EUR 850.00 For Business Accounts Only

Morningstar | Slightly Soft Production for Rio Tinto, but Future Commodity Prices Remain Key

Rio Tinto’s production in 2018 was slightly weaker than expected. Rio's share of iron ore sales came in at 281 million tonnes, which was marginally below our 282 million-tonne forecast. Alumina and aluminium were also a bit softer due to maintenance shutdowns and unplanned disruptions. Those issues aside, aluminium capacity continued to increase at the rate of 1% a year, in line with our long-run expectations for productivity improvements. Diamond output declined 15% year on year with the Argyle mine late in its life. Titanium and iron ore pellet production was disrupted by strikes. However, copper was stronger than forecast, thanks to growth at Escondida and an unexpected contribution from Grasberg, which was sold in late 2018.

While copper output in 2018 was strong, guidance for 2019 is weaker than we expected. Rio Tinto expects lower grades to reduce mined copper output for the group to 550,000-600,000 tonnes in 2019, down about 10% from 2018. Guidance for 2019 iron ore shipments is for growth up to 3.6% to 338 million-350 million tonnes. This is in line with our expectation for shipments to increase towards the planned 360 million-tonne rate by around 2021, despite a recent fire at the Cape Lambert port. Aluminium guidance for 2019 is broadly as we expected, except for bauxite, where the new Amrun mine is ramping up faster.

Our AUD 52 fair value estimate is unchanged, and we believe Rio Tinto shares remain overvalued. Our long-term expectation remains that China is unlikely to continue to support excessive investment activity through ever-increasing debt. This is the key reason for our overvaluation view. Lower fixed-asset investment in China is likely to have an outsize impact on demand for steel and iron ore. Iron ore accounts for about two thirds of Rio Tinto’s earnings. Lower fixed-asset investment should also slow demand growth for copper and aluminium, which make up most of the company’s non-iron ore earnings.

Rio Tinto continued to mould its portfolio with asset sales during 2018. The sales saw some of the firm’s lower-quality assets off the books as well as the strategic exit from coal. Last year saw asset sales of USD 8.6 billion with the sale of all coal assets and the company’s interest in the Grasberg copper mine in Indonesia accounting for the bulk of proceeds. With the sales complete, the firm increased its relative exposure to iron ore with lesser contributions from copper and aluminium. That said, we think the bulk of planned asset sales are now in the rearview mirror. Assets that could still be sold include the firm’s interest in iron ore pellets in Canada and titanium minerals in South Africa.

The balance sheet is in good shape, and we expect net debt to have declined to around USD 3.0 billion by the end of 2018 from USD 5.5 billion at the end of June 2018. The strong financial position, with Rio Tinto arguably undergeared, and relatively constrained capital expenditures have allowed free cash flow to be directed to share buybacks and dividends. We expect a record full-year dividend of USD 3.40 per share in 2018, up 21% from 2017. Higher dividend payments are a worthy use of funds; however, we continue to question buying back shares when the external environment is so favourable and asset prices are relatively high. That said, selling assets at this point in the cycle is likely sensible.

With minimal net debt, the firm is well placed financially for any downturn, which we view as appropriate, given the length of the current upswing in commodity prices. That said, we note Rio Tinto could make a meaningful acquisition, and a purchase up to USD 10 billion could be handled relatively easily. An acquisition of this size would see net debt/EBITDA increase to around 1.0 based on our 2019 forecast. However, we think finding attractively priced assets in this environment is difficult, given that commodity prices are generally favourable and mining firms are generally in good financial shape. As a result, we expect dividends and share buybacks to continue to be a significant use of future free cash flow. However, our contention is that lower commodity prices will reduce dividends and earnings from current buoyant levels.

Rio Tinto has noted that inflationary pressures continue to build, particularly in the aluminium operations, where the price of key inputs such as alumina rose materially in the second half of 2018.