Challenges Ahead For Rio Tinto Iron Ore

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High iron ore prices provided a record interim pay-out for Rio Tinto shareholders yet there are challenges ahead in maintaining production volumes

-Strong cash flow reflects above-normal profits from iron ore
-Current priority is organic growth not acquisitions
-Main challenge in the short term is Pilbara volumes

By Eva Brocklehurst

Rio Tinto ((RIO)) pleased the market with a record first half pay-out amid strong prices across iron ore, copper and aluminium. Yet concerns centre on the tight timeline playing out in the Pilbara as the company works to replace depleting mines.

The company is making an effort to rebuild confidence in its operations and social reputation, Morgans notes, and flagship Pilbara iron ore production remains key to its business, although there was an impressive step up in the profitability of aluminium.

The broker assesses Rio Tinto is also making "smart decisions" with future investment and envisages Jadar will be a tier-1 lithium asset if the company can secure the permits and establish key aspects such as processing.

Capital expenditure guidance for 2021 has been reiterated, at US$7.5bn, and Rio Tinto has also left 2022 and 2023 capital expenditure guidance unchanged, around the same amount.

The first half dividend was a record US$5.61, well ahead of expectations. This incorporated an ordinary dividend of US$3.76 and a special dividend of US$1.85. This implies a pay-out ratio of 75%, above what the company has typically paid out during previous interim results.

The strong cash flow yield and attractive multiples reflect the above-normal profits being generated by the iron ore division and, from here on, Morgan Stanley envisages limited levers for the company.

This view is maintained despite a track record of capital discipline and strong skew towards cash shareholder returns, the broker assessing the risk/reward is balanced compared to European diversified peers.

UBS is more negative and believes, as the iron ore price is the main driver of the stock, the risk/reward remains skewed to the downside despite the high cash returns over the short term.

Other Commodities

Positive fundamentals also underpinned alumina and aluminium prices, Morgans points out. The company has not yet considered any growth options around the global aluminium business but acknowledges this could be considered if current conditions persist.

Morgans suspects substantial expansion is unlikely, given the comparatively low return profile on offer in aluminium. Copper improved its performance, although the broker notes it is still only matching the aluminium business in terms of returns on capital.

Escondida, which provides the bulk of copper exposure, has been impressive but the accumulated impact of the pandemic on the workforce continues to be a drag. Macquarie also notes Rio Tinto has confirmed its current priority is organic growth instead of material bolt-on acquisitions.

The Oyu Tolgoi undercut still needs approvals from the Mongolian government and is progressing slower than expected, although the company is not forcing the issue given the seriousness of the pandemic.

In mineral sands, Rio Tinto will close the remaining three furnaces at Richards Bay by the end of August if the security situation in South Africa does not improve. First ore from Winu has also been pushed back, with a 12-month delay to 2025.

Rio has committed $2.4bn to the Jadar lithium borates project in Serbia, intending to produce 58,000t of battery grade lithium carbonate by 2029. The project remains subject to multiple approvals. The company has also signed an MOU with POSCO to explore low-carbon steel opportunities.

Pilbara

Pilbara unit costs have increased to US$18-18.5/t, driven by higher diesel/contractor rates and partially offset by higher volumes. Production guidance is at the lower end of 325-340mt and Macquarie assesses there is a risk of a further downgrade should adverse weather, or problems with logistics and commissioning materialise.

Citi highlights the company's reluctance to be pinned down on Pilbara system capacity after Gudai-Darri ramps up. Full capacity at that project is expected in 2023 and development plans for the next phase of mine replacement capacity are also in Rio's line of sight.

Yet, to make the lower end of 2021 guidance Pilbara needs to run at 340mtpa in the second half and the broker suggests tie-in pressures and pandemic constraints may make this difficult.

Moreover, Citi asserts previous targets of 360mtpa seem to be a "fading memory", and assumes lower tonnage for in 2021-24. With Simandou appearing to be some way off, increases to seaborne iron ore supply will continue to underperform, the broker adds.

Morgans agrees the main challenge over the short term is any interruption to volumes in the Pilbara in the second half amid broader cost headwinds, noting Rio Tinto as already downgraded expectations around shipments and lifted cost expectations.

The risk, in the broker's view, centres on the tight timeframe in replacing depleting mines. Execution risk is also made more difficult given the increased bureaucracy post the Juukan Gorge incident.

The company has admitted it is slightly behind schedule but remains confident it can deliver its new production hub, Gudai-Darri. Morgans concludes little else matters while iron ore prices remain near record highs and this will offset any other production gaps in the Pilbara, or indeed the rest of the business.

FNArena's database has four Buy ratings, two Hold and one Sell (UBS). The consensus target is $135.57, signalling -0.3% downside to the last share price. The dividend yield on FY21 and FY22 forecasts, at current FX rates, is 12.0% and 8.3%, respectively.

See also, High Expectations For Rio Tinto Cash Flow on July 19, 2021.

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