Why You Cannot Go Wrong With This Stock?

Things seem to be happening pretty fast at Rio Tinto (NYSE: RIO); more so after the new CEO, Sam Walsh took over in January this year. The fact that the commodities market is down doesn’t seem to deter Mr. Walsh in going ahead with his divestment plans. The latest in a string of investments being put on sale is Ivanhoe Australia Ltd., which the company controls through its majority-owned Turquoise Hill Resources Ltd.

In another move, the Chief Executive announced the review of schedules and budgets of three ongoing projects. The stock has lost more than 20% in last three months. This article examines the company in light of the new CEO’s divestment and cost cutting measures.

Rio Tinto, some background

Rio Tinto is a global company engaged in finding, mining and processing mineral resources. The company operates in five segments: aluminum, copper, diamonds and minerals, energy and iron ore. Along with iron, copper, aluminum and diamonds, the company’s products include coal, gold and uranium and a range of industrial minerals like borax, salt and titanium dioxide.

The company took an impairment of $11-billion on account of acquisition of aluminum assets bought in 2007 and a $3 billion write-off of a coal asset acquired in Mozambique. The impairments were the major cause behind the departure of the company’s then and previous CEO Tom Albanese.

RIO is valued at $82.53 billion. The company reported revenue of $50.97 and net loss of $2.99 in the year ended December 2012. However, it had been reported handsome profits in pRior years ($5.83 billion in 2011 and $14.24 billion in 2010). The drop in net income in 2011 and current year’s loss is evidently due to the huge non-recurring write offs. Despite the loss, the company continued with its dividend program. Its current dividend yield is 3.71%. From a negative EPS (-$1.66) in 2012, analysts expect the company to report an EPS of $5.69 in December 2013.

The present CEO, Mr. Walsh now plans to cut costs, sell non-core assets and focus on most profitable assets to cover lost ground. This is not much of a surprise though because competitor, BHP Billiton (NYSE: BHP) is doing the same.

Divestments galore

As per estimates by the Deutsche Bank, Rio Tinto’s current asset sale program has the potential of yielding $10 billion.

RIO Tinto has appointed Citigroup to find a buyer for its 57%, A$83 million ($87.48 million) stake in Ivanhoe Australia Ltd. The sale was expected as the company’s main interest in Turquoise Hill, in which it has a majority stake, was limited to the huge Oyu Tolgoi copper and gold mine in Mongolia . At current valuation of $156.5 million, 57% stake means $84.76 million for RIO Tinto.

Another divestment relates to the sale Turquoise Hill’s 58% stake in SouthGobi Resources Ltd., a Mongolian coal mining company. It would be a while before this asset is sold. An earlier bid, by Aluminum Corporation of China last year, for $920 million also did not mature into a deal due to political reasons and slowdown in China.

RIO Tinto has put up for sale some of its other Australian assets as well. These include a 29% stake Coal & Allied and its interest in Clermont and Blair Athol thermal coal mines and Northparkes copper and gold mine in central New South Wales, Australia. RIO expects a premium to the $405 million value that it placed on Northparkes in 2012 and $3 billion from the thermal coal assets.

For its stake in Iron Ore Company of Canada, RIO has appointed Credit Suisse and Canadian Imperial Bank of Commerce to run the sale of the entire 59% stake or part thereof.

Competitor BHP Billiton, on the other hand has identified 10 assets to divest as it looks to simplify its portfolio. BHP Billiton is world’s largest miner and a holds a diversified portfolio of mining assets. The company operates in nine segments covering a wide range of natural resources: Petroleum, Aluminum, Base Metals, Diamonds and Specialty Products, Stainless Steel Materials, Iron Ore, Manganese, Metallurgical Coal and Energy Coal and has facilities in more than 100 locations across the globe.

Valued at $103.07 billion, BHP reported total revenue of $72.27 billion and operating income of $23.50 billion. With net income of $15.42 billion or $3.60 per share, the company distributes 63.42% of its income to shareholders. At CMP, it gives a dividend yield of 3.55%. Analysts expect the company’s EPS to grow 38% in June 2013 to $4.98 and 61% in June 2014 to $5.81.

Vale S.A. (NYSE: VALE), a Brazil-based miner is not too much in the news for divestments but reported strong production figures for Q1 2013. Vale operates in four segments: Bulk Material (iron ore, manganese and ferroalloys including pellet product), Base Metals (nickel, copper and aluminum), Fertilizers (potash, phosphate and nitrogen) and Logistic Services (cargo transportation).

Vale has a market cap of $82.56 billion. For the year ended December 2012, the company reported revenue of $47.69 billion and net income of $5.51 billion or $1.38 per share. Vale provides a handsome dividend yield (5.13%). The company’s future prospects appear bright as analysts forecast its EPS to grow more than 50% and touch $2.09 in December 2013.

Conclusion

The divestment plan of RIO is a step in the right direction. After having taken a huge impairment loss due to wrongly timed acquisitions, it makes sense to raise capital by selling off non-core assets and focus on profitable businesses.

RIO’s operating margin (22.49%) is above the industry average (8%) and in line with its major competitors. Barring a lean peRiod between mid 1993 and mid 1997, the company has been paying dividends regularly.

In addition, the current CEO is well on course with his plan for cutting costs. Earlier this month, the company announced that it was reviewing schedules and budget for three expansion projects - molybdenum facility under construction in Utah ($600 million), a nickel-and-copper mine in Michigan ($500 million)and modernization of an aluminum smelter in Iceland (the $500 million). These projects will eventually get under way once the company strengthens its balance sheet and restore profitability on the back of divestments and cost cutting measures.

The downward trend in the commodity market may be a matter of concern. However, commodities are cyclical in nature and are likely to rebound sooner or later. Even if the downturn continues for some more time, investors are more or less assured of a reasonable return on investment by way of dividends.

At current market price RIO Tinto is undervalued, trading as it is at 1.73 times book value against BHP Billiton’s price-to-book ratio of 2.55. The stock is trading at a forward P/E (December 31, 2014) of 6.36 whereas BHP Billiton trades at 15.43. In my opinion, the stock has bottomed out. If one has to invest in natural resources, one cannot go wrong in buying RIO Tinto at these levels.

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