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Morningstar | Rio Tinto’s 2Q Soft but Our AUD 69 FVE is Retained. Shares Overvalued.

Higher near-term iron ore forecasts primarily drove the recent upgrade in our fair value estimate for no-moat Rio Tinto to AUD 69 per share. At the current share price of AUD 104, the shares are materially overvalued. Our valuation hinges on two key drivers: steel production growth and iron ore supply. Steel production in China is elevated, up 10% for the year ended June. Strong steel production is a second order impact of the U.S./China trade war and weakening industrial production. The Chinese government has moved to stimulate economic growth by reverting to the fixed asset investment playbook.

Iron ore supply is tight, primarily a function of Vale’s tailings dam failure and, to a lesser degree, cyclones in Australia. We estimate more than 100 million tonnes of iron ore, or 6% of supply, has been lost in 2019. Buoyant steel production and tight iron ore supply feed the iron ore price, which sits at five-year highs. But it’s unlikely to last. Vale’s supply will return, it’s just when? Maybe it will take five years, not three, but as supply returns, the pressure on price from shortages should ease.

Rio Tinto’s second-quarter production was weak. However, the softness is immaterial, particularly relative to recent iron ore price gains and our AUD 69 per share fair value estimate remains. Pilbara iron ore shipments suffered in the wake of cyclones. We’d already factored in the lowered volume guidance of 320 to 330 million tonnes for 2019 from June. But as the company hinted, unit cost guidance has risen by USD 1 per tonne to USD 14 to 15 per tonne for 2019, a minor hit to near-term earnings. Volume guidance at Iron Ore Canada is also down about 7%, but it’s a small operation. First production from the 34% Oyu Tolgoi underground copper mine is delayed by about two years due to unstable ground conditions. Rio Tinto’s share of the capital cost is to rise about USD 500 million to resolve the issues but again, the impact is not enough to move the fair value.

The outlook for near-term earnings is very strong with Rio Tinto benefiting from the unexpected iron ore windfall. With the share price above AUD 100, it’s likely dividends will be the outlet for excess cash as opposed to buybacks. We forecast dividends to total USD 6.40 per share in 2019, representing a 75% payout ratio. In the absence of material acquisitions or new capital expenditure initiatives, the payout ratio can even grow a touch to 80% by midcycle. However, by 2023, we forecast dividends to fall to USD 2.70 per share, primarily due to the influence of our lower iron ore price forecast on group earnings.

On China’s steel demand, elevated lending to state-owned enterprises in China represents a poor source of economic growth--short-term gain for long-term pain. Heightened infrastructure and construction spending pulls forward yet more demand from the future. In the absence of government intervention, underlying demand faces long-term headwinds. The current installed base for infrastructure and housing is already an outlier for an economy of China’s per capita income. With China already mostly urbanised, the rate of urbanisation, and thus demand for new housing, should decline. Additionally, as old cars, machinery and buildings reach their end of life, this scrap will find its way back to steel makers at the expense of demand for iron ore. As China’s stock of steel ages, steel supply will increasingly become circular.