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Rio Tinto's Simmering Doubt Quenched

There are numerous pros and cons to Rio Tinto's Simandou iron ore deal--we are maintaining our positive stance

Mark Taylor 3 August, 2010 | 12:32PM
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Rio Tinto has increased certainty for a multi-billion-dollar development of the Simandou iron ore project in southeastern Guinea. The project in its first stage would come on stream in 2015 at a rate of 70 million tonnes annually. A second-stage expansion could see output at more than 100 million tonnes annually. Rio Tinto announced a nonbinding tieup with Chinalco on Simandou in March. Currently, Rio Tinto holds 95% and the International Finance Corporation 5%. Under a new agreement, Chinalco will earn a 47% interest in Rio Tinto's 95% share by spending $1.35 billion. This would give Chinalco an effective 44.65% interest in Simandou, with Rio Tinto diluting to 50.35%.

To put this in perspective, on a 100% basis, Rio Tinto has produced an average 170 million tonnes annually of iron ore over the past three years. Its equity share was 135 million tonnes. All else being equal, Simandou would add around 35 million equity tonnes annually or an extra one fourth to Rio Tinto's current iron ore output. The iron ore division has generated around $8.5 billion, or just more than half of three-year average group earnings before interest and tax. Average annual iron ore capital expenditure has run at around $2.5 billion or a third of group total spending.

Simandou is high-quality ore rivaling Vale's 65% Carajas iron content. Better-quality Australian ores average a lesser 62%. But Simandou's location is remote and the infrastructure requirement comparatively onerous. Speculation has the total project cost at $4 billion-$6 billion. If the former, then Rio Tinto would have little additional to spend or if the latter, an additional potential $2 billion. That's assuming the Guinean government doesn't exercise its option to back in for 20%. That would dilute Rio Tinto's and Chinalco's stake.

The advantages for Rio Tinto in this deal are that it reduces exposure to Guinea's higher sovereign risk, partly funds development, helps mend fences with a government and major shareholder still smarting from the rebuff when Rio Tinto chose BHP Billiton's iron ore joint-venture proposal in preference to Chinalco's alternative $19.5 billion deal, and might even cement Rio Tinto's claim to the Simandou licenses, something over which there has been some conjecture.

The risks are that it increases Chinalco's say in Rio Tinto's affairs (Chinalco already owns 9% of Rio Tinto), it will pressure Rio Tinto to bring on supply for supply's sake, not for profit--always a risk when dealing with government centrally controlled joint venture partners, and it will increase iron ore exposure to the detriment of an already unbalanced commodity portfolio. A great strength of BHP has been its truly diversified and balanced asset portfolio. Rio Tinto is increasingly exposed to the vagaries of iron ore prices.

We retain our positive stance on Rio Tinto. While meaningful, Simandou is not sufficiently so to discourage investment, even accounting for the negatives. It in any case comes with many positives.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Rio Tinto PLC4,592.50 GBP0.00Rating

About Author

Mark Taylor  is an equity analyst at Morningstar.