Spectacular Upside With or Without Production Growth!
Peter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Rio Tinto (NYSE: RIO) is a giant global mining company with an enterprise value (EV) greater than $100 billion. An estimated 80% of this year's operating income (EBIT) is expected to come from the company's iron ore operations. While that's a heavy concentration in a single commodity, RIO has one of the most profitable iron ore segments in the world with a segment EBITDA margin of ~70%. Margins like that are why the BIG 4 iron ore players Rio, Vale (NYSE: VALE), BHP (NYSE: BHP) and Fortescue Metals are loath to cut back growth plans even though iron ore prices are down to about $115 per metric tonne from highs of $180-$185 last year.
Cash operating costs in the $40's & $50's per tonne make these mega-miners somewhat indifferent to the iron ore price as long as its above, say, $100 per tonne. As profit maximizing firms they want a higher price if possible, but at prices in the lower $100's per tonne they stand to gain market share. Global marginal cost is widely believed to be approximately $110-$130 per tonne. In that range, higher cost Chinese production comes off-line, or at least that's the conventional wisdom.
BHP and Vale have a number of mid-sized, large and massive iron ore projects, both, "brown field" expansions and new "green field" efforts. Some of these projects will be put on the back burner. Not due to currently lower iron ore prices but for cost, labor, equipment, permitting, regulatory, legal, tax & royalty regime uncertainty and environmental reasons. That's a long list of headwinds facing the mining industry, but each is a valid concern. A quick Google search for the words "resource nationalism" is a simple way to see what's going on.
The above suggests that supply additions will not live up to expectations. In fact they rarely do. Yet demand for iron ore, copper, coking coal, potash, aluminum and many others continues to grow. Rio is especially well positioned to capture the growth in Asia. In Mongolia, Rio owns 34% and is growing of one of the largest copper/gold projects on the planet. As with the other mining behemoths, Rio has already deployed 10's of billions of upfront capital towards the development of this and the rest of the company's growth.
I mention the huge cap-ex spend for two reasons. First, if it slows due to projects being delayed and canceled, Rio will be awash in cash that can be returned to shareholders through increased dividend payouts, special dividends and share buybacks. The other reason I mention it is because Rio's 2013 EV/EBITDA ratio is just 3.5x-4.0x. This is 1x-2x below historical norms. As low as this valuation metric is, Rio is even cheaper than that. Why? The 10's of billions of capital deployed in projects that have not reached production are not captured at all in an EV/EBITDA ratio.
That's why analysts correctly use discounted cash flow analysis to calculate a Net Asset Value (NAV)." Turning to NAV, when a sum-of-the-parts exercise is conducted on Rio and peers, the NAV per share calculation is frequently 50-100% above the current share price. For example, in a July 2nd Morgan Stanley research report, the analyst calculated a NAV per share that's now 106% above the current price.
Let's say that the analyst is overly-optimistic in that he incorporates all of the known growth projects into his segment discounted cash flow calculations. If Rio delays or cancels projects then the analyst's NAV will prove to be too high. BUT, if that's the case, then Rio will have tremendous excess cash flow to use for the shareholder friendly purposes mentioned above. Either way, Foolish investors should want to own Rio Tinto over then next few years.
MockingJay2011 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.