Morningstar equity analysts have upgraded their fair value estimate for Rio Tinto (RIO) to £27.70 per share from £26.10. The increase reflects better short-term earnings forecasts, primarily due to very strong commodity prices, particularly iron ore and metallurgical coal in the past few months. The higher forecasts for iron ore, metallurgical coal, and copper prices in 2018 and 2019 also provide a boost.
Our fair value uncertainty rating is high, reflecting operating leverage and cyclical commodity prices. Significant environmental and operating risks are associated with mining, and some of the company's assets have country-specific risks Rio Tinto has low operating costs and a sound balance sheet, but faces the cyclicality of commodity prices, high capital intensity, and poor capital allocation.
We expect capital allocation to improve in the future, given much lower levels of cash available for investment after the China commodities boom. However, the resources industry is still capital-intensive, and cyclicality provides ample opportunity for management to invest at the wrong points in the cycle.
Rio Tinto's financial position is relatively strong. The progressive dividend policy was canned in 2016, providing important additional flexibility.
Investment Thesis
Rio Tinto is one of the world's biggest miners, along with BHP Billiton, Brazil's Vale, and U.K.-based Anglo American. Above-average assets relative to peers mean Rio Tinto is one of few miners profitable through the commodity cycle. Most revenue comes from the relatively safe havens of Australia, North America, and Europe, though the company has operations spanning six continents.
Rio Tinto has a large portfolio of long-lived assets with low operating costs. Operations include aluminium, coal, copper, diamonds, gold, iron ore, industrial minerals, and uranium. This base sets Rio Tinto apart from most peers.
However, the invested capital base was inflated by substantial procyclical investment during the height of the China boom, the rot setting in by overpaying for Alcan, and subsequent excessive iron ore expansion; the combination of these factors means that returns are likely to remain below the cost of capital for the foreseeable future.
