Rio Tinto Stock Rises 80%; Is It Still Undervalued?

by Trefis Team
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Upside
81.40
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Trefis
RIO
Rio Tinto
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Despite an impressive rise of 80% from its March lows of this year, at the current price of $65 per share, Rio Tinto stock (NYSE: RIO) still has some upside left. RIO stock rallied from $36 to $65 off its recent bottom, compared to the S&P 500 which increased 60% from its recent lows. The stock has been able to beat the broader market in the last 8 months on the back of recovery in iron ore prices with the US government announcing a string of measures along with stimulus packages announced in other economies to keep businesses afloat. In addition, with the lockdowns being lifted gradually, we are set to see further rise in iron ore demand and reduction of supply constraints. This will drive faster growth in revenues and margins, thus providing a potential further upside of more than 10% from its current level. Our dashboard What Factors Drove 24% Change In Rio Tinto Stock Between 2017 And Now? provides the key numbers behind our thinking.

The rise in stock price between 2017-2019 is justified by the 7.9% increase in Rio Tinto’s revenues. Revenues went up from $40.5 billion in 2017 to $43.7 billion in 2019, mainly due to a rise in iron ore prices and higher shipments. Revenue growth was partially offset by 5% decline in the P/S (price-to-sales) multiple, which went down from 2.35x in 2017 to 2.23x in 2019. This was because the company’s profitability declined between 2017-19 on the back of a higher base and significant impairment charges. RIO’s P/S multiple crashed further in the beginning of 2020 following the outbreak of the coronavirus pandemic. However, it has recovered over recent months in tandem with a sharp recovery in iron ore prices, and the multiple currently stands close to 2.5x (higher than the Dec 2019 level). We believe the multiple will remain elevated around the current level, while higher revenues will drive the stock further.

Upside Trigger?

The outbreak and global spread of coronavirus led to lockdown in various cities across the globe, which affected industrial and economic activity. Lower demand from construction players and shedding of capacity by major steel companies, mainly in China, has led to a drop in global iron ore prices. Additionally, the lockdown has affected the global supply chain for companies like Rio Tinto which have operations spread across geographies, leading to a decline in production and shipments. This was evident from the recently released H1 2020 results, where Rio Tinto’s revenues declined by 7% to $19.4 billion while net earnings were down by 20%. Though iron ore production was up, it could not translate into higher revenues due to a  drop in price realization.

The actual recovery and its timing hinge on the broader containment of the coronavirus spread. Our dashboard Trends In U.S. Covid-19 Cases provides an overview of how the pandemic has been spreading in the U.S. and contrasts with trends in Brazil and Russia.  As the global lock downs are lifted gradually, iron ore demand is expected to rise with supply constraints easing. This is likely to lead to an uptick in shipments toward the end of 2020. Global iron ore price has also increased since April, from $80/ton to over $123/ton currently. Though the stock has increased significantly over the last 8 months, the recent surge in Covid positive cases in the US and Europe could prove to be an impediment for RIO. If the rise in cases warrant a re-imposition of lockdowns, then the stock could see a sharp drop. However, in the absence of another lockdown, revenue and earnings will see sharp growth in 2021. This will likely lead to further uptick in the stock, where RIO’s investors have an opportunity see more than 10% growth in wealth.

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