Why Rio Tinto Has Significant Valuation Upside

Jun.14.14 | About: Rio Tinto (RIO)

Summary

We are very selective when it comes to adding any commodity-equities exposure to our newsletter portfolios.

Rio Tinto is trading on the cusp of the low end of its fair value range, and the firm is attractive on a relative valuation basis.

We include Rio Tinto in the Best Ideas portfolio, which continues to perform well.

Commodity-driven equities are a unique breed. Though most mining firms, especially in the class of BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO), boast hefty operating margins, the volatility of their performance through the course of the economic cycle is undeniable. The mining industry continues to work toward shoring up their balance sheets and scaling back capital spending in anticipation of lower commodity prices, particularly of the iron-ore variety, but cyclical performance will always be inescapable. Regardless, we applaud these prudent financial moves by management and point to Rio Tinto as our favorite valuation idea within the diversified mining space.

For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas - as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.

We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF - that's why we focus on relative value - and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.

At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Rio Tinto posts a Valuentum Buying Index score of 7, reflecting our "fairly valued" DCF assessment of the firm, its attractive relative valuation versus peers, and very bullish technicals. Importantly, and as we will show below, Rio Tinto is trading at the lower end of its fair value range. If the firm's equity were to breach the lower bound of the range and then reveal strengthening pricing support, shares would register one of the highest ratings on the Valuentum Buying Index, a 9. We tend to hold highly-rated firms of a 9 or 10 in very high regard and may look to add to the position in Rio Tinto in the Best Ideas portfolio under that scenario.

Rio Tinto's Investment Considerations

Investment Highlights

• Rio Tinto earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 29.8% during the past three years.

• Rio Tinto is one of the world's largest miners. The firm is a global leader in the aluminum industry and the second-largest producer supplying the global seaborne iron ore trade. It also has copper, diamonds, and coal operations.

• We continue to like Rio Tinto's decision to strengthen its balance sheet by enhancing cash flows and reducing capital spending. A focus on debt repayment is also welcome news for long-term investors.

• We're big fans of the firm's Australian Pilbara operations, which have close proximity to some of the world's largest and fastest-growing markets for iron ore. The company also has a nice position on the cost curve for aluminum smelting, and its copper assets are of high quality.

• Rio Tinto understands that cost-containment is the name of the game in any commodity-producing industry. Through improved crane scheduling and rationalized training, productivity has improved materially.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Rio Tinto's 3-year historical return on invested capital (without goodwill) is 29.8%, which is above the estimate of its cost of capital of 11.4%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Rio Tinto's free cash flow margin has averaged about 2.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Rio Tinto, cash flow from operations decreased about 44% from levels registered two years ago, while capital expenditures expanded about 5% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Rio Tinto's shares are worth between $51-$85 each. At the time of this writing, shares are trading at just under $52 each, roughly at the low end of the fair value range and implying significant valuation upside potential. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $68 per share represents an implied EV/EBITDA multiple of about 6.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 6.5% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -3.3% (negative 3.3%). Our model reflects a 5-year projected average operating margin of 18.1%, which is below Rio Tinto's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.9% for the next 15 years and 3% in perpetuity. For Rio Tinto, we use a 11.4% weighted average cost of capital to discount future free cash flows.

We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers - those that drive stock prices - pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Rio Tinto to peers BHP Billiton and Cliffs Natural (NYSE:CLF), among others.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $68 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Rio Tinto. We think the firm is attractive below $51 per share (the green line), but quite expensive above $85 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Rio Tinto's fair value at this point in time to be about $68 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Rio Tinto's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $85 per share in Year 3 represents our existing fair value per share of $68 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.