My long-term view is Neutral to slightly positive as iron ore market prospects grow. Various research firms are covering Rio and their consensus remains mixed as of 17 Oct 2019: RBC (underperform), Goldman Sachs (NYSEARCA:BUY), Credit Suisse (underperform), JP Morgan (overweight), Macquarie (outperform), Deutsche Bank (NYSEARCA:HOLD), and HSBC (BUY). While they seem to be supportive on RIO’s successful generation of cash flows in the past three years, they appear to have mixed views on the operational issues and the outlook of the iron ore market in general.
I value Rio Tinto (NYSE: RIO) using a 5.02x NTM TEV/Forward EBITDA multiple, versus the peers average of 4.78x, and a DCF valuation ($US 66.4). A 50-50 split between the two approaches results in a 12-month target price of $US 61.2 per share, compared to the stock price of $US 53.9 as of 3 Nov 2019 (an upside of 13%). Despite this somewhat attractive valuation, I maintain my Neutral view due to the operational and iron ore market challenges. In my perspective, it is a wait-to-see game.
Rio Tinto (ROI) is the third-largest mining company in the world by revenue (Figure 1) and a market leader in producing minerals such as iron ore, copper, aluminum, and diamonds. Iron ore, aluminum, copper and diamonds, energy and minerals, and other operations are the business segments that Rio operates. Iron ore is Rio’s main produced commodity as it makes up 75% of Rio’s 2019 EBITDA and 46% of its 2019 revenue (Figure 2 and 3). Rio holds the second market share of iron ore globally after Vale (Figure 4) and maintains a geographically diversified portfolio by operating globally, with the bulk of the revenue coming from China (43%), US (15%), Japan (9%), India (3%), and Canada (3%).
Figure 1 Ranking of the leading mining companies worldwide based on revenue (Source: Statista)
Figure 2 2019 EBITDA Breakdown (Source: Bloomberg Intelligence)
Figure 3 RIO’s Revenue Breakdown
Figure 4 Major mining players (Source: IBISWorld)
Iron ore is the primary component of steel, for which the main demand driver is China’s infrastructure industry. The global economic slowdown has led to weakening steel production in China and hence investors sentiments are mixed on the iron ore’s outlook. However, I continue to believe that, compared to other commodities, investors’ main focus has been on iron ore, at least in the last year, and the leading mining firms with higher exposure to iron ore have realized a higher value for their shareholders (Figure 5).
Figure 5 Annual stock performance of peers (source: CapitalIQ)
Mining industry is very volatile and, while we are starting to see elevated sentiments, has experienced a very challenging environment in the last couple of years. As such it is crucial to analyze the track history of the firms in the past years to be able to predict their risk and future actions if the industry goes through a downturn again. Cost reduction and automation capabilities have been the focal point of several mining firms due to this environment and Rio has shown a superb cost performance over the last years. Executing on its productivity improvement strategy, Rio has impressively improved its profit margin from - 2.5% in 2015 to 13.7% in 2016, 21.9% in 2017, 33.7% in 2018 and 32.4% in 2019 (a much better performance than its peers) (Figure 6); as the result of that, the firm’s ROE has improved from -2% to 27%. This well positions the company to generate future cash flows, increase the return to shareholders, and take advantage of any unexpected changes in the commodities markets (the current FCF yield is 9 to 10%).
This resiliency embedded in the business model is clear from the company’s past performance. Rio’s revenue has tracked iron ore prices historically, with declines in 2014 and 2015 followed by rises in 2016 and 2017. Despite the fact that iron ore prices in 2019 are lower than those of 2014, the company was able to increase its production enough to counteract the dynamics and avoid a significant drop in sales (Figure 7).
Figure 6 RIO’s Dupont Analysis
Figure 7 Rio has demonstrated a track record of enhancing its business model resiliency
Investors sentiment, however, stay mixed and slightly negative on RIO’s expected operational performance. RIO has lowered its production guidance several times recently due to the operational challenges at various assets (Pilbara, Oyu Tolgoi, and Pacific Aluminium). On Pilbara, the firm’s primary iron ore asset, in 2018, Rio disclosed that by end of 2019 the capacity would become 360 mtpa. Since then the company has reduced its guidance twice; ultimately to between 320 and 330 million tonnes (100% basis). Rio stated that this has resulted in a higher proportion of certain lower grade products to maintain the quality of the flagship Pilbara Blend. In my view, there has not been much transparency as to the details.
It is worth adding that Rio held an investors seminar on 31 Oct 2019 in London to layout its long-term strategy and capital discipline.
Figure 8 RIO's stock historical performance (Source: CapitalIQ)
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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