Rio Tinto And Vale - A Tale Of Two Iron Giants

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About: Rio Tinto plc (RIO), VALE
by: Aitezaz Khan
Summary

RIO's iron ore business on the verge of expansion.

VALE's strong footprints in the iron mining space.

Review of RIO's diamonds business.

In my last submission on Rio Tinto Plc (RIO), I gave an overall viewpoint on RIO's four business segments and indicated the strong resource fundamentals possessed by the company that indicated a positive future outlook. I also included a brief discussion on RIO's iron ore operations, and emphasized the need to diversify investment in other resources due to depressed iron ore prices at that time. However, recently the iron ore prices have witnessed a healthy recovery and I believe it's high time to revisit the RIO iron case.

Investor Takeaway:

The focal point of this discussion will be a comparison of iron mining activities of Rio Tinto and its competitor VALE S.A (VALE). Given that iron prices are currently on an uptrend due to increased demand from China, they will cast a positive impact on the profits of both companies. However since RIO's iron assets have a strategic advantage over VALE due to their location, I believe RIO can derive comparatively higher EBITDA margins from this business segment. The position of RIO's EBITDA margins will be further strengthened by the fact that RIO is planning to dispose of its Canadian iron operations that will enable it to focus on the Australian operations (and closer to its main iron ore market in Asia). Finally, this article will also discuss addition of a new diamond pipeline in Rio's Canadian diamond mine that would help increase the diamond output for the next half decade.

RIO's iron ore business on the verge of expansion:

In FY 2017, RIO's iron ore operations alone accounted for 44% of its revenues and were and continue to be a significant operating segment. Luckily, RIO can continue its dependence on iron ore for the foreseeable future. RIO's iron assets are mainly located in the Pilbara region (Australia).

Good times for iron producers:

Iron ore prices are currently on an uptrend and moving close to the $70/t mark. The graph below indicates that the 62% Fe prices moved ~5% during the past three months.

Source: BusinessInsider

The spot price lies within the median range of the 52-week high and low as shown below:

Source: BusinessInsider

The recent momentum in price rally is supported by increased demand of iron ore from Chinese steel manufacturers as their output explores new heights.

Source: Radio Free Asia

Going forward it may be anticipated that iron ore prices will move up, thanks to the rising demand from China. Besides, there is a noticeable gap between the market prices of 58%, 62% and 65% iron ore fines (a measure of ore quality) as tabulated below and all these categories of iron ore fines have recorded price appreciation recently:

Ore quality (fines)

% gained

as on Sept 07, 2018

prices on 07 Sept 2018
58% fines 2.3% $ 38.64/t
62% fines 2.4% $ 68.39/t
65% fines 0.8% $ 95.90/t

Source: Data taken from BusinessInsiderAustralia

One less from RIO's iron portfolio?

As stated earlier, RIO's iron ore assets are centered in the Pilbara region (Australia), however RIO holds a 59% controlling stake in IOC (read: Iron Ore Company of Canada). This is a Canada-based producer of iron pellets and ore that apparently troubled RIO in the H1 2018 with suspended operations in two out of six months ended H1 2018. It's interesting to note that RIO tried to get this company floated on Toronto Stock Exchange earlier last month, but eventually decided against it. A brief history check on this investment also reveals that RIO tried to sell this Canadian investment back in 2012, due to its non-core significance to RIO, but reconsidered the sale shortly. The twist in the story continued when on 15th August 2018 (only a week later from the previous consideration to float the company), RIO announced another change of plans and decided to finally dispose of this investment worth ~$6 B.

RIO appears to shuffle resources for good:

On 01st August 2018, RIO approved a $146 MM initial investment in its KD (read: Koodaideri iron ore project) in the Pilbara region. RIO characterizes this large-scale project with low-cost and high-quality production.

Source: Presentation (pg. 43)

The construction on the project is expected to start in FY 2019 subject to regulatory approvals and if things go smooth then KD may be expected to deliver first full production in 2021.

At this point, lets consider the current iron ore profile of RIO Tinto. Have a look at the following table:

Source: Annual Report 2017 (pg. 230)

Commentary on RIO's iron ore grade potential:

I consider it relevant to include a thorough evaluation of the above table, with respect to iron ore grades. As discussed earlier, the different % Fe fines (representing ore quality) fetch different prices with significant variations.

65% Fe fines: Only IOC had 65% fines and some good reserves (~300 MT). But RIO is considering the sale of this iron asset, so I have excluded them from the portfolio.

62%-65% Fe fines: Then there is a noticeable few mines where iron grades are greater than 62% (mostly near 63%) but less than 65%. The noticeable assets in the category include Marandoo, Mt Tom Price, Hope Downs 4 projects. Unfortunately, except for the Marandoo project, the reserves are not significant in quantity. Thus I believe, this category is also less impressive for RIO.

~62% Fe fines: This category is the most impressive due to the presence of significant ore reserves (as indicated in the table above). RIO has more than 1.5 BT (read: billion tonnes) of production in this category of ore reserves and this includes the Koodaideri project mentioned earlier. It has a healthy 40 MTpa (read: Million Tonnes per annum) production potential and total reserves of ~600 MT.

~58% Fe fines: Though RIO has rich reserves in this category of ore grades, however due to their low prices (within range of ~$39/T), their impact may be far less significant than the preceding category. Nevertheless, RIO has a good ~600 MT of ore reserve at the Yandicoogina project that adds to the iron ore potential.

Falling grades? Nevertheless, the table also indicates that expected ore reserves have declined in FY 2017 compared with FY 2016. Moreover, the iron mining activity during the FY 2017 also resulted in generally weaker ore grades (refer to the purple arrow columns in the above table).

The bigger picture of RIO's iron portfolio:

RIO's expected disposal of IOC will help RIO reshuffle resources from its non-core Canadian operations to its principal Pilbara operations characterized by low-cost and largely autonomous iron mining. Besides their autonomous nature the Pilbara mines are open-pit and close to surface, and thus help RIO maintain a safety reputation in operations.

But is it good enough that RIO is shifting its iron business focus towards the Australian region?

I have two reasons for a yes in that case. First, more than 3/4th of RIO's iron ore supplies are delivered to China (as shown below) and RIO's Australian iron mines are closer to its major market, China, compared with the Canadian operations. Moreover, RIO has well-established iron projects that will help meet enhanced demand from emerging South East Asian markets.

Source: Presentation (pg.26)

Before moving to the second reason, I consider it relevant to evaluate the position of RIO's competitor in iron business, namely VALE.

VALE's strong footprints in the iron mining space:

Lets consider Q2 2018 production first. VALE's financial report for Q2 revealed production of ~96.8 MT of iron ore against RIO's ~86 MT. Nevertheless, it should be noted that VALE's operations were partially affected by Brazilian truck driver's strike in May 2018 while RIO experienced no such issues thanks to the autonomous Pilbara operations.

On the other hand, VALE is the biggest iron producer in the world. The diagram below shows that VALE's BRBF (read: Brazilian Blend Fines) generally fetched higher prices than RIO's Pilbara output.

Source: Vale's Presentation

VALE's major markets:

VALE's latest Annual Report for FY 2017 provides a depiction of the company's iron markets. VALE's iron ore business model is somewhat similar to RIO's Canadian subsidiary IOC (mentioned earlier) in that it also produces both iron ore and iron pellets and sells them across geographically dispersed markets. The following table demonstrates VALE's geographically diverse markets for its iron ore production:

[Prepared by Aitezaz Khan for Seeking Alpha]

Similarly in case of iron pellets, the Asian markets (including Middle eastern countries) combined with the European and Brazilian markets have the dominant spread. However, the impact of geographical dispersion in VALE's iron pellets market is less significant compared to what it is for iron ore markets. This statement is based on the respective proportion of VALE's iron ore and iron pellets production, a summary of which is tabulated below:

Source: Q2 Financial Report (pg. 5)

RIO's strategic advantage over VALE:

Now let's consider the second reason why I believe that RIO's decision to dispose of Canadian operations, will be beneficial for the company. By converging the above discussions of RIO and its competitor VALE, we can identify that both companies have strong demand for their iron products in Asia (and particularly in China). When you consider the hauling distance between Australia and China (case for RIO), and then again between Brazil and China (case for VALE), you may easily figure out that RIO is at a huge comparative advantage. It enjoys low cost transportation to its major market. Here's a diagram illustrating the distances between the two locations:

Source: Google

The above diagram establishes that RIO's shipments to China are less than half the distance of VALE's shipments to China (Asia). Moreover, if RIO decides to strengthen the focus of its iron mining activities in Australia and dispose the Canadian assets, it will help support margins due to lower transportation costs. This is further validated by a comparison of the 3-year EBITDA margins between the two companies, and indicates RIO's strategic advantage over VALE.

Source: YCharts

Review of RIO's diamond business:

RIO delivers most of its diamond production from two mines namely Argyle (Australia) and Diavik (Canada). In my previous article, I mentioned the fascinating discovery of rare pink diamonds at the Australian mine that would add to RIO's cash flows. To the investor's delight, RIO recently announced the inauguration of a fourth diamond pipe (A21) at the Diavik diamond mine. The company expects this pipeline to help sustain production levels for the next four years. It's expected that full production from the said pipeline will be delivered in the 4Q 2018. Due to the rare nature of the underlying resource, this revenue stream is much less prone to market price variations - a factor that significantly impacts the cash flows from other resources.

Conclusion:

RIO an VALE are two major global suppliers of iron ore and fierce competitors on that note. Their major markets are centered in Asia (particularly China). Given the location of iron mining assets of both companies, one could conclude that RIO is at an advantage over VALE in terms of shipping costs, and likely to dominate in terms of margins. This dominance will be supported by improving iron prices following increased demand from China. Moreover, RIO's recent developments in its diamond business will further help the company's growth, and adds to the attraction of this stock.

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.