Rio Tinto – Great shape justifies hefty price

About the author:

Adrian Prendergast
Author name:
By Adrian Prendergast
Job title:
Senior Analyst
Date posted:
11 July 2019, 9:45 AM
Sectors Covered:
Mining, Energy

  • After a review of our assumptions and forecasts for RIO, along with a mark-to-market on our iron ore forecasts, we lift our valuation (Morgans clients only).
  • Our valuation puts RIO on 5.5x EV/EBITDA FY20, in line with its global peers.
  • Plenty happening at RIO, but the largest uncertainty at the moment is around Oyu Tolgoi Underground project, where we expect an update in August.
  • Buoyant iron ore prices continue to beef up RIO's earnings, we now expect 2019F EPS of US$7.08ps and DPS of US$4.26; putting RIO on a dividend yield of 5.8%.
  • RIO's spot valuation sits at a whopping A$171.96. Which in our view is not a reflection of its true value, but is indicative of the size of upgrade cycle it is in.
  • In great shape but this value already looks priced in, leaving RIO in Hold territory.

Robust earnings strength accelerates

With benchmark iron ore price (62% Fe fines FOB) trading around US$120/t, RIO is finishing the first half with an exceptional tailwind that is helping to offset some of the lost earnings from lower iron ore and copper production.

After flushing through further increases to our iron ore price forecasts for the next twelve months, and reviewing our operational and cost assumptions, we have lifted calendar year 2019 EPS forecast to US$7.08 (from US$6.73).

Meanwhile RIO boasts a FCF yield of 8% and could easily push its balance sheet into a net cash position if it eased off on further buybacks/growth.

Update on Oyu Tolgoi on the way

Not all smooth sailing at RIO however, with the big miner set to update the market in August on progress at Oyu Tolgoi underground expansion (OTUG). The development of Shaft Two was delayed nine months last October after RIO encountered multiple instances of rock giving way.

As a result RIO is:

  1. determining whether it needs to initiate caving (mining) at a different location
  2. whether any infrastructure needs to be moved
  3. how the ramp up profile will change, and
  4. what the slippage in schedule will be

The key questions for us are:

  1. how much will its US$5.3bn budget move
  2. how much reserves will be lost if RIO elects to avoid the areas with variable rock mechanics

We forecast total OTUG capex of US$5.9bn (vs its current budget of US$5.3bn).

Ongoing dividend/buyback potential

We see multiple years of elevated earnings as possible for RIO, with 2019 being a year where iron ore price strength has offset some lost volumes, while 2020 and 2021 should see recovering iron ore volumes against a moderating price.

Assuming a 60% payout ratio, this puts RIO on track for at least three years of +5% dividend yield with ample room for further share buybacks.

Time will tell if RIO introduces additional growth that may claim some of this spare capital.

Still in Hold territory despite surge in share price

Despite its recent share price strength we see RIO as well supported by strong fundamentals and a healthy return profile. Trading equivalent to 5.8x EV/EBITDA, RIO sits just ahead of an average of its global peers at 5.5x.

With a revised valuation-derived price target (Morgans clients only) we maintain our Hold rating. Commodity price risk and sovereign risk are the key risks to our Hold call.

More information

Morgans clients can login to view our detailed report and upgraded share price target for Rio Tinto (RIO). Alternatively, please contact your Morgans adviser or nearest Morgans office for access.

Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

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