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Time to buy oversold Rio

Rio Tinto's recent share price slump mirrors a wider fall among the FTSE 350 miners, but as the shares bounce back from a key support level, we think the fall has thrown up a compelling value argument for the stock
July 18, 2013

Shares in mining giant Rio Tinto (RIO ) have slumped 25 per cent from their 12-month high and are 40 per cent off their 2011 peak. To an extent, this mirrors a wider decline among the FTSE 350 miners but, following the shares' recent strong bounce off a key technical support level, we think that the fall has now created a compelling value opportunity and has elevated the shares' dividend yield to a level that warrants the attention of income seekers.

IC TIP: Buy at 2809p
Tip style
Value
Risk rating
Medium
Timescale
Long Term
Bull points
  • Attractive yield
  • Strong production ramp-up
  • Low-cost producer
  • Low Chinese inventories
  • Cost-curve price support
Bear points
  • Iron ore capacity growth
  • Challenging divestment programme
  • Alcan writedowns

What's more, while the share price slump means Rio already offers a compelling forecast yield of over 4 per cent, a number of industry analysts predict that, along with other big diversified miners, it will be focused on improving the payout by the 2015 year-end as the sector's corporate emphasis reverts to generating free cash flow. Admittedly, the yields linked to sector rivals are also tempting, but on other measures Rio's shares are relatively inexpensive by comparison with peers (see table).

 

CompanyTIDM Fwd PE*FWD EV/EBIT*FWD EV/EBITDA*P/BVHistoric DY
Rio TintoRIO7.66.85.21.73.8%
Glencore XstrataGLEN10.310.56.30.93.9%
BHP BillitonBLT10.97.65.82.44.1%

*Consensus forecasts for the next 12 months

Source: Bloomberg

 

Importantly, given the recent downward trajectory of the shares, as well as the implied value based on forecast fundamentals, the stock's recent strong bounce off a key technical share-price support level at slightly below 2,600p suggests the market is prepared to chase the value on offer, while sentiment has been helped by an encouraging second-quarter update this week. Meanwhile, broker JPMorgan points out that, in the period since October 2009, each of the four times that Rio's share price has dipped to around the 2,700p level, it has been up by an average of 29 per cent six months later. Based on the recent 2,580p low, that average gain would imply a price of 3,328p. That said, were the share price to reverse and breach its support, there could be a long way down, so we'd suggest it would be prudent to set a stop-loss at about 2,550p.

With iron ore producing more than 40 per cent of group revenues and over 70 per cent of cash profit, it's little wonder that gathering fears over an economic slowdown in major iron-ore consumer China, which itself accounts for almost a third of Rio's sales, have weighed heavily on the share price. However, while these fears aren't entirely misplaced, there are good grounds to believe they are now overdone. The performance of the mining sector relative to the wider market hasn't been this poor since the height of the 2008-09 financial crisis, but back then there were genuine fears that the global economy was about to fall off a cliff. And although we're hardly in boom territory now, the outlook for the global economy is far more positive.

Despite the domestic slowdown, Chinese mills have continued to produce steel at near-record levels, and are in the process of restocking iron ore inventories that had fallen to their lowest levels since 2010. Chinese steel production is now running at an annual rate of 796m tonnes, which represents a rise of 12 per cent on 2012. And even if overall Chinese demand falters, the fact remains that the People's Republic is buying an ever greater proportion of its iron ore from Australia-based Rio, as opposed to Brazilian rival Vale SA. Indeed, Australian iron ore sales to China are up 60 per cent since May 2009, according to Platts.

 

RIO TINTO (RIO)
ORD PRICE:2,809pMARKET VALUE:£54bn
TOUCH:2,809-2,810p12M HIGH / LOW:3,838p2,580p
FWD DIVIDEND YIELD:4.6%FWD PE RATIO:7
NET ASSET VALUE:2,644¢NET DEBT:33%

Year to 31 DecTurnover ($bn)Pre-tax profit ($bn)*Earnings per share (¢)*Dividend per share (¢)
201055.220.2503108
201160.522.9809145
201251.012.9503167
2013**53.713.2504183
2014**60.517.3601196
% change+13+31+19+7

Normal market size: 500

Matched bargain trading

Beta: 1.73

£1=$1.51

*Underlying PBT and EPS figures

**Canaccord Genuity estimates

 

Fears of supply outstripping demand have been particularly hard on Rio Tinto given its plans to increase annual iron ore production by around 50 per cent to 360m tonnes a year by mid 2015. However, Rio has the advantage of being probably the lowest-cost large-scale producer with an estimated delivered-to-China cost of less than $50 a tonne. The consensus view is that iron ore prices will average well in excess of $100 a tonne through this year and next. In fact, industry costs support the notion that ore prices will need to remain above this level until midway through 2015 even if demand recedes. Regardless of the usual seasonal Sept/Oct fall in iron ore prices, it is highly unlikely that we will witness a repeat of last year's sharp fall in spot prices to below $80 a tonne.

After a series of huge writedowns linked to the regrettable decision to acquire Alcan in 2007, the group's focus is now on disciplined capital allocation. Capital expenditure is expected to fall appreciably from mid-2015. As part of his remit, Rio's new chief executive, Sam Walsh, will be looking to hive off non-core parts of the group in order to trim the balance sheet and free up cash, although pursuing a divestment programme in the current economic climate will be challenging.