Rio Tinto Secures Oyu Tolgoi Financing Deal

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An agreement to fund a shortfall arising at the highly significant Oyu Tolgoi copper development is now in place, although iron ore is still key to Rio Tinto's outlook

-Rio Tinto to provide new debt facilities
-Other challenges at Oyu Tolgoi still exist
-Rio Tinto's valuation still hinges on iron ore
 

By Eva Brocklehurst

An agreement to fund the shortfall at Oyu Tolgoi has finally been nailed down between Rio Tinto ((RIO)) and Turquoise Hill. This deal sources the US$2.3bn in extra funding required to complete the ramping up of the US$7bn Hugo North underground project at this major copper development in Mongolia.

The agreement, building on the prior memorandum of understanding (MOU) in September 2020, contemplates the pushing back of US$1.5m in debt repayments that are due between 2021 and 2024, allowing for a better alignment with the revised mine plan and cash flow.

Rio Tinto has agreed to a new US$500m senior debt facility from international lenders, with a further facility of up to US$750m. The latter is an addition to the MOU, designed to address any potential funding shortfalls arising from the rescheduling of debt repayments and the new debt facility.

Turquoise Hill will undertake a rights offering and placement of US$500m within six months of the lending facility becoming available. Morgan Stanley notes Rio has rights to maintain a proportionate equity stake in Turquoise Hill (51%) although the company has indicated it has no intention of acquiring additional securities.

Rio has a 34% economic interest in Oyu Tolgoi, accounting for around 3% of Morgan Stanley's attributable valuation. This is expected to contribute around 4% to underlying operating earnings (EBITDA) for the group in 2021 and 32% of the copper division operating earnings.

The equity raising by Turquoise Hill is less than previously expected, and higher financing cost estimates drive a slight reduction to Macquarie's 2023-26 earnings estimates.

Rio Tinto's willingness to provide extra debt to the project surprised Macquarie, which had assumed Turquoise Hill would need to provide more equity instead. Oyu Tolgoi is the most important growth project for Rio, as its copper production is expected to rise to over 600,000t by 2029.

Challenges

The shortfall agreement is essential to progressing Oyu Tolgoi but there are other challenges that suggest the project is not out of the woods yet. A coronavirus outbreak resulted in a force majeure on concentrate deliveries to China in mid-March and this could potentially affect 2021 profits if deliveries do not resume soon.

Morgan Stanley notes there is also an outstanding government approval required to proceed with the underground mine and potential to renegotiate profit sharing with the Mongolian authorities could mean some further leakage of value for the owners.

Another issue is the resolving of an existing dispute with the Mongolian tax authorities with respect to tax claims and losses carried forward that could diminish the economics and cash flow from the assets. Oyu Tolgoi has started international arbitration to resolve the dispute.

UBS notes government approvals are confronted by the upcoming Mongolian presidential elections in June. A power solution is also required to avoid any medium-term production or cost disruptions.

The broker points out the terms of supply from the government-funded power plant were supposed to be agreed by the end of March and construction commence in July. Rio can opt to build the power plant if the terms are onerous and this would lift the shortfall by US$1bn, UBS adds.

Iron Ore

Meanwhile, iron ore keeps on giving. The company is due to report its first quarter production on April 20 and UBS expects iron ore shipments of around 80mt in the quarter, with Rio llikely to meet the upper end of its 2021 target range of 325-340mt.

The valuation of the stock hinges on iron ore and the broker suspects prices are likely to fall with increasing Brazilian supply. On the other hand, Macquarie calculates, on current spot prices, Rio's earnings could be 43% and 155% higher than the broker's base case estimates for 2021 and 2022, respectively.

FNArena's database has four Buy ratings and three Hold for Rio Tinto. The consensus target is $124.22, suggesting 8.1% upside to the last share price. On FY21 and FY22 forecasts is 9.8% and 7.1%, respectively.

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