Is its attractive valuation misleading?
I am neutral on Rio Tinto (Rio) as its attractive dividend yield and strong recent results are offset by its cyclicality and lackluster demand outlook.
Rio Tinto is a major global miner extracting primarily iron ore. The company also mines aluminum 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 around the world, while China is its largest sales market.
About two-thirds of its revenue comes from iron ore and one-fifth of its revenue comes from aluminum. Meanwhile, more than half of its revenue comes from China and about two-thirds comes from Asia.
In this article, I will explain why I am neutral on RIO shares at current prices.
Solid results in the first quarter
RIO’s fiscal first quarter results were strong, but not as impressive as the year-ago quarter results.
Pilbara iron ore shipments were down 15% sequentially and 8% year-on-year. Pilbara iron ore production also fell 15% sequentially and was down 6% year-over-year.
Bauxite production was flat year over year and actually increased 4% sequentially. Aluminum production was down 3% sequentially and down 8% year-over-year.
Copper mined decreased 5% sequentially and increased 4% year-over-year. Titanium dioxide slag production increased 20% sequentially and decreased 2% year-over-year. Finally, IOC’s iron ore pellet and concentrate production decreased 4% sequentially and increased 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 advance the valuable You Tolgoi project, then later in the quarter, it announced that it had makes a proposal to acquire the rest of Turquoise Hill.
High quality miner
RIO has an impressive track record as one of the largest mining companies in the world. It has a stellar balance sheet with no net debt 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 revolving credit facility.
The company has also proven to be an excellent allocator of capital throughout its history, distributing cash generously to shareholders. In fact, management emphasized on its last Investor Day that the dividend is paramount to maintaining its disciplined capital allocation.
By committing to return as much cash to shareholders, RIO is obliged to prioritize its growth investments and avoid value-destroying or excessively risky projects.
RIO’s payout policy is to target paying out 40% to 60% of earnings as dividends to shareholders, paying out at the upper end of this range during periods of strong cash generation and at the lower end of this range during periods of low cash generation.
Moderately attractive share price
RIO’s share 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 futures price multiple to free cash flow is 7.6x, which looks quite attractive compared to its five-year average of 11.1x. Last but not least, its 10.8% dividend yield looks extremely attractive.
That said, the future outlook is poor for the company based on consensus analyst estimates that project EBITDA to decline at a CAGR of 13% through 2026 and free cash flow to decline at a CAGR of 16.3% over the same period.
The Taking of Wall Street
On top of that, Wall Street analysts give RIO a consensus holding rating based on one buy, four holds, and zero sell ratings given over the past three months. Additionally, the RIO’s average price target of $92 puts the upside potential at 25.6%.
Summary and conclusions
RIO is one of the world’s leading mining companies. It owns world-class assets and uses state-of-the-art operational techniques to extract minerals such as iron ore and aluminum. The company is currently generating strong cash flow and paying attractive dividends to its shareholders.
However, it is notoriously cyclical, and a major downturn in the Chinese economy, in particular, would hurt demand for RIO. As the global economy is expected to head into a recession in the near future, analysts expect RIO’s EBITDA and free cash flow to decline significantly over the next few years. coming years.
As a result, even if the stock price currently looks attractive, investors may want to wait for a significant pullback in the stock price before adding shares.
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