|Summary: A 20% rally in Rio Tinto’s share price has closed the gap on its market fair value, and the mining giant now offers limited potential for significant growth in its value over the next 18 months. This mainly reflects the significant write-downs in assets that it has undertaken, leading to a disappointing earnings result. The company also continues to be heavily reliant on iron ore.|
|Key take-out: Rio’s earnings are sensitive to commodity prices and currency, which are volatile and difficult to predict. Further, production costs and volumes may be less variable but are still prone to surprises. Further write-downs would drag down the stock’s valuation below the current market price.|
|Key beneficiaries: General investors. Category: Growth.|
Following a review of the six month result (June 30) for Rio Tinto Limited (ASX:RIO) announced last week, I have decided to sell it from the portfolio at $62.50 (cum dividend).
This decision is not based upon anything other than what I perceive as a disappointing result and an observation that Rio is becoming too iron ore centric for my portfolio. Also I perceive that there is better value in my other holdings – BHP Billiton Limited (ASX:BHP) and Mineral Resources Limited (ASX:MIN). My portfolio simply has too much exposure to iron ore and the 20% rally in Rio’s price has closed the gap on what I have calculated as fair value.
It is interesting to observe that the recent rally in Rio’s share price has been in excess of 20% in just over a month. I do not exactly know what causes such massive price moves for large capitalisation companies, but I would hazard a guess that the relatively good Chinese economic numbers and the sustained iron ore spot price are the reasons.
However, when I do my valuations I stand back from the noise and attempt to make an assessment of value based on realistic assumptions and a considered view of the world. First, it is clearly observable that iron ore futures prices are below current spot prices. It does not surprise me, but what appears to have surprised many pundits is that both the spot and the forward price for iron ore sit firmly above $US100 per tonne.
Readers may recall the claims of many that a Chinese slowdown and oversupply of iron ore would crunch the price. This has not happened, and in $A terms the spot iron ore price is higher than six months ago. The valuations that I rely upon had not assumed a demise in the iron ore price, and so the share price is merely recovering to what it should have been.
Second, I expect the spot price of iron ore to hold above $US110 tone for the next six months as well. There has been a reported sharp decline in steel inventories and so it is unlikely that demand for iron ore can be manipulated down by Chinese steel manufacturers. I can also see the recovery of Japan and a strong South Korea as other iron ore market participants. The iron ore price outlook remains solid, the price of Rio has rightly recovered to fair value, but from here I do not perceive anything other than speculative gains.
Therefore, I have decided sell Rio out of the portfolio at the current price (13/08/13) of $62.62. The 2013 StocksInValue valuation is unchanged at $65.37 based on holding the estimate of normalised return on equity (NROE) at 23% and required return at a conservative 13%. However, the 20% rally over the last seven weeks closed the share price discount towards the valuation to just 5%.
I do not perceive that Rio offers the potential for significant growth in its value over the next 18 months, mainly because of the significant write-downs in assets that it has undertaken. These decisions have diminished the shareholders’ equity of Rio and affected the valuation. Any further write-downs would drag down the valuation below the current market price.
Normally I might be content to hold and wait for a premium to valuation before selling a stock that is not subject to commodity cyclicality, but in the case of Rio I believe I should take profits sooner. Rio’s earnings are sensitive to commodity prices and currency, which are volatile and difficult to predict. Further, production costs and volumes may be less variable but are still prone to surprises. Optimism stemming from the current iron ore price rally and the 15% rise in the interim dividend gives us a welcome opportunity to raise cash levels again in the portfolio.
Cold hard look at Rio
Rio’s product mix includes iron ore, aluminium, copper, energy and diamonds but this is overwhelmingly an iron ore stock. The following table (Figure 4) presents divisional earnings and return on assets from last week’s 1H13 result.
Figure 4. 1H13 Rio – Divisional Earnings and Return on Assets
Gross earnings ($m)
Assets employed ($m)
Proportion of operating earnings
Source: Rio Tinto Limited
The table (Figure 4) reveals the lack of diversification in the ASX’s second-largest resource major and a stock widely considered as a core, blue-chip holding. The dependence on iron ore creates strong leverage to the volatile iron ore price. Not only did iron ore contribute nearly 88% of operating earnings, the other divisions are only marginally profitable perhaps with the exception of copper.
It is not surprising Rio seeks “non-core” asset sales but it recently failed to sell its diamond and Pacific Aluminium operations. Rio’s own returns on these assets, assuming current valuations, would be unattractive to trade buyers in the absence of opportunities to multiply returns, like large operational synergies. Otherwise rational buyers should demand steep discounts to book value. Rio has a different view, so it will retain the diamond business and integrate Pacific Aluminium with Rio Tinto Alcan. The result near-term will be lower group profitability.
This is not to detract from Rio’s competitive position in iron ore, where the strong profitability (19.8% ROA) indicates the main competitive advantage: a strong position on the global iron ore cost curve. Management’s ongoing drive for cost savings, which reduced 1H13 costs by $1.5 billion, should improve this position. Iron ore production volumes should rise following the capital investment of recent years.
A net $2.5 billion of significant non-recurring losses in 1H13 reduced statutory earnings from $4.2 billion to $1.7 billion. There were foreign exchange losses of $1.8 billion and $340 million of charges following a wall collapse at the Bingham Canyon mine in April. These indicate substantial currency exposure and operational risk. Arguably the wall collapse costs should have been included in operating earnings given mine construction and remediation are core businesses.
A marginal negative was an increase in gearing, as measured by net debt to equity, to 40% from 34% on December 31. This was despite strong operating cash flows and reflects the lack of asset sales in the half. I note that S&P’s ‘A’ credit rating for Rio is on negative watch.
I have decided to increase cash levels by reducing our holdings to just 10 stocks. The current market bounce has lifted a few stocks I was considering to well above my buy prices. Readers who jumped upon the stocks that I mentioned last week, in particular Monadelphous Limited (ASX:MND), may consider pocketing the short-term gain. Frankly, I perceive that some stocks, including MND, that had been heavily shorted are caught in a short covering updraft. There is no change in value but rather price has lifted because of the silly games of hedge funds.
Finally, see my video interview today with Eureka Report Managing Editor James Kirby on Finding value in a rising market.
John Abernethy is the Chief investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au.
Editor's note: Tim Treadgold's article Re-examining Rio published on July 10, 2013, had an outperform recommendation on the stock.
Clime Growth Portfolio Statistics
Return since June 30, 2013: 9.06%
Returns since Inception (April 19, 2012): 28.26%
Average Yield: 6.29%
Start Value: $141,128.64
Current Value: $153,911.05
Dividends accrued since June 30, 2013: $0.00
Clime Growth Portfolio - Prices as at close on 13th August 2013
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