Rio Tinto is one of the largest mining companies in the world and the stock offers attractive dividend yields. However, mining stocks are often less known due to its complexity. Hence, I have written this article to provide a comprehensive analysis of Rio Tinto and whether this stock is a good investment.
The article will be split into two segments. The first segment of this article would be focused on understanding the business of Rio Tinto and mining in general. The second segment would be focused on analysing the financials and the risks of investing in Rio Tinto stock.
1. Business Model of Mining Companies
The simplified version of what mining companies do is to dig up whatever resources underneath the earth’s surface and sell it.
However, the entire process of digging up resources and selling it often takes up to years or even decades.
It starts with exploration from geologists and specialised technologies to evaluate the level of mineral deposits on the ground. Samples are drilled and sent to the labs for testing.
Once a particular area is discovered to contain a huge concentration of minerals, it would move on to the next step which is evaluating the economic viability of the project.
This would be assessing the financing, cash flow, environmental impact, regulatory approvals, method of mining, jobs creation, waste disposal, logistics, and infrastructure. There is a whole lot of stakeholders involved and the entire process can be time-consuming and complex.
If all else goes through, the mining company would start construction on the mining facilities, shafts, employee dormitories, roads and transportation systems. It has to consider the most cost-efficient method to extract and transport materials from the ground to the port. It can take multiple years for the construction process to be completed before the real mining begins.
After which, the mining company would start the mining production. The two most common methods are surface mining and underground mining. Surface mining is those open-pit quarries and underground mining is the use of sink shafts to drill a vertical tunnel downwards.
The extracted ores are then crushed, milled and processed before being transported to the ports for shipment and delivery to customers. After the mining site has been fully exhausted, all the facilities on-site would be dismantled and destroyed. Rehabilitation work is done to restore the land back to its original state before mining.
2. Overview of Rio Tinto Stock
Now that we have understood a brief overview of what mining companies do, let’s dive into the details of Rio Tinto.
Rio Tinto is founded in 1873 and the company has been around for more than a century. They are the world leader in the production of aluminium, iron ore, copper, diamonds, uranium, and other industrial minerals.
From the mine to the market, Rio Tinto is involved in the entire value of chain mining. It has some of the world’s largest and best quality mines operating in over 35 countries.
The company is technologically advanced as it employs hundreds of autonomous self-driving haul trucks to transport materials from mines to ports in Australia. Rio Tinto also made history by rolling out the first heavy-haul, long-distance autonomous rail operation in the world.
Breakdown of revenue by geographical segment
Based on the revenue breakdown, Rio Tinto’s main customer comes from China, followed by the US, other parts of Asia and Japan. Most of its key assets are located near Australia, as you will see later.
3. Where is Rio Tinto Stock Listed?
Rio Tinto is listed on three exchanges in the UK, US and Australia. The stock symbol in the London Stock Exchange is known as Rio Tinto PLC and the price is denominated in GBX. Rio Tinto PLC is a component of the FTSE 100 index in the UK.
Rio Tinto is also traded on NYSE with the stock ticker RIO. It is an American Depository Receipt (ADR) which represents a share in foreign stock.
Lastly, the Rio Tinto is listed on the ASX in Australia known as Rio Tinto Limited. It is a component of the ASX 200 in Australia.
4. Rio Tinto’s Business Units
The four main business units are Iron Ore, Aluminium, Copper & Diamonds and Energy & Minerals.
Breakdown of revenue by business units
If we breakdown the gross revenue by business units, Iron ore takes up the largest segment followed by Aluminium. Copper, Diamonds and other energy minerals together made up the remaining one-third of the total revenue.
Here is a snapshot of where Rio Tinto’s assets are located. You can see that most of them are located in lower risk jurisdiction countries such as the US and Australia. The proximity distance between Australia and Asia gives Rio Tinto the competitive advantage to supply materials to Asia where the economic growth engine is.
Let’s go into the individual product categories.
Unlike other commodities, the Iron ore division only has one operation which is in the Pilbara region of Western Australia. This is where all the money is. Their mining area includes an integrated network of 16 iron ore mines, 4 port facilities and 1,700km of the rail network.
Rio Tinto produces five types of iron ore products in the Pilbara region. But their flagship product is the Pilbara Blend Fines and Pilbara Blend Lump. Both of the Pilbara Blend has a higher iron content as compared to Yandicoogina and Robe Valley.
Iron ore is the top commodity export in Australia and it contributes to $38.8 billion of export revenue. 84% of the iron ores exports are headed towards China as the fast-growing country has a huge appetite for steel.
Rio Tinto’s aluminium mines are mostly located in Australia and Canada.
How is Aluminium being made? It starts with mining the bauxite ore before refining it to alumina and finally smelting it to aluminium. So there are three stages to it. Bauxite, Alumina and Aluminium.
Bauxite is the primary source of aluminium. Generally, four tonnes of bauxite are required to produce one tonne of alumina. And two tonnes of alumina are required to produce one tonne of aluminium.
Rio Tinto has access to the industry’s largest and highest quality bauxite reserves. Because of that, they are one of the world’s leading bauxite producers and 25% of the world’s bauxite needs are supplied by Rio Tinto.
The bauxite mines are located in Australia while most of the smelters are located in Canada to produce aluminium. Rio Tinto is more focused on producing bauxite rather than alumina and aluminium.
Copper & Diamonds
The copper mines are located in the US, Chile and Mongolia. The diamond mines are located in Canada and Australia.
In the copper and diamond division, there are three types of products Rio Tinto produces. Mined copper, refined copper and diamonds.
The demand for copper will always be robust as almost everything you see is made of copper. The world uses 19 million tonnes of copper annually and urbanization from developing economies will continue to drive the demand for copper higher.
Rio Tinto has a massive growth project in Mongolia called the Oyu Tolgoi mine. It is the world’s 3rd largest copper mine. Till date, $12 billion has been invested on this project making it the largest foreign investment Mongolia has ever received.
The project is still in the development phase as 80% of its value lies 1.3km deep underground. On Nov 2019, Rio Tinto achieved a significant milestone at Oyu Tolgoi with the completion of shaft 2, which is a 10m diameter shaft sunk 1.3km beneath the surface. This allows for more movement of materials, equipment and resources between the surface and underground.
The anticipated lifespan of the mine is 50 years and Oyu Tolgoi is scheduled to produce 430,000 tonnes of copper annually.
Energy & Minerals
The last business unit is energy and minerals. This includes a variety of product such as uranium, titanium, salt, borate, coal, lithium and ilmenite from mineral sand deposits.
Uranium is often used for nuclear power plants. Coal is highly popular due to its use case for electricity. However, Rio Tinto sold its coal mine to Glencore for $1.7 billion in 2018. This is likely because the attractiveness and demand for coal have fallen as a result of international pressure towards renewables. China wants new energy vehicles to make up 25% of total car sales by 2025 is just one example.
On the other hand, demand for lithium is on the rise as the adoption of electric vehicles would require lithium batteries. Recently, Rio Tinto made headlines for discovering a way to extract lithium from one of the old mining waste.
Therefore, it is important to know what mining companies are producing. As mentioned earlier, it takes years and billions for the construction and development of mines. These are sunk cost that can’t be recovered. If billions of borrowed capital are poured into coal mines and coal prices start falling drastically, the company would run into troubles servicing its debts.
5. The Economics of Mining
So what determines the profitability of mining companies? How do we tell if a particular mining company such as Rio Tinto has a competitive advantage over its competitors? One of the primary factors is the cost curve.
Before delving into what the cost curve is, let’s take a look at the margins of the four product lines. Iron Ore has the highest EBITDA margin of 68%, followed by Copper (43%), Energy & Minerals (38%) and finally Aluminium (32%). Why do they have such high margins?
This is because Rio Tinto is able to achieve economies of scale through technology advances and productivity gain. What you see above is the cost curve of iron ore. The y-axis represents the cost of producing iron ores while the x-axis represents the percentile.
Rio Tinto is positioned at the far left and that means they are one of the lowest-cost producers in the industry. That is the reason why their margins are extremely high.
As the spot price for iron ore goes down, companies with a higher production cost (on the right) would stop producing as they turn unprofitable.
Supply and Demand of Mining
This would thus lead to a decrease in supply which would eventually cause prices to rise again. When prices rise above the production costs, mining becomes attractive again and companies start producing to increase the supply. The cycle then repeats itself until an equilibrium point is reached.
This is the theory of Adam Smith’s invisible hand. But the challenge often comes from the time lag to production and supply shock from new explorations.
For instance, let’s say prices are high and I want to start mining again. But it takes me five years to develop and build the facilities. By the time production is ready, the supply and market price might have already been shifted.
Hence, mining stocks are very cyclical in nature as the supply and demand of commodities are constantly changing. When the economy is good, businesses produce more cars, buildings, phones, laptops and etc. The reverse is true in a bear market.
The upside for mining companies is that they are monopolies and the barrier to entry is extremely high. Millions or billions of dollars are required for financing and you need close government connections.
Additionally, the demand for metals will always be there. No matter how much technology has evolved, the world needs metal to produce things. As long as mining companies are able to innovate and stay within the first quartile of the cost curve, the economics prospect will be bright.
Moving on to the second segment.
6. Rio Tinto’s Financial Performance
Here is a snapshot of some of the key financial figures. Not many insights can be gathered as the figures seem flattish. The financials have been improving since the 2015 bottom but it is not any better from the peak in 2011.
The positive is dividends per share have been going up. However, the dividends payout in 2019 includes a special $1billion dividend due to an increase in iron ore prices.
This brings me to the next point. How sustainable is their dividend payout policy? To do that, we have to compare the free cash flow and total dividends paid (including special dividends). Ideally, free cash flow should be above total dividends paid. The bigger the gap, the more sustainable it is.
Looking from the chart above, it doesn’t look very robust. The difference between free cash flow and dividends is very narrow. This means that the company has very little buffer to work with. If iron ore prices start falling, Rio Tinto might have to cut dividends or borrow more to cover up for the shortage.
7. Rio Tinto’s Liquidity Position
Mining is a capital-intensive industry and financing is a critical component to look at. Companies who are highly leveraged have a very high chance of failure during a downturn. Hence, it is important to consider the liquidity position of Rio Tinto.
There are a few questions that we have to ask. How much debt did the company use? What is the margin of earnings over interest expenses? Can the company tide over a short-term liquidity crunch? How efficient is the company in collecting cash?
The list of liquidity metric is definitely not exhaustive, but it gives us a quick snapshot of Rio Tinto’s liquidity position. In the same order as above, we can use the debt-to-capital ratio, interest coverage ratio, quick ratio and cash conversion cycle to answer all these questions.
7.1 Debt-to-Capital Ratio
Debt to capital ratio measures the % of debt used to finance business operations. The LTM debt/capital for Rio Tinto is 24.2%. This is within the industry average of 25% to 30%. The high and low are 68% and 7% respectively.
In a report by PwC, mining companies have improved their financial positions by paying down debts aggressively. The average of the top 40 mining companies saw their net debt to EBITDA improved by 38%. Looking from the line chart above, Rio Tinto seems to be in a good position, well within the industry mean.
7.2 Interest Coverage Ratio
The second item is the margin of earnings over interest expense. This means how many times can the earnings pay off interest expense. The higher the number, the better.
To be conservative, I used EBTIDA – CAPEX. EBITDA is the best proxy for cash flow as it excludes depreciation expenses. CAPEX is operating requirements which are mandatory expenses. Hence, EBTIDA – CAPEX would provide a good representative of the company’s disposable earnings.
Rio Tinto’s interest coverage looks strong & healthy. 2012 was zero because the figure was negative. But apart from that, 2013 to 2019 shows an upward improvement in EBITDA, probably because the principal loans are being paid down.
7.3 Quick Ratio
The quick ratio is calculated by taking (Current assets – Inventories) divided by current liabilities. The higher the number, the better. It is trying to ask whether a company has sufficient liquid assets to pay off all the short-term liabilities that are due within a year.
Again, I took a conservative metric by using quick ratio instead of the current ratio. The difference is one takes into account inventory while the other did not. This is because inventories are not as liquid as cash or securities. While you can sell shares to the market instantly, you can’t sell 10 million tonnes of iron ores within a few days.
Rio Tinto has consistently maintained its quick ratio between 1 to 1.5. Except for 2012, the quick ratio for most of the other years are above 1.
As of June 30 2019, Rio Tinto has US$9.6 billion of cash and short-term investments sitting on its balance sheet. More often than not, their cash reserves make up >50% of their current assets while the remaining comes from account receivables.
Rio Tinto’s quick ratio metric looks good. There is little concern for any short-term liquidity crisis.
7.4 Cash Conversion Cycle
The last metric to look at is the cash conversion cycle. Cash conversion cycle is finding out the number of days to convert input resources into cash. The lower the number, the better as that means the company is collecting cash faster. Cash is very important as it is the bloodline of a company.
The normal operating cycle is to purchase raw materials, delay payment to supplier, sell goods, collect delayed payment from customers. Ideally, you want to delay payments to supplier and expedite receivables from customers. This is what the cash conversion cycle is about.
The cash conversion cycle of Rio Tinto has been decreasing and even reached negative in LTM. Negative cash conversion cycle means the company is collecting payments from customers before even making payment to the suppliers. This is generally seen as a positive outcome.
After looking at all the four areas of liquidity, I am fairly convinced that Rio Tinto is not in a highly risky position. The use of debt is not aggressive and their liabilities are pretty much covered.
8. What Drives the Price of Rio Tinto Stock?
As seen from the financial figures above, the trend starts from a high in 2011, before tumbling down to a low in 2016 and finally stabilising in 2019. So what exactly drives the stock price of Rio Tinto?
If we look at the past 10 years of commodity prices from Market Insider, it can be seen that the prices of metals have followed a similar trend. Hence, the financial performance of mining companies is highly correlated to the volatility and fluctuations of commodity prices.
Since the prices of commodities are the driving force of Rio Tinto’s financial performance, then the next important question to ask is where are we in the cycle of commodity prices?
The reason for the fall in prices can be attributed to weaker global demand and an oversupply of production in metals. The global automobile market is the second-biggest demand for steel after construction. Car sales in China and Germany have been declining and carmakers are cutting production.
The last two commodity supercycle was from 2000-2008 and 2009-2011. After which, prices of metals tumbled down to the bottom in 2016.
Back then, the demand was driven by population growth and infrastructure expansion in emerging markets. China was growing at double-digit GDP growth and housings were being built at every corner of the streets. The third industrial revolution of internet and technology also spurred demand for smartphones, laptops and all other electronic devices.
Fast forward to today, growth is maturing and we are at the late stages of an economic cycle. “QE4” has commenced and the fed has cut rates thrice. What is the next driving catalyst for the start of a commodity supercycle? This is a question among investors. But my guess is the one belt one road initiative and urbanization in developing economies.
9. Risks of Investing in Rio Tinto Stock
Mining stocks are highly cyclical and volatile. There is the commodity cycle, financing cycle, macroeconomic cycle and assets life cycle. Getting in at the right timing would significantly increase the chances of a multi-bagger investment.
Impairment on Oyu Tolgoi Copper Mine
However, the risks are also significant. Mining takes up huge CAPEX investments and financing. Exploration expenses can be significant and it may take years before finding one mining spot. Even if you found one, the economics of mining might not be viable. When you start mining, engineering challenges might arise and the complexity of the geological location might call for significant additional CAPEX.
This is exactly what happened to Rio Tinto. The estimated project costs for its Oyu Tolgoi copper mine was increased and there was a delay in the schedule to sustainable production. This led to an impairment charge of US$800 million in the first half of 2019.
There are a lot of uncertainties underground and delivery results might deviate significantly from project estimates.
Closure of Aluminium Smelters
Energy costs also play a significant role in the positioning of the cost curve. Power accounts for a third of the total cost for operating the aluminium smelters.
As electricity prices increase, the profitability margin decreases. If supply increases and market prices of aluminium falls, companies with higher production costs would be forced to close down their operations.
Recently, Rio Tinto has shut down its Tiwai smelter in New Zealand and is now considering to shut down some of its smelters in Australia. They have to work closely with government officials to negotiate lower electricity prices. Failing to do so means a cut in production and earnings.
Some of the other risks include failure to obtain support from the local communities, licensing and regulatory issues and extreme weather conditions in Australia. These are some of the risks that are often overlooked but can have a significant impact on mining companies’ profitability.
On the macro level, there are some tailwinds and headwinds in the coming years ahead.
Global manufacturing PMI across all major economies have been declining over the past few months. Global GDP growth forecasts have been adjusted downwards. The prices of commodities are highly correlated to GDP and global demand has softened.
However, the risks are being counteracted by the banks’ increased appetite for lending. This might mean more explorations and expansion, but if demand fails to catch up, prices of commodities will fall sharply due to the increase in supply.
10. Is Rio Tinto Stock a Good Buy?
In closing, there are a few important factors to look at when I consider mining stocks.
- Size of company, location of assets, quality of management
- Ability to generate consistent returns for shareholders
- High margins (*Position on cost-curve)
- Low debt, strong liquidity position
- Increasing earnings and cash flow
Rio Tinto is the 2nd largest mining company in the world after BHP. They are the big boys in the industry. Most of its assets are located in Australia and the US, which reduces a large part of any legal & political risks.
Rio Tinto’s EBITDA Margin & ROIC
If we take a quick look of Rio Tinto’s EBITDA margin and Return on Capital over the past 10 years. It can be seen that the results are very consistent and steady. Rio Tinto’s ROIC has been able to outperform its peers.
The management also has a very favourable policy of returning back value to shareholders. Whenever a divestment is made or commodity prices spiked up significantly, it will always return back the cash generated to shareholder through special dividends.
As seen over the past three years, Rio Tinto has always exceeded the payout ratio policy. Look at the return of disposal proceeds to shareholders.
The management has a very disciplined approach to capital allocation. The three focus areas are balance sheet strength, superior shareholder returns and creating growth options.
All three criteria have been fulfilled as their liquidity position is healthy, dividends are generous and Rio Tinto is actively exploring new growth projects in 18 countries. At the moment, most of their exploratory expenditures are spent on coppers and diamonds.
Rio Tinto’s Production Summary
I have compiled a summary of the production data over the past 7 years. This allows us to see which commodity Rio Tinto is focusing on.
The first thing to note is that they have stopped coal production as their coal mine has been sold off. Bauxite and iron ore remains the largest segment of their business. Copper has not reached its full production as the Oyu Tolgoi mine in Mongolia is still in development.
On the micro-level, Rio Tinto has a strong management team that is highly efficient in allocating capital. However, on the macro-level, the global risks and geopolitical uncertainties still persist. Commodity prices are neither high nor low. The EV growth story and looming recession coexist at the same time.
Adding on to the uncertainties are the expected supply and demand in the coming years. Tracking government infrastructure spending and construction spending might give a hint on the demand for steel. But the supply output at any given time might be harder to measure.
A good time to be buying is when commodity prices are at rock-bottom and junior mining companies are going bankrupt. The time has not come yet. But when it does, Rio Tinto’s position on the cost-curve would be a strong economic moat that enables them to survive a downturn.
A lot more industry research has to be done to understand the changing trends unfolding in the space. Doing up the quantitative valuation would be an entirely separate post by itself.
This article only provides a glimpse of the mining industry and Rio Tinto’s business. If you find the information helpful, do remember to share and subscribe to our newsletter for future updates.