Rio Tinto Irons Out Production Guidance

| About: Rio Tinto (RIO)
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We aren’t expecting a sustained rebound in metal prices soon, and judging by its planned capital expenditure cuts, Rio Tinto sees a similar scenario unfolding.

A poor read of Chinese trade data in the month of September has added to the negative sentiment surrounding the iron ore and steel markets around the globe.

Rio Tinto’s relative balance sheet strength compared to its peers has been one of the biggest reasons why we like the company.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

By The Valuentum Team

Rio Tinto (NYSE:RIO) looks like it's on its way to recovery, but we aren't expecting a sustained rebound in metal prices soon. Judging by its planned capital expenditure cuts, Rio Tinto sees a similar scenario unfolding. The firm recently cut its full-year 2016 guidance for iron ore shipments from its Western Australian Pilbara operations by up to 5 million tons following weak third quarter production results. Calendar 2017 guidance remained unchanged in a range of 330-340 million tons.

A poor read of Chinese trade data in the month of September has added to the negative sentiment surrounding the iron ore and steel markets around the globe, and we don't expect Rio's production guidance cut to make a meaningful difference in the current oversupply in the iron ore market. Supporting such a stance are reports that the world's two largest iron producing countries, Brazil and Australia, are expected to add ~100 million tons of supply to the global market by 2020.

But what does all of this mean for our opinion of Rio Tinto, a former holding in our Best Ideas Newsletter portfolio?

Rio Tinto's relative balance sheet strength compared to its peers has been one of the biggest reasons why we like the company, as it plays a key role in its ability to maintain healthy operations throughout the business cycle. Despite commodity price weakness, Rio has been able to buoy its free cash flow thanks to material reductions in capital expenditures.

The firm's dividend policy had been to increase or at least maintain its payout in US dollar value, but that has all changed. The impact that weakened commodity prices have had on its operations and its dividend have proved too much. Management is targeting a full-year dividend for 2016 of just $1.10+ per share, a large cut from previous years. At the time, the company's Dividend Cushion ratio effectively warned investors of the risks of the payout and remains subdued at 0.8.

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Image source: Valuentum

Rio Tinto's Investment Considerations

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Investment Highlights

• 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. Rio is based in London, the United Kingdom.

• 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. Rio's operational focus is noteworthy.

• 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. Rio's net debt position isn't great at more than $13 billion, but it has fallen from ~$22 billion in mid-2013.

• 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.

• Iron ore and copper prices have been under pressure as of late, and Rio Tinto has not been spared the pain. However, the company has been preparing for such a downswing for some time, and it is better positioned than most of its peers as a result.

Business Quality

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Economic Profit Analysis

In our opinion, 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 18.4%, which is above the estimate of its cost of capital of 9.1%. 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.

Image source: Valuentum

Image source: Valuentum

Cash Flow Analysis

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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 10.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

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. At Rio Tinto, cash flow from operations decreased about 38% from levels registered two years ago, while capital expenditures fell about 64% over the same time period.

Valuation Analysis

We think Rio Tinto is worth $37 per share with a fair value range of $28-$46.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 0.5% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -11.9%.

Our model reflects a 5-year projected average operating margin of 11.4%, 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 3.2% for the next 15 years and 3% in perpetuity. For Rio Tinto, we use a 9.1% weighted average cost of capital to discount future free cash flows.

Image source: Valuentum

Image source: Valuentum

Image source: Valuentum

Margin of Safety Analysis

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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 $37 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 were 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 above, we show this probable range of fair values for Rio Tinto. We think the firm is attractive below $28 per share (the green line), but quite expensive above $46 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

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We estimate Rio Tinto's fair value at this point in time to be about $37 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above 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 $46 per share in Year 3 represents our existing fair value per share of $37 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.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

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.