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Rio Tinto is Still a Buy

May 08, 2011 9:56 PM ETRIO, RFLMF
Peter Hix profile picture
Peter Hix's Blog
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Seeking Alpha Analyst Since 2011

I am a student at Brown University and a member of the Brown Investment Group. I have always had an appreciation of the stock market and have followed its development since high school. I have recently gotten in the game for real, whereas before I simply invested virtually (with MarketWatch's Virtual Stock Exchange). I have a bias towards long-term investing and the consumer cyclical sector. Currently I am an intern at an asset management firm and I hope to eventually work at a hedge fund once I graduate.
Overview and Position
The recent developments in the commodities market have caused people to devalue Rio Tinto (RIO).  The Chinese growth slowdown is another reason that people have been selling off shares of this diversified mining company. I do not believe that this is the right response for numerous reasons:
    • The Chinese slowdown is temporary. Still an increase in infrastructure spending.  Increased standard of living will create demand for a better life.  This is done through industrialization.
    • Iron ore demand will spike back to higher levels once Chinese spending resumes former levels.  China isn’t the only emerging country.  Japan will have to rebuild the damages from the recent tsunami, this will take a lot of steel.
    • The Riversdale (RIV) acquisition is no longer an issue as RIO owns 73.28% of the company.  This is also proof of a diversification effort.
    • RIO’s management is one of the most effective in the industry.  Using return on assets (ROA), return on equity (ROE) and return on investments (ROI) shows that RIO beats the industry average for every metric over a 5 year period.  The CEO has had his current post for 4 years and the CFO has had his for 9 years.
    • RIO realizes that diversification is necessary to limit their exposure to the demand for one product.  Recently they have been expanding into other sectors and increase their portfolio in non-iron ore businesses.  
    • RIO is a healthy company as shown by its balance sheet.  Debt has been decreasing since 2007, while assets have been doing the inverse.  They have plenty of cash and free cash flow is high as well.

The Chinese Slowdown

Despite slowdowns in new businesses and manufacturing production, firms are hiring and the fastest rate since last December.  What this means is that the Chinese people are getting a taste of a better life.  While banks aren’t handing out very many loans, ordered by the People’s Republic, people are still going to want to spend this new found cash.  When people spend, companies sell.  This process will insure the future expansion of China’s infrastructure.  Why does RIO care you ask?  Because of the massive amount of steel needed to make this happen.  RIO is the second largest miner of Iron Ore in the world, mining 239 million tonnes.  

Iron Ore Demand

As stated before, China’s inevitable infrastructure expansion will require a lot of steel.  When demand for steel increases, the demand for steel’s factors of production (read iron ore) increase as well.  China might be the largest importer of iron ore but it is not the only one.  There are plenty of other countries buying iron ore.  The recent tragedy in Japan caused more than $300 billion worth of damage.  All of this will have to be rebuilt over the course of a few years.  Steel will be an integral part of this rebuilding process, increasing the demand for iron ore.


RIO owns 73.38% of RIV and has installed 5 of the 9 board members on RIV’s board of directors.  They have recently announced intentions to delist RIV as only 0.44% of the available shares are unowned (Tata Steel owns the remaining 26.28%).  The bid has recently been extended to May 20, while RIO continues to get offers.  RIO could pull what I would like to call “a Facebook”, wherein they issue a massive amount of shares to dilute the ownership stake of Tata Steel then sell it all to themselves.  The chance of this is small but the thought gave me a good chuckle.


In every metric used to estimate management’s effectiveness, ROA, ROE and ROI, RIO beats the industry average over a 5 year period.  ROA was 10.70% versus the industry’s 10.40%.  ROE was 27.06%, thrashing the industry’s 15.20%.  Finally, ROI was 13.16%, beating the industry’s 12.45%.  This means that RIO’s management created value for investors that beat the industry averages (not to mention the S&P 500’s averages) for 5 years.  The flack management got for the RIV acquisition was undeserved as their track record should have instilled confidence in investors.  The RIV acquisition was also management’s answer to the iron ore exposure problem share owners were complaining about.
The CEO, Tom Albanese, has been in his current position since 2007, covering just about every year used for the effectiveness metrics above.  Mr. Albanese has been with RIO since 1993 when the acquisition of Nerco brought him on board. Not only does he know RIO, he has been on the other side of an acquisition as well.  Guy Elliott has been CFO since 2002 and joined the company 22 years earlier in 1980 before which he was an investment banker.  I think it’s safe to say he has earned his current title.  

Portfolio Diversification

Other than the iron ore department, RIO has been expanding their product lines that are not tied as tightly to Chinese expansion: Aluminum, copper, diamonds & minerals, and energy.  Earnings from copper sales increased by $656 million from 2009 to 2010.  Energy more than doubled its earnings contribution from $1.167B in 2009 to $2.432B in 2010.  The RIV acquisition was an effort to increase this diversification as RIV is an anthracite coal miner.


I ran a DCF analysis using an EPS (TTM) of 7.26, a discount rate of 10.29 and a 5 year growth rate of 10.20%.  I ran these numbers through a DCF calculator by Moneychimp and found that the true valuation of RIO is $106.48 a share.  Even using a conservative growth estimate of 8% RIO should be worth $97.63 a share.  At the time of this writing, RIO is selling for $67.49 a share.  This shows that even with a lower estimated growth rate than provided by analysts, there is huge potential return in shares of RIO.

Looking at the balance sheet we find that RIO’s debt level has been declining since 2007 while the assets have been increasing over the same time span.  While the debt looks high we must remember that mining is a capital intensive industry and debt levels are higher across the board.  What is important is that RIO has been systematically paying back its debt.  RIO has also increased its cash by 120% from $4.701B in 2009 to $10.345B in 2010.  This is incredibly effective management to both decrease debt and increase cash.


Right now RIO is at risk of a continued commodities meltdown.  If the downward trend continues, RIO could see either a cut in profit margins or, if passed on to the customer, a decrease in sales.  With the changes in portfolio diversification, I believe that this threat is being actively hedged by management.

In summary, Rio Tinto is selling at a discount to what it should be valued at.  This recent dip in share price should be used as a buying opportunity before the market realizes the true value.  My price target is $100 a share, the middle of high and low estimates outlined in the valuation section.

Note: I used the NYSE market of RIO for all valuations and metrics.

Disclosure: I am long RIO and might increase position at further price drops.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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