Rio Tinto Ramps Up Shareholder Returns

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Brokers are adding up the substantial returns expected from Rio Tinto over the next 12 months, as the company signals an intention to pay out proceeds from asset sales.

-First half results short of expectations because of higher costs
-Strong returns generated from cash flow and sale of non-strategic assets
-Rio Tinto maintains conservative stance on growth options
 

By Eva Brocklehurst

First half results from Rio Tinto ((RIO)) were weaker than generally expected but this is being overlooked by heightened anticipation of capital management. Rio Tinto is set to pay out 72% of earnings including a further US$1bn buyback. The ability to deliver such strong industry returns has been a function of both healthy cash flow from operations and the disposal of non-strategic assets.

The company has completed the sale of its remaining coal assets for US$2.95bn, all of which is expected to be returned to shareholders. Smelter and Grasberg proceeds are also expected over the next 12 months.

The results fell short of UBS estimates, largely from higher costs and expenditure on items such as restructuring and information systems. Net debt increased to US$5.2bn, resulting from a catch-up payment on 2017 tax, increased capex and shareholder returns.

Rio Tinto has declared an additional US$7.2bn will be returned to shareholders, topping up its market buyback by US$1.0bn and declaring an interim dividend totalling US$2.2bn. Details on the remaining $4bn in returns will be dealt with in the second half.

Higher Costs

UBS lowers 2018-20 earnings estimates by -6-7% to reflect higher central office costs and inflation across the product group. While "other items" were significant in this half-year, these are expected to ease in the second half as many were one-off set-up items, such as restructure of the operating model and establishment of a Singapore hub.

However, offsetting rising raw materials costs, particularly in aluminium and energy, were higher volumes and prices, UBS points out. Sales volumes increased the underlying operating earnings by US$887m year-on-year, a function of more iron ore from the Pilbara, more copper from Escondida, Kennecott & Oyu Tolgoi and higher bauxite sales.

Higher aluminium cash costs contribute to a -4% reduction in Ord Minnett's estimates over the next few years. While disappointed, the broker maintains an Accumulate rating given the attractive valuation and strong returns.

An increase in valuation offsets the impact of earnings downgrades for Citi as well. Although costs are increasing, and an escalation of the trade wars amid a slowing Chinese economy is a threat, upside risk exists to estimates from spot iron ore prices and cash generation.

Morgans was disappointed legacy contracts held down realised alumina prices and bauxite supply from Guinea continues to keep a lid on pricing. Morgans also notes margins appear to have already peaked.

Production guidance for all major divisions remains unchanged from the June quarter results with the exception of coal, which is reflecting the earlier-than-expected disposal of assets. Iron ore stood out as a division while aluminium and copper were weaker than Macquarie expected. High costs in aluminium and lower revenue in copper were the main causes.

Returns Or Growth?

Channelling excess cash flow back to shareholders is a more attractive investment proposition than a large miner offering hefty premiums to acquire development assets, and so Morgans is comfortable with the company's current stance on capital deployment.

Nevertheless, investor demand for growth is expected to increase as the cycle progresses and this may mean a shift in the company's current conservative approach.

The broker's impression from the first half result is that Rio is more conservative and measured when it comes to considering growth options than previously supposed. Morgans had expected that spare capital from the divestments might be spared for growth but instead the company has flagged an intention to return net proceeds from asset sales entirely to shareholders.

CLSA believes the balance sheet is too conservative and calls for higher capital management and an increased focus on growth, citing an opportunity cost of not utilising debt capacity or holding excess cash on the balance sheet. CLSA, not one of the eight stockbrokers monitored daily on the FNArena database, has an Outperform rating and $85.10 target for the stock.

Rio Tinto is ready to pounce on the right growth opportunity but UBS suggests, currently, there are none. The broker retains a Buy rating with a view that the company will focus on value over volume and return surplus cash to shareholders.

The database shows six Buy ratings and two Hold. The consensus target is $88.02, suggesting 11.7% upside to the last share price. Targets range from $80.67 (Morgans) to $94.00 (Ord Minnett). The dividend yield on current FX values for 2018 is 5.0% and 2019 4.8%.

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