Rio Tinto has managed to turn many heads as the stock has close to doubled since late 2020. Is the company still worthy of an investment?
Rio Tinto (NYSE: $RIO), once known to promiscuously flout regulations, has after 32 years ironically agreed to fund a study of environmental damage caused by its former Panguna Mine in Bougainville, which led the island nation to descend into a civil war. What does this say about this mammoth of a company?
Rio Tinto is one of the world’s largest mining companies and has mines all over the world, with the bulk of its operations in Australia and Canada. Rio Tinto has been gaining a lot of popularity from investors due to the sky-rocketing commodity prices. The company mines for Iron Ore, Aluminium, Copper, and other minerals, and seems to have achieved a fair amount of diversification with its commodity operations.
Earnings Analysis and Valuation
In the short term, Rio Tinto seems like a solid bet on continued high iron ore prices. Thorough examination revealed that Rio Tinto’s recent earnings have been driven almost exclusively by soaring Iron Ore prices which recently reached all-time highs, largely driven by Chinese demand for steel.
Looking at the company’s financials for 2020, Iron Ore contributed 78.8% of the company’s underlying EBITDA, up from 62% in 2017. This large increase in EBITDA was largely due to the rising price of Iron Ore as the Company’s production remained roughly constant. It was actually surprising that 2020 iron ore shipments increased by 1% and production increased by 2% despite the COVID-19 pandemic. This is a testament to the company’s safety protocols as well as Australia’s fine handling of the pandemic.
Looking at the P/E ratio at face value, the stock seems cheap relative to its 5- year average. However, leverage to commodity prices is a double-edged sword. In the bear market of 2018, the price of gold declined by 2.66% with junior miners taking a heavier hit with an average stock decline of -31.66%. It is therefore important to examine how Rio Tinto would do if it faces a decline in the underlying commodity price.
Compared to its peers, it has a relatively low sensitivity of production prices with respect to commodity price changes.
Given the low production cost of Rio Tinto’s Iron Ore, the EBITDA sensitivity is not very high. Looking at the latest EBITDA sensitivity published in 2020, a 10% price change in Iron Ore would have translated into a $2.3 billion impact to EBITDA. This is roughly 12.3% of Iron Ore EBITDA and 9.7% of total EBITDA. In other words, a small decline in the price of Iron Ore would not tank Rio Tinto’s profits.
Iron Ore price to stabilize in the long-term
This is an important finding as it allows us to evaluate Rio Tinto as a long-term investment. Another reason is that the shift to electric vehicles will drastically increase the demand for Iron Ore. This is because the battery in new electric vehicles requires more Iron Ore than traditional vehicles. Although a little skeptical about this metric, it can be assumed to be true for now, and having said that, people won’t immediately junk their existing cars and replace them with EVs. Therefore, the roll-out of EVs could be slower than what analysts are expecting. The other opposing factor is that autonomous vehicles and the shift to work from home could reduce the total number of vehicles needed.
BMO’s latest Steel Monitor commented on the spot prices for US hot-rolled coiled steel, to have climbed to an all-time high with the current supply squeeze, which it said is poised to ease out with increasing domestic production and higher imports.
The Feds have maintained their view that prices will remain well above historical averages throughout 2021 and 2022. This comes as a result of burgeoning end-market demand and a staggering time for upcoming greenfield capacity additions.
There is a strong likelihood that Iron Ore prices will further increase in the short term.
The company still has a surefooted presence in the global mining space and seems to be working on its frugal ESG infrastructure. The company isn’t too sensitive to the price of Iron Ore, making it a moderately risky investment. Being an established dividend payer with a solid 5.5% payout, this company is almost never a bad investment, rather a strong and defensive one.