Rio Tinto: Is Its Attractive Valuation Deceiving?

I am neutral on Rio Tinto (RIO) as its attractive dividend yield and strong recent results are offset by its cyclicality and the gloomy demand outlook.

Rio Tinto is a leading global miner that primarily mines iron ore. The company also mines aluminium and a plethora of other types of minerals and metals. The company extracts its minerals and metals from world-class assets using world-class methods across the globe, while China is its largest sales market.

Roughly two-thirds of its revenue comes from iron ore, and one-fifth of its revenue comes from aluminium. Meanwhile, well over half of its revenue comes from China, and about two-thirds comes from Asia.

In this article, I will lay out why I am neutral on RIO stock at current prices.

Solid Q1 Results

Fiscal Q1 results for RIO were solid, albeit not quite as impressive as the year-ago quarter’s results.

Pilbara iron ore shipments declined 15% sequentially and 8% year-over-year. Pilbara iron ore production also declined 15% sequentially and saw a 6% year-over-year decline.

Bauxite production was flat year-over-year and actually increased 4% sequentially. Aluminium production saw a 3% sequential decline and an 8% year-over-year decline.

Mined copper was down 5% sequentially and up 4% year-over-year. Titanium dioxide slag production was up 20% sequentially and down 2% year-over-year. Finally, IOC iron ore pellets and concentrate production was down 4% sequentially and up 3% year-over-year.

During the quarter, RIO announced that it had reached an agreement with Turquoise Hill Resources and the Government of Mongolia to be able to move the valuable You Tolgoi project forward, and then later in the quarter, it announced that it had made a proposal to acquire the remainder of Turquoise Hill.

High-Quality Miner

RIO has an impressive track record as one of the world’s greatest mining companies. It has a stellar balance sheet that is net-debt-free and earns it an A credit rating from S&P. The company also has no corporate bond maturities for several years and has a $7.5 billion back-stop revolving credit facility.

The company has also proven to be an excellent capital allocator over the course of its history, distributing cash to shareholders generously. In fact, management emphasized at its latest Investor Day that the dividend is paramount for maintaining its disciplined capital allocation.

By committing to return so much cash to shareholders, RIO is forced to high-grade its growth investments and avoid value-destroying or excessively risky projects.

RIO’s payout policy is to target paying out 40%-60% of profits as dividends to shareholders, paying out at the high end of that range during periods of strong cash generation and at the low end of that range during periods of weak cash generation.

Moderately Attractive Stock Price

RIO’s stock price currently looks attractive based on valuation multiples.

For example, its forward EV/EBITDA multiple is 3.6x, which is low compared to its five-year average of 5.1x. Meanwhile, its forward price-to-free-cash-flow multiple is 7.6x, which looks quite attractive compared to its five-year average of 11.1x. Last but not least, its dividend yield of 10.8% looks mouthwateringly attractive.

That said, the forward outlook is poor for the company based on consensus analyst estimates that expect EBITDA to decline at a 13% CAGR through 2026 and expect free cash flow to decline at a 16.3% CAGR over that same time span.

Wall Street’s Take

On top of that, Wall Street analysts give RIO a Hold consensus rating based on one Buy, four Holds, and zero Sell ratings assigned in the past three months. Furthermore, the average RIO price target of $92 puts the upside potential at 25.6%.

Summary and Conclusions

RIO is one of the leading mining companies in the world. It owns world-class assets and employs leading operational techniques to extract minerals such as iron ore and aluminium. The company is currently generating significant cash flows and paying out attractive dividends to shareholders.

However, it is notoriously cyclical, and a major downturn in the Chinese economy, in particular, would harm demand for RIO. Given the expectation that the global economy is headed for a recession in the near future, analysts are expecting RIO’s EBITDA and free cash flow to decline substantially in the coming years.

As a result, even though the stock looks attractively priced right now, investors might want to wait for a meaningful pullback in the share price before adding shares.

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