In many races, the fabled tortoise always beats the hare. That's
the lesson learned by diversified miner
Rio Tinto (
RIO
)
, which tried to race ahead, stumbled badly, and is now running the
race at a more moderate and safer pace.
At the height of the commodities boom in 2007 and 2008, Rio's
executives were enraptured by a stock price that had tripled and
abandoned their historical moderate growth plans by making a $40
billion bet on Alcan to become a massive player in the aluminum
market. The deal made strategic sense. The price did not. And when
credit markets eventually swooned, Rio Tinto nearly choked on its
massive
debt load
, sending shares down more than -85% from $140 in early 2008 to
just $16 in early 2009. Shares have since rebounded to $66.
That stumble provided a valuable lesson. Rio has since pared debt
and is more content to simply grow in line with the broader
commodities market. The company now has a much better reputation on
Wall Street, thanks to the relative youth of its mines and its
low-cost operations. The company's main focus is iron ore mining
(54% of revenue), aluminum (21%), copper (10%) and coal (10%). That
kind of diversity means Rio is not as beholden to pure play miners
such as copper producer
Freeport McMoran (
FCX
)
.
Right now, Rio appears to be firing on all cylinders, as
commodity
prices have rebounded from the 2009 lows. Just-released quarterly
results came in slightly ahead of forecasts, pushing the stock to a
fresh 52-week high. Yet shares remain at less than half of their
early 2008 peak, and though it may be several years before Rio gets
there, the rebounding global
economy
could propel results back to previous peaks.
That's not to suggest that commodity prices will again be in a
bubble. They'll likely fall short of those 2008 peaks, but Rio's
rising production is making up for lower prices. Rio's
net income
should rise from $6.3 billion in 2009 to more than $13 billion this
year. And analysts think profits could top $16 billion next year,
assuming commodity prices don't fall.
Judicious use of debtleverage
As noted above, Rio has been working off debt after getting carried
away in 2008. Yet the company still employs enough debt to generate
impressive returns on its equity base. The company is on track to
generate a return on equity of more than +25% this year, thanks to
EBITDA margins approaching 45%.
Yet management is more careful these days not to employ too much
debt
leverage
, just in case the global economy slumps and commodity prices fall.
Nevertheless, investors should know that shares would take a pretty
serious hit if China's voracious appetite for commodities comes to
a halt. That's not an expected scenario, but some investors such as
well-known short-seller James Chanos think China is in a bubble and
headed for a crash. He's in the minority with that view, but it's
worth noting.
Action to Take -->
Many investors try to focus on the best commodity play. Gold and
copper have been the strong plays in recent quarters. [Read our
recent takes on gold
here
and copper
here
]
But a broad-based approach to commodities is the best bet, and Rio
Tinto offers almost all of the
diversification
you need in one place. Despite the recent run, shares look very
reasonable at around eight times projected profits. That multiple
is unlikely to expand too much further, perhaps to 10 or 11,
representing +25% to +35% upside. To re-visit the stock's 2008 peak
of around $140, we'd need to see a clear resumption of global
economic growth, which would push commodity prices up. That's a
possibility, but not something you should bet on. Instead, look at
Rio as a great long-term holding to make sure your portfolio has
exposure to commodities.
-- David Sterman
David Sterman started his career in equity research at Smith
Barney, culminating in a position as Senior Analyst covering
European banks. David has also served as Director of Research at
Individual Investor and a Managing Editor at TheStreet.com. Read
More...
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.