Treasure Chest: Rio Tinto Gaining Support

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

By Greg Peel

It’s been a tough couple of months for Rio Tinto ((RIO)) shareholders as iron ore price weakness and determined foreign selling of Australian large cap stocks has driven the share price from its early August peak close to $68 to near $60 currently. The story is much the same for BHP Billiton, Rio’s low-cost iron ore production rival, while severe selling in the junior iron ore space has simply reflected price fears.

That said, both BHP and international rival Glencore have relatively outperformed Rio since their recent profit results, which can largely be attributed to relative dividend yield support. Thus despite lower iron ore prices suggesting lower cash flow in the second half 2014 than the first, Morgan Stanley still expects capital management at Rio’s full-year result in February.

Morgan Stanley suggests the iron ore price would have to fall to US$65/t (US$79 currently) to put Rio’s progressive dividend policy under pressure.

Relative underperformance is one reason why Rio attracts a full suite of Buy or equivalent ratings from the eight brokers in the FNArena database, and 30% upside to consensus target, while BHP attracts a mix of four Buys, three Holds and a Sell, with 20% upside to target.

Non-FNArena broker Morgan Stanley has now decided to join the herd, upgrading Rio to Overweight from Equal-Weight. The broker is encouraged that management is now reverting to pre-supercycle principles.

Between 2003 and 2008, Rio’s capital expenditure peaked at 2.6x depreciation and amortisation expense and 18% of sales, but with fiscal discipline now resumed, Morgan Stanley forecasts those numbers to fall to 1.4x D&A and 13% of sales over 2015-19. What is really compelling, nevertheless, is an anticipated doubling of free cash flow to US$8bn (using current commodity/currency spot prices) by 2016 on sustained 3-6% earnings growth.

Rio is not just about iron ore. While cost overruns for the company’s aluminium business over past years have been unfortunate, they are now in the past. Morgan Stanley can see an additional US$3bn in earnings over 2015-17 if aluminium prices track above base case forecasts. Rio trades at a discount to aluminium peers despite having a higher dividend yield and return on equity. This lack of appropriate pricing suggests modest valuation upside is there to be unlocked.  

Morgan Stanley can see a six month window in which Rio can convince the market of its objectives, being one of solid cash flow generation and shareholder reward in the “production” phase of the mining cycle rather than the extensive capex investment and shareholder frustration which dominated the “investment” phase of the mining cycle. The broker has made its recommendation upgrade in anticipation, raising its target price to $75.00 from $68.50.

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