Concerns Of Iron Ore Oversupply Weigh On Rio Tinto

| About: Rio Tinto (RIO)

Over the past several weeks, the diversified mining sector has been under attack, as Vale (NYSE:VALE), BHP (NYSE:BHP) and Rio Tinto (NYSE:RIO) have seen their share prices decline considerably. Given the relative performance of the S&P 500, as well as improving macro fundamentals in the United States, the decline may seem inexplicable - until we consider the dynamics of the iron ore industry.

Iron ore (one of the most important and profitable commodities in recent years) prices rose over 60% in relatively short order during the beginning of the year, suggesting robust demand from China. However, China responded aggressively to the rise in prices, accusing the big three of iron ore mining (Rio, BHP, and Vale) of manipulating prices by artificially limiting iron ore supplies while Chinese steel mills ramped production. Prices have subsequently fallen more than 10% of the peak.

Prices in the range of $130-$145 should be strong enough to support strong cash flow generation, in our view, and the range is slightly lower than where the market is currently situated. Unfortunately, strong prices may not hold. Rio Tinto's Pilbara iron ore President Greg Lilleyman anticipates prices to fall in the back half of 2013, saying:

"We are going to see a number of projects bring supply on in the second half of this year around the globe. Inevitably that is going to put some downward pressure on iron ore prices."

Supply remains the largest threat to Rio's profitability and cash flow because significant mining supply is coming online at Rio, Vale and Anglo American's Minas Rio project. In effect, large amounts of iron ore supply could come to market at the same time demand growth moderates to reflect less robust demand from China. While certainly a valid concern, we think these fears may be slightly overblown and underestimate other emerging markets' role in consumption. Further, Chinese real estate steel demand growth may decelerate, but the country will still add several millions of cars to the road over the next decade. Vale's CFO concluded that long-term, prices are likely to fluctuate between $110 and $180 per metric ton, strong enough for Rio and other low cost miners to earn positive operating margins. We've provided a sensitivity analysis on iron ore prices below. (Revenue, operating earnings, production in millions).

Source: Valuentum, Rio Tinto annual filings

While clearly the $155 price level is most attractive for Rio shareholders, we can see that the firm will likely generate strong operating earnings even in a bear-case scenario for iron ore prices. Assuming the company exercises prudence over capital expenditures, and cash flow could also remain strong.

Although we think Rio can earn plenty of money even if iron ore prices shrink, we also believe the company has ample flexibility to divest of its non-core assets in the event that it needs to raise cash - though we see no near-term liquidity issues. The Diamonds and Minerals segment has long been rumored to have its uranium assets on the chopping block, as new CEO Sam Walsh indicated he wants to clean-up the firm's assets after years of disparate acquisitions. More recent news indicates that the diamond business and New Zealand iron sands are also for sale. It should be noted that BHP and Anglo could also look to divest of disparate assets, so asset valuations could be relatively depressed compared to previous purchase prices.

Overall, while we are not particularly fans of the commoditized mining sector, Rio possesses new management, the potential for an additional $5 billion in cost-savings, and an already compelling cost curve position, leaving its shares undervalued. We think the market is pricing in iron ore prices having a more devastating impact on operating income than our analysis suggests. We continue to hold shares of Rio Tinto in the portfolio of our Best Ideas Newsletter, though we have slightly lowered our fair value to reflect lower iron ore margins in the future.

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: Valuentum holds shares of Rio Tinto in the portfolio of its Best Ideas Newsletter.

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