Value Investor: When China goes to Rio

Chinese steel intensity still has a long way to catch up with developed countries, good news for Rio which is overwhelmingly an iron ore stock.

Despite a diversified portfolio of commodities, Rio Tinto Ltd is overwhelmingly an iron ore stock. It is the world’s second largest producer of iron ore and its main competitive advantage is a strong position on the global iron ore cost curve and high product quality.

Iron ore will continue to increase in importance to Rio as its capital expansion plans in Australia are completed, production ramps up and Rio leverages its low-cost position on the curve.

Resource businesses are among the most challenging to value as profitability is often erratic and forward estimates volatile. Rio’s earnings are very sensitive to commodity prices, in particular iron ore, and currency movements.

It makes sense to be conservative and insist on a margin of safety. Our FY14 valuation of $71.11 is derived from an adopted normalised return on equity (NROE) of 23 per cent and required return (RR) of 13 per cent. As per the below chart, Rio is trading marginally above value, so we would seek a larger margin of safety before investing.

Graph for Value Investor: When China goes to Rio

Figure: Rio Tinto Limited Price vs. Value Chart

Source: www.StocksInValue.com.au

Rio is positioned to capitalise on the urbanisation of China with the expansion of its iron ore operations. Close to 90 per cent of earnings come from iron ore and future earnings will be underpinned by Chinese demand for the commodity.

Overall, last week’s third-quarter production results from Rio were strong, reflecting momentum in the iron ore division and a faster-than-expected recovery in the Kennecott Bingham Copper mine. The group materially upgraded production guidance in its Copper, Energy (Coal) and Bauxite businesses and reaffirmed iron ore volume guidance of 265 million tonnes a year.

The production results confirmed the miner is on track with the $16 billion expansion of its iron ore operations. In August, Rio expanded capacity from 237 million a year to 290 million, four months ahead of schedule and $400 million under budget. Further expansion of the port, rail and power infrastructure to support production of 360 million tonnes annually is underway for completion by 2015. Approval for mine development from 290 million to 360 million will be decided at the November board meeting.

The majority of Rio’s iron ore sales go to export markets, with China its largest customer and incremental buyer of new volumes. Iron ore demand is underpinned by the urbanisation of its population which requires a far more steel intensive lifestyle compared with rural living. Premier Li Keqiang plans to have 60 per cent of China’s 1.35 billion population as urban residents by 2020, a 15 per cent increase on current levels.

While periodic hiccups will no doubt plague investor confidence, we view the long-term outlook for Chinese economic growth as sustainable. China’s growth has slowed from 10 per cent to 7 to 8 per cent -  and will trend lower over time due to a high base effect -  but its demand for commodities will keep growing. As per the figure below, Chinese steel intensity still has a long way to catch up with developed countries, supporting our view iron ore demand will continue to grow.

Graph for Value Investor: When China goes to Rio

Figure: Chinese Steel intensity

Source: Rio Tinto Chart Pack

Amelia Bott is an Equities Analyst at StocksInValue, a joint venture between Clime Investment Management, a value fund manager, and Eureka Report. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For an obligation free, FREE trial please visit www.stocksinvalue.com.au or call 1300 136 225.

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