Shares in focus: Hitch a ride with Rio Tinto
Phil Oakley Jan 28, 2013
Rio Tinto is heading for a fall eventually, but buy in for short-term profits, says Phil Oakley.
Rio Tinto is one of the world’s largest mining companies. Its operations are split into five main product groups: aluminium, copper, diamonds and minerals, energy (coal and uranium), and iron ore. Although it has operations in Europe, South America and Africa, most of its assets are in Australia and North America. The group’s profits are dominated by its iron-ore operations, which accounted for around 75% of net earnings in 2011.
Today’s Rio Tinto has its history in two separate companies. Rio Tinto was formed in 1873 to reopen ancient copper mines beside the river Tinto in southern Spain. The Zinc Corporation was set up in Australia in 1905.
In 1962, the British operations of Rio Tinto and Consolidated Zinc merged to form Rio Tinto Zinc (RTZ). At the same time the Australian interests of both companies were merged to form ConZinc Rio Tinto of Australia (CRA Ltd). In 1997, both firms came together under the Rio Tinto name.
The company has tried to reduce its dependence on iron ore. The $38.1bn purchase of Alcan Inc in 2007 made Rio Tinto the world’s largest aluminium producer. But the deal has not worked out well – it was a classic top-of-the-market purchase, and stretched Rio’s finances so badly that it needed a $14.8bn rights issue in 2009 to shore up its balance sheet. Meanwhile, a recent attempt to expand its coal business in Mozambique has also been disappointing.
As a result, last week Rio announced it would write $14bn off the value of the aluminium business and the coal operations. Chief executive Tom Albanese also stepped down.
The chief executive
Following Albanese’s departure, Sam Walsh has taken over the top job. He is seen as a safe pair of hands, having run Rio’s iron-ore unit since 2004. He’s worked for Rio for over 20 years, having previously worked in the car industry. The new job will see him take home an annual salary of $1.9m.
Should you buy the shares?
Most City analysts are keen on Rio’s shares, but the market seems decidedly non-plussed. Rio’s profits have recovered from the depths of the crisis, but have been volatile in recent years, moving in line with commodity prices.
What troubles investors most is that the company remains very dependent on iron ore. Iron-ore prices in turn largely depend on China continuing to import lots of it. Longer term, there is also some worry that new iron-ore capacity coming on stream from Brazil will depress prices.
At MoneyWeek, we believe the worries about Chinese demand for iron ore are well-founded. The country’s over-reliance on investment suggests it can’t go on building at the same rate as it has been. But while we’ve no doubt that China is in for a hard landing, it’s clearly making an effort to delay the inevitable for a little longer.
Meanwhile, investors have started 2013 in an upbeat mood, looking for beaten-down sectors to buy into. This leaves scope for anyone looking to profit in the short term from a rally in the mining sector to take a bet on the right stock. But is Rio the one?
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Looking at the positives, Rio is sitting on a great iron-ore asset: the Pilbara mine in Australia. Its low costs and proximity to China give it a big competitive advantage over other sources of supply, so even if overall Chinese demand slows, Rio could still sell its product. Last year was a record one for production and there is possibly more growth to come.
This mine could keep producing lots of surplus cash for shareholders for a while yet. Rio will also hope that its copper investment in Mongolia pays off, while it is also bullish on the outlook for titanium oxide sales. Rio is reducing investment and cutting costs. It aims to save $5bn in operating costs over the next two years, which should be good for profits.
Despite the big write-offs, its finances are in good shape, with debt at comfortable levels. Make no mistake, its reliance on iron ore and China makes Rio Tinto a risky investment, more so than its more diversified peers. But the shares are not expensive, and pay a reasonable, well-covered dividend. As long as Chinese demand does not collapse in the very near term, the shares could easily rally.
If you’re after a short-term trade with limited downside, Rio is a buy – but use a 20% stop-loss. We’ll update you on the progress of this trade later in the year.
Rio Tinto (LSE: RIO): the numbers
Stockmarket code: RIO
Market cap: £67.2bn
Net assets (June 2012): $65.6bn
Net debt (June 2012): $13.4bn
P/e (current year estimate): 9.5 times
Yield (prospective): 3.0%
Interest cover: 28.3
What the analysts say
Average price target: 3,959p
S Walsh (CEO): 46,950
G Elliot (FD): 103,078
J Du Plessis (chairman): 30,000
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