Rio Tinto CEO Is Out, Should Investors Get In?

Marshall is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Should investors be looking at Rio Tinto (NYSE: RIO) now that CEO Tom Albanese has been shown the door? The real thesis is that after trading at depressed multiples for some time, could the multiple suppression be over? If so, Rio could be poised to move higher. Albanese's firing comes after his acquisition binge that has led a $14 billion write down on two of its large acquisitions, Alcan Aluminum Group and Riversdale. Doug Ritchie, the former head of strategy who played key roles in the acquisitions, is also being shown the exit as well. 

The $14 billion write down of assets related to the acquisitions is $10 billion for Alcan and $4 billion for Riversdale. The $38 billion Alcan acquisition was made in 2007 and the Riversdale (coal) deal in 2011 for $4.2 billion. The recent news puts the total write downs for the acquisitions to around $30 billion. Riversdale had coal assets in Mozambique, but Rio Tinto was unable to secure government permits to transport coal down Zambezi River, thus the miner has been forced to hemorrhage capital to build out a rail system. Other issues with the coal assets is the fact that the amount of coal previously thought to be there was overestimated. 

The new CEO, Sam Walsh, previously ran the iron ore segment that already accounts for some 80% of Rio's profits. Walsh took Rio Tinto's iron ore reigns in 2004, and according to Credit Suisse, earnings for the segment have jumped fifteen-fold and production (measured by tons) has doubled. Other major miners that have managed to perform much better than Rio have been Vale SA (NYSE: VALE), BHP Billiton Limited (NYSE: BHP) and Cliffs Natural Resources (NYSE: CLF). However, these miners have still had their share of troubles. At least 20 mining CEOs have stepped down in the past year due to costly mining projects that have not produced a suitable return on investment for shareholders. BHP is looking to replace its CEO, Anglo American recently replaced its CEO, Xstrata's CEO is leaving the company following its merger with Glencore, and Vale hired a new CEO last year. Over the last five years Rio Tinto and ArcelorMittal (NYSE: MT) are down 32% and 71%, respectively, where the other three major miners are up:  Vale (+16%), BHP (+28%), and Cliffs (+67%). 

In looking across the industry to see where some of the other mining companies may have failed, or may potentially fail in the near future, a good measuring stick is still cash flow growth to capital spending growth:

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>Rio Tinto</strong></p> </td> <td> <p><strong>Vale</strong></p> </td> <td> <p><strong>BHP Billiton</strong></p> </td> <td> <p><strong>Cliff Natural</strong></p> </td> <td> <p><strong>ArcelorMittal</strong></p> </td> </tr> <tr> <td> <p><em>Cash flow growth (past 5-years)</em></p> </td> <td> <p>2.4%</p> </td> <td> <p>26%</p> </td> <td> <p>7%</p> </td> <td> <p>42%</p> </td> <td> <p>-3%</p> </td> </tr> <tr> <td> <p><em>Capital spending (past 5-years)</em></p> </td> <td> <p>24%</p> </td> <td> <p>26%</p> </td> <td> <p>24%</p> </td> <td> <p>46%</p> </td> <td> <p>11%</p> </td> </tr> </tbody> </table>

Notably, Rio Tinto has increased its spending 24% annually over the last five years, but only seen cash flow up 2% annually; not a great return on investment if you ask me. Looking across the table above, it also appears that BHP Billiton has a large dichotomy between cash flow and spending as well. As a result BHP could also be the victim of large write downs; this prediction is in line with that of Deutsche Bank, which believe that other mining companies will have to write down billions of dollars this year in capital projects.

From a price to earnings valuation standpoint, Rio is the cheapest:

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>Rio Tinto</strong></p> </td> <td> <p><strong>Vale</strong></p> </td> <td> <p><strong>BHP Billiton</strong></p> </td> <td> <p><strong>Cliff Natural</strong></p> </td> <td> <p><strong>ArcelorMittal</strong></p> </td> </tr> <tr> <td> <p><em>Price to Earnings (next year earnings)</em></p> </td> <td> <p>8.2</p> </td> <td> <p>8.9</p> </td> <td> <p>15.9</p> </td> <td> <p>11.8</p> </td> <td> <p>19.4</p> </td> </tr> </tbody> </table>

So, Rio is the cheapest, but for good reason? The peer average from above is 14 times and Rio currently trades with a forward price to earnings ratio that is a 40% discount to peers. Theoretically, what would Rio’s stock price look like if it did manage to shed some of the pressures related to its valuation multiples? The estimated EPS shapes up as follows:

<table> <tbody> <tr> <td> <p><strong><em>Earnings Per Share</em></strong></p> </td> <td> <p><strong>2012</strong></p> </td> <td> <p><strong>2013E</strong></p> </td> <td> <p><strong>2014E</strong></p> </td> </tr> <tr> <td> <p>Rio Tinto</p> </td> <td> <p>$5.43</p> </td> <td> <p>$6.71</p> </td> <td> <p>$7.11</p> </td> </tr> </tbody> </table>

Placing the peer average on 2013 estimated EPS suggests that Rio might be undervalued by as much as 60%. Although shares of Rio Tinto's announcement took the market by surprise and pressured the stock, the stock has managed to hold up relatively well, suggesting that investors see the move as a long-term positive. Worth noting is that the write downs are non-cash and will not impact earnings. However, the write down is nothing to shrug off, since a big majority of Rio’s business is its ability to invest in and monetize assets. The fundamental business of Rio Tinto is its iron ore segment, which is driven by steel demand, whereas the steel industry is driven by economic growth and activity. Assuming global GDP sees the expected growth analysts estimate, the industry could be at the bottom of a cyclical trend. Rio could be an a great speculative play in the industry, assuming you have faith in Walsh's abilities, which he has provided to be fruitful in the past. Or investors could take a look at Vale, which is relatively cheap on a price to earnings basis, and that has managed to grow cash flow in line with spending. 

mhargra has no position in any stocks mentioned. The Motley Fool owns shares of ArcelorMittal. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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