What Odds A Rio Buyback?

This story features RIO TINTO LIMITED. For more info SHARE ANALYSIS: RIO

By Greg Peel

Last week Rio Tinto ((RIO)) held back-to-back seminars in London and Sydney to update investors on the company's activities. Iron ore and copper were in focus, unsurprisingly, and Rio reviewed its production expectations, costs, expansion intentions and balance sheet situation.

First up, there was a shift in the timing of earlier capital expenditure guidance. Rio will only end up spending US$4bn in 2010 instead of US$6bn but will shift the expense out to 2011 for a total of US$11bn. Delays due to the uncertainty of mining tax policy were blamed.

Rio plans to grow its iron ore production from 220Mtpa to 333Mtpa by 2016 and on to 433Mtpa if there is the demand. Rio is clearly bullish on the iron ore price and suggests that Chinese steel demand has not yet peaked given the shift in focus to construction in the interior cities and away from the now more developed coastal cities. Ongoing project delays for prospective iron ore producers could well lead to global undersupply.

On the other side of the ledger, costs are an issue. This is particularly the case in Australia where the small population cannot supply enough skilled workers, the massive Gorgon gas project is sucking up a lot of the available workforce, and the plethora of mining and gas projects across the continent are competing for workers from a small pool. The labour problem only causes further delays.

UBS suggests Pilbara operating costs are now up 40% from June 2009 if the currency effect is included. Such costs will only support the iron ore price, and UBS believes the market is too bearish in the shorter term.

Current iron ore price strength nevertheless sees Rio pulling in buckets of cash, and Deutsche Bank expects the company will reach a net cash position by the end of 2011 despite rising costs. Not bad for a company which in 2008 was close to going out the back door, before China came to the rescue and allowed Rio to screw over Chinalco. And it is the thought of no debt which has the market salivating over the possibility of capital management ahead in the form of increased dividends or a share buyback.

Rio teased the attendees with talk of capital management, but it came third on the wish list. Clearly the “overwhelming focus”, as Macquarie puts it, for management is for single-A credit rating to be achieved.

Next up was an intention to exploit small to medium M&A opportunities, several of which are currently being evaluated by management. Outside of iron ore, which Rio believes is best served through expansion, copper took the spotlight in the M&A stakes. The company revealed it faces a 16% reduction in copper production in 2011 before a bounce-back in 2012, with the new Oyu Tolgoi project leading the charge.

Rio is not alone in facing lower copper production, as the world's major copper mines in Chile and elsewhere are all quietly passing their peak. There have been no major recent discoveries, suggesting copper production is now very much an incremental business. This is why analysts are mostly very bullish on the prospects for the copper price ahead.

There are some possibilities, with management highlighting that the perversely named Democratic Republic of the Congo is a valuable prospect. The problem is it's also a dangerous prospect, taking projects further up the sovereign risk scale than current African projects in the likes of Guinea for example.

Nevertheless, having used its cash to achieve its desired credit rating and then to pick up some new assets, only then will Rio turn to capital management, it is assumed. It therefore becomes a debate as to just when that might be, or whether plans A, B and C may run concurrently.

Management did suggest that it expects earnings to be volatile to reflect volatility in markets, and on that basis it wanted to keep a strong balance sheet for the bad times and have reserves ready to take advantage of opportunities. That's after the single-A is in the bag. So Goldman Sachs' interpretation is “modest” dividend increases and no buybacks until probably 2012 depending on what market conditions might be.

Macquarie is not asking too much of its crystal ball, suggesting capital management appears a “low probability” in the first half of 2011. Yet UBS believes a buyback “is increasingly likely in our view,” and RBS believes there could be an announcement when Rio releases its 2010 result in February.

So you can spin your own chocolate wheel there. Clearly the likelihood and timing of a buyback will fluctuate as iron ore prices fluctuate, and Goldmans, for one, sees robust prices for at least the next two years before the markets mature after 3-5 years.

But the real concern investors might have for this positive outlook – one in which Rio seems spoiled for choice of what to do with all its cash – is not European debt defaults, not Chinese tightening, nor a rebounding US dollar (indeed the latter sends the Aussie lower anyway). The real problem is every one of the brokers in the FNArena database has a Buy on Rio, and history suggests this is (often, but not always) a kiss of death.

The consensus 12-month price target is $103.44, or about 28% above today's trading price. Nice work if you can get it. The last time Rio saw a price above $100 was in 2008 just after the GFC. At that time the shares were in free-fall on their way from $140 to about $32. The first time the shares ever saw $100 was in late 2007, when China Mania was about as rampant as it is now at a time when the US subprime crisis was deteriorating.

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