Analyst Note
Rio Tinto (RIO) generated record underlying fiscal 2010 earnings of $14.0 billion that came in 3.5% ahead of our $13.5 billion forecast--a very pleasing result, particularly from iron ore where earnings before interest and tax (EBIT) increased 150% to $15.6 billion. This division performed better than we anticipated, thanks to operating costs and rampaging prices. Iron ore unit costs rose a softer than expected 26% to $38 per metric ton, considerably less in Australian dollars. Compare that to the average $127 per metric ton price achieved--an 80% increase on fiscal 2009--or current $170 per metric ton freight on board spot prices. Iron ore earnings before interest, tax, depreciation, and amortisation (EBITDA) margin rose from an already impressive 57% to 70%. And the first half of 2011 is shaping up even better.
Iron ore more than offset mild underperformance from aluminium, copper and industrial minerals. By underperformance we mean falling short of our forecast. The worst in this regard was aluminium, though copper was more meaningful from a larger base. It should be stressed that both are considerably improved on full-year 2009, copper EBIT up 34% to $4.2 billion, and aluminium turning the corner from negative $1.0 billion EBIT to a $0.8 billion profit. This is still nowhere near good enough for aluminium and Rio has flagged further divestment. That said, we expect the fortunes of the light metal to improve due to delinking of alumina prices, a key aluminium input. A higher alumina price, reflective of underlying fundamentals, will lead to higher aluminium prices, just as higher energy prices will. Every $0.05 per pound move in aluminium price shifts our Rio earnings and valuation by 1% and 4%, respectively.
Group net operating cash flow doubled to $18.1 billion and net debt declined to $4.4 billion, gearing just 7%. Assisting was a decline in capital expenditure from $5.4 billion to $4.6 billion--both years low in the historical context--and a further $2.9 billion in noncore asset sales, a turnaround from a 200% gearing just 18 months ago. With a balance sheet like this, Rio can reward shareholder loyalty which included having to fork out $15 billion in 2009's entitlement issue. The company upped the final 2010 dividend from $0.45 to $0.63, well ahead of expectations, and announced a $5 billion share buyback by end 2012. This is still modest compared to current cash flows and will allow ample for growth expenditure. There is $12 billion of capital works approved, two thirds in the Pilbara. And Rio's $3.8 billion bid for Riversdale remains open. The dividend sets a new benchmark in the "progressive" policy, interrupted in 2009. We raise our valuation marginally and forecast a 30% increase in fiscal 2011 profit.
Thesis (Last Updated 14/02/11)
Rio Tinto 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 Tinto one of the few miners to earn more than its cost of capital through the commodity cycle. Geographic and product diversification give the company 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 Tinto 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 Tinto apart from most of the rest of the pack, and supports above-average returns for both the resource industry generally, and its more select diversified mining peers.
Rio Tinto's operating practices are geared toward creating long-term economic value. The company is constantly seeking to enhance efficiency. 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 program to seek out and secure new opportunities for profitable expansion. A more recent focus on Alcan-related debt reduction saw much new investment relegated to the back burner. The strategic partnership with Ivanhoe Mines (IVN) to develop its Oyu Tolgoi copper and gold deposits enhances Rio Tinto's portfolio. Oyu Tolgoi is the largest undeveloped copper deposit in the world.
Rio's board came under criticism for leveraging up the balance sheet to acquire Alcan right at the cusp 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, and Rio Tinto is now conservatively geared.
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 assign a narrow economic moat to Rio Tinto, given the firm's large, low-cost, and nonreplicable operations. The lack of comparable mega-deposits and increasingly prohibitive capital costs pose barriers to entry. Additionally, some pricing power outside of iron ore is shifting toward producers, including in aluminium and copper, though to a lesser extent.
Valuation
We're raising our fair value estimate to 4,921p from 4,800p per share following a pleasing fiscal 2010 earnings result. Higher near-term iron ore price forecasts and longer-term aluminium prices are positives. For iron ore, we raised first-half calendar year 2011 13% to $153 per metric ton, second-half calendar year 2011 6% to $143 per metric ton, first-half calendar year 2012 11% to $134 per metric ton, and second-half calendar year 2012 3% to $124 per metric ton. Our long-term aluminium price forecast increases 8% to $1.30 per pound. We don't believe $1.07 per pound spot reflects realistic longer-term fundamentals.
These price increases positively impact near-term earnings forecasts. Our fiscal 2011 forecast is marginally higher, up 4% to $20.5 billion, capturing that strong iron ore pricing. Our fiscal 2012 earnings forecast of $20.8 billion reflects higher volumes offset by some contraction in commodity prices. Key long-term valuation assumptions are $70 per metric ton iron ore, $70 per metric ton thermal coal, $2.50 per pound copper, $1.30 per pound aluminium, a long-term 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 Tinto offers broad diversification, low costs, and a 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, 52, 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. It is widely accepted that Rio Tinto overpaid for Alcan, impacting its capacity to fund growth projects and putting it at unwarranted risk during the global financial crisis. Albanese has been identified as the architect of the inauspicious purchase. 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 company is now on strong financial footing. Returns on invested capital have averaged 15% during the last five years, and head back toward 20% following fiscal year 2009's aluminium-impacted 9%. Rio Tinto has now largely sold the lower-margin, noncore aluminium assets held longer than expected due to the global financial crisis. Five-year average EBITDA margin is a healthy 30%, and is currently rising.
Profile: Rio Tinto searches for and extracts a variety of minerals worldwide, 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 RTS 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 Tinto is one of the direct beneficiaries of the increasing appetite for natural resources in China.
-- Rio's cash flow base is diversified, and the company is less susceptible to the vagaries of the market than single-commodity producers are.
-- The company is run exceptionally well at the asset level, and enjoys a broad portfolio of first-class, low-cost assets.
-- Growing producer concentration is slowly tipping pricing power away from the end user toward miners like Rio.
-- As staple commodities for developing nations, prices for iron ore and copper in particular are performing very strongly. Two thirds of Rio's value derives from iron ore and copper.
Bears Say
-- Sovereign risk heightened following the Australian government's intended Resource Super Profits Tax. The softer replacement Mineral Resource Rent Tax has reduced, but not erased, this risk.
-- The global economy is cooling off. Demand for natural resources in China may have peaked, and the Chinese economy could begin to cool off.
-- Diversified miners' stocks 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.
-- Rio is subject to the long-term supply/demand balance for metals, the major factor in determining the company's profitability. Rio is top-heavy in iron ore, and needs more balance in its product mix.
-- Chinese minerals investment, for production rather than profit's sake, risks eroding some of the limited pricing power mining companies have more recently won.
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