A Look At Rio Tinto's Iron Ore Exposure

Aug.25.12 | About: Rio Tinto (RIO)

This article will cover the exposure of Rio Tinto plc (NYSE:RIO) to the present iron ore pricing collapse, in the same manner as my previous article on BHP Billiton Limited (NYSE:BHP).


Although Rio Tinto also has some mineral diversification, much like BHP Billiton, iron ore is a much more important part of its business. Using 2011 full-year results, iron ore represents 49% of RIO's revenues and 83% of its underlying earnings. Worse still, using the most recent H1 2012 data, iron ore represents a full 92% of RIO's underlying earnings (sources: 2011 annual report, H1 2012 presentation).

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Average selling price and breakeven

RIO had $29.9 billion in 2011 iron ore revenues and $12.9 billion in iron ore underlying earnings. For an overall production of 245 million tons, this gives us an average selling price of $122.1 per ton. Taking into account that the underlying earnings represent a margin of 43%, this would mean the underlying earnings' breakeven point for RIO would be $69.6 per ton. However, the underlying earnings are after tax. If we consider a 30% tax rate, then the margin becomes 61.4% and the breakeven point is $47.1, comparable to BHP's EBIT breakeven point ($46.9).

RIO had net underlying earnings before one-off items of $15.5 billion during 2011, which gives us an EPS of $8.38. At the present quote, $46.0, that's good for a P/E of 5.5, which already shows us how the market is punishing RIO for its large iron ore exposure and lack of effective diversification - that is, the diversification exists (half the revenues come from outside iron ore), it just doesn't have an expression in terms of earnings.


There's a bit of a problem here. In its annual report, RIO puts the impact of a 10% move on iron ore prices at $1.7 billion in underlying earnings. In its H1 2012 presentation, however, RIO reduces this to $1.073. This seems rather inconsistent since the share of underlying earnings represented by iron ore actually went up between the end of the year and the end of H1 2012. Seeing that the $1.073 figure isn't realistic, I will use the larger figure from the annual report (it might happen that the $1.073 is a typo as moving the "7" one position would make it about the same as in the annual report).

With RIO's average selling price for last year hovering around $122, a drop to $100 would be a drop of 18%, and to $80 would imply a drop of 34.4%. The underlying impact as per RIO's calculation would be around $3.06 billion for the drop to $100, and $5.85 billion for the drop to $80.

So iron ore at $100 per ton means a 19.7% hit to earnings, and at $80 means a 37.7% hit to RIO's earnings. It's important to take into account that this is just from iron ore, and many other minerals in RIO's book are be correlated to iron ore and dropping along with it. Also, a realized price of $100 per ton for RIO/BHP means a slightly higher selling price in China, so $100 is somewhat optimistic at this point.


RIO's H1 2012 earnings show the importance of iron ore, with 92% of RIO's underlying earnings coming from it. Overall, RIO seems to have iron ore margins comparable to BHP's, but a less efficient diversification strategy, which ends up making it much more reliant on iron ore.

The market is already punishing RIO due to this exposure, as can be seen from the much lower valuation multiples it trades at. At this point I'd expect RIO to continue falling as iron ore drops, but it's also clear that RIO's low costs will make it one of the survivors if the market is subjected to a shakeout.

In light of this analysis, I believe that shorting AUD/USD (CurrencyShares Australian Dollar Trust ETF: FXA), given Australia's exposure to iron ore, makes for a better trade than shorting either RIO or BHP. I wouldn't recommend buying RIO or BHP, though.

One final observation, directly from BHP's presentation, which I also made on BHP's article regarding the same theme:

"Going forward, therefore, those who invest in iron ore should do so in the full knowledge that supply will meet demand in due course and that the scarcity pricing that we have seen over the last 10 years is unlikely to be repeated."

Disclosure: I 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.

Additional disclosure: I am short AUD/USD.