable turnaround in an industry infamous for its completion delays and cost blow-outs.
  2. A third number is 3, because that’s the dividend yield available on an investment in Rio Tinto, which has reacted to shareholder criticism about excess spending on project development and insufficient rewards for investors. This is a problem being managed by a steady increase in dividends, even during periods of low profitability.

Since calendar 2011, and despite a hefty loss in 2012 from asset-value write-downs, Rio Tinto has progressively lifted its annual dividend from $US1.45 to $US1.67, with a forecast of $US1.76 this year, rising to $US1.81 next year.

  1. A fourth factor, which lacks a number, is a management decision to build infrastructure (rail and port) ahead of mine development. In a way that seems like putting the cart before the horse, but what it really means is that Rio Tinto has the option to produce more tonnes – but not the obligation – unless markets are available.

It is also an excellent example of iron ore being more of a play on transport economics and less of an investment in mining itself.

The dividend, and its implied yield, forms the backbone of Rio Tinto’s investment appeal. What’s happening at a management level, and in what appears to be the start of a sea-change in global economic growth (which will bring increased demand for all commodities) adds to the argument in favour of the stock being a buy or, at worst, neutral until seasonal changes wash through the iron ore market.

Management changes

Pinpointing precisely what Walsh and his team are doing at Rio Tinto is not easy. There has been no “big bang” moment which has changed the spots on a scruffy leopard. Rather, there have been a myriad of small changes encapsulated in an over-arching management approach of under-promising and over-delivering.

That’s why the analysts’ tour of the iron ore division, and its resulting flow of advisory notes to clients, was an event of importance that goes beyond a single business unit, even if that unit generates the lion’s share of the company’s profits. Some analysts estimate that iron ore will be a worrying 87% of 2013 earnings, a level which could earn Rio Tinto the tag of “one-trick pony”.

The difference this year from the old Rio Tinto is that, with Walsh in charge, the lessons learned in iron ore about efficient capital allocation, strict cost controls and an incentivised workforce should be transferable to other divisions.

Few of the analysts who inspected the company’s iron ore operations connected the dots that lead to copper, coal and aluminum, or praised Walsh for defying the demands of big shareholders, such as BlackRock’s Evy Hambro, who had been critical of the company planning to produce 360m/t of iron ore a year.

Last May, Hambro chastised Rio Tinto for investing too heavily in iron ore, questioning whether it made financial sense to chase a production target of 360m/t.

“Is that a sensible thing to do?,” Hambro asked. “Is the investment going to add additional tonnes to the market which will reduce the price of iron ore and therefore the profitability of the iron ore they are already producing.”

Given that BlackRock owns a combined 15% of Rio Tinto’s British and Australian listed shares, it was a courageous decision of the company’s board to ignore his plea for even fatter dividends now in preference for a potentially higher payout sometime in the future.

What’s happened since then is that the global growth worm has started to turn, as China resumes its relentless drive to expand, the US and Japan start to grow again (albeit slowly), and even Europe is showing signs of recovery.

At the same time, most mining companies have been pulling back on expansion plans, and while iron ore could still be heading into a period of large annual surpluses it will be Rio Tinto that emerges relatively unscathed thanks to that ultra-low $US35/t cost target.

Analyst forecasts

The collective view of analysts who inspected the company’s Pilbara operations is that the stock remains a buy, even if there is a decline in the iron ore price.

Unusually for any company, every investment tip after the tour (bar one) was a buy. Goldman Sachs went against the tide with a neutral ranking because of concern about the iron ore surplus, which could knock prices down sharply next year.

Goldman Sachs argues that Rio Tinto is already well priced and sees a 12-month target of $62, which has already been exceeded.

“Qualitatively, Rio’s Pilbara operations are impressive due to the sheer scale and quality of the assets and high morale across the business,” Goldman Sachs told clients in a September 6 note to clients.

JP Morgan agreed, but was more enthusiastic, saying of the expansion plans that “project returns are compelling” and then adding that “while an expected decline in the iron ore prices medium term could act as a headwind, we continue to believe the stock will re-rate as projects are delivered ahead of plan, and free cash flow improves, providing greater options for capital.”

The JP Morgan 12-month price target for Rio Tinto is $79, up $2 from before the Pilbara operations tour.

BA Merrill Lynch has a target price of $77. Citi is $71, and RBS Morgans $74.20.

The highest 12-month price forecast is from UBS, which has $80 as the target, with the potential for major future cost and efficiency benefits coming with the introduction of driverless trains by the second quarter of 2015 – a “game-changer” for the iron ore network, according to UBS.

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