Rio: Even Leaner And Meaner

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

– Rio to speed up Pilbara 360
– Abandons greenfield expansion and reduces capex
– Will pay down debt and establish progressive dividends
– Brokers relieved

By Greg Peel

If readers examine Rio Tinto ((RIO)) using FNArena’s Stock Analysis the first aspect that strikes is the full suite of eight from eight Buy or equivalent ratings from brokers. Domestic iron ore rival BHP Billiton ((BHP)) cannot boast such a claim, with three Holds balancing the Buys. But further investigation reveals an even more striking feature in the extent of distance between the brokers’ consensus target price on the stock and the price the stock actually trades at. Not just right now, nor even this year, but for a considerable period of time.

Back in March, Rio was trading around $70 and the consensus target sat in the $75-80 range. By June the share price had fallen to $50 and right now is trading around $66 but in all that time the consensus target has remained stubbornly within that $75-80 range despite some tweaking from brokers.

Do the analysts know something the market doesn’t? Or do they simply have rose-tinted glasses on? Or is it that they just don’t share the market’s caution? The market has been bombarded in the press with talk of “the end of the mining boom” when indeed the mining boom has not ended at all. It has simply shifted from investment to production, and in Rio’s case, investment remains ongoing in iron ore.

Perhaps the former CEOs of both the big diversified could be accused of having the rose-tinted glasses firmly affixed, but both have since been shown the door. It was in March when FNArena published Lean, Mean Mining Machines — an assessment of the new strategy both companies were planning to take under their new CEOs and in the face of a lower economic growth profile in China. Into the bin, or at the very least the backburner, would go the overly ambitious tier one expansion plans. Out would go the non-core assets in peripheral commodities, assuming buyers could be found, or at the very least operations would be moth-balled. Down would come capital expenditure targets. Down would come operating costs. Every existing asset would be sweated to extract the last drop of earnings potential. Only expansion plans already in progress would be retained.

And most importantly, both companies would look to finally reward their long-suffering shareholders by setting progressive dividend payout schedules, once debt levels were reduced. It wasn’t as if the rivals did not have rivers of cash flow. Earnings would be filtered off to shareholders rather than retained for quixotic mega-project development plans.

Nine months on, Rio is already looking leaner. An investor seminar held this week suggests the company is about to become meaner. Despite the change of strategy, Rio did not decide earlier in the year to ditch its Pilbara iron ore expansion plan, known as “Pilbara 360” (representing production capacity of 360mtpa). Nor did BHP waver from its Pilbara target. The bottom line is Rio had already sunk a considerable amount of capex into the pre-emptive construction of requisite infrastructure – processing, rail, port and so on – and already had new greenfield sites at the ready to provide for the big push to 360. Clearly, the market was worried.

The market was worried because expansion was all still going to cost a lot of money. China’s steel-making industry is perplexing at best, and destock-restock cycles are often difficult to predict. The sudden plunge in the spot iron ore price in late 2012 had spooked everyone concerned, taking iron ore briefly to a price near US$80/t which would have rendered pure-play Fortescue Metals ((FMG)) uncommercial if it had persisted. But the price recovered and much to everyone’s surprise, has held up all through 2013. China is still pumping out steel. Still building roads and railways and bridges and social housing, if not quite so aggressive on private sector property development.

There is nevertheless a risk the global iron ore market will reach balance, and then shift into oversupply. Why, then, would Rio continue to pour money into production expansion? Oversupply is not a given, and not all brokers are making this call, but surely by pouring more money (which could otherwise be directed to shareholders) into new iron ore mines in the Pilbara is risky when existing operations already offer up comfortable cash flow levels?

At its investor seminar, Rio management delivered the news the market wanted to hear. The company will not pursue greenfield projects in the Pilbara, namely Silvergrass and Koodaideri, and has deferred investment decisions on those sites for a year or more. The company will reduce its capex plans by no less than $3 billion, but still push ahead to the 360 target and in a shorter time frame (the final 60mtpa will be added in 2014-17). How? By getting the whip out and cutting the rations. Expansion will only occur at brownfield projects. Productivity gains will be sourced at existing operations. Rio is going to pick up every rock it digs out of WA and squeeze it and squeeze it until every last drop of earnings potential has been extracted. Management has reduced its “all-in capital intensity” guidance on the final 60mtpa to A$120-130/t from a previous $150/t (current spot ~A$154).

As soon as debt is reduced – and this has now become a priority – Rio will re-establish a progressive dividend policy. Debt reduction will likely occupy 2014, analysts note, but by 2015 shareholders may finally be able to smile. As Credit Suisse has put it, 2015 will be “the year of the shareholder”.

Playing into the shareholders hands, just like the banks appear to have done? Maybe. But even sceptical analysts cannot help but crunch the numbers and come up with even more valuation potential. No one in the FNArena data base has wavered from a Buy rating. The new consensus target is $79.21, still suggesting around 19% upside.

Clearly the market has been scoffing at such targets for some time. And the market has been right, or at least collectively proven the brokers to be somewhere off in La La Land. It may yet take some time before the market can really feel comfortable about an investment in Rio. Despite needing to feel more comfortable with Chinese growth, it will be those dividends which may finally convert the sceptical. And they’re not due immediately.

Either way, the Rio that once foolishly dived into one of the worst acquisitions in history – Alcan (and notwithstanding BHP’s aborted but legitimate attempt to take over Rio shortly afterward) – is now a distant memory. The early noughties offered up a once in a generation windfall for the big diversifieds. On an average basis, the share prices of Rio and BHP have not improved since. The tens and twenties require a different approach and while this realisation has taken a while to sink in, finally Rio appears to be getting it.

At least the analysts think so.
 

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