Value Over Volume For Rio

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

Rio Tinto delivered a first half result which was broadly in line, retaining a strict discipline on costs and a value-over-volume strategy.

-Growth emanating from Amrum bauxite, Oyu Tolgoi copper and Silvergrass iron ore
-CEO considers Silvergrass one of the most value accretive projects for Rio Tinto
-Lack of near-term re-rating catalysts but stock well positioned

By Eva Brocklehurst

Rio Tinto ((RIO)) has approved the final phase of the development of Silvergrass iron ore project and delivered a first half result broadly in line with expectations. Net debt ended the half year lower than many brokers expected, largely because of lower-than-forecast capital expenditure. This marks a 12-year low for capex for a half year result but that could change in the second half.

Macquarie does not believe Rio Tinto has the same luxury as Fortescue Metals ((FMG)) in being able to reduce cut-off grades and strip ratios to reduce sustaining capital. While the new iron ore division chief, Chris Salisbury, is expected to do all he can to keep costs down, the broker anticipates low levels can only be maintained in the short term.

Earnings were supported by results in aluminium and energy & minerals offset by a weaker performance in iron ore, copper and diamonds. Iron ore continues to be the main support for the company, generating 64% of underlying earnings. Earnings of US$5.37bn were within reach of most broker estimates. Capex guidance of US$4bn for 2016 and cost reduction guidance of US$2bn over 2016, 2017 are unchanged.

Of interest were comments from the new CEO, Jean-Sebastien Jacques, who reiterated the value-over-volume strategy in iron ore and refrained from providing guidance on the ultimate 360mtpa Pilbara target, instead reiterating a 330-340mtpa 2017 target. Macquarie observes he downplayed the potential for a spin-off of the newly formed energy & minerals division.

Jacques indicated growth will emanate from Amrum bauxite, Oyu Tolgoi copper and Silvergrass iron ore, which should underpin production into the next decade. This implies there will be no further project approvals in the near term.

The expansion of Silvergrass will cost US$338m and increase mine capacity by 10mt, with low phosphorous Marra Mamba ore lowering unit costs. Most of the capital will be spent in 2017, with first production expected in the fourth quarter of that year. The company assumes the return to be well in excess of 100%, with pay-back in less than three years at consensus prices of US$50/t or less. The new CEO has reassured brokers that he remains committed to disciplined capital allocation and considers Silvergrass one of the most value accretive projects.

Portfolio simplification is expected to continue and the company indicates it remains open to divesting non-core assets. UBS believes Rio Tinto can deliver over US$4bn from divestments over the next three years. The CEO, as a former head of copper & coal, has delivered around 70% of the divestments since 2013 and UBS expects him to reinvigorate the portfolio and to shy away from acquisitions.

The broker believes the company can sustain Pilbara earnings margins at US$20/t in the medium term and expects iron ore price to become less cyclical, with the upside capped by oversupply and the downside limited by the cost curve. UBS believes the company is well positioned in the current challenging commodity environment with long life, low-cost and well invested assets. Hence, a Buy rating is maintained. On the other hand, Ord Minnett prefers a Hold rating, given a lack of near-term re-rating catalysts.

Macquarie believes the stock is well positioned relative to BHP Billiton ((BHP)) in the race on lowering costs, and retains a preference for Rio Tinto. Deutsche Bank also believes Rio Tinto has the best balance sheet, production growth and cost reduction plans of the major diversified miners. The broker was particularly impressed with the cost performance in coal, alumina, aluminium, bauxite and minerals. The company has downgraded mined copper guidance slightly, to 545-595,000 tonnes.

Deutsche Bank reduces 2016 earnings estimates by a modest 1% after reducing aluminium metal premiums, bauxite price assumptions, and lowering group copper production in line with revised guidance. These charges are partly offset by lower depreciation across most divisions and lower alumina, coal and mineral costs. The latter three cost estimates lift the broker’s 2017 and 2018 forecasts.

The result was weaker than Citi anticipated although the US45c interim dividend was higher than expected. The company is maintaining a US$1.10/share 2016 minimum dividend. The main miss for both Citi and Credit Suisse was on copper, with the latter noting Kennecott reported a US$208m loss. Citi expects iron ore prices to fall to US$42/t in 2017 as supply increases and Chinese steel demand weakens but acknowledges, if current spot prices prevail, upside risk exists.

FNArena’s database contains four Buy ratings and four Hold. The consensus target is $53.30, suggesting 5.7% upside to the last share price. Targets range from $48 (Citi) to $57 (Macquarie, UBS).
 

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