How Will The Recent Decline In RIO’s Iron Ore Output Guidance Affect The Company’s Stock Valuation?
Iron ore operations in Western Australia’s Pilbara region are affected following last week’s tropical cyclone Veronica, which has had an adverse impact on Rio Tinto’s (NYSE: RIO) operations. As a result, Rio now expects FY 2019 iron ore production to come in at the lower end of its previous guidance of 338M-350M metric tons, with storm damage and an earlier fire at the Lambert A port facility causing the loss of ~14M mt of annual production. However, we believe that the production cuts will not have any major impact on RIO’s stock valuation. We expect RIO to maintain its valuation of $62 per share, driven by earnings per share (EPS) of $5.16 in 2019 and a forward price-to-earnings (P/E) ratio of 12x.
We have summarized the impact of lower production on Rio Tinto’s stock price in our interactive dashboard – What impact will the recent iron ore production cuts have on RIO’s valuation? In addition, here is more Materials data.
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Lower iron ore production
- In line with the company’s expectations, we have assumed RIO to meet its lower level of production guidance of 338 million tons at Pilbara in 2019.
- This translates into RIO’s share of 280.5 million tons for the year, which is 83% of total Pilbara production (in line with historical trend – 82% in 2016 and 2017, followed by 83% in 2018).
- Thus, iron ore production is expected to see a marginal decline of 0.3 mt or 0.1% in production attributable to the company.
Effect on revenue from iron ore
- In spite of the fall in volume, iron ore revenue is expected to increase by 6.2% to $19.6 billion in 2019 from $18.5 billion in 2018.
- Higher revenue would most likely be driven by an increase in price to $70 per ton for the year from $65.8 per ton in 2018. Iron ore prices have witnessed an increase since the beginning of the year on the back of easing trade tensions between the US and China, coupled with rising demand from other emerging markets.
- Additionally, production cuts by Vale, due to the recent dam accident at its site in Brazil, is expected to support an elevated price level throughout the year in view of supply constraints.
Effect on total revenue
- Though iron ore revenue is set to rise by 6.2%, total revenue is expected to decline by 2.7% to $39.4 billion in 2019 from $40.5 billion in 2018.
- Lower revenue would likely be a reflection of a sharp drop in copper revenues as RIO has sold its interest in the Indonesian Grasberg mine in December 2018. Lower shipments would likely lead to a significant decline of about 38% in copper revenues in 2019. Additionally, with coal revenue attributable to the company completely ceasing following the completion of the sale of Rio Tinto’s interests in Kestrel and Hail Creek in August 2018, revenue from the Energy and Minerals segment is expected to further decline by about 8% in 2019, after marking a decline of 26.6% in 2018.
- Thus, Iron ore is expected to remain the best performing segment for RIO in spite of lower volume expectations.
Effect on Profitability
- Our EPS of $5.16 for RIO in 2019 is a reflection of expected net income of $8.9 billion, driven by projected revenue of $39.4 billion, and a net income margin of 22.5%.
- Projected margin of 22.5% in 2019 is lower than the margin in 2018 which was bloated by non-recurring gains, but higher than in 2017.
- Net income margin increased from 21.9% in 2017 to 33.7% in 2018. Such a large increase in margins reflects profits from the sale of the coal business and a few aluminum assets, lower interest expense due to the bond buyback program of 2018, higher capitalized interest, and profit from the sale of a stake in the Grasberg operations, partially offset by higher mining, exploration, and evaluation costs.
- Margin growth is expected to remain robust in 2019 primarily due to lower interest expense and productivity improvement.
Thus, the projected drop in production and shipments of iron ore is expected to have negligible impact on RIO’s revenue growth, margins, and stock price. Trefis’ price estimate of $62 per share of the company’s stock is slightly higher than its current market price.
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