BHP - Rio Tinto: China Construction Stimulus Is Coming

2023-07-26 16:26:47 ET

Summary

• China's new stimulus policies, including rate cuts and subsidies for refurbishing and modernising existing apartment buildings, could benefit the construction materials industry, including iron ore producers like Rio Tinto.
• The Chinese government is shifting from tearing down aging buildings to implementing subsidies for their overhaul and modernisation, which could lead to a new decade of prosperity for construction materials and iron ore companies.
• Rio Tinto has signed a Memorandum of Understanding with China Baowu, the world's biggest steelmaker, to explore projects in China and Australia to help decarbonise the steel value chain, signalling preparation for market.

China is passing a series of stimulus measures

Rio Tinto ( RIO ) is one of the largest iron ore producers in the world. China is the largest steel consumer . The slowdown in Chinese construction with the debacle of Evergrande ( OTC:EGRNF ) and other Chinese developers has sent the prices of some Steel producers and raw material iron ore miners downwards based on the headwinds of an overbuilt Chinese economy rife with ghost cities. I wrote my first-ever article on Rio Tinto , and it's nice to see some new catalysts lining up.

One frequently noted Chinese stimulus policy that has been in the news as of late is the rate cuts. China is one of the only central banks in the world currently cutting rates to stimulate organic growth. Another policy is being finalized that would subsidize the refurbishing, rebuilding and modernization of existing old apartment buildings in the cores of China's major metros. This is a huge news drop that has largely gone unnoticed. Rio Tinto and others in the construction materials industry stand to benefit.

H1 earnings update

Just in, the first half earnings for Rio Tinto are less than stellar . The interim dividend is going to be cut as lower prices of iron ore commodities damaged the increase in volume being exported. This was expected par for the course of Rio Tinto's dividend policy:

Rio also declared an interim dividend of $1.77/share, equal to 50% of underlying earnings; a year ago, it paid an interim dividend of $2.67/share, also 50% of underlying earnings.

No surprises here. However, as we'll see below with new Chinese construction stimulus just getting started, I think we could be at the entry point of higher demand. The volume uptick is there, the iron ore prices just have yet to track in my view.

The normal cycle of Chinese real estate

I think anyone familiar with China and their economy knows that it is largely dependent on property development and purchase as the end-all solution to everything. It is the GDP stimulator. It is a flippable commodity. It is always a leasehold estate. All of these items make real estate unique to China as an economy, it is an irreplaceable cog in a machine, one that is incomparable to other economies around the world.

When I say flippable, many properties in China are purchased and not finished, they are just left as an empty concrete box in a monolith. If finishes were added, it could diminish the property value and make them more difficult to flip to the next buyer. The ease at which property trades hands in China also makes the stock market much less attractive as a means of gaining wealth. Real Estate is always choice number 1.

Leasehold estate

Being that Chinese properties are only sold in leasehold fashion, this gives the Chinese government-wide authority to exercise eminent domain. The normal practice is an aging building is marked with the Chinese character ? chai, which means its marked for demolition:

After it's marked, and all residents have been negotiated with, the building is ripped down, and the land is exchanged to a new developer who constructs a new project. Compensation is usually fair and sometimes includes a unit in a new building. There is little to no fight by residents. One unique Chinese investment strategy is to buy dilapidated apartment units in the hope that they will be marked for demolition. Usually, this investment circle relies on some sort of inside information.

The cycle of build-up and tear-down in under a few decades, normally, is another unique part of Chinese Real Estate that is incomparable to other markets. Nothing is built to last and new buildings are expected to go up regularly even in cities that may be overbuilt to begin with.

The new policy

All information translated from daily economic news via Baidu :

Premier Li Qiang of the State Council presided over the executive meeting of the State Council on July 21, at which the "Guiding Opinions on Actively and Steadily Promoting the Transformation of Urban Villages in Megacities" (hereinafter referred to as "Opinions") was reviewed and approved.

The meeting pointed out that the active and steady implementation of the transformation of urban villages in megacities is an important measure to improve people's livelihood, expand domestic demand, and promote high-quality urban development. We must persist in seeking progress while maintaining stability, be active and prudent, give priority to the transformation of urban villages with urgent needs of the masses, and have many hidden dangers in urban security and social governance, advance one by one when they are mature, implement one by one, and truly do good things well and do practical things.

Translations don't always do justice to the effect to which Chinese netizens know what these policies mean. Rather than tear down aging buildings, the Chinese government is now going to implement massive subsidies to overhaul and modernize old buildings to preserve them. A similar idea to the Western society where we take aging houses, hipster them up, and call them "craftsman houses". I have associates in a major Chinese city who are going through a renovation order right now. They only paid about 500 yuan and the rest will be subsidized by the government. They are focusing on plumbing systems, windows, courtyards, and exterior building renovations as well as flood mitigation systems. Some old buildings will also be torn down completely and rebuilt. There is a buzz once again in Chinese real estate.

The property manager notifies the residents that their building has been marked for renovation and dates are set for the overhaul. Since all apartments are both leasehold and condominium style, all the government needs to do is place the order with the building owner, and it will get done in short order with the residents.

Furthermore, from the Baidu article:

Considering the large scale and long cycle of the urban renovation projects, the participants are expected to be mainly large central state-owned enterprises, and other types of social capital may also participate in the renovation. In order to promote the transformation process, financing measures such as government supporting financial funds and policy-based financial instruments are expected to be introduced one after another.

The above is via the linked article. This is indicating the possible sources of funding for the reconstruction projects. Some of these include special financing funds, special local government bonds, fiscal land transfer fees, government resources, city bond funds, loans to property owners, and REITS. The availability of funds is being prioritized by city size.

The top tier of cities being prioritized [8] are those over 10 million in population size, rankings indicated above.

Moves in Posco

Moves in Korean-based steel producer Posco ( PKX ), may be a harbinger of things to come for Rio Tinto and others in this category. They have a Chinese subsidiary and the local stock market in Korea may be better suited to anticipate this move than Western markets via their access to local information. By contrast, the western iron ore producers have not moved much.

If there are new reconstruction policies about to be implemented, the iron ore producers may be laggards, but should follow the steel producers in due time.

Rio Tinto and China Baowu ink a deal

Announced on Rio Tinto's news release section of their website last month , a new deal with Baowu could signal a preparation for market growth:

SHANGHAI--(BUSINESS WIRE)--China Baowu, the world's biggest steelmaker, and Rio Tinto, the world's largest iron ore producer, have signed a Memorandum of Understanding [MOU] to explore a range of industry leading new projects in China and Australia to help decarbonize the steel value chain.

Under the MOU, China Baowu and Rio Tinto plan to jointly advance specific decarbonisation projects, demonstrating their commitment to play a leading role in the industry's low-carbon transformation.

The MoU, signed in Shanghai by Rio Tinto Chief Commercial Officer Alf Barrios, and China Baowu Vice President Hou Angui, follows the recently announced $2 billion Western Range Joint Venture in the Pilbara region of Western Australia, involving Rio Tinto and Baowu.

The projects include: Research, build and demonstrate a pilot-scale electric melter at one of Baowu's steel mills in China. This will enable low-carbon steel making utilizing Direct Reduced Iron [DRI] that has been produced from low and medium-grade ores.

Optimize pelletization technology for Australian ores as a feedstock for low-carbon shaft furnace-based direct reduction.

Expand the development of China Baowu's HyCROF technology which can largely mitigate CO ₂ emissions from the blast furnace process.

Jointly study opportunities for producing low-carbon iron in Western Australia.

Valuation

This is not a growth company, but rather a hard asset commodities dealer where both assets and earnings are relevant. Finding a fair Graham Number value, where the P/E times the P/B is not exceeding 22.5 is where we'll start in defining Rio Tinto's intrinsic value. Our inputs for the formula are:

• TTM book value = $30.98.
• Forward EPS = $7.95/share.
• The square root of $30.98 X $7.65 X 22.5 = $73.25 /share.

In this case, I'm using the analyst's high-end 2023 EPS estimates as some of these new pieces of evidence would indicate growth and earnings beats.

Balance sheet

Long-term debt remains below current assets by a good amount. A check mark in Peter Lynch's book. The company's long-term debt to current asset situation looks very healthy.

The shares outstanding chart does not show a propensity for buybacks, but there is no rapid share dilution historically either.

Compound drip model and Rio Tinto dividend policy

The long-term policy of Rio Tinto is to payout 40-60% of underlying earnings as a dividend. With this being the case, the dividends are not like a dividend aristocrat that aims to raise incrementally every year. Near-term growth entry points are a great place to buy the stock to collect a larger total return. With that being the case, let's look at the trailing 10-year dividend yield average to get a fair idea of what we could expect over the long run.

With a current yield of 7.05%, Rio Tinto seems to hug a yield line between 4-8.5%. We'll use the median of about 6.25% as a static assumption moving forward.

A ten-year drip analysis with a static average dividend of 6.25% and an anemic 5% per year upside could provide a market-beating return for the next decade. To achieve even a 5% per year growth rate, I am assuming we are at the precipice of a new Chinese construction cycle that will take at least a decade to complete.

Summary

New regulations by the Chinese government, fresh off the presses I think could mean a new decade of prosperity for construction materials and iron ore companies. Rio Tinto has a great balance sheet, is inking new deals with Chinese operators, and is moving well behind the biggest non-Chinese far east steel producer, Posco in terms of price movement. The same goes for BHP ( BHP ) and Vale S. A. ( VALE ). I am putting Rio Tinto back on my leaderboard, it's out of the bullpen.

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