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 Rio Tinto Plc Full Year Update – 16 April 2015   

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 RIO.L Latest Close 2,857.00
52 Week High 3,530.50 52 Week Low 2,600.00 P/E (F) 13.6
Dividend Yield % 4.72 Dividend Cover 1.6 CEO: Sam Walsh
CFO: Christopher Lynch Previous Price Target  3,360.00 Current Price Target 3,030.00

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Rio Tinto shares disappoint during the first quarter, despite a positive full year update

The performance of Rio Tinto shares has been disappointing throughout the closing stages of 2014 as well as in the first quarter of the current year.

With the benefit of hindsight it becomes easier to see why, as a sharper than expected slowdown in China and an extension of the iron ore bear market have each contributed to lower expectations for earnings at Rio Tinto.

In February 2015 Rio Tinto released its full year results, in which it announced an earnings performance that was marginally ahead of consensus expectations, in addition to a sharp increase in cash returns to shareholders.

This was initially positive for the shares, prompting a rally which pushed them back up to a six month high by the close of the month. However, the shares have since fallen back and the most striking thing about this most recent decline is that it appears to be the fault of no one other than the mining heavy weights themselves.

We say this because the beginning of March saw a flurry of headlines appearing to illustrate a spat between the larger producers over whether or not the industry should or shouldn’t increase production further during the current year.

The end result of this confrontation was almost unanimous declarations from the iron ore industry’s leading companies that each of them would in turn be increasing production of the mineral during the 2015 year, which then prompted another sharp reduction in forward iron ore prices.

Rio Tinto Share Price / Daily Intervals

RIOEASTER

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Rio Tinto and the commodities conundrum revisited

Since 2013 many of the major markets for raw materials have been locked in a period of structural adjustment as the upgraded levels of production capacity which occurred as a result of the boom years, have coincided with a slowdown in China and some other emerging markets.

This has led to deep price reductions across a broad number of materials including iron ore, crude oil, copper & gold. One of the most important for Rio Tinto has been the reduction in iron ore as this is by far the largest contributor to earnings at the group.

To date Rio has responded to the price pressures in iron ore by reducing costs and continuously increasing its production in the hope that higher volumes will offset the effect of lower prices.

So far this strategy appears to be working, to a degree, as it has enabled the group to increase free cash flows while continuing to grow its dividend and reduce balance sheet leverage.

However, it has not been able to avoid taking a knock to earnings and after several years of falling EPS, dividend cover at Rio Tinto is now at 1.6X which suggests that we may be close to the limit for increasing cash returns to shareholders for the time being.

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The road ahead for raw materials markets

There has been no real change to our outlook for commodities markets since our last update for Rio in that the current economic outlook for China, combined with present day supply dynamics across several industries, still implies lower prices for some time to come, particularly for Iron ore.

Given that the slowdown in China’s economy is likely to be protracted over a number of years we view any potential rebound in raw materials prices over the medium term as more likely to come from a consolidation in industry, and a consequent contraction in supply, than it is from any form of substantial increase in demand.

We see support for consolidation in the industry coming from the fact that despite 2014’s decline in commodity prices, many of the larger organisations like Rio Tinto still intend to increase production in 2015.

This is bad news for smaller producers who have been holding out for a recovery in prices, although it also adds credibility to a growing consensus among analysts that iron ore prices will probably fall again in the current year.   

We also note that the starting pistol has already fired when it comes to consolidation in the oil and gas sector, with the first example of a large scale merger being the deal announced by both Royal Dutch Shell and BG Group in the UK.

Any such eventual consolidation in the minerals space should be positive for earnings at the acquirer companies as well as for the relevant raw materials prices over the longer term.

Having said this, North America, Europe and other areas of Asia still account for a substantial portion of global commodity demand and considering that the developed economies in many of these regions are now gaining in strength; it appears reasonable to expect that further declines in raw materials prices should be milder than those experienced during the last 18 months.

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An overview of Rio Tinto’s full year 2014 results

In contrast to the performance of Rio Tinto’s shares the group’s financial numbers for 2014 were actually quite good when all things are considered.

The headline of the group’s 2014 performance was a 12% increase in the full year dividend and a $2 billion share buyback program to be carried out in March. However, this was not the only talking point to be drawn from Rio’s results.

In detail, total underlying earnings fell by just 9% to $9.3 billion for the period, which is a result that was significantly ahead expectations. This is was primarily the result of a softer than expected decline in iron ore earnings, which fell by 18% to just over $8 billion, despite a much deeper decline in market prices.

Rio also made significant headway in its internal reform program during the period when it overshot its cost reduction target and reduced net debt from $18 billion this time last year to just over $12 billion for 2014.

Overall, February’s results highlighted a very positive performance from Rio Tinto during what has been an incredibly tough year for almost all commodity focused businesses.

This now places Rio ahead of the diversified mining pack across a whole suite of KPI’s and thumbs the proverbial nose at Glencore Xstrata, who had previously sort to make one of the largest (top 10) corporate takeovers in history out of the group.  

Despite this, the current outlook for the group in 2015 appears to offer no respite to the wicked as most commodity prices are either expected to remain at their current low levels, or to fall further during the period.  

It is with this in mind that we caution against overzealous expectations when it comes to cash returns this time next year as, with dividend cover at Rio now down to 1.6X it is possible that if there is even a small increase to the payout in 2016, it may be the last until raw materials prices are able to recover some lost ground.

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Balance sheet, dividend and valuation

In relation to the balance sheet, Rio Tinto made notable improvements in 2014. This was as higher cash flows and what was a solid earnings performance, with all things considered, the group managed to cut net debt by 30%.

This means that at the close of the year net debt stood at $12 billion, down from $18 billion, a movement that consequently reduced the group’s gearing ratio from 25% down to 19% at the end of the period. This is a very reasonable level for a company that still has much to do in terms of cost reductions and deleveraging.

In terms of the dividend, Rio Tinto increased the total cash payout by 12% to 134.8 pence for the period, which was covered 1.68X over by sterling earnings per share.

As we wrote earlier, we are becoming more cautious in our outlook for dividend growth at Rio Tinto as the group still has a tough year ahead of it and without further progress in terms of cost reductions, we see only limited room to manoeuvre when it comes to cash returns.  

From a valuation perspective, Rio Tinto is close to being fairly valued at present. This is as the group now trades on a multiple of 13.5X consensus estimates for EPS in 2015, which is close to the diversified mining industry average of 14X, while maintaining the typical discount of diversified miners to the sector average of 17X.

While we believe that the qualities demonstrated by Rio during the 2014 year probably entitle it to a premium over many of its counterparts, the impact of any such adjustment will only be minor, while the outlook for earnings across the commodities space also makes a sector wide downgrade a genuine possibility for 2015.

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Summary – Rio remains best in class however, this probably won’t be enough to save the shares in 2015

From a results perspective Rio Tinto was by far the best performing diversified miner in 2014. This is as 2014 arrived to be a year in which the group cut costs faster than was expected, while increasing production in its key iron ore unit.

From a perspective of finances the group also made notable achievements during 2014, most notably it managed to reduce balance sheet leverage down to just 19%, while increasing the cash dividend to shareholders by 12%.

These are not feats to be snuffed at in an environment where mining organisations are facing both demand and supply side pressures. However, despite the best in class performance, the outlook for the shares has continued to darken.

The reasons for this are twofold in that a) the Chinese economy is slowing faster than many had expected which creates additional concerns over demand while b) many of the world’s leading iron ore producers are still planning to increase production during the coming months.

A further increase of iron ore supply will probably drive iron ore prices lower during the current year or, at the very least, serve to keep them weighted down at the current low levels. This creates additional concerns over earnings for investors at the likes of Rio Tinto.

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The takeaway

Looking ahead, consensus expectations for earnings at Rio imply a double digit drop in EPS for the 2015 year, which leads us to our earlier conclusion that the shares are close to being fairly valued at the current level.

However, even if consensus expectations prove to be overly bearish and Rio Tinto surprises on the upside again, it is unlikely that the prospective differential between the two earnings figures will be enough to support any notable gains in the shares over the near to medium term.

As a result it is with this in mind that we, once again and with regret, reduce our expectations for Rio Tinto in the current year. In doing so we revise our price target lower, from the current 3,360.00 down to 3,030.00 pence, which implies an earnings multiple of 14.5X consensus estimates for the current year.

This valuation is at the higher end of the range for the diversified mining sector which, in our view, fairly reflects the greater progress made at Rio in terms of restructuring and reform.

However, we note that the risks to our outlook are to the downside as if the slowdown in China accelerates, or if iron ore prices fall further during the current year, then the mining sector as a whole could undergo another re-rating lower.

The next scheduled event of note for Rio Tinto is the release of the first quarter operations review on 21 April, which is followed by the second quarter operations review on 16 July.

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