Rio Tinto’s Juggling Act

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Two of Rio Tinto’s major growth projects are currently beholden to geopolitical influences, positive and negative, and it’s got nothing to do with the war.

-Rio Tinto moves on Oyu Tolgoi
-Geopolitics halt Simandou development
-Real assets recommended at this time

By Greg Peel

Rio Tinto ((RIO)) issued a one-line statement last week, noting it was “in the process of terminating all commercial relationships it has with any Russian business”.

The immediate impact is to put Rio’s alumina joint venture with state-owned Rusal under review. Rio owns 80% of Queensland Alumina Ltd and Rusal 20%.

But for Rio, Ukraine is not the only source of geopolitical influence at present.

Last month the diversified miner issued a disappointing set of second half 2021 results, impacted by issues of productivity, cost, and culture (Juukan Gorge), Morgans points out, as well as uncertainty surrounding the company’s growth portfolio. Fortunately for Rio, surging commodity prices (up till this week) have overshadowed the negatives.

In the wake of the result, Rio has announced a bid for the remaining 49% of shares in Toronto-listed miner Turquoise Hill Resources it doesn’t own. The acquisition will take Rio’s stake in the Oyu Tolgoi copper-gold project in Mongolia to 66%, with the Mongolian government owning the balance.

Despite offering a 32% premium to Turquoise Hill’s previous closing price, brokers agree the offer still represents a discount to their own Oyu Tolgoi valuations. Indeed, after crunching a lot of numbers, including copper price forecasts, and taking Turquoise Hill’s debt into account, Goldman Sachs suggests the offer amounts to an implicit -43% discount to the valuation of Oyu Tolgoi included in its target price.

The bid remains subject to Turquoise Hill shareholder approval, albeit only in excess of 50%.

Oyu Tolgoi

The Oyu Tolgoi underground copper-gold project has been in development now for over a decade, beset with both geotechnical issues and government-driven schedule delays. In short, the Mongolian government decided they wanted more from the project. In return, Rio agreed to waive US$2.4bn of debt owed by the government.

Now everyone’s happy, and the road has become open for Rio to make its move on Turquoise Hill. First commercial production at Oyu Tolgoi is expected in the first half of 2023, however, the capex budget and expected ramp-up to full production are now under review.

Morgan Stanley believes some investors may be alarmed with an acquisition at the (perceived) top of the commodity cycle, but the broker notes Oyu Tolgoi has been somewhat de-risked now the Mongolian government is on the same page.

Oyu Tolgoi is one of Rio’s most important growth assets, Goldman Sachs suggests, as the project will double earnings from copper to over 25% on the broker’s estimates. Mine life is estimated at over 40 years, the project is low-cost and offers over 50% expansion potential. The area is also, in Goldman’s view, under-explored.

Assuming the successful full takeover of Turquoise Hill Resources, Oyu Tolgoi will deliver an extra 52ktpa of copper to Rio from the existing open pit operation, and as much as an extra 160ktpa from the underground expansion expected around 2028.

While Morgans sees this as “arguably value neutral”, the diversification of earnings and growth in copper, to which Rio is under-exposed, are important positives.

Looking further across Rio Tinto’s growth portfolio, there are also negatives.

Simandou

Rio Tinto has invested in excess of US$1bn towards its 45% ownership of blocks 3 and 4 of the four-block Simandou iron ore project in Guinea, in joint venture with the Guinean government. Simandou’s reserves are estimated to be 2.4bn tonnes of 65%-iron ore, making it one of the biggest reserves in the world.

Unluckily for Rio and other stakeholders, Guinea was subject to a military coup in September last year. The new leaders are now “doing a Mongolia” – demanding more from the deal. It is believed activities at the site have now been suspended pending talks between the government and stakeholders.

Morgans eludes to an inherent conundrum for Rio with regard its Simandou stake.

With Brazil’s Vale still suffering production issues both technical and covid-related, Western Australia’s Pilbara region remains China’s only reliable source of high-grade iron ore. If Simandou does ramp up, this has implications for pricing out of the Pilbara.

But perhaps for Rio, that’s the whole point. Best to be in on the action in Guinea. The company has not recently commented on the situation but as Morgans suggests, if Simandou does go ahead it will be on lower fiscal terms for stakeholders.

Valuation

On the balance of a weak earnings result, Olu Tolgoi upside and Simandou uncertainty, Morgans has a Hold rating on Rio Tinto, with a target price of $117.

The FNArena broker database shows three Buy, three Hold and one Sell (UBS) rating, with a consensus target of $116.93, some 9% above the current trading price.

Goldman Sachs, not a database member, has a Buy rating and a $131.50 target.

Another non-database member, Shaw & Partners, stands out with a $99 target and Hold rating (current trading price around $107).

Noting the impact first from covid and then the war have had on commodity prices, Shaw recommends buying “real assets” is a much better bet than buying “ethereal” assets at this time (eg tech). Earnings and cash flow matter, says Shaw, and mining/oil & gas stocks are trading at significant discounts, in some cases, to valuations implied by spot commodity prices.

Which thus leaves room for blow-off tops in some of the more parabolic prices.

Sure enough, Shaw issued its report last week, before commodity prices did begin to blow off, specifically oil, but also iron ore, base metals and gold. The uranium price nevertheless remains in a solid uptrend for now.

Backing its “real asset” claim, Shaw likes South32 ((S32)) and BHP Group ((BHP)) at the “big end”, noting BHP is about to deliver a whopping dividend post the completion of the Petroleum division spin-off.

Anything in energy (oil, gas, coal, uranium) is preferred, given the valuation disconnect to prices is now extreme. Shaw also likes gold as a safe haven, as well as “laggard” base metal plays, including South32 but also Alumina Ltd ((AWC)).

Shaw does not make mention of Rio Tinto, other than to generally suggest iron ore names as a funding source to invest elsewhere. This would imply Fortescue Metals ((FMG)), but presumably also Rio and BHP, although the two biggies are balanced by their diversification. So perhaps the long list of smaller iron ore miners is being implied.

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