Morningstar equity analysts are raising their fair value estimate for Rio Tinto (RIO) shares due to better-than-expected third-quarter 2016 production and higher near-term commodity prices. Aluminium and coal volumes were stronger than expected, as were the prices for coal, aluminium and iron ore. Commodity prices have generally remained favourable into the final quarter of 2016. Third-quarter copper output was slightly weaker than we forecast and 2016 volume guidance was lowered by about 4%.
While the timing was uncertain, Rio Tinto’s agreement to sell its 46.6% share in the Simandou iron ore deposit to Chinalco does not surprise. Rio stands to receive $1.1 to $1.3 billion in per tonne royalty payments if Simandou reaches production. The new managing director is cleaning up the company’s asset portfolio but it is also a concession that development is probably uneconomic.
Rio Tinto’s development of Simandou made no sense given the company has better options in the Pilbara. Also, production from Simandou could lower the global iron ore price and dilute returns for the existing assets. As we’ve said before, it would be better had Rio Tinto never found Simandou, particularly as the Guinean Government was keen for it to be mined.
Rio remains overvalued with the market generally more bullish than us on commodities. We think 2016’s renaissance in prices reflects a postponing of China’s economic transition from investment to consumption-driven growth, rather than its cancellation. Iron ore is particularly exposed to shift. The unchanged no-moat rating reflects investment during the height of the boom which swelled the asset base and destroyed Rio Tinto’s excess returns. We forecast midcycle adjusted returns on invested capital of about 5% versus a cost of capital of 9.3%. Our unchanged high fair value uncertainty rating reflects operating leverage and cyclicality.
Rio aims to sign a binding sale agreement in six months and if completed will see Chinalco emerge with 87.9% of Simandou. Simandou hosts 2 billion tonnes of high-grade iron ore and has the potential to underpin at least 50 million tonnes of annual production for decades. The key risk with the transaction is the potential for a strategic deposit to be owned, controlled and developed by one of China’s state-owned enterprises. China has the ability to use cheap debt to develop a mine to bring some direct influence to the iron ore market.
While development of Simandou may not make sense financially – we think returns will fall well below any reasonable cost of capital – it could be strategically important to China. China Inc. may consider a broader reduction in the iron ore price, and the commensurate reduction in the cost of imports, sufficient to justify investment. If China chooses to develop Simandou, it would be a step beyond the indirect efforts to date to encourage and finance additional iron ore production, particularly from Fortescue and Vale. Simandou’s development is not factored into our base-case iron ore supply forecast. We think development is probably still unlikely in the medium term given the economic transition we expect to see in China. But if China decides to push ahead, the additional supply could be a fundamental headwind for the market not currently factored into the prevailing price in excess of $60 per tonne.
As detailed in our recent note on fair value sensitivities for the Australian iron ore miners, and taking into account the current small fair value increase, Rio Tinto is pricing in the equivalent of approximately $39 per tonne iron ore in perpetuity, versus our $30 per tonne base case. This assumes all commodity prices increase proportionally from the base case, and that Rio Tinto retains half of the benefit of the rise in commodity prices, as was the case during the China boom, with the other half lost through increased production costs.
Guidance for iron ore shipments is lowered marginally from 330 million tonnes to 325 to 330 million tonnes due to maintenance. As usual, the summer cyclone season may impact the final result. Copper guidance was also lowered from 545,000 to 595,000 tonnes to a range of 535,000 to 565,000 tonnes. Rio Tinto’s expectation for diamond production is also slightly lower.
