Martin Barraud
The doom and gloom of some months in the past a few double whammy of stagflation hitting demand for metals appears to be distant historical past. The Rio Tinto Group (OTCPK:RTPPF; OTCPK:RTNTF) share value has gained 43% from the low it hit solely 3 months in the past. It’s now lingering at multi-year highs. Recession, what recession? The outlook from a number of months in the past of financial Armageddon has not materialized (but) and had undoubtedly been brushed apart by patrons and traders in metals – and in mining teams.
Metals staged a formidable rebound
Regardless of numerous laborious and delicate commodities shedding steam over the previous yr, industrial metals have staged a dead-cat bounce since October-November. Over the identical interval, Brent oil dropped by 13%, common pure fuel costs dropped by round 40%, and delicate commodities have softened in value as properly.
On the opposite hand, the iron ore value is up 55% since its nadir final November, whereas copper is up by 30% since September. This spectacular rebound in iron ore costs has been defined by strong demand, strengthened by resilient Western economies and the reopening of China’s financial system after the comfort of Covid-related lockdowns. Provide, however, has been restrained attributable to numerous causes, together with unhealthy climate in Australia and Brazil, and upkeep closures in Australia. The COVID-era slowdown in investments by mining teams can be nonetheless creating tightness in provide. Copper’s value is being propped up by related elements, with civil unrest in Peru, the world’s second-largest producer, limiting manufacturing on the large Antapaccay mine, whereas Chile, the world’s largest producer, predicting a shrinkage in manufacturing this yr.
How about the long run?
One of many important elements that mining and commodity traders should deal with is the excessive stage of volatility, and the impossibility of predicting commodity costs – and thus the degrees of profitability of commodity teams. Not less than within the brief time period. For long-term traders who can abdomen the excessive stage of volatility within the brief time period, the image could possibly be clearer. Ignore the every day doom and gloom of the press, and traders can see there are very clear long-term world developments that don’t wane with no matter is going on within the subsequent weeks and months. World inhabitants will continue to grow, economies will continue to grow, industrialization and urbanization proceed to develop closely, and the shift to renewable vitality and electrification is accelerating at an exponential price.
On the similar time, provides of metals usually are not anticipated to get higher; there are restricted volumes of steel within the floor, and a handful of teams on the planet have enough monetary muscle and experience to extract it at an financial price. Put all these elements collectively, and it’s crystal clear that costs of business metals needs to be heading in a single route over the long run – to not point out the short-term pressures I famous beforehand on this article.
Conservative method of administration is reassuring
Warren Buffett used to say that it’s higher for a penny to be burning a gap in your pocket than in another person’s pocket. In previous steel booms, there was frenzied deal-making that resulted in billions of {dollars} being written off after unhealthy, costly acquisitions have been made. Glencore (OTCPK:GLCNF) nearly collapsed a number of years in the past because of accumulating mammoth ranges of debt. And Rio’s earlier administration suffered blows after their very own value-destructive acquisitions, together with buying Alcan in 2007 for an eye-watering USD $38 billion, when metals have been on the peak of an excellent cycle. That acquisition led to large write-downs and destroyed billions of shareholder worth.
4 years later, Rio acquired a coal mine in Mozambique for USD $3.4 billion – all of which was written off two years later. Add to that the newer scandals that Rio confronted attributable to destruction of aboriginal websites in Australia in 2020 – and the general scandals concerning the poisonous and discriminative work tradition at Rio – and one can perceive why Rio’s present administration is tip-toeing in any new acquisitions or investments.
Rio Tinto’s administration has been eager to emphasize that they like natural progress and that they’ve a really excessive bar to think about acquisitions. They careworn that they don’t need to pay full worth for acquired property and that any acquisitions have to suit totally of their construction and plan. In different phrases, they won’t rush to deploy Rio’s considerable money coffers in shopping for every part underneath the solar. Rio’s shareholders are extra worthy of receiving such money in dividends and share buybacks, somewhat than the shareholders of acquisition targets that don’t add clear and apparent worth.
Probably the most seen latest acquisition was a plain vanilla, risk-free one, that could possibly be hardly even known as an acquisition. Rio paid USD $3.1 billion to extend its share of the Oyu Tolgoi copper mine in Mongolia Oyu Tolgoi, which is predicted to succeed in annual manufacturing of 500,000 tonnes of copper per yr, making it one of many largest mines on the planet.
Who to consider – the naysayers or the bulls?
Final July, the Monetary Occasions printed an article filled with a bearish outlook for mining traders. The article began by noting that:
“Mining outlook darkens as twin threats loom Buyers set for final spherical of bumper payouts as margins are squeezed by falling commodity costs and value inflation.”
The article quoted an analyst who mentioned that:
“Rio’s money movement would “evaporate” in 2023. Rio will see its free money movement compress by 75 % on numbers subsequent yr. It is that mixture of upper prices and decrease commodity costs.”
The timing of that article was well-timed; iron ore costs dropped by roughly 25% from July to the November backside, and are nonetheless 20% beneath the height of final March. Costs are at this time just a few proportion factors above the USD $120 per tonne that was quoted when that article was printed.
However the doom situation predicted in that article does appear now overstretched. Costs have rebounded strongly since This fall of 2022, and are nonetheless in a powerful uptrend. Concurrently, vitality costs and inflationary pressures have waned. And the operational efficiency of Rio has been strong. Iron manufacturing grew by 6% in This fall versus Q3 and versus This fall 2021, copper manufacturing grew by 6% in 2022 versus 2021 (though down barely in This fall versus Q3 and This fall 2021), aluminum manufacturing grew by 3%, and the manufacturing of titanium oxide, the brand new child on the block, grew by a staggering 42% in This fall 2022 versus This fall 2021. Titanium is an important materials in industries resembling medical units, aerospace and gasoline cells, and the West has been eager on rising manufacturing away from China, which holds the lion’s share with a 3rd of world manufacturing. Rio has not too long ago reached an settlement with the Canadian authorities to reinvigorate the dormant Sorel-Tracy mine in Quebec, which is probably going to offer a great addition to Rio’s manufacturing of the steel.
Dangers shouldn’t be taken frivolously
As I famous in my article printed on the ninth of June final yr, Rio’s traders face a number of dangers that they should assess diligently earlier than chipping in. The seesaw value volatility is unquestionably not for the faint-hearted; iron ore traded at USD $220 per tonnes 18 months in the past, USD $80 per tonnes 3 months, and is buying and selling at the moment within the USD $120s. Rio’s share value has seesawed accordingly from GBP 60 per share 18 months in the past to GBP 44 final October, and again to GBP 63 now.
I’ve famous that the shortage of diversification is a focus danger for Rio, with the majority of revenues coming from iron ore. Rio has been working slowly however absolutely on diversifying its metals portfolio – with some pitfalls such because the messy acquisition of Alcan – and the portfolio needs to be extra balanced with time, particularly when the mega copper mine in Mongolia begins bearing fruit.
Inflation proved to be a particular tailwind to Rio somewhat than a headwind. Solely USD $1.3 billion of extra bills have been booked final yr because of inflation – a drop in Rio’s ocean of money.
Monetary energy is prone to be sustained
Though the froth of astronomical profitability and money technology will rationally wane off, Rio is prone to stay a sturdy money machine. Within the final reported financials of H1 2022, the group generated USD $10 billion of working money. That was 23% lower than the comparable interval of 2021 however double that of the identical interval of 2020. Free money movement of USD $7 billion was a 3rd lower than 2021 however 150% larger than the identical interval of 2020. And dividends per share have been 50% decrease than H1 2021 however nonetheless 72% larger than 2020. With steel costs in a rebound mode, and manufacturing ranges holding up, it’s laborious to think about a meltdown in Rio’s monetary efficiency or in returns to shareholders.
The depressed valuation of Rio offers traders with a buffer of security – though I consider a wider margin of security is required earlier than chipping in, given the recessionary outlook and the elevated rates of interest. At a P/E of seven instances and market cap to working money movement of 5.25 instances, Rio appears barely undervalued in comparison with BHP’s P/E of 8.8 instances and market cap to working money movement of 5.5 instances. However that is justified; Rio’s RoCE of 34% in H1 2022 was method decrease than BHP’s 48.7%. And BHP is a lot better diversified than Rio, and it does have larger manufacturing prospects within the foreseeable future.
The dangers of investing in a miner on the whole, and in Rio particularly, shouldn’t be ignored. The volatility of costs, political, environmental and social dangers, and the present overshadowing cloud of potential recession are all legitimate causes to tip toe into mining funding. However the overarching long-term view doesn’t get impacted by any of those brief to medium-term dangers; the worldwide financial system will continue to grow, demand for metals is irreplaceable, and the change to renewable vitality is at full velocity.
Rio Tinto Group, and its fellow class A miners, doubtless have a sustainable long-term future, however traders should time their entry cautiously and regularly. As Rio’s administration is pedantic about inserting cash in new acquisitions or investments, so needs to be Rio’s traders be pedantic about investing on this engaging money machine.
Editor’s Observe: This text discusses a number of securities that don’t commerce on a significant U.S. change. Please concentrate on the dangers related to these shares.
