The analysis of Rio Tinto (RIO) that follows is from Abe Silk. Abe's been contributing to the blog and sent me this analysis of RIO on January 30th. I think a two month delay before posting it sets some sort of record for lost and forgotten analysis. Abe, I'm sorry and it won't happen again. I only got around to reading this this morning when I remembered you'd sent it to me. You've borne your disgust in silence, my friend, but I hope I can make it up to you somehow. This is, by the way, a very good analysis. My comments follow it:
FROM ABE SILK:
Meaning: Rio Tinto PLC (RIO) is a major international mining group, based in the U.K. The company locates, develops, mines, and processes a diverse range of mineral resources. Major products include aluminum, copper, iron ore, and diamonds. The company also produces energy assets, such as coal and uranium, as well as industrial minerals, such as borax, titanium dioxide, and salt. Rio Tinto operates across the globe, with a significant concentration in Australia and North America. Other operations are located in South America, Asia, Europe and South Africa. RIO’s diversity, both geographically and in terms of its resources, gives us a measure of safety that some more single-focused companies cannot provide.
The stock has a clear meaning, as it’s one of the world’s leading producers of the mineral resources listed above. It’s the third largest publicly traded mining company in the world in terms of market capitalization ($115 billion), behind only Brazilian Vale and Australian mining giant BHP Billiton. What’s more, there are astronomically high barriers to entry: Finding the mines or purchasing the mineral rights, the cost of labor and extraction, getting the goods to market across the globe; it would be almost impossible to start a mining operation on such a large scale from scratch. This is the first evidence of a wide moat. More evidence can be found in the numbers:
ROIC: 16% (10yr); 18% (5yr);
BVPS: 15.5% (10yr); 18% (5yr);
EPS: 15.5% (10yr); 17% (5yr)
Sales: 18.5% (10yr); 24.5% (5yr)
Cash Flow: 14.5% (10yr); 16% (5yr)
RIO’s debt/equity ratio is a manageable 0.29, which could be paid off with a few years of cash flow.
Management: The CEO of Rio Tinto is Tom Albanese, who fits the mold of a Rule # 1 chief executive. Mr. Albanese has been with the company since 1993 and has been CEO since 2007. He has both a bachelor's degree in mineral economics and a master's in mining engineering. On the conference calls, he seems passionate and utterly engaged in the business. His annual salary of $12.5 million does not seem out of line with a company that is one of the largest in the world. At 54 years old, he seems likely to remain with the company for a good many years and to continue to help it prosper.
Margin of Safety: The analysts’ 5 year growth rate is 16.8%, and the 10 year PE values range from 7.7, where it is now, to 45, with a historical average of just under 15. The extremely cheap PE ratio leaves RIO with an exceptional earnings yield of close to 13%. (It should be noted that RIO’s competitors such as BHP and VALE are also currently trading at attractive PEs, but none had as attractive numbers as RIO.)
The analysts seem bullish on RIO, but a 16.8% growth rate seems high. The ten year trailing BVPS growth rate was 15.5%. If Phil has taught us nothing else (aside from Rule #1 that is), it’s to err on the side of caution, so we’ll call the growth rate 11% to be safe. Since we’ll want to sell when the market is good, we’ll call the future PE 18. If we’re right in our valuation, we get a sticker price of $102.69 and a MOS price of $51.34. RIO is currently selling at just under $60 per ADR, with a healthy 2% dividend.
Phil is sure to ask how RIO is going to maintain this fairly lofty growth rate projection, so we might as well answer that question here. More than anything else, a long play on RIO is a bet on China’s continued growth and development. A large part of RIO’s business is coal extraction, and most of China’s power comes from coal, as their pollution problems would attest. RIO is also a huge producer of copper, and as rapidly developing country China will need huge amounts of copper piping for its buildings, in addition to other things. The largest percentage of RIO’s profits (by a factor of around 5 according to the company’s SEC filings) comes from iron ore, a key component of smelting steel. Steel, more than any other material, is fundamental to large buildings the world over, and are particularly important to countries with emerging economies and population booms. RIO is based in London, but has a huge operation in Australia. Its main business goal at the current time, as we’ve said, is to provide China the energy and mineral resources it needs to continue its growth.
In terms of Payback Time valuation, the situation here is really great. Even if we go as low as a 9% annual growth rate, we get an outstanding 5 year payback time. As Phil has taught us, that’s beyond excellent, and from this perspective would be dirt cheap even in a private equity environment.
Unfortunately, we can’t say the same about RIO having a real MOS when it comes to Price/Book. RIO is trading at 1.9 times its book value, which is only mediocre. The ratio of price/tangible book is even higher, and thus less attractive. If it were trading closer to (or ideally under) tangible book value, it would be a third and almost impossibly desirable MOS. This doesn’t present an especially worrisome problem, however, since we are buying Rio Tinto as a thriving business going forward, and not one that might be liquidated anytime soon. Two different margins of safety still make Rio Tinto a compelling value.
Possible Red flags:
Though RIO’s ROIC has often met our 10% minimum over the past 10 years, there is no denying that the trend has been bouncy. Some of this surely can be attributed to commodity cycles and the crisis of 2008, but some questions still remain. Since ROIC is the most important number, we want to be more sure than we are here that management is investing its capital wisely. Even though the ROIC average comes out well above 10%, we would rather see consistency and a nice, upward trajectory.
Another red flag comes from the questions over demand for commodities in China. Some smart investors out there, like Jim Chanos (of Enron fame) have publicly stated that they are shorting companies largely dependent on the Chinese economy, including those related to construction. The thinking here is that China has been growing at such a blistering pace that it is bound to crash down to earth, and bring many businesses along with it. Rio Tinto seems to fit right into that group, or so the thinking goes. The last thing we want is for Chanos to be right, or for us to play Berkowitz to his Einhorn in the whole St. Joe saga. If we are wrong about China, and its slowing growth prompts a decline in RIO’s earnings, the worst case is that we have a great company at a so-so price. But having laid out those red flags, it still seems rational to say that Rio Tinto is a great company, with great, impossible-to-replicate assets, selling at a wonderful price. It’s hard to see the greatest population boom in human history faltering badly enough for Rio Tinto’s earnings to collapse along with them. Furthermore, the company has worldwide distribution channels, and China is hardly the only horse in its stable.
Let’s hear some comments from the Rulers out there.
I think Abe nails the central issue - first, what happens to China happens to RIO, second, it looks like its massively on sale from a Payback Time POV. The good news about me camping out on his analysis is that the stock was at $60 on January 30 and today its at $54.
I don't have a lot to add to his presentation except BlackRock hedge fund is adding RIO to its mining portfolio and selling BHP. They don't like it that BHP has been buying into the Shale natural gas play because the payoff is too long-term for them.
Here's the downside that I see: It could be years before the impact of the financial debacle works its way through China and RIO, BHP and VALE all just sit there or go down farther. The limit, I think, is the potential for inflation is starting to increase as the massive liquidity injected into the world financial system works its way out of banks and into the economy. The impact will be felt first in gas prices and food prices and it will spread from there. Eventually these commodity businesses stock prices will rise with inflation.
Also, I'd like to encourage us all to think in terms of 'story'. Like, what is the story about RIO that makes it the best investment in the group ... better say than BHP? Always create a story. Write it down. Make sure you believe in it totally. Then don't change anything you're doing unless the story changes. And when it changes, act.
Now go play.
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