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Morningstar | Inflation Starting to Pressure Rio Tinto’s Margins; FVE Maintained

We maintain our AUD 48 per share fair value estimate for no-moat-rated Rio Tinto. First-half 2018 adjusted net profit after tax of USD 4.4 billion was 5% higher than a year ago but slightly below our expectations. Adjusted EBITDA increased 1.7% to USD 9.2 billion, with the contribution from copper and diamonds up 76% to USD 1.4 billion on stronger prices and volumes. This outweighed the headwind from energy and minerals, where EBITDA fell 28% to USD 1.0 billion, mainly due to the loss of earnings from Coal and Allied, sold in the second half of 2017, and the strike at Iron Ore Company of Canada. Pilbara iron ore EBITDA was flat at USD 5.7 billion, with increased volumes offsetting lower prices, while aluminium increased 10% to USD 1.8 billion with higher prices and volumes, partly offset by higher costs. Inflation pressure continued to build, particularly in the aluminium operations, where the price of key inputs rose materially. Higher costs offset about 70% of the benefit from higher prices in the aluminium division.

Returns to shareholders were a feature of the result. Rio Tinto declared a first-half dividend of USD 1.27 per share fully franked, up 15% from USD 1.10 per share a year ago. This was in line with the 15% increase in adjusted earnings per share to USD 2.52, with the payout ratio steady at 50%. The company will buy back a further USD 1 billion of shares. The share repurchases are relatively expensive, being in a period of relatively high commodity prices and earnings. However, the additional buyback is relatively small, representing less than 1% of issued capital. This means the potential value destruction is not material to our fair value estimate. Rio Tinto plans to return a further USD 4.0 billion in aftertax proceeds from asset sales in the second half, but the form of returns is yet to be decided. We favour a greater proportion of earnings being returned to shareholders but question the merit of procyclical buybacks.

Rio Tinto has maintained its capital expenditure guidance for fiscal 2018 and 2019 but modestly increased it by 8% to USD 6.5 billion for 2020. This is to bring forward some of the replacement expenditure in the Pilbara and for a new power station to support the Oyu Tolgoi mine in Mongolia. Rio Tinto noted a 40% increase in new mining job listings in Western Australia versus a year ago. We’re also seeing increased activity on the capital expenditure side, notably BHP’s South Flank development and Fortescue’s new Eliwana mine, as well as activity from some of the smaller growth-orientated miners, such as Mineral Resources. This is to be expected, given the maturity of the upswing in the commodity price cycle.

The past couple of years were unusual in that commodity prices were favourable and rising, yet mining firms had held down capital expenditure and growth. So long as commodity prices remain high, we expect industry capital expenditure plans will again start to rise, feeding broader industry inflation. This dynamic is likely to challenge the market’s assumptions for Rio Tinto’s margins to expand in future.

The balance sheet remains very strong with net debt of just USD 5.2 billion, down about 30% in a year. We don’t see any pressing need for a further strengthening of the balance sheet, with annualised net debt/EBITDA at just 0.3. The firm is well placed financially for any potential downturn, which we think is appropriate, given the length of the current upswing. Rio Tinto has the financial capacity to make a meaningful acquisition, and we think a USD 10 billion purchase could be handled relatively easily. But management isn’t seeing any attractively priced assets, which is understandable, given that commodity prices are buoyant and mining firms are generally in strong financial shape. In the absence of a meaningful acquisition, the door is left open for a greater proportion of future cash flows to be returned to shareholders. This is most likely to occur through an increase in the payout ratio and/or further share buybacks.