Rio Tinto

Rio Tinto’s chief executive, Tom Albanese, recently described the miner’s iron ore division as the world’s second best business after Apple’s iPad. Investors don’t seem to agree (incidentally, nor do we); Apple’s share price marches relentlessly higher, but Rio’s has been thumped. Since we recommended selling Rio stock in Why you should sell Rio Tinto on 29 Nov 10 (Sell – $83.65), the share price has fallen 30%. In the past three months alone, it has fallen 14%. Despite the savage price falls, Sam Walsh’s ill-considered boast isn’t completely without merit; last year Rio generated earnings before interest, tax, depreciation and amortisation (EBITDA) of US$20bn from its iron ore division, a return on assets of 100%. The figure for BHP is just 50%.

The resource base is truly epic; Rio can continue mining existing resources until 2069. But an explosion of new production, (see Iron ore: It’s (not) different this time) risks lower prices; a fall of $10 a tonne in iron ore prices, for example, will cut Rio’s underlying profits by about US$1.7bn. At least Rio is the industry’s lowest cost producer and can stay afloat longer than the competition. The decision investors need to make is whether expectations for lower iron ore prices are adequately reflected in the share price.

We’ve previously argued (on 29 Nov 10) the iron ore division alone is worth about $100bn. We’re reviewing that number at the moment, but it's currently close to the enterprise value of Rio, which is $120bn. Concerns about iron ore prices persist, and Rio will never again be the marvellous business it was before acquiring Alcan, but there is little doubt the share price is starting to reflect lower expectations. We're upgrading to HOLD.