Rio Tinto: Depressed Environment, Still A Buy

seekingalpha11-20

The acquisition of Arcadium Lithium, despite a high valuation, positions Rio Tinto as a top lithium producer, enhancing long-term growth and maintaining a stable dividend payout.Q3 2024 production ...

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JHVEPhoto  Including the latest update and following the Q3 results, we are back to comment on Rio Tinto (NYSE:RIO, OTCPK:RTPPF, OTCPK:RTNTF). The company is one of the world's largest mining players with a diversified commodity MIX exposure (iron ore, aluminum, copper, and industrial minerals). Rio Tinto's operations are mainly located in Australia, North America, and Asia. Our buy rating was supported by M&A optionality (there were crucial developments in the quarter), Simandou & Oyu Tolgoi upside, and a better free cash flow yield than BHP Group. Aside from the fortress balance sheet and commodity diversification, the company has a dividend policy of a 40-60% payout of underlying earnings that offers downside protection across the cycle. Since our last update (Q2 2024 production results), Rio Tinto's stock price has slightly decreased, with a minus 2.97%; however, the company's total return has been approximately flat (Fig 1).   Mare Ev. Lab previous rating Fig 1 Q3 2024 production results and M&A Upside Starting with the Q3 2024 production results, Rio Tinto reported Q3 production results with volumes aligned in all divisions (Fig 2). The company's Fiscal Year 24 production guidance has been reiterated for all commodities except for the Iron Ore Company of Canada segment (IOC). This was lowered from 9.8-11.5 mt to 9.1-9.6 mt as a consequence of forest fires in July 2024 (Fig 3). Regarding commodity production, Iron ore Pilbara shipments reached 85 mt, with cost guided upper half between $21.75- $23.50/t. We see that costs remain high as inflation proves to be stubborn. In terms of copper, the company's output reached 168kt. In detail, we notice that Kennecott production guidance was decreased by approximately 50 kt due to “highwall movement” in the pit. The company will provide an update at the Investor Seminar in December. According to our estimates, this mine makes up 6% of Rio Tinto Group 2025 EBITDA forecast. However, we should report that the Escondida and Oyu Tolgoi copper ramp-up should totally offset the Kennecott mine high wall instability issues. Concerning the aluminum output, the company's production reached 809kt in QAL/Yarwun mines, normalizing toward Q4 of 2024.   Rio Tinto Q3 production results Source: Rio Tinto Q3 report - Fig 2   Rio Tinto 2024 Cost Guidance Fig 3 In early October, Rio Tinto announced a deal to acquire Arcadium Lithium. This is an all-cash transaction for A$ 5.85 per share cost with a premium of 90% to Arcadium's closing price on 4 October. Rio Tinto valued Arcadium Lithium at $6.7 billion, and including minorities and net debt, the enterprise value reached $7.8 billion. Here at the Lab, we believe Rio Tinto overpaid the target with an EV/EBITDA multiple of 7/8x in 2025; however, the company will be a significant worldwide lithium producer (top 3). This will provide a long-term upside for Rio Tinto, and the EV/EBITDA will likely drop to 7/8x in 2028. On a positive note, following the acquisition (which is still pending Arcadium shareholder approval and is expected to close in mid-2025, following regulatory green lights), Rio Tinto's net debt would increase from $5.1 billion to $12 billion. This is still below <0.51x net debt/EBITDA, and there will be no change in the dividend payout level. On the M&A front, the company acquired total control of Sumitomo Chemical Company’s interest in New Zealand Aluminium Smelters. This deal was completed in early November. There are also two negative news items to consider. Firstly, the Australian Financial Review (AFR) reports that the Mongolian government and Entrée Resources are in the process of consolidating the operations into the Oyu Tolgoi mine. Rio Tinto has not commented on the report. Our team acknowledges some risks associated with these operations and the impact this could have on the mine grade & volume profile. In Europe, the Serbian Jadar project is also paused, given the challenging in-country backdrop. These are two new critical risks in Rio Tinto. Earnings Changes and Valuation There were almost no changes in cost guidance, as well as in Rio Tinto's production output. Additionally, China reported net finished steel exports at a record high of 125 mt in October. Even if Trump introduces tariffs on Chinese imports, direct steel flows to the US are minimal. We might expect indirect flows, which will likely expedite anti-dumping investigations in other geographical areas. On a positive note, we greatly support China's internal stimulus. This significantly improved Rio Tinto's risk-reward. Indeed, China's growth is now prioritized, which might benefit the company's valuation positively. In our last update, we cut our 2024 EBITDA projections, anticipating a turnover of $51.6 billion and an EBITDA of approximately $24 billion. Today, with minor changes, we slightly reduced our EBITDA projection to $23.3 billion due to IOC's lower production and Pilbara's higher guidance costs. On the CAPEX, the group anticipates essential CAPEX at $7 billion (and $3 billion in growth CAPEX). Our estimates still do not include Arcadium's new CAPEX, which is projected at $500 million per year. On the net debt, our calculation might guide net debt from $6.1 billion to $12 billion. Considering the limited EBITDA consideration of Arcadium Lithium, this might result in a non-accretive deal. We decided not to include the latest acquisition in our numbers at this stage. Therefore, applying an unchanged 5x EV/EBITDA and considering the company is on track to meet its 2024 guidance, we arrive at a $68 per share valuation. This provides a 10% upside to the current share price and does not include our unchanged view for a DPS of $1.7 per share. Risks Our team has extensive coverage of Rio Tinto risks. So, we report:  Volatile nature of commodity prices; FX and political issues include the Mongolia Government, which owns a 34% equity stake in the Oyu Tolgoi mine. (NEW), we also report the latest AFR news; Operational delays and CAPEX restraint in Guinea (Simandou mine); Change in regulations; Cybersecurity risks; Disruptions due to strikes and weather could affect the company's P&L; In addition, Rio Tinto's sales derive from China; (NEW) the Serbian Jadar project postponement.  Conclusion A solid production report leaves the company's critical divisions on track to meet the 2024 outlook. Additionally, Rio Tinto is accelerating on M&A, and even if these deals are not year-accretive, the company is reinforcing its leadership position and diversifying its future earnings. In this depressed environment, Rio remains a buy.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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