What should a mining company do when one commodity's price fall drives a 22% drop in its first half earnings?
Rio Tinto's answer is to keep plowing money into iron ore, the metal which now contributes 80% of its net profit. Rio is planning a major expansion of its iron ore operations in Australia, tying up most of its capital spending in the next three years. But with signs emerging of slowing Chinese steel demand, investors are entitled to wonder whether Rio has the right idea.
Deutsche Bank estimates that if iron ore prices stay high, Rio should keep generating a decent return on investment, thanks to its low cost operations. The miner is spending AUD 16.9 billion to increase output at its key Pilbara mines by 60% to 353 million tonnes per annum from 2015. Assuming iron ore prices, currently around AUD 115 per tonne, stay above AUD 80 after 2018, the Pilbara expansion could generate a 24.8% internal rate of return, well above Rio's 9% cost of capital.
The risk is that iron ore demand falls lower and more quickly than expected. Chinese steel production is key. Rio reckons it could rise towards 1 billion tonnes a year by 2020 as compared with around 700 million tonnes last year.
But China has arguably gone through its most rapid phase of investment growth, with steel consumption around 8% of GDP each year since 2004. Japan's consumption, for example, is now around 2% of GDP: Replicated in China, that could mean steel demand dropping to 480 tonnes per year in 2020, Citi estimates just five years after Rio's Pilbara expansion comes on stream.
Citi estimates that Rio's near term iron ore exposure is clear, too. Every 10% fall in its price causes its earnings to fall by AUD 1 billion, it estimates. Its free cash flow would be just 40% of its expected dividend in 2013 if prices fall to AUD 80 per tonne in 2013. With investors still wary of Rio after its misguided 2008 investment in Alcan, its stock trades at a 19% discount to its more diversified peers based on expected 2013 earnings.
Only with less iron in Rio's diet will that gap narrow.
Source - The Australian
(www.steelguru.com)
