The iron ore price has been in free-fall, dropping from over $180/tonne in 2011 to the $30s.
Producers of the metal have suffered over the last two years, mainly as a result of falling demand from big consumers such a Brazil, Russia and most importantly, China.
Reuter’s data shows over a two-year period, BHP, Rio and Vale have fallen 58%, 33% and 75% respectively. So is it time to buy?
According to Sydney-based investment firm Intelligent Investor, Rio Tinto stands out among its peers helped by its high-standing iron ore business.
“I’d call its iron ore business the finest of its kind in the world, and no one else can replicate it,” says Gaurav Sodhi, resource analyst at Intelligent Investor.
Rio’s other commodities include coal, copper and diamonds, which form part of a “diversified model” that was designed to limit volatility. But in the last decade the model has transformed into a company dominated by iron ore.
“It’s become an iron ore business now, and it’s become more apparent that you can’t separate Rio from the iron ore implosion,” says Sodhi.
In an interview with Bloomberg, the miner’s head of copper and coal, Jean-Sébastien Jacques said the company was still optimistic about copper and coal adding that it did not embark on diversification for the mere sake of it.
“Diversification has not proven to, necessarily, be a hedge against the tough times, as many of us had previously believed,” he said.
Intelligent Investor says that despite the low prices in the iron ore market, the miner generated Ebitda margins of more than 60% last year and return on assets (ROA) of 40%.
It has re-invested more than $40 billion into the iron ore business over the last ten years. “In our view, it’s a really good mining asset because it re-invested cash flows where it was making the best return. But it transformed the company into what is primarily an iron ore business and we are concerned…” says Sodhi.
The investment firm believes that Rio has demonstrated that it has the type of asset quality and capability to continue generating decent returns for shareholders. It has relied on the use of autonomous trucks and automated drill rigs to cut costs and managed to save $16 million alone by maintaining the tyres on its trucks. “Rio Tinto generates the best margins on iron ore, it is by the far the best mover of material in the world, and it creates the most efficient logistics,” says Sodhi.
According to Sodhi, the cash cost of production is the lowest in the industry, and has dropped from $24 to $15 per tonne over the last few years. He expects the ROA from its iron ore business to fall from the decade average of 52% to 35% due to lower prices. “Although it’s high, earnings will probably halve from what they were generating last year to about $6 billion.”
Intelligent Investor is concerned about the company’s other assets due to the focus of management on the iron ore business. Its aluminium business consists of large-scale alumina refineries, aluminium smelters and bauxite mines. Based on the investment firm’s calculations, Rio has generated a median ROA of just 3% from aluminium over the last ten years and after writing-off $30 billion, it still struggles to generate meaningful returns.
“They are good at counter-cyclical investments, selling at the peak and buying at the trough,” Sodhi says, adding that the aluminium business appears to have died after bringing in less than $1 billion this year. “They might hang onto aluminium after having a go at trying to sell it,” he explains.
The miner is bullish about its new copper ore bodies Resolution, La Granja and Oyi Tolgoi projects that promise investor’s years of profitable output, but Sodhi says that depends on whether the price of copper will recover.
“The copper business generates about 10% of profits, and it will take up most of their capex especially the expansion of the Mongolia mine,” says Sodhi.
If the diversified miner reduces costs and the global market improves, Intelligent Investor expects the diversified miner to generate earnings per share (EPS) of about $1.60 that could climb to about $2.40 by 2017. The share price is currently is trading at $28.50 in New York.
“We still see it as a quality stock even at this point in the market cycle but it’s not attractive enough to buy if you take into consideration the weak iron ore prices,” he adds.
Intelligent investor will consider changing their recommendation if enough iron ore supply exited the industry that the company could return to generating an expected free cash flow yield of over 5%.