Fair Value Estimate: 5000p | Uncertainty Rating: Medium | Economic Moat: Narrow
Thesis (Last updated 21/12/10)
Rio Tinto (RIO) is a top-tier global miner along with BHP Billiton (BLT), Brazil's Vale (VALE), and UK-based Anglo American (AAL). A world-class asset base and capable management make Rio one of the few miners to earn more than its cost of capital through the commodity cycle. Geographic and product diversification give Rio relatively stable cash flows and lower operating risk than many of its mining peers. Most revenue comes from the relative safe havens of Australia, North America, and Europe, though operations span six continents.
Through selective acquisitions and grass-roots exploration, Rio has assembled a large portfolio of long-lived, low-cost assets. Operations include world-class hubs in aluminium, coal, copper, diamonds, gold, iron ore, industrial minerals, and uranium. This competitive resource base sets Rio apart from most of the rest of the pack and supports returns above average for both the resource industry generally and its more select diversified mining peers.
Rio's operating practices are geared toward creating long-term economic value; the company is constantly seeking efficiency improvements. Planning horizons and existing operations ensure average production levels should be sustained for at least 20 years. The company has a portfolio of quality projects under development or appraisal and a focused exploration programme to seek out and secure new opportunities for profitable expansion. A more recent focus on Alcan-related debt reduction saw much new investment on the back burner. The strategic partnership with Ivanhoe Mines (IVN) to develop its Oyu Tolgoi copper and gold deposits enhances Rio's portfolio. Oyu Tolgoi is the largest undeveloped copper deposit in the world.
The board came under criticism for leveraging up the balance sheet to acquire Alcan immediately ahead of the credit crisis. Planned asset sales were late to be realised, necessitating drastic expenditure cutbacks. A $15 billion entitlement issue significantly reduced balance sheet pressure.
Rio has limited pricing power over most of its products. The notable exception is in iron ore, where, along with BHP and Vale, Rio is a member of the global seaborne export oligopoly with 25% market share. Minimal pricing power is aggravated by the volatile and cyclical nature of commodity prices. However, we do ascribe a narrow economic moat to Rio, given the firm's large, low-cost, and nonreplicable operations. The lack of comparable megadeposits and increasingly prohibitive capital costs are barriers to entry.
Valuation
We've increased our fair value estimate to 5,000p from 4,930p. We upped our 2011 and 2012 iron ore price forecasts 16% and 7% to $126 per tonne and $103 per tonne, respectively. Ongoing strength in Chinese demand and spot iron ore price rises prompted the change.
BHP and Rio Tinto terminated their proposed Pilbara iron ore production joint venture. Next year's gearing for Rio Tinto will be higher without BHP's $5.8 billion equalisation payment. Despite all of this, the impact on earnings and valuation is relatively minor.
For near-term earnings in the context of currently very high iron ore prices, the greater equity share of production is more meaningful than the foregone JV equalisation payment from BHP.
But in the longer term--more meaningful from a valuation perspective--the foregone savings from capital expenditure synergies is more important. Infrastructure spend will now necessarily be duplicated. Key long-term assumptions are $60 per tonne iron ore, $70 per tonne thermal coal, $2.50 per pound copper, $1.10 per pound aluminium, an Australian dollar/US dollar exchange rate of 0.80, and a 10% discount rate.
Risk
Significant environmental and operating risks are associated with mining. Some of the company's assets have country-specific risks. Overall, Rio offers broad diversification, low costs, and strong financial position. Because of the volatility in the underlying commodity prices, we think our fair value estimate carries a medium uncertainty rating.
Management & Stewardship
Tom Albanese became CEO in May 2007, taking over from Leigh Clifford. Albanese, 51, is the first US citizen to lead the company. He was appointed to the board in 2006 as director of group resources, which is responsible for exploration, operational and technical excellence, human resources, communications and external relations, and global business services. Jan du Plessis fills the chairman role, having replaced Paul Skinner in April 2009. He is chairman of British American Tobacco (BATS), a nonexecutive director of Marks & Spencer (MKS), and was previously nonexecutive director and then chairman of the audit committee of Lloyds TSB (LLOY).
Overview
Financial Health: The Alcan acquisition in 2007 saw interest coverage plummet to 5 and leverage rise to 172%. A $15 billion entitlement issue, asset sales and strong cash flows have returned debt to very comfortable sub 20% levels.
Profile: Rio Tinto searches for and extracts a variety of minerals around the world, with the heaviest concentrations in North America and Australia. Major products include aluminium, copper, diamonds, energy products, gold, industrial minerals, and iron ore. The 1995 merger of RTZ and CRA, via a dual-listed structure, created the present-day company. The two operate as a single business entity. Shareholders in each company have equivalent economic and voting rights in Rio as a whole.
Bulls Say
-- Rio is one of the direct beneficiaries of the increasing appetite for natural resources in China. The company's alumina, coal, and iron ore operations in Australia in particular should benefit.
-- The company is run exceptionally well and enjoys a broad portfolio of first-class, low-cost assets.
-- The company is inherently less risky than pure plays because of its broadly diversified natural-resources asset base.
-- Rio is more profitable than some of its competitors in a host of commodities, and we forecast it to at least earn its cost of capital.
-- The company's positioning in new technologies, including steelmaking and hydrogen, bodes well
Bears Say
-- Demand for natural resources in China may have peaked, and the Chinese economy could begin to cool off.-- Diversified miners always trade at discount valuations to pure plays. Investors interested in gaining exposure to a specific commodity would be better off investing in pure plays.
-- Although diversification is an important advantage for Rio, the company is subject to the long-term supply/demand balance for metals, a bigger factor in determining its profitability.
-- Rio is top-heavy in iron ore and needs more balance in its product mix.
-- Rio paid too much for Alcan, and its capacity to fund growth projects will be affected for the medium term.
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