Rio Shareholders Should Not Hold Their Breath

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

– Rio Tinto determined to persist in the Pilbara
– Return forecasts compelling
– Balance sheet priority one
– No near term capital management likely
 

By Greg Peel

ANZ Bank did it. Westpac did it. Even an investment bank, Macquarie Group, did it. And it’s not just limited to the financial sector, because Woodside Petroleum, good heavens, did it. In order to placate the angry, torch-bearing, pitch fork-wielding mob, each of these major Australian companies have provided beyond-the-usual capital returns to shareholders in the past few weeks.

Some might call it placating, some would say pandering, and others simply call it sound strategy. Of the above group, the commercial banks are meant to be significant dividend payers because they are lower risk and lower growth “defensives”, assuring yield is the predominant source of shareholder value. By contrast, investment banks are supposed to be higher risk, higher growth businesses offering shareholders capital appreciation. Riskier still, typically, are resource sector companies which must ride out cycles and constantly churn profits back into growth for the next cycle.

There is little doubt about it. Yield has become a drug for the investment masses in a low interest rate environment. Listed companies are being rewarded or punished not on their profit results, but on how much of that profit they hand out. Somewhere amidst the frenzy a certain principle is being lost. Money in the hand today is only as good as money in the hand today. Money in the hand tomorrow requires more profits to be available for distribution, more profits require growth, and growth requires investment. Today’s windfall is potentially tomorrow’s disappointment.

When Woodside announced a lift in dividend payout ratio to 80% from around 50% last month, and a special dividend to boot, Woodside shares leapt in value. Finally, long suffering shareholders would see some reward. Even with the leap, Woodside shares are little changed in value over four years and below 2006 levels, but for dividends paid over the period. Woodside has up to now been churning its profits back into growth, but now the growth opportunities have all but run out. Shareholders will enjoy 80% of profits rather than just 50%, but 80% of a diminishing amount is a diminishing amount.

As they say, be careful what you wish for.

Rio Tinto ((RIO)) shareholders were far from philosophical when they accosted company management at last week’s annual general meeting. Rio shareholders are also looking at a share price little changed from 2006, and only a 20% payout in the meantime. The ill-timed Alcan acquisition nearly killed the company, and has remained a burden ever since. Iron ore, coal and copper assets are providing cashflows, so please, the shareholders begged, no more Alcans. We want cash, they chanted.

It is understandable that the masses are fired up when not only are many companies providing increased hand-outs, Woodside’s case is almost a template for Rio. Both resource sector companies have been forced by a sluggish global economy and weak commodity prices, along with conflicting cost inflation, to shelve big ticket growth developments. Both now wish to consolidate, cut costs, improve efficiencies and ride out the cycle. Yet there are fundamental differences between Woodside and Rio.

Woodside does not have a debt issue. Aside from legacy assets, the company’s Pluto LNG development is now generating plenty of cash. Yet where once management hoped Pluto would grow from one LNG train to two or even three, now the returns on such expansion do not stack up. Worst still are forecast returns on other, less developed projects. Woodside will now look to pursue one or two developments but will shelve others that only a year or two ago were offering all sorts of potential. Hence not all of the cash will be needed, so it might as well go to shareholders.

Rio does have a debt issue. Like Woodside, Rio has shelved its more grandiose new development plans and like Rio, legacy assets are generating pretty substantial levels of cash. However Rio does wish to continue with existing project expansion plans, in particular Pilbara iron ore, because unlike Woodside’s, Rio’s forecast return numbers do stack up.

Stock analysts tend to have a bigger picture view on resource sector stocks than shareholders smitten by thoughts of immediate cash. So it was that a group of stock analysts from major houses sat down with the Rio CEO and CFO ahead of the company’s AGM last week. They wanted to hear the real story, before the angry mob intervened.

Specifically up for debate is whether Rio’s plans to pursue a Stage Two Pilbara iron ore expansion to 360mtpa from 290mtpa is wise at a time when global growth is tenuous, Chinese growth in particular is uncertain, and iron ore prices are potentially teetering. The executives clearly put up a good argument, given Deutsche Bank came away from the meeting suggesting:

“Recent market debate of the wisdom of [Stage Two] is misplaced.”

Deutsche’s analysis suggests that Rio’s US$19bn Pilbara expansion, from 220 to 390mtpa over two stages, has one of the highest returns of any large mining project in the world, offering an internal rate of return (IRR) of 23% on a long term iron ore price assumption of  US$80/t (current spot US$130/t). Stage One will be complete in the September quarter and Stage Two has all infrastructure in place for a target completion date of first half 2015. It is the most accretive project on Rio’s books.

Were management to decide to delay Stage Two (and, presumably, pay out some funds to shareholders instead), Rio would risk a competitor jumping in to fill the supply gap, having to forego operating cost reductions achievable on the economies of scale, and having to pay contractors sizeable fees to demobilise now and remobilise at a later date, Deutsche suggests.

The Deutsche bank analysts do have one recommendation, nevertheless, and that is that Rio pursue only brownfield expansion in the Pilbara and not greenfield, thus saving US$3bn which could be tossed to the hungry masses, albeit sacrificing around 2% in IRR. The analysts also suggest Rio should defer its Kitimat aluminium smelter project as it currently only suggests an IRR of 8.7%, or would need an aluminium price of US$1.80/lb (current spot US83c/lb) to match the Plibara’s Stage Two 22% IRR. If nothing else, that earmarked capex could be tipped into the Pilbara.

JP Morgan also queried the executives on the low-return Kitimat project, but found them to be stubbornly committed. While comparative returns may be low, the project has progressed to the point where return on remaining capex is actually quite good, they argued.

While management is keen to go ahead with Pilbara Stage Two, the board will review the company’s iron ore price and currency projections before granting approval. When pushed on the matter of whether the company could pay higher dividends, the CFO emphasised that balance sheet flexibility, in the face of commodity price volatility, was priority number one. A credit rating downgrade would not be the end of the world but Rio would like to sort out its debt levels before contemplating greater hand-outs.

The drive for balance sheet strength will involve a strenuous cost cutting drive, and Rio employees should be very afraid. “Large numbers”, including middle management, will be axed and remaining salaries frozen. Service contractors need also be concerned given Rio intends to put pressure on margins.

Divestments are still a possibility, and maybe even a source of capital management, but only non-core assets will be up for grabs and they will not be sold for a song. Rio is not desperate. On the other hand, JP Morgan got the impression the Oyu Tolgoi project in Mongolia will go ahead but not until down the track.

Citi is not quite as convinced about the Stage Two expansion. The analysts calculate it would generate $8bn in value but would add 70mtpa iron ore production to the market at a time at which Citi is forecasting a move into global surplus. It would take only a US$15/t drop in the iron ore price to negate Stage Two value, the analysts calculate, while an alternative share buyback of $5bn would be around 7% value accretive. Nonetheless, Citi is resigned to what seems the inevitable:

“Without significant asset sales or a deferral of capex [Pilbara, Mongolia],” warn the analysts, “Rio will likely not be in a position to increase shareholder returns until the second half of 2014”.

Rio chairman Jan Du Plessis, was not going to be intimidated by the pitch forks at the AGM last week. When the Australian Shareholders Association pointed out Rio had plenty of franking credits it could pay out, Du Plessis pointed out that franking credits do not “belong” to shareholders. Rio could hand back a lot of cash, he noted sarcastically, if the company sold up all its assets.

The mob fell silent, the torches sputtered. There is no point in shareholders making assumptions with respect to recent dividend policy changes from other companies. There is no precedent.

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