Blame it on Rio?

PORTFOLIO POINT: Rio Tinto management has a lot riding on iron ore, and with ore prices likely to drop due to over-supply, the mining giant will need more commodity irons in the fire.

Four years ago Rio Tinto put a lot of its eggs in an aluminium basket, only to discover that the basket was broken. Today, it’s putting a lot of eggs in an iron ore basket – leaving shareholders to pray that history does not repeat itself.

The aluminium experience, which involved the $40 billion acquisition of the Canadian company, Alcan, just as the global financial crisis hit, almost destroyed Rio Tinto, with low-profit aluminium remaining an albatross around the company’s corporate neck.

Iron ore, say the supporters of the company’s current policy of tipping billions of dollars into Australian and African expansion projects, is different.

But, when pressed on why iron ore in 2012 is different to aluminium in 2008, the answer is alarmingly familiar – Chinese demand.

If Rio Tinto management is right, and Chinese demand for iron ore is many years away from peaking, then the company could be on a winner and the stock deserves the buy rating that major brokers have maintained – all the way down from its 12-month high of $83 in July last year to its latest price of $55.80.

If Rio Tinto management is wrong with its view of iron ore, as it was with aluminium, then sentiment could quickly change.

BHP Billiton has also fallen sharply as the price-driven phase of the commodity boom has come to an end, though its 28.8% drop from a 12-month peak of $43.78 to its latest $31.16 is slightly less than Rio Tinto’s 32.7% fall.

The difference between the two big resource stocks is widely seen as BHP Billiton’s oil division providing more reliable cash flows, but another factor is that BHP Billiton is not as heavily reliant on iron ore as Rio Tinto. In its full year to December 31, iron ore accounted for 73% of Rio Tinto’s pre-tax earnings. BHP Billiton’s iron ore division in its half-year to December 31 accounted for 50% of pre-tax profit.

Both companies will suffer if the iron ore price falls from its current level of around $US130 a tonne to its long-run price level of less than $US80 a tonne, which a number of analysts are tipping could occur over the next few years as an estimated $200 billion is spent on expanding iron ore production around the world.

Brokers at CLSA are tipping an iron ore price of $US70 a tonne in three years. Goldman Sachs has pencilled in a price of $US77 a tonne as its forecast long-run nominal price from 2016. Both could be wrong, but their cautious outlook reflects concern that the growth rate of Chinese demand for iron ore will slow just as new supplies hit the docks – a classic squeeze of rising supply and flattening demand.

Right now, Rio Tinto sees no problems for its all-important iron ore operations, or it would not have committed a fresh $US4.2 billion expanding its Pilbara operations in north-west WA, and $US501 million on additional infrastructure at its emerging Simandou project in the west African country of Guinea.

Sam Walsh, chief executive of Rio Tinto Iron Ore, argues that both investments have solid financial foundations, and at the current iron ore price of $US130 a tonne he’s right, especially as Rio Tinto’s Pilbara costs are around $US40 a tonne.

Walsh also argues that Chinese steel demand is continuing to rise, and remains on target to hit one billion tonnes around the year 2030, which means strong ongoing demand for iron ore.

Competition, Walsh argues, will be minimised by the difficulty (and cost) of developing new mines, leaving the way clear for Rio Tinto to hit its target of producing an annualised 353 million tonnes of iron ore from the first half of 2015.

Rio Tinto has a lot riding on Walsh delivering on his projections, and while he has a strong track record there are three reasons why investors will be watching carefully. They are:

The critical importance of iron ore to Rio Tinto’s profit, which has reduced the company to a status once sharply criticised by a former managing director, Leigh Clifford: “one-trick pony”.

The success, or otherwise, of iron ore competitors as they rush to develop their new mines to catch the same forecast wave of Chinese demand, and

The risks associated with committing shareholders’ fund to African countries such as Guinea, which has a poor record of nationalising foreign-owned assets.

If Rio Tinto can manage those challenges then it should be able to dig its shares out of the hole into which they have fallen.

But, if the Chinese economy continues to struggle with its flip from export focus to internal-demand focus, then Rio Tinto’s dream of an iron ore recovery will be slow in coming.

Also, at the first hint of a significant fall in the iron ore price back to where CLSA and Goldman see it in three-to-four years’ time, then Rio Tinto’s shares could crash, replicating the 2008 experience when the company last put too much faith in a single commodity.

A hint that something unpleasant is stirring in the iron ore market came last week with reports that the price-premium enjoyed by high-quality “lump” ore, the best ore that is normally rationed out by miners because it can fetch an extra $US25 a tonne, had virtually disappeared.

What that means is that lump is being sold for roughly the same price as “fines”, the standard ore which, in Rio Tinto’s case, is sold as its Pilbara Blend – a development seen as a precursor to a widespread fall in the overall iron ore price.

On balance, and despite what big brokers such as Deutsche Bank, Macquarie, Citi and J.P. Morgan are telling clients, Rio Tinto is more of a sell story, than a buy, even after looking at both sides of the investment coin.

On the plus side there is the broker argument that Rio Tinto is a “conviction” buy, and has been oversold. J.P. Morgan, for example, sees the stock rising to $86.53 over the next 12-months, echoing a view that iron ore demand will remain strong (as will prices), demand for copper will recover, and because of the potential for higher dividends, or a share buy-back.

Cash is certainly not a problem for Rio Tinto today, as it isn’t for all of the big miners. The Canadian-based BMO Capital recently calculated that the world’s top seven mining companies are sitting on a collective cash pile of $US86 billion, a number which puts them in the same league as the global cash-leaders, the tech-specialists Apple, Google and Microsoft.

To put the miners’ $86 billion in perspective back in 2008, as Rio Tinto embarked on its ill-fated Alcan plunge the collective cash balance of the top seven was estimated by BMO to be standing at $US1.7 billion.

It is the cash, and a promise to not waste it this time, that could make the big miners attractive investment propositions.

At its latest price Rio Tinto has drifted into yield play territory with annual cash flow of around $27 billion (and an estimated $9 billion of cash in the bank) and the company could easily maintain its current annual dividend of $US1.45 a share, and perhaps pay even more given that underlying earnings per share last year totalled $US8.08.

On any traditional investment multiple, such as a price/earnings ratio of around 7, acquiring Rio Tinto share makes good sense, and for investors with a medium-to-long term horizon now is the time to top up their position in one of the world’s leading resource companies.

However, that 7-times multiple is the market sending a warning signal about a business with a record for making bad investment decisions, wasting shareholders’ funds, failing to keep costs under control, and now embarking on an iron ore expansion program loaded with risk.

For investors seeking yield, Rio Tinto at its current price is good value, relative to the rest of the market and the alternatives of putting cash on deposit or in government bonds.

But, if you’re investing in expectation of a return to strong share price growth you could be disappointed, until global growth resumes, and that means Europe ending its free-fall, China stabilising, and the US recovering.

Without a widespread recovery, and with iron ore possibly heading into a period of over-supply, there is a risk that too much faith in a single commodity could produce Rio Tinto’s second Alcan event.