Is Rio Tinto undervalued after Q2 earnings?
Rio Tinto's earnings met our expectations but there may be better opportunities elsewhere.
Mentioned: Deterra Royalties Ltd (DRR), Barrick Gold Corp (GOLD), Iluka Resources Ltd (ILU), Rio Tinto Ltd (RIO), Vale SA (VALE)
Rio Tinto (ASX: RIO) is one of the world’s biggest commodity producers and the ASX’s second biggest miner by market value. The company’s profits and share price are mostly driven by its iron ore operations, which make up around three quarters of our estimate for the company’s profits.
Rio Tinto has a large portfolio of long-lived assets with low operating costs, meaning it is one of few miners profitable through the commodity cycle. As a further plus, most of Rio Tinto’s major operations are located in relative safe havens like Australia and North America.
What did Q2 earnings reveal?
The short answer is that earnings didn’t really hold much in the way of surprises. 2024 second-quarter shipments of 66 million metric tons from Rio’s Pilbara iron ore operations were similar to last year. This was roughly in line with the expectations of Morningstar’s Rio analyst Jon Mills.
Rio realised prices of USD 106 per metric ton over the first half, putting them modestly ahead of Mills’ full-year forecast of about USD 102 per ton. While 2024 first-half shipments were 3% lower than in 2023, Rio maintained its iron ore guidance as seasonal factors are likely to drive higher sales in H2.
What next for Rio?
Mills thinks Rio’s share of 2024 Pilbara iron ore sales will be roughly 280 million metric tons. This would be similar to last year. Mills does, however, expect 6% higher costs of USD 23 per metric ton due to inflation.
Over the medium term, Mills expects earnings to materially decline with demand for many commodities likely to soften with the end of the China boom. This is particularly pertinent for iron ore, which has disproportionately benefited from the boom in infrastructure and real estate investment.
Rio’s recent focus has been to run a strong balance sheet, tightly control investments, and return cash to shareholders. The firm is also focused on winning back the trust of investors and other stakeholders after the firm’s operations led to the destruction of indigenous caves at Juukan Gorge in 2020.
The company's major expansion projects are the Oyu Tolgoi underground mine and the expansion of the Pilbara iron ore system's capacity from 330 million metric tons to between 345 and 360 million metric tons. Those projects are expected to complete in the next few years.
Otherwise, the focus is on incremental expansions through productivity and debottlenecking initiatives. Mills thinks these will be small but capital-efficient and should modestly improve unit costs and returns.
Rio shares look fairly valued
In light of Rio’s earnings update, Mills made no change to his $112 per share fair value estimate. While Rio tweaked its guidance for copper, alumina and bauxite, the changes were immaterial to his estimate as Pilbara iron ore remains the key driver.
Mills forecasts 2024 EBITDA of USD 24 billion, similar to last year, with iron ore comprising around 75% of that figure. His forecast for fully franked dividends of USD 4.35—about AUD 6.44—per share in 2024 assumes a 60% payout ratio at the top end of Rio’s target payout ratio of 40%-60% over the cycle.
This is also similar to 2023 and represents a yield of about 5.5% at the current price. At a current share price of around $117, Rio shares trade roughly 4% above Mills’ estimate of fair value.
Better value elsewhere?
Rio isn’t the only mining major trading modestly above Morningstar’s estimate of fair value as of July 17th, with BHP and Anglo American also trading at single-digit premiums.
Vale (NYS: VALE) looks the cheapest of the majors, with the risk of increased government oversight from Brazil’s Lula administration appearing to be more than reflected in its share price. Vale shares currently trade around 20% below Morningstar’s fair value estimate.
Elsewhere in the industry, mineral sands producer Iluka Resources (ASX: ILU) continues to look cheap. Iluka shares have been weak on lower mineral sands prices on reduced demand from China’s property sector. Rising interest rates and slowing housing markets in the West are also a near-term headwind, while the value of Iluka’s 20% stake in Deterra Royalties (ASX: DRR) fell after the company’s announcement of its first acquisition.
On the bright side, a lack of longer-term, maturing mines and a lack of large, high-grade, undeveloped resources are likely to support mineral sands prices. Further, Iluka’s proposed rare earths refinery in Eneabba is an option on elevated rare earths prices and potential Western tariffs on Chinese production. At a recent price of $6.77, the shares traded almost 30% below Jon’s estimate of Fair Value.
Gold mining shares also look cheap despite gold’s strong price performance.
This includes no-moat Barrick Gold (NYS: GOLD), which has experienced weak sales volumes and elevated unit costs recently. Mills thinks these are temporary issues and that sales volumes are likely to recover led by Barrick’s generally larger and lower-cost mines. In turn, unit cash costs are likely to fall, improving margins. Barrick Gold shares currently trade at a 13% discount to his fair value estimate.
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Terms used in this article
Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.
Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.