Rio Says All The Right Things

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

Greg Peel

A check of FNArena's Broker Call archive shows that on the 1st of September, 2010, BA-Merrill Lynch upgraded Rio Tinto ((RIO)) to Buy. Why is this significant in August 2012? Because it marks the date the last of the leading brokers in the FNArena database held anything other than a Buy or equivalent rating on the stock. Merrill's upgrade brought the total to eight from eight, and from that day to now all eight brokers in the database have maintained a Buy rating on Rio.

In September, 2010, Rio's share price was bottoming around $70 before heading towards $90. It didn't quite get to $90, and today it is $56, having bounced off a price near $50 last month. Over the period Rio has scored and maintained a full set of Buys in the FNArena database, its share price has fallen 40% from its peak. When Rio last reported full-year earnings a year ago, it was trading around $70. Analysts remained excited about Rio's underlying value. The shares are since down 20%.

Source: eSignal

After the closing bell on Bridge Street yesterday, Rio reported its first half 2012 earnings. Given the late release not all FNArena brokers have published updated reports, but of the six that have, all have reiterated Buy ratings. As the result was well-received, it is not likely we'll see any downgrades in tomorrow's reports either. Rio will carry a full set of Buys into the second half.

One might be tempted to add, “for what it's worth”.

The ratings may have remained intact but brokers' 12-month price targets have certainly come down, from an average of over $100 a year ago to $84.57 today. That's still represents 50% upside to target. 

In twelve months? 

FNArena's Stock Analysis tool reveals consensus FY13 earnings growth expectations for Rio of 18%, which is pretty attractive. Of most interest is a comparison to Rio rival BHP Billiton ((BHP)), for which analysts expect a 3.6% reduction in earnings in FY13. Mind you BHP still attracts five Buy ratings out of eight in the database and the other three are Hold. But for Rio's stock price to rise 50% on 18% earnings growth we would need a big jump in market sentiment, reflected in a solid increase in Rio's price/earnings ratio. For this to be achieved, the market would have to shift from cautiously confident but largely terrified, as it is now, to confident full stop.

[Note: Rio reports on a calendar year basis and BHP on a June-end basis so these numbers are not directly comparable, but nevertheless paint a picture.]

A consensus earnings growth forecast of 18% did not come about as a result of Rio's earnings report released yesterday. Indeed, analysts mostly left their forecasts intact or tweaked them only slightly. Thus for the report to be as well-received as it has today in the market (up 3%) there needed to be detail in the numbers and confidence in management's commentary.

Rio's interim profit result featured underlying earnings of $5.15bn against consensus expectation of $4.9bn. EBITDA was down 29% from the second half of 2012, but share price response is all about expectation, not absolutes. Investors were concerned Rio might take the opportunity for asset write-downs, a la BHP, with the struggling aluminium business the prime contender. An impairment was booked for aluminium but it was only marginal, and the division did surprise with a small profit, yet management intends to undertake a broader review in the December quarter. Copper and diamonds also surprised to the upside.

Citi is quick to point out a US$1 billion gain representing deferred Minerals Resource Rent Tax was a nice little earner on paper, while an achieved income tax rate of 27% was below expectations and added to Rio's “beat”.

Rio may be labelled as a “diversified” miner, with reason, but iron ore is now contributing 92% of underlying earnings. “We feel we will see Rio's share price reflecting spot iron ore prices in the short term,” lament the analysts at RBS, “rather than its underlying value”.

This comment rather hits the nail on the head. Over the past twelve months analysts have been screaming “underlying value!” but commodity prices have fallen, including that of iron ore, on a combination of Europe and, more directly where Rio is concerned, a slowing China, as well as a gradual supply-side ramp-up. Despite Europe having been an ongoing issue for years now and China having slowed from double-digit GDP growth to 7.6% at the last count, both Rio and BHP decided not long ago to direct the bulk of their cashflow riches into capital expenditure on expansion programs and acquisitions, with China the driving factor. With yields from the big miners hardly troubling the scorer, and no talk of share buybacks, investors have shunned the Big Two as commodity prices have fallen. That's why their share prices have tanked.

Rio did not announce any capital management yesterday either but no one was expecting such. It may have disappointed some investors, nevertheless, that a 72.3cps interim dividend was announced which represents exactly half of the full dividend for 2011. Management suggested it would review its capital management policy but in the meantime, consensus expectation is for 6% dividend growth in FY13 (for a 3.2%) yield. Credit Suisse has pencilled in a 10% increase in the final dividend for 2012 over the interim.

So the Rio news is marginal on the looking-after-shareholders front, and BHP appears to have learnt it doesn't pay to ignore long-suffering investors. While Rio's Hamersley iron ore sales were down a bit as stocks built over the half, other mines in the portfolio surprised to the upside, RBS Australia notes. The upshot is Rio is still bringing in cash by the barrow load, and shareholders would like to know where it's going to end up.

On that basis, shareholders should be pleased with management's new approach to capex. Capex guidance for 2012 remains at US$16bn, with $14bn still earmarked for 2013 barring any additional project approvals, but while sanctioned projects will remain on track, further large projects approvals will depend on market conditions. Management is not going to go rushing headlong into significant expansion at a heavy cost in these uncertain times. The Blair Athol thermal coal mine will be closed after 30 years of production and Mt Pleasant appears to have been deferred. BA-Merrill Lynch does see thermal coal prices as near their nadir at present but with coal-fired power generation now a “dirty” word, analysts in general struggle to see any great bounce.

Just prior to the commencement of the reporting season we saw the full suite of resource sector June quarter production reports, and a wary tone was evident with respect to China, the global economy and the outlook for commodity prices. Not so from Rio:

“Whilst we are mindful of short-term uncertainties we remain convinced of the strength of the long-term demand outlook.

“Although sentiment remains negative in Europe and the US recovery is still fragile, our order books are full and we expect Chinese GDP growth to be around eight per cent in 2012. We expect to see signs of improvements in Chinese economic activity by the end of the year”.

Just about everyone expects China to pick up in the second half and post 8% GDP growth, so this is no scoop. However Merrills offers “These are, by far, the most positive outlook statements we have seen from a mining company so far with this round of results. Quiet confidence?”

Indeed. Quite confidence or talking one's book? A finger more firmly on the global pulse or blind faith? The market liked these comments but shall have to see. It's a long road back for the Rio share price. 

Citi points out that were commodity prices to remain at current spot levels, with iron ore clearly the big factor, the analysts' earnings forecasts would be reduced by 5% in 2012 and 20% in 2013. On the other hand, RBS rather sums up the general feeling in suggesting “Rio is generating strong cash flow due to its relatively low-cost iron ore businesses and improving margins in copper. Furthermore, Rio's aggressive organic expansion plan underpins significant production growth in coming years. We maintain our Buy rating”.

And Credit Suisse throws in “We expect Rio to reap the near term benefits of higher market share given iron ore supply chain challenges faced by peers”.

So the brokers are all bullish Rio. Mind you, they have been for years and look where that's left investors. One thing we can hang our hopes on, however, is an ECB-driven “resolution” in Europe. Were this to occur, and bear in mind we've been waiting for this for as long as we've been waiting for a turnaround in Rio's share price, Europe would stabilise, China and the US would feel the export benefits, commodity prices would rise and, perhaps most importantly, the “risk on” response would push up PEs for Australia's big miners.

At least we'd be starting from a lower share price base, in regard to Rio.
 

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