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Digging for Value: Rio Tinto, a Wide-Moat Multinational Mining Company

November 22, 2011 | About:
Rio Tinto (RIO) is a multinational mining company with a global footprint. Its operations focus on just a handful of key minerals, such as iron, aluminum, coal and copper, plus a variety of auxiliary minerals. Rio Tinto is so large that it produces 772,000 ounces a year worth of gold, $1.3 billion at current market price, as a “by-product” of its mining operations.

Being big isn’t an advantage in itself, but the large scale does come with a benefit: economies of scale. One of the company’s primary strengths is its focus on Tier 1 (world class) projects, which Rio Tinto defines as “the largest, most cost competitive resources that are profitable at all parts of the natural price cycle and that deliver sustainable competitive advantage.” These projects are large and have lives measured in decades. The size of these projects allows realizing greater economies of scale than would be possible with smaller projects, while long lives can provide greater cost visibility. Moreover, with large-scale projects, cost optimization is much more worthwhile, as what is just a modest saving for a small five-year operation, can become a significant one in a large 20-year project. Of course, large projects have risks: With just a few large projects, a problem at a single site can significantly affect the performance of the whole company.

Rio Tinto’s focus on large projects means that if a property fails to reach the Tier 1 status, it is disposed of. With its size and expertise, the company can afford being selective about its opportunities, reporting that since 2008, it “has completed more than 20 divestments with total gross proceeds in excess of $11 billion.” At the same time, the company maintains a steady flow of acquisitions and investments to replace these projects with new opportunities. At the end of 2010, Rio Tinto was actively exploring for various commodities in 16 countries and assessing opportunities in another 7 countries. The company discovered eight Tier 1 projects between 2000 and 2010.

Recent investments include the increase in Rio Tinto’s stake in Ivanhoe Mines to 49%. Rio Tinto manages Ivanhoe Mines’ 66%-owned Oyu Tolgoi project in Mongolia, which, according to the company, is “scheduled to be a top ten copper producer and a significant gold producer.”

Another notable investment is the completion of the $3.7 billion acquisition of Riversdale Mining Limited in Mozambique, which completed in August and represents a “substantial Tier 1 coking coal development pipeline.”

Earlier, in 2007, Rio Tinto acquired aluminum producer Alcan for $38 billion and now appears to be trimming excess fat, announcing in October that it would dispose of an array of Alcan’s assets “to concentrate on its strategy to grow the value of its high quality, tier one assets and improve the product group’s financial performance.” The announcement wasn’t surprising as Rio Tinto mentioned in its 2010 annual report that it would review its assets, specifically mentioning “higher cost aluminium assets.” This shedding of non-core assets pursues the goal of removing smaller and lower-margin aluminium operations. At the same time, the company says it is in no rush, mentioning that it will choose “the most opportune method and timing,” suggesting that management will try to get as high a price as possible for these assets, even if this means waiting through the current economic uncertainty. Thus, it may take a year or two before the business becomes leaner.

The company’s mining operations require significant capital expenditures to develop its properties and bring them to production. Average annual investment in PPE has tripled in the past 10 years – from $1.4 billion in 2001 to $4.6 billion in 2010. Over half a billion dollars (gross) was spent on exploration and evaluation activities in 2010.

Rio Tinto has significant R&D operations, developing new technologies for mining, as well as for subsequent processing of mined minerals. The company reports that its R&D staff doubled during 2010 to 538 employees, driven by “an increase of demand for the design and build of major projects.” R&D activities include the development of the HIsmelt (high-intensity smelting) technology, which Rio Tinto says is “the world’s first commercial direct smelting process for making iron straight from the ore […] and [which] offers significant economic and environmental benefits to the steel industry.” A memorandum of understanding was signed with Jindal Steel and Power Limited for the commercialization of this technology.

Rio Tinto is developing the Mine of the Future™ concept in collaboration with universities and equipment producers, which focuses on automation and remote operations. According to Rio Tinto, this project led to the opening of the Perth Operations Center, “from which Rio Tinto people can control iron ore mining and infrastructure at our Pilbara operations, more than 1,000km away.” As part of this project, Rio Tinto has recently announced that it will purchase 150 driverless trucks for the Pilbara project – to become the largest such fleet in the world, which will be controlled from the same center, illustrating the company’s commitment to implementing new technologies in real operations to drive efficiency, lower costs and improve safety. Assuming that Rio Tinto can implement this concept for other projects too, it will have an additional central management tool at its disposal, which can increase its responsiveness and operational efficiency.

Another major development with potential to increase the company’s efficiency and competitiveness further is its underground tunneling and shaft sinking technology, which Rio Tinto hopes will more than double the excavation rates in block cave mines versus conventional methods. Rio Tinto reports that if this technology proves successful, it will be implemented in its next generation block cave mines, pointing out that as ore deposits are increasingly found deeper in the ground, this could become a strategic advantage.

Once again, the company’s size is an important competitive factor here, as only large players can afford maintaining similar R&D activities.

In addition to individual strengths, Rio Tinto should benefit in the long run from the expected strong demand for commodities from emerging markets, especially China and India. China is already the largest consumer of minerals and as the country is expected to continue growing, its consumption should grow too. Of course, if China trips, so will the global commodities markets. Rio Tinto has set up a joint venture with Chinese company Chinalco to explore China for world-class deposits, Rio Tinto’s share in JV is the maximum allowed 49%, which represents a certain risk, but which probably is worth taking from the long-term perspective.

The largest risk facing Rio Tinto is undoubtedly the volatility of commodity prices. These depend in large part on the health of the global economy and thus can be very unstable, especially given the current uncertain outlook. Almost all increase in earnings in 2010 was due to rising commodities prices – from 26% for gold to 69% for iron ore, after similar declines in 2009. With the global economy still in a limbo, fortunes may reverse once again for Rio Tinto in case of another economic decline. It is worth noting that even if the company’s portfolio of minerals is fairly diversified, most commodities will move together in a recession.

Another significant set of risks is closely tied to the nature of mining operations: environmental and occupational health and safety. The company is making great strides to improve its record, reporting an 18% reduction in injury frequency rate in 2010 and being listed on the FTSE4Good, the Dow Jones Sustainability Indexes and the Carbon Disclosure Leadership Index. At the same time, Rio Tinto was purged from the portfolio of the Government Pension Fund of Norway due to environmental concerns.

Union representation of mine workers is another notable risk. In October, Rio Tinto mentioned the disruption of operations at the Grasberg mine in Indonesia, which has been on strike since mid-September. The company does not report the total number or proportion of its workforce represented by unions, but we suspect it is material.

The company also faces political risks due to projects in politically unstable countries – there is always risk of nationalization, as well as limits on foreign ownership shares of 49%, which could impair the company’s ability to control such projects. Even if the company has shareholders' interests in mind, the majority stakeholders may not. At the same time, Rio Tinto’s operations are spread all around the world, providing a fair degree of geographic diversification to withstand political and economic shocks from individual countries, as well as other region- and country-specific risks (e.g., natural disasters).

A recent and ongoing development in the commodities markets is their securitization. As commodities are increasingly traded on exchanges and securitized through various derivatives, this is likely to have a dual impact on Rio Tinto: On one hand, it should increase the liquidity of commodity markets and provide additional opportunities for hedging risks; on the other hand, this may increase the impact from speculators who may increase market volatility. As commodities are increasingly used as investments, this trend may lead to bubbles forming in the market, which will hurt unhedged producers when they burst.

Operational Performance

Rio Tinto’s operations have grown sevenfold over the past 10 years – from $8 billion in 2001 to over $56 billion in 2010, at a CAGR of 24.6% (Table). At the same time, as the gross margin has declined, the net margin has doubled, although both have exhibited much volatility, which is inherent in commodity markets. This volatility is also reflected in the relatively low stability of earnings and free cash flows, while revenues and equity per share are much more stable (Table). The stability of cash flows is also affected by the uneven acquisition and disposal activities.

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Balance Sheet:

Rio Tinto’s debt stood at about $18 billion at the end of Q2-2011, with a debt to equity ratio of 0.29, generally in line with the industry’s 0.26 and at a historically low level (10-year average is 0.77). Debt increased from $3.5 billion in 2006 to $46.8 billion in 2007 as a result of the acquisition of Alcan, but has more than halved since then. Interest coverage is at a historically high 34x, comparing favorably with the industry (Reuters reports ‑0.22x). Since the end of Q2-2011, Rio Tinto has issued $2 billion of additional debt. Given the company’s active program of disposals, good cash generation capability and $7.5 billion in cash at the end of Q2-2011, the balance sheet remains quite strong. Rio Tinto reports that in April 2011, Standard & Poor’s raised the company’s long-term credit rating to A-.

Management Efficiency

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Rio Tinto’s turnover ratios are currently at historically high levels. As a result, the cash conversion cycle in the TTM period stood at just 14 days versus the 10-year average of 73 days. We must point out that some of this improvement is due to rising commodity prices which inflate revenues without a similar appreciation of inventories and payables.

Relative Valuation:

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This stock is volatile, is coupled to the global economy, and is not without risk. We believe Rio Tinto is well positioned to take advantage of the eventual recovery of the global economy, as well as the longer-term trend of rising demand from emerging markets. At the same time, the company has the scale and resources to weather difficult and uncertain times. Our valuation models place the intrinsic value anywhere between $70-85 per share. The volatility of the share price presents multiple opportunities to scale in with a reasonable margin of safety. In our opinion, its competitive strengths make it a good long-term investment.

About the author:

Margin of Safety
Margin of Safety Equity Research is a value-investing focused company providing equity research services, the Securities Analysis System investment software, stock valuation models, and other financial resources for value investors. Members of our subscription services have access to the Margin of Safety value-oriented portfolio and discounted access to our software.

We apply Buffett's and Charlie Munger's four filters in selecting stocks as part of a concentrated portfolio (10-15 equities). Criteria for selecting companies are:

1.They are strong businesses; as defined by high long-term cash generation, above-average return on invested capital, possession of favorable underlying economics and a durable ...More competitive advantage, good financial health, and above-average profit margins

2. We understand the business

3. They are run by competent management

4. They are available at bargain prices.

We require a 25-50% margin of safety, depending on the stability and economic moat for the company.

In addition to equity research services, we are a member of the Gerson Lehman Group Expert Counsel of Advisors and provide research/consulting services to investment banks.

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Rating: 4.1/5 (22 votes)

Comments

boutch2fr
Boutch2fr - 3 years ago
62,8 Billion USD shareholder's equity at 30th June equals a P/B of 1,5 at today's price... Doesn't it?

on top of that, I'd mention past year (TTM) dividend of 0,63 + 0,54, which at today's price gives a dividend yield of 2,4%.

I also recommend Trefis analysis, where you can "play" with market prices or Rio's products:

www.trefis.com/company#/RIO?from=search

long Rio.

G.

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