Rio Tinto: Mining for value

20th January 2014

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Edmund Shing, Global Equity portfolio manager at BCS Asset Management, looks at the prospects for the mining firm below. 

Over at least the past decade, UK-listed mining stocks such as Rio Tinto (RIO) have been tightly correlated with two key financial asset classes:

Industrial commodities (industrial metals such as copper, nickel and aluminium and coal for making steel) and Emerging markets such as the Brazilian, Russian, Indian and Chinese (BRIC) stock markets, as well as the Australian stock market (which is itself heavily-weighted towards mining stocks).

Tight correlation between UK Mining stocks and Metals Prices

Source: Bloomberg, Author’s calculations
The reason for this is clear: the main sources of growth in demand both for these industrial metals and for coal have been China and India, as they have expanded their heavy manufacturing bases to become the world’s centres for all types of manufactured goods, from white goods to toys.

UK Mining Stocks Have Also Followed the Australian, Emerging Stock Markets

Source: Bloomberg, Author’s calculations

Nothing new or particularly interesting to note so far. Recall that the worst-performing major regional stock markets over 2013 were indeed Emerging Markets; and that one of the worst-performing industrial sectors in the UK stock market last year was the Mining sector, both driven by concerns over slowing growth in the major BRIC economies.

But Rio Tinto is Now Diverging from Emerging Markets

However, now for a more interesting and perhaps less obvious fact: Since the middle of last year, the major UK-listed diversified mining company Rio Tinto has managed to de-correlate from the poor trend in emerging market stocks (chart 3).

Rio Tinto Starting to Diverge From Emerging Markets

Source: Bloomberg, Author’s calculations

While the last few months have seen no change in the downtrend for major emerging market stocks, Rio Tinto has in contrast established a positive uptrend, albeit one that is somewhat volatile.

Why would this be? A key reason is the returning optimism that world economic growth will indeed accelerate in 2014 after a 2013 that was dragged down by a lack of growth in Europe and slowing growth trends in the developing economies. The World Bank has just recently upgraded its outlook for global economic growth for this year thanks to better momentum both in the US and also in Europe. Added to this is the fact that China looks to be maintaining an overall growth rate around 8%, far from the bearish predictions of many economists who expected Chinese growth to slip far further.

Chart 4 underlines that both the G10 economies (the major 10 global economies) and China are both seeing accelerating economic momentum, and are both beating economists’ expectations. This is one key underpinning for the better trend in industrial commodities that has been in evidence since mid-October

Chinese, Global Economies Enjoy Improving Momentum

Source: Bloomberg, Citi

Dr. Copper is on the Rise, Giving Rio Tinto a Helping Hand

Key beneficiaries of this improved macro outlook have been economically-sensitive industrial metals including copper, aluminium and nickel. After all, it is not for nothing that copper’sfinancial markets moniker is “Dr. Copper” – the commodity with an Economics PhD, as it generally provides a reliable guide to the overall trend in global economic growth.

As is evident from chart 5 below, Rio Tinto has enjoyed a geared version of this recovery in copper prices.

Rio Tinto rallying together with copper prices

Source: Bloomberg, Author’s calculations

And Rio Tinto is Still Cheap

Given the relatively poor price performance of the UK Mining sector last year, it is perhaps unsurprising to learn that Rio Tinto sits at attractive valuation levels: an end-2014 forecast P/E of just over 9x, and an Enterprise Value/Earnings Before Interest and Taxes (EV/EBIT) ratio of 5.8x, far below the average valuation ratios for the UK stock market. In addition, Rio’s prospective dividend yield is a decent 3.6%, with the potential for solid dividend growth ahead given a dividend payout ratio that is a mere 35% of earnings.

With Catalysts in the form of Improving Business Activity, Cost-Cutting

The final element in Rio’s (admittedly simplified) investment story is a stated improvement in underlying business trends, with output up 7% to 55.5 metric tons over the last quarter. This boost to output was coupled with a reduction in cash costs of over $2bn, with exploration spending cut in two to just $948m last year.
Rio’s management stated last month that Rio had already completed a drive to cut annual costs by $2bn (including the cutting of 4,000 jobs across the group), part of a wider initiative to cut expenses by an ambitious $5bn over two years. According to Rio Tinto’s CEO Sam Walsh, the cost-cutting programme now has “rolling momentum”.
Large global mining companies like Rio Tinto, BHP Billiton and Vale in Brazil are all tightening their belts in terms of investment spending, which has the twin effects of (a) booting short-term profitability as costs come down, and potentially also (b) supporting long-term industrial metals and coal prices, as less new supply of these commodities will come on-stream from new mines over the next few years.

Summarising RIO’s Key Points

There are a number of reasons for taking a long hard look at Rio Tinto’s investment case today:

1. Global economic growth is being revised up, and the Chinese economy could well maintain an decent 8% growth rate after all, implying sustained demand for industrial commodities;

2. Industrial metals prices including copper are moving higher in reaction to this greater macro optimism, which in turn should be translated in time into higher selling prices and thus turnover for UK Mining companies like Rio;

3. Rio Tinto is sitting at cheap valuation levels versus its own history and versus the overall UK stock market averages, and offers a decent dividend yield to boot;

4. Curbing of investment spending (as greater investment discipline is imposed) and operational restructuring within the very complex global mining conglomerate that is RIO is also improving profitability, driving future profit growth.

5. All of which is resulting in a rising share price trend, completing my favourite combination of value, momentum and positive catalysts.

The UK Mining sector has been an area of the stock market to avoid over the last twelve months; however now looks to me like a good time to re-assess the relative merits of Rio Tinto.

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