Rio Tinto Riding The Chinese Urbanization Wave

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By USAStockValuation :

Rio Tinto Plc ( RIO ) is a diversified mining company involved in finding, mining, and processing resources such as aluminum, copper, diamonds, thermal and metallurgical coal, uranium, gold, industrial minerals (borax, titanium dioxide and salt) and iron ore. The company has a number of major operations in Australia and North America, with other significant operations in Asia, Europe, Africa and South America.

The company was founded in 1873 with its first operation being on the Rio Tinto river in Spain. Throughout its history, the company has acquired whole and partial stakes in a myriad of smaller companies allowing the company to diversify both in terms of commodities as well as geographical presence. The largest acquisition was in 2007 which was a purchase of Canadian aluminum company, Alcan for $38.1B which took RIO's net debt to equity to a dangerously high 180%. RIO is about the 4th largest publicly listed mining company in the world based on market capitalization.

RIO has now got its balance sheet in order, which puts the company in such a stronger and safer position. RIO was highly leveraged in 2007 which put them in a very difficult situation once the global financial crisis set in and commodity prices took a dive. The company was almost taken over by BHP Billiton ( BHP ) during that period, and in the end accepted a large investment by Chinalco, a Chinese mining enterprise, in order to meet its debt obligations.

The company is broken down into 5 business units as follows:

  • Aluminum: includes bauxite, alumina and aluminum. RIO is the largest bauxite producer in the industry. A lot of these operations are self powered by hydroelectricity

  • Copper: includes gold, molybdenum, silver, nickel and copper. RIO is the worlds 5th largest producer of copper

  • Diamonds & Minerals: includes diamonds, borates, titanium dioxide feedstocks, talc, high purity iron, metal powders, zircon and rutile. RIO has a number of projects in the pipeline in this business unit.

  • Energy: includes thermal coal, coking coal and uranium. Much of its products are sold in Asia in close proximity to their mines in Australia.

  • Iron Ore: includes iron ore and salt. RIO is the 2nd largest producer supplying the global seaborne iron ore trade. Much of its iron ore comes from Western Australia which is in close proximity to China.

click to enlarge

RIO Bus Unit

Source of Data: riotinto.com

Recent Performance

2010 was a stellar year for RIO with net income increasing from $4.9B in 2009 to $14.3B in 2010. Most of this increase came due to much larger volumes of iron ore produced as well as the high price of iron ore. The revenue of the Iron Ore division, which is by far the largest, doubled from 2009 to 2010.

The company faced challenges in early 2011 due to severe weather conditions which hampered some of RIO's operations but the company bounced back well in 3rd quarter 2011, which was another record quarter.

By the 12th October this year, 69 million RIO shares had been bought back at a total cost of $4.4B. While the shareprice is below Intrinsic Value, buying back shares is a good idea as it adds shareholder value. RIO announced that it intends to spend a further $2.6B in share buy-backs by the end of 1st quarter 2012.

RIO's balance sheet is healthy with a net debt to equity of 9%, with $14B of long term debt, $1B of short term debt, and almost $10B in the bank. It also generated an impressive $13.7B in cashflow during 2010. RIO is a wonderful generator of cash which places it well to purchase other assets, pay down debt, pay a dividend, or buy back shares.

Quality Rating

RIO QR

Source www.usastockvaluation.com

Interestingly, RIO only scores a moderate quality rating score. This is due in part to the serious effect that the Global Financial Crisis had on RIO and also its aggressive capital expenditure regime. Importantly RIO scores a perfect 10 on cash flow.

Intrinsic Value

RIO IV

Source: www.usastockvaluation.com

RIO is well positioned to capitalize on the China growth story should it continue. Unless China falls in a heap, RIO's IV will continue to rise dramatically in the coming years.

RIO IV Graph

The performance of RIO is in general dependent on the price of iron ore. The hiccup in performance of RIO during the Global Financial Crisis is plain to see. For the last few years though, with the price of iron ore and other commodities strong, the performance of RIO has improved drastically. For stock market participants interested in investing in RIO, the graph illustrates that now looks to be a good time. The value has stormed ahead, and the price has yet to catch up.

Investment Grade Score

The Margin of Safety of RIO is 44% based on the USAStockValuation.com method of calculating Margin of Safety which is: (Intrinsic Value - Share Price) / Intrinsic Value. And the Quality Rating of RIO is 65/100.

This gives an Investment Grade Score of (44 x 65) / 100 = 29 which places RIO at number 54 on the USAStockValuation.com Investment Grade Table. By multiplying the Margin of Safety by the Quality Rating, only those companies with a good combination of quality and value make the upper echelons of the Investment Grade Table.

Drivers of Future Growth

On the back of a stronger balance sheet, RIO is investing for its future by ramping up its capital expenditure. RIO's capital expenditures of $5.1B for the first half of 2011 already exceed the total capital expenditure for all of 2010 which was $4.6B. The below production profile gives an illustration of the expected increase in production up to 2015 as a result of the current and future projects in RIO's portfolio:

RIO Prod Profile

Source: riotinto.com

With mining companies, the general rule is the bigger they are, the lower the costs per unit to produce. This is because high production means economies of scale and lower cost per unit measure of the resource being produced. Another advantage of large mining companies such as RIO is their project execution capabilities which have been proven time and time again over many years.

The major risk on RIO is its large iron ore division and its subsequent dependence on the price of iron ore, which in turn is dependent on the China growth story continuing. 28% of RIO's sales come from China, but more importantly the urbanization of China is propping up the price of iron ore. If China were to fall in a heap it would be disastrous for RIO, at least in the short term. See below an illustration on the urbanization of China with the US as a point of reference.

RIO Urb

Source: zdlaw.com

Conclusion

Through operating large scale operations, RIO produces at a lower cost per unit volume/weight than most of its peers. It enjoys strong cash flows and its future looks bright. RIO is also paying a $1.07 dividend which based on the current shareprice of $55.5 provides a yield of 1.9%.

The risk to investors in RIO is a downturn in the Chinese economy and for those who believe the Chinese economy may dive will want to stay away. Conversely, the current price of RIO should be very attractive for investors who believe the China urbanization story will continue.

Disclosure : I have no positions in any stocks mentioned, but may initiate a long position in RIO over the next 72 hours.

See also From Destocking To Restocking, Joy Global Weakens Case For A Commodities Crash on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: BHP , RIO

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