Christmas Comes Early For Rio Tinto Shareholders

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Christmas has come early for shareholders of Rio Tinto, which will increase the purchases of its shares by US$2.5bn, taking the total being bought back in 2017 to US$4.0bn.

-Makes good on promise to return sale proceeds of Coal & Allied assets
-After-tax benefit could be as high 17% for a non-taxpaying shareholder
-Upside risks to spot commodity prices suggest significant investment case
 

By Eva Brocklehurst

Christmas has come early for shareholders of Rio Tinto ((RIO)), which will increase the purchases of its shares by US$2.5bn. The total now being bought back in 2017 amounts to US$4.0bn. Along with US$4.9bn in forecast dividends, Ord Minnett calculates this represents cash returns to shareholders in 2017 equivalent to 10.3% of market capitalisation.

A US$1.9bn on-market portion in plc (London-listed) shares will commence December 27 and be completed by the end of 2018. In addition to increasing and extending the UK buyback, a purchase of $700m (US$560m) worth of ASX-listed (Ltd) stock will also occur. The split between on-market and off-market reflects the split in the share register, 78% for the plc stock and 22% for the Ltd stock.

Brokers suggest the company has made good on a promise to return the sale proceeds from the Coal & Allied assets and UBS particularly commends the company for not sitting on the cash. The announcement, earlier the many brokers expected, is in addition to on-market buybacks in the UK of US$500m and US$1.0bn announced in February and August 2017, respectively.

Citi observes previous off-market buybacks (2015) achieved a -14% discount and typically were up-sized because of strong demand. Companies are able to achieve these discounts through off-market buybacks in Australia, as some of the proceeds are deemed to be a return of capital, with the balance as fully franked dividends that allow franking credits for those that can use them.

The broker's example cites an investor with a 15% tax rate that would be able to tender into the buyback at a -14% discount and still receive a premium of around 10% to the current share price, after taking into account the dividend and value of the capital loss.

Depending on the individual tax rate, the after-tax benefit could be as high 17% for a non-tax paying shareholder, UBS estimates. The broker does not see why the off-market proportion could not have been increased further. The decision to buy in the ratio of the share register when there is an opportunity to buy at 14% does not make sense, although the broker acknowledges it could be for liquidity concerns in the Ltd stock.

Additional Returns

Nevertheless, UBS is not complaining too much, as a strong balance sheet should deliver additional returns upwards of US$3-4bn, inclusive of US$3bn in dividends in February 2018. The broker's worked examples show that the off-market buyback would be most attractive for those on a low income tax bracket. In Australia the majority of super funds are in the 15% bracket and, as such, the buyback may be attractive although there are other considerations to be taken into account.

The off-market portion on the ASX surprised Macquarie, in a positive way. Should the company be successful in selling the remaining Queensland Coal assets and/or Pacific Aluminium, which the broker estimates could raise US$5-7bn, further buybacks are considered likely in 2018.

Recent rises in aluminium and alumina prices and iron ore lump premium suggest a spot commodity price scenario for the stock that offers considerable upside to the broker's base case. Macquarie makes modest changes to forecasts, with estimates rising 2 -3% for 2018-20. The broker upgrades its price target by 1% for the Ltd stock while the UK target falls -4% to GBP43, after incorporating recent moves in the GBP/USD exchange rate.

Credit Suisse observes the iron ore price took a hit in the past week and pressure is expected in the December quarter, when demand in China falls as production is curtailed throughout the winter months.

While the broker is forecasting weakness in the iron ore price the same is not expected for steel, which is expected to remain tight throughout the winter, as strong premiums for higher grade products are expected to continue. Couple the upside risks to spot prices with a strong balance sheet and desire to return cash and the stock is considered a risk-adjusted investment case of significance.

Citi calculates full completion of the buybacks will drive 3.6% accretion to 2019 estimates for earnings per share although, in the context of the large upside risk from spot prices in 2018/19, considers the continued discipline of returning excess cash to shareholders the more important message.

ASX Buy-Back Detail

Eligible Australian and NZ shareholders will be able to tender shares at an -8-14% discount to the prevailing market price. The ASX buyback price will include a capital component of $9.44, with the remainder being a fully franked dividend. The shares will trade ex the buyback on September 27, with the tender running from October 10 to November 11.

FNArena's database shows seven Buy ratings and one Hold (Morgans, yet to comment on the increased buyback). The consensus target is $72.75, suggesting 9.3% upside to the last share price. Targets range from $61.99 (Morgans) to $83.00 (Macquarie). The dividend yield on 2017 and 2018 forecasts is 5.0% and 4.3% respectively.
 

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