Value Investor: Dark days for Rio

Rio Tinto's strategy of reducing debt and increasing returns to shareholders suggests a lack of investable opportunities and an uncertain outlook. The falling iron ore price is adding to the pressure.

Despite a strong market position, a sustained downward trend in the iron ore price spells revenue and margin pressure for Rio Tinto (ASX: RIO). However, with the share price trading at nine-month lows and at a discount to value, should we consider investing in Rio?

Once considered a diversified miner, Rio Tinto is largely a play on iron ore. Iron ore generated 85 per cent of operating earnings in fiscal 2013. The lack of diversification and high sensitivity to the iron ore price belies Rio’s blue-chip status.

Excluding iron ore, in fiscal 2013, Rio Tinto's other assets employed around $43 billion of capital but delivered only $1.76 billion of earnings -- a return on assets of 4 per cent. This is disappointing, especially considering the risk of investing in a global miner.

Graph for Value Investor: Dark days for Rio

Figure 1 – Revenue by commodity and by destination
Source: Rio Chart Pack, April 2014

The iron ore division, in contrast, exhibits strong profitability (47 per cent return on assets in fiscal 2013) due to its strong position on the global iron ore cost curve and production of higher quality grades of iron ore, which Rio Tinto can sell at a premium above the benchmark price.

Graph for Value Investor: Dark days for Rio

Figure 2. Iron ore cost curve
Source: Rio Tinto, Wood Mackenzie

With iron ore prices weakening below the psychological $US100 mark, the outlook for Rio Tinto has been tempered with some concern. Every $US10 movement in the iron ore price wipes $1.2 billion from Rio Tinto’s bottom line.

As covered in an earlier article, the iron ore price faces downward pressure from falling steel prices, a softening Chinese property market and increases in the global supply of iron ore, as miners ramp up production – both BHP Billiton and Rio Tinto announced record production guidance for the next quarter.

Should iron ore prices continue to fall, competitors who are higher up the industry cost curve would risk being pushed out and lower prices would discourage new entrants to the market.

Meanwhile, Rio Tinto remains one of the lowest-cost producers and can weather a weaker iron ore price. Rio Tinto’s installed infrastructure also allows it to increase or decrease production in response to market conditions.

Rather than invest and acquire, Rio Tinto’s strategy is to reduce debt and increase returns to shareholders, with the target debt at $US15bn. If debt falls to target, management has stated that it will consider distributing cash to shareholders.

While this leads us to predict a buyback in 2015, this strategy suggests a lack of investable opportunities and uncertainty in outlook.

An interesting development was Rio Tinto’s landmark agreement to develop Africa’s biggest mining project -- a $US20 billion Simandou iron ore project in Guinea. Despite the project’s potential, it has been fraught with political instability since Rio Tinto obtained exploration rights in 1997.

Fears over broken government promises, contractual disputes and commodity price volatility are barriers to financing a railroad and port to the mine, which is needed to make the project profitable. Also, the agreement still has to be ratified by parliament.

Rio Tinto’s earnings are sensitive to commodity prices and currency, which are volatile and difficult to predict. Management remains focused on the variables it can control: cost reduction, productivity, and divestment of non-core assets. On Monday of last week, Rio Tinto completed the sale of a 50.1 per cent stake in the non-core Clermont coal mine to GS Coal.

The Australian dollar is under pressure from weaker iron ore prices, weak global bond yields, offshore quantitative easing, dovish statements from the RBA and concerns about the Chinese economy. As Rio Tinto reports its earnings in US dollars, it benefits from a weakening Australian dollar.

We adopt a forecast sustainable Return on Equity of 23 per cent, which is below consensus. However, sustained weakness in the iron price should see downgrades to consensus forecasts. Along with a required return of 13 per cent, our fiscal 2014 valuation is $69.18.

Rio Tinto is currently trading at a discount to value. However, we remain cautious due to uncertainty around realised commodities prices and currency. The price of iron ore and the Australian-US dollar exchange rate are key risks to Rio’s profitability.

Before investing in Rio, investors should ensure they are comfortable with iron ore price volatility. We think investors should expect a 20 per cent first-year shareholder return, comprising grossed-up dividend yield and convergence of the share price to intrinsic value.

By Brian Soh and Amelia Bott of StocksInValue, with insights from Adrian Ezquerro and George Whitehouse of Clime Asset Management. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For a no obligation FREE trial, please visit StocksInValue.com.au or call 1300 136 225.

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