Rio Tinto: Get Paid The Iron Price

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About: Rio Tinto Group (RIO)
by: Patrick Kroneman
Summary

Rio Tinto's returns are mainly driven by iron ore.

Valuation multiples are unreasonably low.

The balance sheet gives room for M&A.

Strong cash flows are rewarding shareholders.

Reliance on China could be an issue if the trade war escalates.

Rio Tinto (RIO) is one of the largest mining companies in the world and is an excellent way to get exposure to basic materials. Rising prices of iron ore have boosted H1 results, but since then the stock has gone down. With iron ore trading at a 30+% premium over last year, now is an ideal entry point.

Company overview

Rio Tinto is an Anglo-Australian multinational and one of the world's largest metals and mining corporations. The company was founded in 1873, when a multinational consortium of investors purchased a mine complex on the Rio Tinto, in Huelva, Spain, from the Spanish government. Since then, the company has grown through a long series of mergers and acquisitions to place itself among the world leaders in the production of many commodities, including aluminium, iron ore, copper, uranium, and diamonds. Although primarily focused on extraction of minerals, Rio Tinto also has significant operations in refining, particularly for refining bauxite and iron ore. The company has operations on six continents, but is mainly concentrated in Australia and Canada, and owns its mining operations through a complex web of wholly and partly owned subsidiaries. Rio Tinto has joint head offices in London (global and "plc") and Melbourne ("Limited" – Australia).

Rio Tinto is a dual-listed company traded on both the London Stock Exchange, where it is a component of the FTSE 100 Index, and the Australian Securities Exchange, where it is a component of the S&P/ASX 200 index. Additionally, American Depositary Shares of Rio Tinto's British branch are traded on the New York Stock Exchange, giving it listings on a total of 3 major stock exchanges. - Source: Wikipedia

As a mining company, revenue is generated by mining and selling commodities. A look at this mix might be more useful for an investor than a simple description.

Source: Rio Tinto Chartbook

Looking at where the buyers of Rio Tinto are located, it's clear to see that China has a huge demand for commodities. Representing half of the revenue, Rio Tinto has a heavy reliance on the Chinese economy. The other half of the pie chart is more diverse with demand coming from all over the globe.

Iron ore accounts for 59% of Rio Tinto's total sales. Aluminum comes in second with 24% and gold brings in 7%. The remaining 10% is composed out of diamonds, copper, uranium and other metals and minerals.

These are of course revenue numbers, but a look at the earnings numbers shows a wider dependency on iron ore:

Source: Rio Tinto 2019 H1 Earnings Report

Unfortunately, Rio Tinto reports under product group consolidations and not one the same commodity revenue model as shown above. This makes comparisons for the smaller commodities a bit harder.

What is clear is that 80% of earnings result from the iron ore segment. This effectively means that the other segments chip in, but for the overall results they are marginal.

Evolution of commodity prices

Even though there might be a lag in contract prices as compared to spot prices, looking at spot prices will in the long term provide guidance to the profitability. Since Rio Tinto's profits are leaning on the price of iron ore, lets have a look at the price development first:

Source: Trading Economics

Earlier this year two events caused a surge in iron ore prices. The first was a dam disaster in Brazil. The second was a cyclone in Australia. These things caused Rio Tinto and competitors Vale (VALE) and BHP (BHP) to reduce production. For Rio Tinto in 2018 the average realized sell price for iron ore was $57.8 USD per ton at a production cost of $13.3 USD per ton, as stated in its 2018 annual report. According to page 34 of Rio Tinto's chartbook, these numbers came in at $85.3 USD per ton while costing $14.6 USD per ton in the first half of this year. With the supply side normalizing the last few months, for example with Vale restarting production at the mine hit by the dam break, the price has contracted but is still significantly above the levels seen in 2018.

Aluminum has been one of Rio Tinto's main revenue pillars since it took over Alcan in 2007. At the time this was the largest takeover for the company. Looking at the price chart of aluminum, in retrospect one could ask if this was a wise decision:

Source: Trading Economics

As soon as the Global Financial Crisis broke out, aluminum prices plummeted. Even now, the price has not recovered. Worse, since 2018 prices have moved south again. Reading what Rio Tinto states in its chartbook, things are far from looking rosy for the year so far:

Source: Rio Tinto Chartbook

Before looking at the financial statements a quick look at the gold price might be worth the time:

Source: Trading Economics

As can be seen at the start of this article, gold sales represent 7% of total revenue at the end of June. Since the start of this year prices have steadily risen. This might be an offset for aluminum for Rio Tinto. If the central banks of China and Russia keep buying, there might be more upside for the second half of year for gold.

Financial statements

Source: Seeking Alpha

Looking at the figures and focusing in on the operating income numbers, one can clearly see how the end of the commodity boom affected the business. This downturn shook up the mining industry and gave need for a more disciplined way of using capital and matching demand and supply. The figures show that for the last few years, management has had this in mind. Take for example what the CEO said after divesting the coal business. Judging by operating income, the business looks to be still highly profitable. What about the assets?

Source: Seeking Alpha

The primary thing here to take note is that management also delivers here. Net property, plant & equipment has been slowly going down the last years. In the long term this of course mustn't go to zero, but in a commodity-like business over-investment often leads to gluts in supply which leads to lower prices and write-downs. This happened in the first part of this decade, so managing supply is key here.

Source: Seeking Alpha

Putting the liabilities against the assets shows again a healthy company. Current assets are significantly higher than the current liabilities. Long-term debt has more than been cut in half since its highs in 2013. This makes it just a small portion of the equity. That capital leases have gone up is primarily an accounting thing due to the new IFRS 16 standard. Finally, lets review the cash flow statement:

Source: Seeking Alpha

Again, the capital discipline stands out when looking at capex. This cutting here means the company has excess cash to buyback shares and pay dividends. In the current state this $88 billion behemoth produces roughly $13 billion in cash from operations on ~$44 billion of equity, so it truly is a cash machine.

Valuation

As of the 10th of September Rio Tinto trades at a bit over $52 per share at a market cap of $88 billion. The dividend yield stands at healthy 6.3%. This means the following selected value metrics:

The ratios for sales and book value are left out because they are rather irrelevant. Price versus iron ore price might be more useful and book value I find to be a remnant of a time long gone.

When combining the previous ratios with the profitability ratio, this shows a premier investment proposition:

Source: Seeking Alpha

Risks

The main risks for Rio Tinto can be seen in the in the very first picture shown in this article. The reliance on the Chinese market and the price of iron ore can distort the company greatly. The current trade war between the US and China can damage not only those two economies but also that of the world. A downfall in China's growth would immediately hurt Rio Tinto. The spot price of iron ore is to a great extent correlated with these developments on the demand side. On the supply side risk comes from competitors overdeveloping mining assets and putting them online. This is a risk which can be seen in every commodity business. Luckily there seems to be discipline among all the major mining companies as can been seen in the price surge earlier this year. As long as this relative price elasticity can be maintained it should be good.

To mitigate these main risks, a significant takeover could be appealing at the moment, especially one which would make the company less reliant on one market and one commodity. Personally I'd like to see a shift more towards nickel and copper in a bet on a world moving away from fossil fuels. The balance sheet has ample space for such an acquisition so this might be a good way to reinvest some of the windfall profits from the iron ore surge.

Conclusion

At current valuations Rio Tinto is an ironclad investment. Management has shown to be conservative on capital spending. They've rewarded shareholders with hefty dividends and buybacks. The balance sheet has improved the last couple of years and the company has steady cash flows. As long as the iron ore price doesn't plummet, the company should produce ample returns. With ratios being as low as they are now, there is plenty of upside. For this reason I'm highly bullish on Rio Tinto.

Disclosure: I am/we are long RIO, BHP. 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.