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Rio Tinto Plc – 10th March 2014 

Company Overview:

Rio Tinto is one of the world’s largest, diversified mining organisations with core businesses in iron ore, copper and aluminium. The company boasts what is often described as a world class asset base and experienced management team.

The company also has a significant CSR (Corporate Social Responsibility) footprint, developed through pioneering annual tax paid reports, developing and publishing clear human rights policies as well as contributing to a number of environmental initiatives.

Index FTSE 100 Ticker LSE.RIO Latest Close 3131.00
52 Week High 3642.00 52 Week Low 2579.50 P/E 8.09
Dividend Yield % 3.79 Dividend Cover 3.06 CEO: Sam Walsh
CFO: Chris Lynch Forecast

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Rio Drops, Dragged Lower by Falling Iron Ore Prices

Mining stocks fell out of favour with the investor community during 2013. This was as many attempted to come to terms with the prospect of reduced future growth in China and the potential that metal prices could be about to enter bear market territory.

This saw companies begin to adopt a heightened focus on costs, increased production and returning capital to shareholders in order to secure relief from the indiscriminate selling pressure that plagued resources stocks throughout the year.

Rio Tinto is one such company. Following the steady depreciation of iron ore prices and the slow but sustained deterioration in the economic outlook for China, Rio Tinto has implemented a raft of changes and reforms within the business since summer 2013. Despite these, the company’s share price has remained under pressure well into 2014.

Rio Tinto Plc Hourly Chart

This pressure became amplified during early March as the first Chinese (onshore) corporate debt default in modern history coincided with the announcement of an 18% year on year reduction in exports from the nation. The final outcome from this was yet further declines in both iron ore prices and, among others, Rio Tinto’s shares.

Some analysts have cited growth concerns derived from the economic data as the main driver behind declining prices; however, there is an alternative theory to this which may have the potential to brighten the outlook for the mining sector. The South China Morning Post reported that the depreciation of iron ore prices is accepted locally as being due to the liquidation of large stockpiles by financial firms.

The liquidations are said to have arisen in the wake of the Chaori Solar and Technology debt default and were reportedly caused by “margin calls” from financial firms to clients, on both loans and trading positions. It is a widely acceptable practice in China for private investors and corporations to post commodities as collateral against such things.

Regardless of the cause behind the most recent decline in iron ore and many mining shares, the prevailing longer term view holds that with the Chinese government looking to re-balance the economy away from the infrastructure investment-driven growth of the past, and toward a consumer/consumption driven form of growth, the economy is almost certain to slow as a result.

With China accounting for the largest portion of global iron ore imports, expectations have developed for a medium to longer term decline of iron ore prices. If this holds correct, then companies such as Rio Tinto will be likely to suffer, regardless of by how much they are able to increase production.

Our view offers a different outlook for iron ore prices and some of the mining companies focused on this area. Rio Tinto is one of these companies.

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Global Infrastructure Investment Plans and Iron Ore Prices

China has previously accounted for the largest portion of steel production and iron ore demand globally, followed by Europe, Japan, the USA and India. Most of the demand for raw materials in China has arisen from an infrastructural development binge within the world’s number two economy.

While the trend in China is for a gradual reduction in the pace of such investment, recent research has identified shifting trends which could help to prop up demand from China over the coming years.

This research, commissioned by Rio Tinto, has shown a marked reduction in iron ore demand for the purpose of infrastructure and property development. However, the same research has also shown a simultaneous increase in iron ore demand for things such as machinery, transportation and white goods. A further development and continuation of this trend could help to minimise the anticipated mass reduction in Chinese consumption of the material.

In addition to shifts in the way that iron ore is consumed within China, there are also changing conditions within the other top global consumers of the resource. Japan, Russia and India have each earmarked significant sums of cash for infrastructural spending.

Japan has a budget of $260 billion set aside for the ongoing repair programme resulting from the 2011 tsunami, a programme which is likely to take another eight years to complete. Russia, in 2012, set an annual infrastructure budget of $60-68 billion to fund the renewal of power networks and an improved system of roads.

Last, but by no means least, India earmarked a significant sum of cash in 2012. As part of the 12th five year plan, the government announced plans to meet a targeted spend of $1 trillion dollars between 2012 -2017 which will see the strained road and rail networks of the nation renewed. The government also intends to build a number of new air and seaports.

Further from here, there are signs of an increasing appetite among Chinese institutions (state owned and private) for investing in infrastructure elsewhere in the world. The UK, US, Canada, Australia, Europe, India and Africa have each received significant offers of funding for infrastructure projects over the last 18 months, with many countries accepting these offers.

From nuclear power to roads and railways, the Chinese appetite for sensible investment over the long term continues to grow steadily. In addition, allocations toward this type of investment are also increasing within the institutional world. This is according to S&P and McKinsey and Co Consultants.

These are positive longer term influences for global iron ore producers and demand. This becomes particularly apparent when looking at the demand side of the investment equation. The one thing that both developed and emerging nations have never fallen short of is the need for capital and better improved infrastructure.

Standard and Poor’s (S&P) estimates that the global requirement for infrastructure investment and funding between 2012 – 2030 will total $57 trillion. If this is correct then, over the longer term, demand for raw materials would be expected to continue to exert pressure upon cost viable supplies, particularly in iron ore production as there are few, if any, suitable substitutes available (key steel component).

These dynamics should continue to ensure that quality companies such as Rio Tinto Plc are able to retain their constituencies within investor portfolios over the broader term.

In the short term (6-12 months), iron ore prices could continue to experience some volatility, although this is expected to flatten out as investors begin to adjust to the shifting dynamics of demand.

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Company Performance: Management Progress Shines Through in Full Year Results

During a time when the wider industry has faced fierce criticism due to poor cost control, the management team under Tom Walsh (former head of Iron Ore) have made solid progress in their pursuit of a nimbler, more stable and efficient Rio Tinto.

2013 full year results announced a 10 % increase in underlying earnings due to increased production, higher shipment volumes and the company’s outperformance against its own cost reduction target.

This saw operating cash costs reduce by $2.3 billion against a targeted $2 billion dollar reduction. The cost reduction also accompanied record production across Iron Ore, Bauxite and Thermal Coal. This was while Capex (capital expenditure) came down by 26% over the period. Net debt also came down by 5.7% to $18.1 billion while the company reported that it had maintained a healthy cash position of $10.2 billion on its balance sheet.

In addition to the positive operational and financial performances, management also demonstrated their commitment to maintaining a progressive dividend policy by increasing the full year pay out by 15%. The total dividend paid, in sterling, was 120.1 pence for the year. This equates to a yield of nearly four percent that is covered 3x over by earnings.

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Risks

The main risks facing Rio Tinto centre on the potential for further price weakness in its key product area, iron ore. This is likely to be derived from an anticipated slowdown in Chinese growth, tightening in CNY financial conditions and oversupply emanating from the mining industry and de-risking in the financial sector.

Secondary risks include the potential for political instability and civil unrest to affect infrastructure investment plans in other markets or areas of production.

Interest rate expectations have also featured prominently in determining the valuations of many mining companies of late; however, two thirds of Rio Tinto’s overall debt pile is secured at fixed rates of interest. As a result, the effects of an eventual rise in interest rates upon Rio’s existing debt servicing costs are minimised.

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Summary

In response to risks, and on a macroeconomic level, the likelihood of a slowdown in China does pose a risk to Rio in the near term. However, as we know, this is not a new item on the agenda. Investors have long held concerns about the sustainability of Chinese growth.

These concerns have manifested themselves most apparently in the performance of share prices throughout the mining sector during much of 2013, a fantastic year for the markets in general but that Rio and Co will most likely welcome the opportunity to forget. As a result, much of the anticipated slowdown in China, we feel, is close to being fully priced into Rio.

Rio Tinto Plc Daily Chart

This is while the market appears to have overlooked the potential for a medium to longer term recovery in iron ore prices. This would be as the steel trading industry in China eventually consolidates, while broader economic growth and global infrastructure continue at what is still a healthy pace relative to that of the past.

Size, brand and the geographical positioning of key assets are able to provide Rio with a modest competitive advantage over rivals. It is a strong balance sheet, firm control of costs, competent management and a now reducing debt pile that  complete the tools required for a resources-focused company to prosper in the current environment. Following the change of leadership in the boardroom last year, Rio Tinto Plc now has each of the above characteristics in abundance. This should aid the company in its efforts to add value to existing resources at a difficult time for mining companies.

In addition to this, the outlook for medium to longer term iron ore demand remains sound, despite the near term behaviour of investors. Should the current momentum behind efficiency and cost savings continue while the market adapts to new demand dynamics for raw materials, this would be expected to provide strong support for the share price throughout any near term bad weather.

In our view, the company represents a quality long term play upon the need for infrastructural investment to support a growing global population and ever more urbanised lifestyles. Rio also offers the added benefit of being highly geared to the global economic recovery and improving investor confidence.

It is worth noting that consensus estimates among analysts assign a fair value price of 4,100.00 pence per share for the company. Our view is that shares currently trading at 3,131.00 appear vulnerable to a further leg down to the 2,900.00 mark in the near term; however, firm support is expected in this region.

Our longer term price target for the stock sees a gradual retracement back toward the 3,800.00 pence level taking place over the medium term.

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