AU earnings: Rio Tinto - when the going gets tough, the tough get going

In this week's Investor Spotlight, we explore Rio Tinto's 1H23 earnings which faced challenges as net cash generated and net earnings declined, leading to a lower dividend. Despite diversification efforts, iron ore remains a major revenue source and analysts project varying outlooks for iron ore prices.

Was the 1H23 results a hit or miss?

Rio Tinto's first-half earnings came in lower than most analyst expectations with a 34% decline in net cash generated and a 43% fall in net earnings year-on-year, resulting in a corresponding 30% lowering of the dividend. The company retained its 50% dividend payout policy.

Rio Tinto's market challenges and diversification efforts

While Rio Tinto is diversifying with a push into green aluminum, increased copper production, and lithium, iron ore continues to generate the bulk of earnings, constituting 78% in 1H23, with 90% coming from Pilbara. Management attributed the softer-than-forecast results to weaker commodity prices and higher costs, although they expect certain costs, such as diesel, to decline in 2H23.

The company also reported a $828 million post-tax cash impairment for the Gladstone alumina refineries as part of the decarbonization process of Scope 1 emissions. Additionally, Rio acknowledged that it won't achieve its 2025 15% emission reduction targets without purchasing credits.

Rio Tinto daily chart

Invest, evolve, and transition

As these results displayed, Rio Tinto remains a company that is heavily exposed to the iron ore price cycle, and the outlook for the Chinese property market remains one of the key drivers for iron ore prices, via steel demand. Last week, market speculation jumped again from a more positive tone struck by the Politburo about providing some assistance to the slower-than-expected post-COVID Chinese economic recovery.

The reality of a heavily indebted property market and cautious Chinese investors/buyers continues to subdue hope into a more realistic outlook for iron prices.

As of July 28th, iron ore futures were lower due to concerns about possible steel output caps and impatience around the lack of further stimulus updates from China. The September iron ore contract on China’s Dalian Commodity Exchange was 2.68% lower at $116.60 per metric ton, and the Singapore Exchange, benchmark September iron ore, was down 2.34% at $107.20 per metric ton.

Below is a summary of historical iron ore prices and the forecast prices to be achieved according to Goldman Sachs.

Of note, are the super high prices that were realized in the last few years, as the re-opening trade boosted iron ore prices to $160 per metric ton.

Commodity & FX forecasts chart

The outlook for prices varies greatly between brokers, with Goldman's forecasting around an $80 price in 2025 and Ord Minnett more bearish at $60 per metric ton.

At the earnings update, Rio's management highlighted 'iron ore supply bottlenecks faded, cost curves steepened, and in real terms, the iron ore price is below the average since 2010.'

Rio Tinto's growth projects: Pilbara and Oyu Tolgoi copper mine

Rio Tinto's management continues to develop and execute two key growth projects – the ramp-up of Pilbara iron ore to over 340 million tonnes per annum (Mtpa) and Oyu Tolgoi, the underground copper mine in Mongolia.

The company recently hosted a global analyst tour of Oyu Tolgoi, where they have invested $14 billion in the underground ramp-up of what is expected to be the world's fourth-largest copper mine by 2030. The project aims to mine 1 million tonnes of copper within 5 years, with an additional $1.4 billion to be invested. Between $300 million to $400 million is estimated as the sustained capital expenditure requirements over the next decade.

Goldman Sachs emphasizes that Oyu Tolgoi will be one of Rio's most important projects and is expected to deliver over 30% of the group's earnings before interest, taxes, depreciation, and amortization (EBITDA) from copper, with free cash flows of $1 billion in 2025 and $2.5 billion in 2026.

For the full year, Rio lowered total capital expenditure to $7 billion from $8 billion, with Simandou capital expenditure expected to be $0.5 billion in the second half of 2023. For FY24 and FY25, capital expenditure guidance remains unchanged at up to $10 billion, including $3 billion in growth capital expenditure and $3.5 billion in sustaining capital expenditure.

During the earnings conference, management highlighted that negotiations on the Simandou project continue between themselves and the other three partners and the Guinean government.

Regarding other growth projects, Rio Tinto (RIO) has approved a further US$190 million for the Argentina Rincon lithium project, and US$700 million for 50% of the North American recycling company Metalco, which has a 900,000 metric ton remelting and casting capacity to produce recycled aluminium.

Outlook, earnings, and recommendations

According to Refinitiv, the median price target is $120.99, with 2 strong Buy recommendations, 5 Buys, 3 Holds, and 3 Sells amongst the analyst community.

In comparison, FNArena’s consensus target is $114.17 per share.

Simandou project outlook

Goldman Sachs is one of the more optimistic brokers with a price target of $126, while Ord Minnett is more cautious with a target of $107, based on the more conservative mid-cycle iron ore price forecast.

Rio remains a cyclical company that is highly exposed to the fluctuations and sentiment around iron ore prices and the measures taken by China’s government to stimulate demand. In the long term, the potentially profitable copper expansion will enhance the company’s exposure to one of the most sought-after metals for 'decarbonising.'

However, much depends on diversification, investment, cost controls, and capital management.

Addendum

It is worth highlighting that Australia’s iron ore producers, namely BHP, Rio Tinto, and Fortescue Metals Group (FMG), moved into the top dividend payers in 2021 due to the spike in iron ore prices and the tremendous cash flows generated by these companies.

The macroeconomic environment has since shifted, so similar payouts are not forecasted going forward. However, FNArena reports a yield of 5.7% for FY23 and 6.7% for FY24 for Rio Tinto.