Is The 125% Rise In Rio Tinto Stock Justified?

RIO: Rio Tinto logo
Rio Tinto

Despite an impressive rise of more than 125% since its March 2020 lows, Rio Tinto stock (NYSE: RIO) does not seem to be overvalued. In fact, at the current price of $84 per share, RIO stock is almost close to its fair price, with a marginal upside still possible. The stock has rallied from $37 to $84 off its recent bottom, compared to the S&P 500 which increased close to 75% from its March 2020 lows. The stock has been able to beat the broader market in the last 11 months on the back of a strong 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 in 2021. This will drive faster growth in revenues and margins in the coming quarters. Though the price is 40% more than its level at the end of 2019, improvement in financials in 2021 will help the stock remain at current elevated levels, with it even having a potential marginal upside. Our dashboard What Factors Drove 58% 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 8% 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 effect 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 over 3.1x (much higher than the Dec 2019 level). We believe the multiple will remain high at over 3x, which along with higher revenues will keep the stock price elevated.

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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 picking up with supply constraints easing. This is likely to lead to an uptick in shipments in 2021. Signs of recovery were already visible toward the end of 2020 with iron ore production for full year 2020 rising 2% y-o-y. Global iron ore price has also doubled since April 2020, from $80/ton to $160/ton currently. Though the stock has increased significantly over the last few months, the recent announcement by China that it plans to cut its crude steel production (which will lead to lower iron ore demand from the country) is likely to lead to some short-term volatility in RIO’s stock. However, with investors’ focus having shifted to 2021 and the company expected to report healthy growth in production, shipments, revenue and earnings during the year, the stock is likely to stay at current levels and could even see a marginal uptick in the near term.

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