Rio Tinto: Leave It Alone

| About: Rio Tinto (RIO)

Summary

Poor sector outlook.

Lack of value/margin of safety.

Not an ideal short target.

Rio Tinto (NYSE:RIO) is not a stock which I would include in my portfolio today. That said, it is also not an ideal short target for those who are bearish on China or the global mining sector.

Poor sector outlook

Rio Tinto derives its majority of operating cash flows from Iron Ore (>50%), Aluminum (30%) and Copper (10%). In writing this section, I refer to reports published by Wood Mackenzie (Iron Ore, Aluminum, Copper), Resources & Energy Quarterly from the Australia's Department of Industry, Innovation & Science and management statements from Rio Tinto.

Iron Ore

Iron ore spot prices (FOB Australia) staged an unexpected rebound through July and August this year to US$54/TE, up 14% year on year. This is mainly due to strong demand from China's steel sector, underpinned by credit-fuelled resurgence of the property markets.

Most market forecasters have a bearish outlook on prices, as the demand resurgence due to China's construction boom is unlikely to sustain for long. Further growth in low cost supply is expected, hence prices will have to fall to force out high cost supply. Prices are expected to remain at depressed levels for at least ten years, as there is no requirement to incentivize additional supply prior to 2030.

Aluminum

The London Metal Exchange (LME) aluminum prices have increased 9% year to date, mainly due to production cuts across China, Russia and the US as well as stronger-than-expected demand globally.

In the near term, prices are expected to strengthen mildly, as strong demand, especially from the automotive sector, outweighs increased production from capacity restarts in China. Over the medium term, however, multi-year surpluses through 2019 are expected to place a cap on any potential upside.

Copper

The LME copper prices were down 17% year on year over the first three quarters. This is the result of slowing consumption growth and increased production capacity.

Prices are expected to trend higher moving forward, supported by stronger economic growth and in anticipation of emerging deficits from 2021.

Conclusion

Rio Tinto is a stock which provides an 'old economy' exposure to China. While it is difficult to predict whether China is bound for a hard landing, the Chinese government has no other choices but to orchestrate rebalancing towards a service-based economy. Any credit-side expansion is going to be cautious, i.e. the ongoing property boom is likely to run out of steam soon. The only commodity with a favourable supply outlook is copper, however, it only accounts for 10% of Rio Tinto's business.

Given this, I would rather seek China exposure through 'new economy' stocks, such as internet, consumer, healthcare and insurance.

Lack of value/margin of safety

Since its Jan. low, Rio Tinto has rebounded approximately 46% in USD terms.

In Table 1-2, I attempted a back-of-the-envelope calculation to estimate the fair value of Rio Tinto. Based on an aggressive set of inputs, the upside/margin of safety is only 7.9% at the current market capitalisation. This is certainly not enough, given the poor sector outlook as discussed above.

I might only consider to go long on Rio Tinto if there is a margin of safety of at least 35%, that is, a share price decline of at least 30% from the current level.

US$b

Note

Operating cash flow

7.8

Consensus FY17 projection from Vuma

Sustaining CAPEX

2

Management disclosure

Sustainable free cash flow

5.8

Value of ongoing production

62.4

Assume perpetuity, WACC = 9.3%

(Aggressive assumption)

Click to enlarge

Table1. Author's estimate of ongoing production value

US$b

Note

Value of ongoing production

62.4

From Table 1

Disclosed new projects

15.0

Amrun, OT, Silvergrass; NPV estimated from IRR>20%

Net debt

-12.5

Fair value

64.9

Upside/margin of safety

7.9%

Based on market cap US$60.1b as at 16 Oct. 2016

Click to enlarge

Table 2. Author's estimate of fair value and margin of safety

Not an ideal short target

However, Rio Tinto is not an ideal short target even for the biggest of China bear, for the following reasons:

  • It is a competitive, low-cost producer across its main businesses
  • Post commodity boom, there has been a proactive approach to reduce costs and focus on capital efficiency
  • Balance sheet is relatively strong.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.