Rio Tinto Poised To Climb Beyond $70

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About: Rio Tinto Group (RIO)
by: Joshua Hall
Summary

In this article, I provide 3 catalysts that have shares of Rio Tinto ready to smash through the $70 barrier.

Rio Tinto's weekly chart points to a continued breakout.

The iron ore segment is set to enjoy 70%+ EBITDA margins for several years. It is generating an enormous amount of cash.

I see $34 billion of free cash flow from 2019 to 2021 for shareholder "bonuses."

Aluminum and copper will eventually take the baton from iron ore to keep this locomotive running.

Introduction

In this article, I provide 3 catalysts that have shares of Rio Tinto (RIO) poised to smash through the $70 barrier. I recommended the stock last week to subscribers of Industrial Minefinder™ at $58 per share, and so far, we are off to a good start. This recommendation builds upon some of the research in the following articles that I recently published for the broader Seeking Alpha community:

June 5, 2019 - The Iron Bull Is Out Of The Pen

May 31, 2019 - Near-Term Acquisition Seems Likely For Rio Tinto

These 2 articles are helpful for a deeper understanding of the situation. This 1-2 punch of fundamental metals research alongside company-specific research is the main approach I take in Industrial Minefinder™.

For starters, here is a weekly logarithmic chart of Rio Tinto that provides a good reference for how the stock has been performing:

Rio Tinto weekly price chart

Chart courtesy of barchart.com

The stock broke out of its longer-term weekly downtrend in late 2017, fell back to the support of that downtrend line in late 2018 and is now off to the races again.

Catalyst #1: An Iron Bull

I am currently projecting an iron ore ("Fe") deficit of 100.4 million tonnes in 2019 and 57 million tonnes in 2020. The primary source of extra supply to plug this gap is Chinese port stocks and these continue to draw down rapidly. A Reuters article this morning reported that they are down to 121.6 million tonnes. The price of iron ore continues to reach new multi-year highs and the 62% Fe benchmark is now above $100 per tonne.

This deficit is going to drain stockpiles and create a structurally tighter market for several years until new production comes online. My base case right now is for 62% Fe to average $85 per tonne in 2019, $80 per tonne in 2020, and $75 per tonne in 2021 before retreating to my long-term target of $70 per tonne. Given this outlook, I estimate that Rio Tinto will derive 71.5% of its EBITDA from iron ore in 2019 and 69.4% in 2020. Furthermore, I see EBITDA margins at 70%+ in this $80 to $85 per tonne average price environment.

The takeaway is this: more than 2/3s of Rio Tinto's earnings are currently coming from iron ore which (1) is in the early stages of a raging bull market and all this even while the U.S. and China remain mired in negative trade war rhetoric and (2) is throwing off enormous amounts of cash given such high margins (specifics to follow).

Finally, on this catalyst, Rio Tinto also has a bit of spare capacity in the Pilbara (Australia's renown iron ore region). 2019 production is headed toward 338 million tonnes, but 2020 production guidance is likely to rise to 350 million tonnes or potentially 360 million if they go all out.

Catalyst #2: Shareholder "Bonuses" Coming

Under my iron ore price scenario, I see free cash flow ("FCF") coming in at $11.7 billion in 2019, $11.5 billion in 2020, and $10.7 billion in 2021. This is an average of $11.3 billion and a 59% increase over the 3-year 2016 to 2018 average. To be clear for readers who may not be as familiar with free cash flow, this is the cash that the company will have available after spending all its sustaining and expansionary CAPEX (or capital expenditures). All of this $11.3 billion of average annual FCF will be available for dividends, share repurchases, acquisitions, and debt repayment (which Rio does not have that much of).

$11.3 billion is enough to pay $7 billion in dividends (equates to a 7% yield at a $61 share price) and repurchase $4 billion in stock each year. 3 years of share repurchases at the current price would reduce share count by almost 8%. What this would effectively do longer term is support earnings per share at the $7.00 level assuming $70 per tonne iron ore and a modest increase (e.g., 10%) in copper prices. At $61 per share, this is a price multiple of 8.7 whereas I see a moderate long-term multiple of 11 as justified. This undervalues the stock by 26.4% and implies a price target of $77. The chart at the beginning of this article reveals that shares of Rio are in a "vacuum" that will easily take it through $70. I expect investors will likely get at least 7% in dividends while they wait but there remains the potential for a special dividend also.

Rio Tinto is presently wrapping up a share repurchase plan initiated last year with only $1.1 billion committed so far for 2019. There has yet to be any announcements regarding a new repurchase plan or dividend hikes, but we may see something in the next quarterly release. Given where iron ore is at, we are likely to see some big numbers that will get the attention of investors and spike the share price the day the announcement is made. If we do not get a big number, then I expect a meaningful acquisition could be underway.

There are a number of deeply undervalued projects outside of the traditional iron ore-copper-aluminum purview of Rio Tinto that could be added to its Energy & Minerals segment to diversify the business longer term. Rio recently exited thermal coal and is now more focused on clean energy technologies. It has one lithium development project underway (Jadar in Serbia), but I wonder if another lithium project is not out of the question either. No one talks about Rio when it comes to lithium (yet), but the addition of another major project or producer would certainly swing the discussion. Now is a good time for Rio Tinto to not only buy a project but to also bring in some more technical know-how in-house while the lithium market remains depressed.

Catalyst #3: Aluminum & Copper Rebound

Both aluminum and copper are near 2 years lows being driven down by negative sentiment on the global economy and trade concerns. Nevertheless, the supply & demand fundamentals for copper remain exceptionally strong. It will take real economic damage, not just media hype and trader sentiment, to move copper materially lower from here. The following long-term monthly logarithmic chart of copper reveals strong support here:

monthly chart of copper

Chart courtesy of barchart.com

In this chart, I see copper funneling towards an eventual breakout.

Rio Tinto derives almost all of its other earnings power (beyond iron ore) from aluminum and copper. At some point, one or both of these is going to provide an additional catalyst. Given the dominance of iron ore to the bottom line, it might not seem like a big deal on paper; however, roaring copper boosts sentiment across the entire industrial metals & mining industry. Shares of Rio are poised to reap their share of the gains when this happens.

The way I am thinking about this third catalyst is that as aluminum and copper rebound from their somewhat depressed levels they will be able to "take the baton" from the iron ore segment as the price of iron ore eventually settles down. This potential transition could keep fuel in the locomotive.

Strategic Conclusion

I see shares of Rio Tinto smashing through $70 in short order driven by the iron bull, shareholder goodies, and rebounding base metals segments. At the very least, a 6% dividend yield is easily supported given the exceptional underlying profitability of the dominant iron ore segment.

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.

Additional disclosure: Rio Tinto is a holding in some client and family portfolios. I have an economic interest in the stock. I'm an investment advisor and owner of True Vine Investments, a Registered Investment Advisor in the State of Pennsylvania (U.S.A.). I screen electronic communications from prospective clients in other states to ensure that I do not communicate directly with any prospect in another state where I have not met the registration requirements or do not have an applicable exemption. Any investment advice or recommendations involving securities referenced in this article is general in nature and geared towards a readership of sophisticated investors. This article does not involve an attempt to effect transactions in a specific security nor constitute specific investment advice to any particular individual. It does not take into account the specific financial situation, investment objectives, or particular needs of any specific person who may read this article. Individual investors are encouraged to independently evaluate specific investments and consult a licensed professional before making any investment decisions. All data presented by the author is regarded as factual; however, its accuracy is not guaranteed. Investors are encouraged to conduct their own comprehensive analysis. Positive comments made regarding this article should not be construed by readers to be an endorsement of my abilities to act as an investment advisor.