Dwindling confidence in the global economic recovery and a slowdown in China’s economic growth have collectively taken a toll on demand for industrial-related commodities such as iron ore and copper. Rio Tinto (NYSE:RIO), by virtue of being one of the world’s largest miners, is vulnerable to these factors even though its product portfolio spans basic metals like iron ore, copper and aluminum to energy products like coal and uranium.
In the wake of recent economic developments and numerous other factors, we have revised our price estimate for Rio Tinto to $63, which is around 25% ahead of the current market price. We have also updated our model to reflect the change in company’s reporting structure.
Iron Ore Holds the Key for Growth Even as Price Outlook Remains Dull
The company’s key commodity, iron ore, has seen falling demand and prices after skyrocketing for two years. Construction activity in China has slowed, leading to a pileup of inventories and a resulting decline in demand, as iron ore is primarily used in steel production. We expect iron ore prices to remain weak in the near-term due to additional capacity expected to come online over the next two years. However, we still expect China to remain the leading demand driver going forward.
Rio Tinto believes that its iron ore shipments can rise by more than 50% by 2015 and doesn’t seem to be deterred by weak iron ore prices as it is undergoing a $3.7 billion iron-ore expansion in its Pilbara mine in Australia. This will ramp up its annual production capacity to 353 million metric tons by 2016, from the current 230 million metric tons. Further, a greenfield expansion at Simandou in Guinea is expected to add 95 million metric tons by 2015. We expect that in the long term, these moves will create significant value given the fact that the company enjoys healthy margins on the commodity compared to other minerals and metals. While iron ore prices have come down to about $135-$140 from as high as $200, the company still produces the commodity at one-fourth of the current price.
Most of Rio Tinto’s iron ore operations are in Australia, whose relative proximity to China gives the company a proximity advantage over world’s largest iron ore producer, Vale (NYSE:VALE). Further, Rio Tinto also has a competitive advantage with its cost of production being much lower than other small miners and new entrants. If iron ore prices remain weak, in line with our expectations, new entrants and iron ore producers from China and India will find it difficult to sustain lower prices. With these factors, we believe the company will be well-positioned following an eventual economic recovery.
Cautious on Copper in Near Term
Copper, another major commodity for Rio Tinto, has also seen a correction owing to its high correlation with global economic activity. Still, we believe copper consumption in China will pick back up thanks to growing demand from the renewable energy sector and several other industries, while the copper price may remain subdued as rising global production is beginning to close the demand-supply gap. The company has several expansion projects going on, such as Oyu Tologi, which are expected to boost copper production in 2013 onwards.
No More Focus on Aluminum, Diamond
Per our revised estimate, the aluminum division’s percentage contribution to Rio Tinto’s value has been reduced to single digits as the company has spun off its higher-cost aluminum assets in Australia and New Zealand, cut capacity across the geographies and put many aluminum assets on the auction block. Further, sluggish demand and an oversupply of aluminum is likely to remain a headache for the company.
While we currently expect diamond demands to continue to show strength, Rio Tinto is reviewing whether its diamond business fits with its bigger strategy of operating large scale, long-lived, expandable assets. Should the company decide to spin off its diamond business, it may lead to a change in our price estimate.
Rising input costs remain a concern
We expect the iron ore, copper and aluminum divisions’ margins to decline gradually going forward, mainly due to rising energy, labor and other input costs. Iron ore will likely be the most affected due to the expected decline in iron ore prices. However the Pilbara expansion plan could lead to lower production costs. Further, any change in contract pricing mechanism will also impact the division’s EBITDA margins.
We expect margins to improve in the company’s other non-core businesses such as energy, diamonds and minerals mainly on the back of economies of scale and the company’s efforts to improve operational efficiency.
Taxes could increase
In March, the Australian government passed legislation imposing a new 30% tax on iron ore and coal mining to cut its fiscal deficit. The tax will be applicable in July and will lead to an increase in the company’s overall tax burden. Mining companies have always been susceptible to macroeconomic and political risks, and those may impact the share price in the near-term. However, we believe that these issues won’t hamper the company’s long-term prospects and believe its outlook is strong.