Rio Tinto Heading For The Sweet Spot?

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

By Rudi Filapek-Vandyck

The most important event for Rio Tinto ((RIO)) this week was not the release of the December quarter production report. That proved largely a confirmation of what analysts and investors already knew and that is the company seems to have a good handle on its operations and if anything the bias is to the upside for the most important product that flies off the shelves in the Rio Tinto commodities shop and that is still iron ore.

The most important event happened independently from the release with analysts at both BA-Merrill Lynch and JP Morgan lifting their price forecasts for iron ore for this year and for the years ahead. Rio Tinto, as every other producer of raw materials, has an in-built leverage to future prices and thus these adjustments in forecasts have a significant impact on what possibly lies ahead.

In the case of Rio Tinto, the board has committed to a significant increase in production of iron ore between 2013 and mid-2015, plus Oyu Tolgoi in Mongolia (copper) is about to commence commercial shipping from Q2 this year so a stabilisation in prices of iron ore and copper, at the very least, will ensure that Rio Tinto shareholders can look forward to healthy growth numbers in 2013 and 2014. This could well mean the share price will finally fill that gap with stockbroker price targets (consensus target currently sits at just under $80, circa 20% above the share price).

Assuming the current rise in market expectations will prove more or less accurate, this means Rio Tinto's two year horizon is looking very healthy. We could be talking double-digit increases in profits and dividends in 2013 and in 2014. What happens after that remains open for discussion. It'll all depend on what prices Rio Tinto and other producers will receive for their expanded supply and we have all seen over the past six months how "flexible" the concept of price forecasts in the commodities space is.

For what it's worth, JP Morgan previously had assumed iron ore wouldn't be much higher than the magical US$100/tonne this year, forecasting US$110/tonne would be the average for the year and it was pretty much expected that iron ore would average no more than U$100/t in the following years before diving into double-digits after 2016. The latter is still expected, but in the years leading up to that event the price curve is now expected to be much higher. In a highly leveraged environment every dollar makes a difference, so in this case Rio Tinto can now boast the best growth profile amongst all resources majors and it is all related to the fact the company also happens to have the highest leverage to iron ore.

On JP Morgan's revised forecasts, iron ore should average US$130/tonne this year (pretty much unchanged from last year) and then decline to US$115/t in 2014 and then to US$105/t in 2015.

At BA-Merrill Lynch, price forecasts have gone up too, but not as high with annual averages of US$120/t this year, US$110/t next year and US$100/t for 2015. Judging by the commentary, BA-ML is not 100% convinced that India will now stay permanently out of the export game. As I pointed out last year, one particular change in dynamics for the global iron ore market has been that India, the world's number three producer, has virtually removed itself from the supply side. Another element of support has come from the world's number one producer, Vale, where targets have been repeatedly missed.

This has opened up a new window for Rio Tinto. If Vale doesn't get its act together, and everything goes according to plan in the Pilbara over the next two years (give or take), then Rio Tinto might possibly become the world's number one producer of iron ore.

Management might have bodged the expansion into aluminium a few years ago, but they certainly have ticked all the boxes in iron ore (thus far). Mitigating the need for no weakness in the prices of copper and iron ore is the fact that Rio management remains confident it can strip no less than US$5bn off its operational costs in the years ahead. This target should not be underestimated. It is huge. It represents 10% of total costs across the group.

If achieved, an extra US$5bn off the costs should underpin the double-digit growth profile for this year and for 2014. Moreover, the combination of all three key factors -increased production, higher than previously anticipated prices and a significant saving on operational costs- could well put Rio Tinto into the mining sector's sweet spot the coming 24 months. Its growth profile looks far superior to peers like BHP Billiton ((BHP)) and Xstrata.

In the same breath, it has to be acknowledged Rio's growth also has a much narrower base than those peers. Of course, Rio digs diamonds and aluminium and mineral sands, and a whole slew of other stuff out of the ground, but when it comes to growth in the years ahead it's pretty much all related to iron ore, with copper a distant second.

Shareholders will be keeping their fingers crossed all those warnings about unsustainable growth in China will remain just that, warnings, while India and Brazil won't change the current outlook for iron ore supply and prices, or that Europe does something silly.

In the short term, there's still some bad news that needs to get out. Firstly, earnings per share for the year to December are likely to show a dramatic fall on 2011, probably to the tune of minus 40%. Plus analysts are anticipating more write-downs from that once ill-advised expansion into aluminium. Might as well get over it in February.

Expect more price increases from other experts in the weeks ahead.

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