Rio well placed to benefit from stimulus
We believe Rio Tinto is defensively positioned given its low production costs, excellent quality of iron ore reserves, strong balance sheet and continued free cash flow generation. Management has demonstrated very good capital discipline during the past 4 years, unlike what happened in previous cycles.
A relatively balanced supply/demand curve in iron ore should also assist with more robust prices. From a valuation perspective, RIO currently trades on a 10% cash flow yield and a 6% dividend yield.
Furthermore, we believe global stimulus post-COVID-19 should result in demand for commodities over the next 12-18 months following very weak demand and low commodity prices in Q2/Q3 2020.
A portfolio of world-class assets
As a refresher, Rio Tinto is a global mining company operating across 4 divisions:
Iron ore: Based in the Pilbara region, it consists of world-class iron ore assets. RIO is one of the lowest-cost producers of iron-ore and ship mainly to China, Japan and Europe. This division generates EBITDA margins in excess of 70%, and contributes approximately 80% to the group's EBIT.
Aluminium: Operations are mainly located in Canada and Asia Pacific. The vertically integrated aluminium portfolio spans from bauxite mines, to alumina refineries, to smelters, which in Canada are powered by clean renewable energy and located in the first decile of the cost curve. This division generates about 10% of EBIT on a through-the-cycle basis.
Copper and Diamonds / Energy and Minerals: These 2 divisions span across the globe. Copper plays a key role in electrification and power generation including, but not limited to, renewable energy and electric cars. Oyu Tolgoi, an underground copper and gold mine in Mongolia, is one of these growth options. The mine is still in early stages of development and has experienced delays and higher capital costs than initially anticipated.
RIO has a strong exploration programme to feed future growth. During FY19 it invested $624m across 69 programmes in 7 commodities spanning 17 countries, with copper remaining the focus, for example, the Winu copper/gold exploration project in Western Australia.
7 reasons we like Rio
- This company is a portfolio of world-class assets, in particular iron ore mines in the Pilbara.
- Rio is one of the lowest-cost producers of iron ore with a strong safety record. It also should benefit from post-COVID stimulus of the Chinese economy with longer-dated growth in Japan and Europe.
- Growth optionality in aluminium, copper and the robust pipeline of exploration.
- A robust business model that can flex its capex profile to adjust to changing conditions. Invested heavily in technology and innovation e.g. automation of trucks and rail.
- Very strong margins (iron ore) and free cash flow generation. Consistent ROCE of mid-teens during the past 10 years.
- It is run by a high quality and focused management team with a proven track record of sensible capital allocation.
- Strong ESG credentials
- From a valuation perspective, it stacks up as well, with a 10% cash flow yield and a 6% dividend yield.
Handling the impacts of Coronavirus
Up to now, RIO has not been impacted from an operational perspective. RIO and other major Australian miners already have a very strong ethos and operational commitment to safety for its workers. This safety discipline has stood them in good stead in embracing additional COVID-19 measures.
Furthermore, Rio has invested heavily in technology and innovation, including automation (autonomous trucks, automated rail network and remote control centres), in particular in the Pilbara. This automation has made it less reliant on direct interaction with employees in the field.
Indirectly, RIO has been impacted by less demand for its commodities, in particular from China. As discussed before we view this is a timing issue.
A very attractive margin of safety
The key metric for us is the implied value of the iron ore business, which constitutes the majority of the value.
We would reverse engineer from the current share price, spot price (62% iron ore Fines CFR Qingdao) and average FX and look at the implied margin of safety. RIO’s current operating cost of $15/t (excluding royalties, sea freight, sustaining capex, tax and interest) compares very favourable with the current spot price of $85/t.
Even if we account for all capex, royalties and overhead we are still left with a very attractive margin of safety. Our key metric has not materially changed pre and post COVID.
RIO has a robust balance sheet, very strong cash generation and has demonstrated a disciplined capital allocation framework. Even under different scenarios of spot prices for its commodities there is more than an adequate margin of safety regarding its cash generation capability. As an example for the FY19 year operating cash flow was $14.9bn, free cash flow $7.2bn and net debt stood at $3.7bn. A capital raising is therefore very unlikely in our view.
What does the rest of 2020 look like for Rio?
Early indications in China are positive as factories are opened up again. It is important to note that the steel smelters have largely been running consistently during the COVID crises. The bottleneck appeared where the finished product moves to end-users and this should normalise in due course.
As mentioned before we think RIO is well placed to benefit from a renewed stimulus in China post-Covid-19.
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Anton is Deputy CIO and Fund Manager for the Pengana Australian Equities Fund. Prior to joining Pengana, he was with Rand Merchant Bank. In this role he managed a proprietary value fund in Australia, and before that a similar RMB fund in South...