Re-examining Rio

Miner’s hard decisions and renewed discipline attracts attention.

Summary: New CEO Sam Walsh's moves to cut $5 billion costs over the next two years and unwind failed deals has gained positive attention from resource analysts, with even the cautious Rio watchers hopeful of capital appreciation and better dividend yields.
Key take-out: Rio finds favour with analysts.
Key beneficiaries: General investors. Category: Shares.
Recommendation: Outperform (under review).

It requires a degree of faith, as well as financial scrutiny, to accept that the Rio Tinto “leopard” has changed its spots and will, after years of disappointing, actually deliver value for investors.

But that is the consensus view of analysts, and one that I agree with though probably for a different reason to those of stockbrokers and bankers who tend to look only at the numbers.

Important as commodity prices and mineral production rates are in assessing the second biggest mining company listed on the Australian stock exchange, there is another factor at work - the determination of management to not stuff up again.

Hard decisions are being made by Rio Tinto as the company adjusts to a world of reduced demand for its minerals and metals, especially from its biggest customer, China.

Rio Tinto is not the growth story it tried to be over the past decade. It is a cost-cutting, yield-driven story with a growth option for the next upward swing of the commodity-demand pendulum.

Buying the stock today at around $52 will generate a dividend yield of 3.1%, which is better than most cash management accounts, with dividend projections likely to see the yield rise to around 3.5% over the next two years.

From a capital appreciation perspective even the most cautious analysts see Rio Tinto’s share price rising by around 30% over the next 12-months – while the most optimistic reckon will rise by around 60%.

Graph for Re-examining Rio

Source: Bloomberg

The lowest of the future price tips, from brokers at Credit Suisse and Goldman Sachs, are for Rio Tinto’s Australian-listed shares to rise from their current $52 to between $66 (GS) and $68 (CS).

The highest tips, from UBS and Deutsche Bank, are for the stock to clear the $83 mark sometime over the next 12-months.

When combined, the nine share price tips I’ve seen point to a future share price of around $75, or roughly 44% higher than it is today. And while investment analysts tend to behave like a herd and mimic each other’s forecasts to avoid being seen as different there is an argument to support their optimism.

If the experts are correct it means an investment in Rio Tinto today is a no-brainer though the wide gap between the high and low future price predictions are a clue as to the uncertainty which dogs a company which has a record of poor recent decisions and the wholesale destruction of shareholder wealth.

Shedding the baggage

The worst decision was the 2008 acquisition of the Alcan aluminium business for $40 billion in cash, with most of that outlay now written off thanks to the price of aluminium remaining depressed because of chronic global over-production of the metal. Not far behind in the dud decisions category was the acquisition of coal assets in Mozambique, which have also been written off.

Unwinding failed deals and minimising future possible losses from exposure to high risk countries (such as Mongolia, where a big new copper project has just started exporting, and Guinea in West Africa, where a major new iron ore project is slowly taking shape) is one of the priorities of Rio Tinto’s new -and probably temporary - chief executive, Sam Walsh.

A rushed replacement for the unfortunate Tom Albanese, Walsh has a solid track record as boss of Rio Tinto’s most profitable business, its iron ore division. His new role, taken on at the unlikely age of 63, is radically different to running the high-margin and rapid growth iron ore business.

Walsh today is fulfilling the role of a change agent with his major aims being to achieve cost savings of $5 billion over the next two years through a combination of sharply reduced capital expenditure, asset sales, staff cuts, and minimal fresh investment – and to never again commit the cardinal corporate sin of over-promising and under-delivering.

Source: Rio Tinto

Source: Rio Tinto

Future performance

First glimpse into how the business is performing will come next Tuesday when Rio Tinto files its second quarter operations review which is expected to show steady progress in most divisions but lower-than-expected iron ore production because of unseasonally heavy rain in the Pilbara region of WA.

The real test of the company’s new-found interest in financial discipline will come on August 8 with the release of the half-year results. That statement will reveal how successful Walsh has been so far in re-shaping the company, though a detailed look will not be available until early next year when the full 2013 calendar year results are published.

What investors will want to see in the results is proof that Rio Tinto really is applying strict capital management controls and achieving its primary goals of improving its balance sheet, cutting costs, selling surplus assets and only expanding the business units which deliver the highest rates of return.

The market will also be watching China’s rate of economic growth closely, as well as the new-found optimism emanating from the U.S. because it is those two economies which will determine future commodity demand.

In his most recent briefing of analysts after Rio Tinto’s annual meeting in May, Walsh said expansion of the company’s all-important iron ore division was expected to continue with the aim being to lift annual output from 290 million tonnes a year to 360 million tonnes for a simple reason: “We are the lowest cost producer,” he said.

Other key messages from Walsh including:

  • A focus on maintaining the company’s single A credit rating with the proceeds of asset sales bolstering the balance sheet rather than being used to return capital to shareholders.
  • Maintenance of a progressive dividend policy which could see higher dividend rates in future years with analysts tipping a payout rate rising from $1.67 a share last year to $1.80 this year, and then up to $1.90 in 2014.
  • Steady progress on asset sales, but only at the right price and with assets withdrawn from sale if a fair price cannot be negotiated which is what happened with the diamond division which was taken off the market last month (“This is not market day at the bazaar,” Walsh said in a London interview last month), and
  • A forecast compound annual production growth rate (CAGR) on a copper equivalent basis of 8% over the next four years.

Analysts are slowly warming to Rio Tinto and its new chief executive, even if he is only likely to be in the job during the change process and to assist with the selection of a long-term successor.

The next few months will reveal much more about the direction in which the company is travelling. News flow is likely to be dominated by asset sales such as the disposal of a 59% stake in the Iron Ore Company of Canada for around $2.7 billion, and the Northparkes copper and gold mine in NSW for much less.

Operationally, iron ore production is expected to continue growing and the new Oyu Tolgoi copper mine in Mongolia will generate its first cash flows. In fact the plant shipped its first concentrate earlier this week.

Apart from production news investors will be watching closely to see how Walsh handles two particularly complex issues; the timing of the proposed Simandou iron ore project in Guinea, and the future of the troubled aluminium division.

Walsh says he is committed to developing Simandou despite its cost blowing out from an original $US9 billion to more than $US16 billion, while the aluminium division has been described as “too unwieldy to keep and too big to merge”.

Identifying the risks ahead

There is a risk that Walsh will not deliver on his objectives, but that is largely confined to commodity prices turning sharply against Rio Tinto, or a foreign government (Mongolia or Guinea) demanding a bigger share of the businesses inside their borders.

On balance, the stock is today being assigned a worst-case pricing having fallen by 24% since Walsh took control on January 17 with analysts starting to recognise that major cost reductions are being achieved and asset sales, while slow, are being made.

The next six months will be critical for the Rio Tinto recovery story but right now the stock is probably as cheap as its going to be for some time.

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