Analysts are raising the fair value estimate for Rio Tinto (RIO) to £15.40 per share from £15 after incorporating higher near-term earnings as a result of the rally in commodity prices in 2016, taking into account the time value of money, and making some minor changes to the model after factoring in the lower Australian dollar to US dollar exchange rate.
Despite the upgrade, Rio Tinto remains overvalued. We think the market remains too bullish on iron ore in particular, and this is the company’s dominant source of earnings. The unchanged no-moat rating reflects overinvestment during the boom. Unprecedented pro-cyclical investment has bloated the asset base and destroyed Rio Tinto's cost advantages. Our unchanged high fair value uncertainty rating reflects operating leverage, cyclicality, and reliance on iron ore.
Profitable through the Commodity Cycle
Rio Tinto is one of the world's biggest miners, along with BHP Billiton, Brazil's Vale, and U.K.-based Anglo American. Above-average assets relative to peers and a solid operating record make Rio Tinto one of the few miners that are profitable throughout the commodity cycle. Geographic and product diversification, however, provide only modest benefit. Most revenue comes from the relatively safe havens of Australia, North America, and Europe, though the company has operations spanning six continents.
Rio Tinto has a large portfolio of long-lived assets with low operating costs. Operations include aluminium, coal, copper, diamonds, gold, iron ore, industrial minerals, and uranium. This competitive resource base sets Rio Tinto apart from most peers. However, capital costs were inflated by substantial procyclical investment during the height of the China boom, the rot setting in by overpaying for Alcan, and subsequent excessive iron ore expansion at the resource boom; the combination of these factors means that returns are likely to remain below the cost of capital for the foreseeable future.
A more recent focus on debt- and cost-reduction sees much new investment relegated to the back-burner. A strategic partnership with Ivanhoe Mines delivered Rio its latest copper development, Oyu Tolgoi in Mongolia. Oyu Tolgoi was the largest undeveloped copper deposit in the world and enhances Rio Tinto's asset portfolio.
As a commodity producer, Rio Tinto is a price taker, not a price maker. The lack of pricing power is aggravated by the volatile and cyclical nature of commodity prices. We don't assign an economic moat to Rio Tinto, given the bloated invested capital base doesn't permit returns in excess of the cost of capital. The firm's assets are large, however, and despite being overcapitalised, generally have low operating costs.
