Buy This Miner Before It Strikes Gold In Mongolia

Oct.30.12 | About: Rio Tinto (RIO)

Rio Tinto's (NYSE:RIO) business in Mongolia has never been smooth, and the recent arrest of an employee only seems to make matter worse. However, Rio Tinto's tumultuous presence in Mongolia may not necessarily be a liability for the company, and I have reasons to believe that recent incidents in Mongolia will not affect the company's fundamentals in a negative way. While the current scenario is certainly shaky in that country, it is always wise to understand the background of the problem to predict future outcomes. Before I proceed further with my thesis, I would just like to state my opinion that Mongolia does not have a choice but to compromise and adhere to agreements once signed with foreign oil companies including Rio Tinto, and it will.

The transition from a communist government to a democratic one has historically been spectacular in most countries. In Russia, the fall of the Soviet Union was dramatic, under the rule of Mr. Gorbachev and what followed was not something very pleasant. The Russian economy never grew and the divide between the wealthy and the poor only increased, thanks to corruption. In Romania, the dictator was shot dead right in front of his palace dramatically but what ensued after that has hardly been spectacular.

In Mongolia too, the sudden transition from being a communist country under the shadow of China and Russia to being an isolated mineral-rich Central Asian country was spectacular. That certainly grabbed the attention of all those major oil and gas corporations and mining corporations and they soon set up their shops in Mongolia. However, just like in other former communist countries, corruption, red tape and bureaucracy continue to be major issues in Mongolia. The country is not as innocent, minimalist and beautiful as its landscape is, and is plagued by corruption, favoritism and plain fraudulent activities.

Rio Tinto has been working amidst this mess in Mongolia for a long time, and has encountered its share of problems there. Oyu Toolgoi's copper-gold mine is owned by the Mongolian government and Turquoise Hill Resources (NYSE:TRQ). Turquoise Hill Resources owns a share of 66% in the mines, whereas the government owns 34%. Rio Tinto is the majority owner of Turquoise Hill Resources and has been extremely guarded about Mongolian activities within the country.

Rio Tinto officials have refused to be entrapped in bizarre negotiations in which the government is likely going to force Rio to give up a part of its 66% share. While the government asks for a total of 50% in the Oyu Tolgoi mines, the matter will not rest there. I believe the Mongolian government will convince and coerce Rio Tinto officials to part with 17% of the 66% share, so that the government can own a majority of the mines.

The latest from the land of confusion is that Sarah Armstrong, an Australian lawyer and an employee of SouthGobi Resources (a subsidiary of Rio Tinto) has been detained and not allowed to leave Mongolia. SouthGobi Resources is embroiled in an anti corruption investigation headed by Mongolia's new government that was elected a few months ago. The new government has been particularly antagonistic towards companies that were friendly with the previous government. Every employee of SouthGobi Resources left Mongolia to Hong Kong except Sarah Armstrong. Her fate will be decided in the next few weeks amidst high level talks between Australian and Mongolian governments, and Rio Tinto executives.

The pattern in which these former communist countries behave is pretty clear. Most of these countries started out as poverty stricken, resource-rich and corrupt nations. They evolved into countries with higher levels of poverty than before, more corruption and non-utilization of resources. Foreign investment in countries like Mongolia has done little.

Rio Tinto's mines were not able to function because of lack of electricity (China refused to part with its share of electricity). The complex nature of former communist nations, corruption and red-tape that still exist in these countries and the depressing culture of unquestioning acceptance of authority and rigid hierarchies within their societies will ensure a lengthy and complicated challenge for foreign companies like Rio Tinto.

Rio Tinto is not the only mining company that is challenging the adversities posed by Mongolian government. VALE (NYSE:VALE) recently announced that it would start drilling in Mongolia for copper and gold in September. VALE is planning to use many of the mining techniques that it developed in the Amazon region, in Mongolia. VALE hopes to compete with Rio Tinto and establish its own presence in the Central Asian country.

AngloGold Ashanti (NYSE:AU) has plans of mining gold in Mongolia too, and has already begun work on that front. It may well be on its way to becoming one of the regional leaders in mining gold, which Mongolia is rich in. Barrick Gold (NYSE:ABX) is not out of the scene either. It acquired a stake of 9.5% in QGX, which is a pioneer of gold exploration in Mongolia. Though this happened way back in 2003, it continues to be one of the major players in Mongolia.

Both Barrick and AngloGold have faced problems in Latin America, with regard to infrastructural issues. BHP Billiton (NYSE:BHP) closed its office in Mongolia and cleared the path for Rio Tinto. BHP faced a number of challenges in Mongolia, forcing it to close its operations. On the other hand, Rio Tinto is forging ahead in Mongolia in spite of several problems and confusions that exist at the moment.

Rio Tinto currently trades at $50 and has a market cap of $92 billion. With an enterprise value of $105 billion, it is one of the largest and most important mining companies in the world. The company has a profit margin of 7.26% and an operating margin of 31.88%. The company has a return on assets to the tune of 9.30% and a return on equity to the tune of 7.12%. With a total cash of $7.77 billion and a total debt of $21.18 billion, Rio Tinto is no stranger to fiscal issues.

However, with an operating cash flow of $14.69 billion and levered free cash flow of $299.75 million, it is in a very strong position at the moment. Now is the right time to invest in Rio Tinto as eventually it will strike gold in Mongolia. According to a recent report from Bloomberg, "The Oya Tolgoi mine in Mongolia's Gobi Desert is one of the world's biggest copper and gold discoveries."

Once the current fiasco ends, Rio Tinto will outgrow most of its competitors, and that is a good sign for investors.

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.