Rio Tinto: Short-term challenges, long-term potential (RIO)

Investment Thesis

Rio Tinto’s (NYSE: RIO) share price is down 14% year-to-date due to lower iron ore prices and demand uncertainty. This could be a time to add to my long position in Rio Tinto?

Chinese demand for iron ore has likely settled, and emerging economies (such as India) will not be able to recover their weakness in the short term.

Due to changes in the steelmaking process, the demand profile for iron ore is expected to shift towards high grade ore. The decarbonisation goals of steel production are driving these changes. Some expect this shift in demand to result in a supply shortfall by 2030. Rio’s stake in the Simandou mine, due to begin production in late 2025, is expected to produce a significant proportion of high-grade ore, making it well positioned for this intended. change.

Rio is diversified into aluminum and copper segments, accounting for approximately 37 percent of its revenue in the first half of 2024. Demand for aluminum and copper is expected to grow significantly in the coming years, driven mainly by electrification.

Decline in Chinese demand is immediate, while increased demand for high-grade ore, aluminum and copper may materialize. I expect Rio Tinto to maintain its dividend capacity, but growth prospects look muted at the moment, resulting in a hold.

Brief overview of the company

Rio Tinto is one of the largest producers of iron ore. It has a dual listed company structure and is incorporated in England (as Rio Tinto plc) and Australia (as Rio Tinto Limited).

Investors can gain exposure to Rio Tinto shares in three ways: listing them on the LSE, the Australian Stock Exchange (ASX) or through ADRs listed on the NYSE.

Business Segments: Half/Half Iron Ore, Energy Transition Metals

To get a basic understanding of the drivers and risks for RIO, let’s consider the figures for the first half of 2024 for its four segments: iron ore, aluminum, copper and minerals:

Click to enlarge

(2024 HY Results Report; pp. 16-22)

In the first half of 2024, Rio’s iron ore segment accounted for 53% of revenues and 82% of earnings (92% and 78% in 2022 and 2023, respectively). The iron ore price is the main driver of Rio’s ability to create shareholder value. While the price of iron ore has fallen this year, the prices of the second and third segments have increased:

The Company publishes its calculated sensitivities to the prices and exchange rates of selected commodities. While this theoretical exercise has severe limitations—such as the complex relationship between currencies and commodity prices, let alone the difficulty of forecasting either—it still shows how RIO earnings rise or fall.

Changes in the price of iron ore would have the most significant impact, but as we can see below, a change in aluminum or copper prices in the opposite direction could offset this:

However, the iron ore segment is the number one driver of RIO’s earnings.

Peer comparison

In this section, I will review Rio Tinto’s performance against its listed peers, which derive a significant portion of their revenue from iron ore production:

• Vale SA (VALE), $34 billion (81% of total revenue) in 2023
• BHP Group Ltd. (BHP), $24.8 billion (46%) in FY2023 (ended June 30)
• Fortescue Ltd. (OTCQX:FSUMF), $16.8 (100%) in FY2023 (ended June 30)

(Rio itself reported $32.2 billion (60%) in FY2023)

As we can see from the above, all four companies have followed a similar downward trajectory in terms of YTD total returns.

Turning our attention to EV to EBITDA, we see that the market is consistently willing to pay more for BHP than Vale. Rio was placed in the middle:

Finally, considering dividend parameters, we note that the peer group has similar debt to EBITDA and dividend coverage ratios, but very different yields.

In short, when considering these valuation metrics, Rio Tinto is in the middle of the pack overall. It is neither the cheapest nor the highest yielding stock in this peer group.

Market Outlook

China’s iron ore demand has surpassed the peak…

Wood Mackenzie published an article in late 2023 claiming that a decline in Chinese iron ore demand is “inevitable”. He cited the use of scrap and reduced output from blast furnaces as reasons, resulting in a 20% reduction in iron ore consumption.

…and the iron ore market will be oversupplied

From IEEFA in July:

China will also try to recycle more steel in the future, further reducing demand for iron ore from the country that produces most of the world’s steel. As a result, the world seaborne iron ore market is about to enter a period of significant surplus and lower prices.

Its report refers to a forecast of 200 Mt of oversupply in 2026-2028.

Demand in emerging economies could pick up, but it won’t make up for lagging demand in China

Emerging economies will become more critical to demand in the coming years, but it is critical to consider how much this growth will matter. The list of major producers by the World Steel Association makes it clear that:

India’s production grew by 12% year-on-year. But even if it maintained this growth for ten years, for example, it would only reach about 388 Mt – less than 40% of China’s output.

Even RIO acknowledges how much it is banking on rising Chinese commodity demand in this 2023 investor day slide:

This graph illustrates that even a much higher CAGR in a large market like India is far from compensating for a declining potential demand from China. The IEEFA report linked in the above paragraph also discusses this issue:

(..) as India and Southeast Asia should have filled the demand gap for iron ore and metallurgical coal. However, S&P Global analysis suggests that only a quarter of the expected 100 million tonnes per annum (Mtpa) of additional steel production (..) can be expected to be built by 2030.

India is targeting a total steel capacity of 300 Mtpa (but) it is not fast enough to achieve this target.

However, all is not lost: demand for high-grade ore could outstrip supply

The same IEEFA report looks at Vale and Anglo American’s outlook for demand for high grade (DR lumps) ore. Vale expects a gap of 70 Mt by 2030:

The Anglo American Climate Change Report 2023 (p. 11) discusses this gap and the shift in focus on iron ore quality (edited for clarity by the author):

It is unlikely that the scrap supply will be sufficient to meet the demand (..) There is thus a risk that failure to accurately recognize the role of high grade iron ore (..)

DRI production is expected to grow rapidly, (..) resulting in an additional demand for direct reduced (DR) pellets of nearly 400 Mt. (..) before 2030 there will be a deficit between the production of DRI (..) the supply of DRI pellet feed. From 2030 to 2050, an additional ~300 Mt of DR pellets or other feedstock (..) will need to be brought online leading to a shift to iron ore quality and higher DR pellet premiums.

With these predictions coming to fruition, Rio Tinto has taken a promising position in the Simandou project, from which a significant amount of its output will be high-grade iron ore.

Aluminum demand looks promising…

Several research bodies expect aluminum demand to grow significantly over the next decade. Electric cars are one of the drivers of demand. With Rio Tinto deriving 22% of its revenue from its aluminum segment in the first half of 2024, increased demand and bauxite prices will help.

Rio is experimenting with emission-free smelting in the ELYSIS joint venture with Alcoa. The plant, which is expected to be the first to implement ELYSIS technology, is expected to produce 2,500 tonnes of aluminum annually starting in 2027. For context, Rio produced around 1.65 million tonnes of aluminum in the first half of the year 2024, so added production capacity won’t revolutionize its operations. However, the shift to new production methods is underway and we will see more of these.

… Same as copper

In a recent report, Wood Mackenzie estimates that demand for copper will increase by 75% by 2050 due to its key role in electrification. With 15% of Rio’s H1 2024 revenue coming from its copper segment, it will benefit from this increase in demand.

Arizona’s Rio Resolution project, which could supply up to 25 percent of U.S. copper demand, and Peru’s La Granja project, one of the world’s largest undeveloped deposits, would benefit Rio in that demand forecast scenario.

However, these projects are still many years away from production: Resolution was discovered two decades ago and has yet to begin an anticipated ten-year construction process; the La Granja project was acquired in 2006.

Conclusion

This article assessed Rio Tinto as an investment opportunity for exposure to iron ore and aluminum and copper production and compared it to its listed peers through the lens of an income-oriented investor. Rio Tinto was found to be in the middle of the pack in terms of the indicators considered.

Demand for lower-grade iron ore, which dominates the market today, is expected to contract due to lower Chinese demand. However, demand for high-grade iron ore is set to increase and supply shortages could occur by 2030. There is uncertainty about the ongoing transition to new, lower-emission production methods using high quality ore. In any case, Rio Tinto has a stake in high-grade ore production and diversification into copper and aluminum.