Rio Tinto - Approaching strategy crossroads
About the author:
- Author name:
- By Adrian Prendergast
- Job title:
- Senior Analyst
- Date posted:
- 21 July 2020, 10:38 AM
- Sectors Covered:
- Mining, Energy
- Iron ore makes up 80% of EBITDA, but won't always be this strong. Does Rio Tinto (ASX:RIO) use the opportunity to change its business?
- A good first half from RIO overall, with solid volumes vs soft metal prices.
- 2Q20 Pilbara iron ore shipments of 86.7mt (+1% y/y) came in ahead of our estimate of 85.5mt. While average price marginally trailed.
- Mined copper was close to our estimates while aluminium volumes impressed.
- 2020 capex guidance was lifted to US$6bn (from US$5-$6bn), while production and opex guidance across the business was unchanged.
- A good operational result supporting RIO's upcoming first half earnings due to be released on 29 July, and a healthy interim (cash) dividend.
Approaching strategy crossroads
With the iron ore price sitting 70% above marginal cost, and several other metals in the doldrums, we see now as the optimal time for RIO to consider its future.
RIO has a solid but somewhat lopsided business, with iron ore attributing for 80% of group EBITDA. Iron ore will not always be this strong, so does the big miner use its current earnings strength to make some changes.
The two options we see:
- Spin off its non-iron ore assets into a separate entity with a dedicated management team and focus on its iron ore business, or
- Re-introduce diversification through acquisitions (i.e. boost copper exposure through acquiring bite-sized OZ Minerals? Or even Newcrest for a gold/copper combo?)
Good 2Q20 production result
2Q20 Pilbara iron ore shipments of 86.7mt (+1 y/y) came in ahead of our estimate of 85.5mt, although realised price marginally trailed at US$85/t CFR (vs Morgans US$88/t).
Mined copper in 2Q20 of 133kt was -3% y/y (vs MorgansE 136mt), although was unexpectedly carried by Escondida which flexed throughput to support group copper volumes.
RIO's aluminium division volumes (bauxite/alumina/aluminium) were 5-12% ahead of our estimates while prices remained in the doldrums.
Meanwhile RIO lifted 2020 capex guidance to US$6bn (from US$5-$6bn) due to currency swings. 2020 production and opex guidance was left unchanged.
Set for healthy first half dividend
We see the 2Q20 operational result as setting RIO up for first half underlying NPAT of US$4,124m MorgansE, roughly flat y/y with buoyant iron ore prices and better volumes holding earnings up.
On our estimates this sets RIO up for an interim dividend of US$1.74ps (with forecast 2020 dividend yield of 5.6%), after assuming a small reduction in payout ratio to 65% in the first half result.
Maintain Add rating
We see some long-term strategy questions that need answering, but maintain our Add rating on a TSR basis with RIO boasting exceptional earnings quality (group EBITDA margin 46%), heavy free cash flow generation (FCF yield >9%), and attractive dividend yield (>5%).
After updating our model for the result our estimates have only shifted slightly, with an updated target price (Morgans clients can login to view detailed reports and price targets).
The key risk to our call remains iron ore price volatility and broader macroeconomic risks (demand drivers for metals).
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