Should Rio Be Broken Up?

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

-Alumina stocks rally, not RIO
-Should Rio Tinto spin off Alcan?
-Simandou not affecting supply this decade
-Low capex outlay for RIO a positive
 

By Eva Brocklehurst

Rio Tinto ((RIO)) is a large diversified miner but the market seems to be preoccupied with its iron ore assets. Justifiably so, given the downward push on iron ore prices of late and the fact a large percentage of the company's earnings come from iron ore. Now the company's Simandou iron ore project consortium has just signed off on a revised investment framework for developing blocks three and four. Citi wonders whether the iron ore focus is overwhelming the leverage Rio Tinto has regarding other metals.

The broker observes aluminium stocks have rallied 30% in the past six months but Rio Tinto has declined 6% on the back of the iron ore price. Rio Tinto is the world's largest producer of bauxite, the third largest in alumina and the second largest in aluminium. Citi considers there is significant upside to the stock and retains a Buy rating. This is particularly so given the broker thinks iron ore prices will soon find a low. The reason for the rally in bauxite prices, which has underpinned other alumina producers, is that investors are extrapolating the impact from Indonesian bans on ore exports to bauxite from nickel.

Nickel has rallied strongly, given Indonesia is the world's largest producer of nickel. In contrast, Indonesia is only the fourth largest producer of bauxite. Moreover, China has around six months of nickel ore inventory versus 12 months or more in the case of bauxite, so to Citi a lag was always anticipated. Bauxite is more abundant than nickel too, and higher prices will ultimately encourage other supply to come on board.

Although aluminium is not a significant contributor to Rio Tinto's earnings in 2014, Citi expects the percentage of earnings from the Alcan division will increase as iron ore prices decline and alumina/aluminium prices increase. Citi thinks Alcan is worth considerably more than is implied in the Rio share price. If the market fails to recognise the value in Alcan, the broker thinks Rio Tinto should unlock this value by spinning off the division.

Back to iron ore. The Simandou project combines a 100mtpa iron ore mine and associated port and rail infrastructure, located in Guinea. The development consortium consists of the Guinea government, Rio Tinto, Chinalco and IFC. Rio Tinto's ownership share is 46.57%. Once the investment framework is ratified a bankable feasibility study will be finalised. An infrastructure consortium will finance and develop the rail and port and Rio Tinto is not expected to participate in this. UBS observes the project is high quality, with 65.1% iron product at a very low strip ratio. The Guinea government will take an initial ownership of 7.5% and can increase this to 35% by 2024. Accordingly, Rio Tinto's share of the net present value is US$5.3bn, indicating a US$2.86 per share uplift. UBS attributes no value to the project in valuing Rio Tinto and neither does JP Morgan.

JP Morgan would rather the project was on Rio Tinto's back burner, while the iron ore market looks well supplied, preferring instead that the company focus on reducing debt and delivering on capital management. Acknowledging there appears to be a "use it or lose it" situation regarding Simandou, and the Rio Tinto commitment is likely to be long dated and relatively low versus total capex requirements, the broker thinks it sensible to pursue the revised investment framework. Capex is estimated at around US$20bn, which is high but not surprising to JP Morgan, given the requirement of greenfields rail and port infrastructure. The capital intensity at US$200/t compares with Rio Tinto's Pilbara projects at US$120-130/t.

The broker also notes the time line to production targets December 2018 for first ore. This looks to be a stretch as it assumes 3-4 years to build port and rail. At any rate, JP Morgan believes the project is unlikely to add material iron ore to the market in this decade. The broker remains Overweight, as the stock looks cheap even under the bear case scenario for iron ore.

CIMB also considers the project is long term in nature and does not expect first product shipments until at least 2019. The addition of the Guinea government as a 7.5% shareholder is a positive change, in the broker's opinion. CIMB estimates Rio Tinto will spend US$500m on Simandou in 2014 and in 2015 but suspects, given the company's recent focus on eliminating non-essential capital expenditure, that these estimates may be at the high end. The capital burden on Rio Tinto appears to be limited and this is a good development so CIMB maintains an Add rating.

There are seven Buy ratings on FNArena's database and one Hold (BA-Merrill Lynch). The consensus price target is $77.96, suggesting 27.2% upside to the last share price. Targets range from $70.00 to $86.30.
 

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