Summary
- The comeback of metal prices over the past three months has been nothing but impressive.
- Long-term macro trends support a bright future for Rio Tinto Group.
- Conservative approach to expansion is warranted.
- Risks are obvious but not existential.
- Diversification investments are on track and should pay off for Rio Tinto Group.
The doom and gloom of a few months ago about a double whammy of stagflation hitting demand for metals seems to be distant history. The Rio Tinto Group ( RTPPF ; RTNTF ) share price has gained 43% from the low it hit only 3 months ago. It is now lingering at multi-year highs. Recession, what recession? The outlook from a few months ago of economic Armageddon has not materialized (yet) and had definitely been brushed aside by buyers and investors in metals - and in mining groups.
Metals staged an impressive rebound
Despite various hard and soft commodities losing steam over the past year, industrial metals have staged a dead-cat bounce since October-November. Over the same period, Brent oil dropped by 13%, average natural gas prices dropped by around 40%, and soft commodities have softened in price as well.
On the other hand, the iron ore price is up 55% since its nadir last November, while copper is up by 30% since September. This impressive rebound in iron ore prices has been explained by robust demand, strengthened by resilient Western economies and the reopening of China's economy after the relaxation of Covid-related lockdowns. Supply, on the other hand, has been restrained due to various reasons, including bad weather in Australia and Brazil, and maintenance closures in Australia. The COVID-era slowdown in investments by mining groups is also still creating tightness in supply. Copper's price is being propped up by similar factors, with civil unrest in Peru, the world's second-largest producer, restricting production at the massive Antapaccay mine, while Chile, the world's largest producer, predicting a shrinkage in production this year.
How about the long term?
One of the main factors that mining and commodity investors have to contend with is the high level of volatility, and the impossibility of predicting commodity prices - and thus the levels of profitability of commodity groups. At least in the short term. For long-term investors who can stomach the high level of volatility in the short term, the picture could be clearer. Ignore the daily doom and gloom of the press, and investors can see there are very clear long-term global trends that do not wane with whatever is happening in the next weeks and months. Global population will keep growing, economies will keep growing, industrialization and urbanization continue to grow heavily, and the shift to renewable energy and electrification is accelerating at an exponential rate.
At the same time, supplies of metals are not expected to get better; there are limited volumes of metal in the ground, and a handful of groups in the world have sufficient financial muscle and expertise to extract it at an economic rate. Put all these factors together, and it is crystal clear that prices of industrial metals should be heading in one direction over the long term - not to mention the short-term pressures I noted previously in this article.
Conservative approach of management is reassuring
Warren Buffett used to say that it is better for a penny to be burning a hole in your pocket than in someone else's pocket. In past metal booms, there was frenzied deal-making that resulted in billions of dollars being written off after bad, expensive acquisitions were made. Glencore (GLCNF) almost collapsed a few years ago as a result of accumulating mammoth levels of debt. And Rio's previous management suffered blows after their own value-destructive acquisitions, including acquiring Alcan in 2007 for an eye-watering USD $38 billion, when metals were at the peak of a super cycle. That acquisition led to massive write-downs and destroyed billions of shareholder value.
Four years later, Rio acquired a coal mine in Mozambique for USD $3.4 billion - all of which was written off two years later. Add to that the more recent scandals that Rio faced due to destruction of aboriginal sites in Australia in 2020 - and the overall scandals about the toxic and discriminative work culture at Rio - and one can understand why Rio's current management is tip-toeing in any new acquisitions or investments.
Rio Tinto's management has been keen to stress that they prefer organic growth and that they have a very high bar to consider acquisitions. They stressed that they do not want to pay full value for acquired assets and that any acquisitions have to fit fully in their structure and plan. In other words, they will not rush to deploy Rio's abundant cash coffers in buying everything under the sun. Rio's shareholders are more worthy of receiving such cash in dividends and share buybacks, rather than the shareholders of acquisition targets that do not add clear and obvious value.
The most visible recent acquisition was a plain vanilla, risk-free one, that could be hardly even called an acquisition. Rio paid USD $3.1 billion to increase its share of the Oyu Tolgoi copper mine in Mongolia Oyu Tolgoi, which is expected to reach annual production of 500,000 tonnes of copper per year, making it one of the largest mines in the world.
Who to believe - the naysayers or the bulls?
Last July, the Financial Times published an article stuffed with a bearish outlook for mining investors. The article started by noting that:
"Mining outlook darkens as twin threats loom Investors set for last round of bumper payouts as margins are squeezed by falling commodity prices and cost inflation."
The article quoted an analyst who said that:
"Rio's cash flow would "evaporate" in 2023. Rio will see its free cash flow compress by 75 percent on numbers next year. It's that combination of higher costs and lower commodity prices."
The timing of that article was well-timed; iron ore prices dropped by approximately 25% from July to the November bottom, and are still 20% below the peak of last March. Prices are today only a few percentage points above the USD $120 per tonne that was quoted when that article was published.
But the doom scenario predicted in that article does seem now overstretched. Prices have rebounded strongly since Q4 of 2022, and are still in a strong uptrend. Simultaneously, energy prices and inflationary pressures have waned. And the operational performance of Rio has been solid. Iron production grew by 6% in Q4 versus Q3 and versus Q4 2021, copper production grew by 6% in 2022 versus 2021 (although down slightly in Q4 versus Q3 and Q4 2021), aluminum production grew by 3%, and the production of titanium oxide, the new kid on the block, grew by a staggering 42% in Q4 2022 versus Q4 2021. Titanium is an essential material in industries such as medical devices, aerospace and fuel cells, and the West has been keen on increasing production away from China, which holds the lion's share with a third of global production. Rio has recently reached an agreement with the Canadian government to reinvigorate the dormant Sorel-Tracy mine in Quebec, which is likely to give a welcome boost to Rio's production of the metal.
Risks should not be taken lightly
As I noted in my article published on the 9th of June last year, Rio's investors face multiple risks that they have to assess diligently before chipping in. The seesaw price volatility is definitely not for the faint-hearted; iron ore traded at USD $220 per tonnes 18 months ago, USD $80 per tonnes 3 months, and is trading currently in the USD $120s. Rio's share price has seesawed accordingly from GBP 60 per share 18 months ago to GBP 44 last October, and back to GBP 63 now.
I have noted that the lack of diversification is a concentration risk for Rio, with the bulk of revenues coming from iron ore. Rio has been working slowly but surely on diversifying its metals portfolio - with some pitfalls such as the messy acquisition of Alcan - and the portfolio should be more balanced with time, especially when the mega copper mine in Mongolia starts bearing fruit.
Inflation proved to be a definite tailwind to Rio rather than a headwind. Only USD $1.3 billion of additional expenses were booked last year as a result of inflation - a drop in Rio's ocean of cash.
Financial strength is likely to be sustained
Although the froth of astronomical profitability and cash generation will rationally wane off, Rio is likely to remain a robust cash machine. In the last reported financials of H1 2022, the group generated USD $10 billion of operating cash. That was 23% less than the comparable period of 2021 but double that of the same period of 2020. Free cash flow of USD $7 billion was a third less than 2021 but 150% higher than the same period of 2020. And dividends per share were 50% lower than H1 2021 but still 72% higher than 2020. With metal prices in a rebound mode, and production levels holding up, it is hard to imagine a meltdown in Rio's financial performance or in returns to shareholders.
The depressed valuation of Rio provides investors with a buffer of safety - although I believe a wider margin of safety is needed before chipping in, given the recessionary outlook and the elevated interest rates. At a P/E of 7 times and market cap to operating cash flow of 5.25 times, Rio seems slightly undervalued compared to BHP's P/E of 8.8 times and market cap to operating cash flow of 5.5 times. But this is justified; Rio's RoCE of 34% in H1 2022 was way lower than BHP's 48.7%. And BHP is much better diversified than Rio, and it does have higher production prospects in the foreseeable future.
The risks of investing in a miner in general, and in Rio specifically, should not be ignored. The volatility of prices, political, environmental and social risks, and the current overshadowing cloud of potential recession are all valid reasons to tip toe into mining investment. But the overarching long-term view does not get impacted by any of these short to medium-term risks; the global economy will keep growing, demand for metals is irreplaceable, and the switch to renewable energy is at full speed.
Rio Tinto Group, and its fellow class A miners, likely have a sustainable long-term future, but investors have to time their entry cautiously and gradually. As Rio's management is pedantic about placing money in new acquisitions or investments, so should be Rio's investors be pedantic about investing in this attractive cash machine.
For further details see:
Rio Tinto Group's Surprise Comeback