Rio Tinto's (RIO) strong first half is unequivocally positive for its full-year 2014. We're raising this year's full-year earnings forecast by 35%, chiefly due to impressive iron ore cost reductions. Our 2015 earnings forecast is marginally higher, though still down on 2014 in anticipation of weaker commodity, primarily iron ore, prices.
Our fair value estimate is unchanged at £41.65 per share. We don't consider one half-year's earnings sufficient to meaningfully alter our overall long-term outlook. At £34, the shares remain undervalued, a benefit in a company of Rio's pedigree. Rio probably has the best iron ore business in the world. We remain upbeat on the outlook for capital and operating cost savings.
Rio Tinto reported much stronger-than-expected first-half 2014 underlying earnings of $5.1 billion, up more than 20% on the previous corresponding period. The company remains all about iron ore, that division reporting a 10% increase in underlying contribution, and making up more than 90% of earnings overall. The next largest contributors, copper and aluminium, also exceeded expectations, but they remain almost immaterial. The strong result reflects Rio exceeding its targeted $3 billion in operating cost savings six months ahead of schedule, although record volumes also featured. Cost-reduction momentum is now expected to realise an additional $1 billion by end 2015.
This is a very impressive result, with management true to their cost cutting word. Lower Pilbara iron ore network expansion capital costs support our narrow economic moat rating, and our medium fair value uncertainty rating. This is founded on low-cost supply, thanks to high-quality geological deposits and economies of scale. The excessive level of iron ore earnings reliance continues to dictate a mild preference for BHP Billiton's more diversified earnings stream, with both stocks trading at similar discounts to their fair value estimates.
Despite no overall change, the mix in our fair value has moved somewhat due to trends gleaned from the first-half result. Iron ore has risen to over 80% of our fair value estimate, given favourable capital and operating cost trends, but also as other divisions decline. Rio guides for reduced 2014 capital expenditure, down $2 billion on previous guidance, to USD 9 billion, largely in reduced iron ore capital intensity. Fair value contributions from aluminium and copper fall, despite better-than-expected half-year earnings, due to a cut in forecast margins. Aluminium reporting in particular is complicated by seemingly endless earnings restatements, as components exit and re-join depending on the mood. Energy coal is a partial offset, with the benefits of an aggressive cost and productivity improvement program in evidence.
Rio remains confident in long-term demand fundamentals. It cites effective Chinese economic rebalancing and steel production growing 20%, to reach one billion tonnes by 2030, as urbanisation rates reach 70%. Rio expects 125 million tonnes of high cost Chinese iron ore supply to exit the market this year, supplanted by new Australian and Brazilian seaborne product.
Chinese government data released today revealed more bad news for coal; thermal power generation, mainly coal-fired, declined 3.2% in July compared with the prior year, dragging year-to-date growth down to 3.5%.We maintain our view that Chinese coal demand is likely to peak shortly, then flatline through 2020. We expect two broad catalysts will produce this surprising outcome. Both catalysts were clearly evident in July.
The first catalyst is economic: a sharp deceleration in electricity demand due to a transition away from the energy-intensive, investment-led economic model of the past decade. Power use by industrial sector, which accounts for 74% of China's power demand versus a 30% share in the U.S., for example, drives the total power demand outlook. Data released today suggested China's industrial output decelerated in July and is on pace to post its slowest annual growth rate in more than a decade.
.jpg)
.jpg)
