UBS Investment Research Key Call: Rio Tinto Limited

Transcription

1 UBS Investment Research Key Call: Rio Tinto Limited Diamonds & Minerals Business Feedback Day 2 in Montréal Greetings from Montréal. The Rio Tinto site tour found itself in Montréal on Day 2 after a 4.5 hour flight from Salt Lake City. Briefings were conducted on the Diamonds & Minerals Business, led by Alan Davies, the newly appointed Chief Executive of the business. Focusing on mineral sands Today's briefings were widely anticipated, especially by those that follow the mineral sands industry closely. Rio Tinto is looking to price product on a value in use basis, and generate a return commensurate with what they see as a required return to justify future investment in the business. The bulk of Rio's TiO2 contracts roll off at end of 2012 such that 75% of volume in 2013 will be off contract and on quarterly pricing. Rio said that new quarterly pricing contracts are seeing a % jump in price depending on what price customers were originally paying. Diamonds Not of Sufficient Scale Diamond business has strong fundamentals. However, Rio Tinto has made up its mind that the diamond business can never achieve sufficient scale to warrant holding on to it, but the strategic review for sale is unlikely to conclude before the end of So watch for a sale in Valuation $92.83 (DCF, 10% discount) Our target price is $93.00ps, inline with our NPV Highlights (US$m) 12/10 12/11 12/12E 12/13E 12/14E Revenues 55,171 60,537 52,897 60,404 62,540 EBIT (UBS) 20,892 15,274 15,555 19,492 19,599 Net Income (UBS) 13,901 15,549 10,828 13,473 13,550 EPS (UBS, US$) Net DPS (UBS, US$) Profitability & Valuation 5-yr hist av. 12/11 12/12E 12/13E 12/14E EBIT margin % ROIC (EBIT) % EV/EBITDA (core) x PE (UBS) x Net dividend yield % Source: Company accounts, Thomson Reuters, UBS estimates. (UBS) valuations are stated before goodwill, exceptionals and other special items. Valuations: based on an average share price that year, (E): based on a share price of A$55.09 on 12 Sep :37 EST Global Equity Research Australia Mining 12-month rating 12m price target Price RIC: RIO.AX BBG: RIO AU Trading data (local/us$) 52-wk range Market cap. Shares o/s Buy Unchanged A$93.00/US$97.61 Unchanged A$55.09/US$ September 2012 A$ /US$ A$102bn/US$107bn 1,846m (ORD) Free float 62% Avg. daily volume ('000) 3,509 Avg. daily value (m) Balance sheet data 12/12E Shareholders' equity A$188.8 US$60.2bn P/BV (UBS) 1.8x Net Cash (debt) Forecast returns (US$15.3bn) Forecast price appreciation +68.8% Forecast dividend yield 3.0% Forecast stock return +71.8% Market return assumption 8.2% Forecast excess return +63.6% EPS (UBS, US$) 12/12E 12/11 UBS Cons. Actual H H2E /12E /13E Performance (A$) /09 Stock Price (A$) 10/09 Source: UBS 01/10 04/10 07/10 10/10 Price Target (A$) (LHS) 01/11 Rel. All Ordinaries (RHS) 04/11 07/11 10/11 01/12 04/12 Stock Price (A$) (LHS) Rel. All Ordinaries 07/ Glyn Lawcock Analyst glyn.lawcock@ubs.com Myles Allsop Analyst myles.allsop@ubs.com James Brennan-Chong Analyst james.brennan-chong@ubs.com This report has been prepared by UBS Limited UBS 57 SEE REQUIRED DISCLOSURES SECTION AT END OF NOTES. BELL UBS POTTER does and SECURITIES seeks to do business LIMITEDwith companies INFO@BELLPOTTER.COM.AU covered in its research reports. As a result, investors should be aware ABN that the firm 390 may 772 have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only AFS a single LICENCE factor NO. in making their investment decision.

2 Feed back from Montréal Today's briefings were widely anticipated, especially by those that follow the mineral sands industry closely. What we were all keen to learn was what was Rio Tinto's marketing strategy for mineral sands. In summary: Rio Tinto is looking to price product on a value in use basis, and generate a return commensurate with what they see as a required return to justify future investment in the business. Rio is selling all the TiO2 product they produce, and have no inventory, but this is because they are selling predominantly on legacy contracts, which are at a considerable discount to its peers (~70+% to its peers). Pigment inventories are still high but coming down. Normal is 60 days, and they were at 120 days, but are now at 90 days. The bulk of Rio's TiO2 contracts roll off at end of 2012 such that 75% of volume in 2013 will be off contract and on quarterly pricing. Rio said that new quarterly pricing contracts are seeing a % jump in price depending on what price customers were originally paying. Rio Tinto will take 2 furnaces off line in 2013 which means at least 180Kt less TiO2 production in 2013 against capacity of ~2.3Mt (100% basis). Rio has one furnace down in 2011 also, which is there way of managing production to meet market demand. A furnace shut for overhaul is generally a 6 month process followed by a 3 month ramp up. The furnace shuts in 2013 are necessary for the future viability of the furnaces, and potentially come at an opportune time, when demand for feedstock in early 2013 may still be low according to Rio Tinto. On zircon Rio believe tile inventory has started to come down but only slightly. Zircon inventory though is all at the producer end and once tile inventory comes down, the tile producers will need to buy zircon. Currently tile producers are just buying sufficient zircon to get by. Sounds a bit like the steel mills in China and their buying of iron ore. Rio conducted a zircon auction last week and got considerable interest from 25 buyers, with 23 buyers being satisfied. Diamond business has strong fundamentals, and Rio Tinto is proceeding with the Argyle underground mine in Australia, which will see production double to >20Mcts pa, while the Diavik mine in Canada is building back up to 6-7Mcts pa. Mine life extensions are being considered at both Argyle and Diavik, but nevertheless, Rio Tinto has made up its mind that the diamond business can never achieve sufficient scale to warrant holding on to it, but the strategic review for sale is unlikely to conclude before the end of So watch for a sale in 2013.

3 Zircon market perhaps bottoming It s been a tough year for all zircon producers. Rio Tinto would not quantify what levels of zircon stock they were carrying, but we suspect they too like Iluka are not selling all they produce. Rio did say that a recent zircon auction (last week) did see 25 buyers submit bids with 23 buyers being successful, so demand is returning, but we suspect it is still producers living hand to mouth. Rio was not clear on zircon inventories in the system, but did indicate that it thought inventories were more at the producer end rather than with the customers. Tile inventory remains the issue, but Rio thought that this was now coming down, albeit ever so slightly. Sold out of TiO2 Rio Tinto is carrying NO inventory of TiO2, with all production able to be sold. This in our view reflects the fact that Rio Tinto has a furnace down at Richards Bay Minerals (RBM) in 2011 and thus production is not at full capacity, but more importantly, we believe Rio is able to sell all its production because the majority of its sales are still being carried out under legacy contracts which carry prices that are 70+% below current market prices. So why wouldn't customers continue to buy from Rio Tinto rather than its peers who are charging 3-4x as much for similar product. More furnace shuts in 2013 Rio Tinto Iron & Titanium (RTIT) will bring two furnaces down for rebuild in One at RBM and one at QIT in Quebec. This should see ~180kt less production in 2013 against rated capacity across the group of 2.3Mt (100% basis). Rio is cautious on the TiO2 market in the first half of 2013, but sees a recovery in demand in H2 13. So the timing of the furnace shuts is quite timely and could serve to tighten the market if Rio is wrong on the timing of the recovery and it is earlier than originally anticipated. Should Rio be wrong on timing, they are unable to push put the shuts as they are mandatory requirements. Contract prices rolling off Rio provided much more colour today on its contract roll off schedule. In 2012, ~70% of committed volume is under longer term pricing arrangements, while this drops down to ~25% in Price rises of 3-4x were mentioned by Rio Tinto as long term contracts roll off and are replaced by long term volume agreements but with quarterly pricing arrangements. While ~2.25Mt of TiO2 feedstock is committed for 2013 as per below chart, RTIT expects that a soft market may see volume sold down on contract, plus the two furnace outage will mean that RTIT is unable to satisfy full demand commitment anyway in With the bulk of Rio's product on full pricing terms, we may see RTIT sell less than its production anyway, and RTIT does need to build up inventory at some stage, as running at zero inventory is not a desirable position.

4 Chart 1: Long term vs short term pricing contracts Source: Rio Tinto Pricing Protocols Rio Tinto emphasised that it wanted to receive a price that reflected the value in use of its product. In essence it sounded to us like Rio Tinto is not prepared to sell its product at a break even price as it has done for the past 5 years under the legacy contracts. So Rio will roll off contract in our view and step its customers up towards the current pricing of >US$2,000/t for feedstock product. This would result in EBITDA margins of >60%, which is not sustainable in our view, but we believe the industry recognises this, and will look to manage margins down to a more sustainable level once the market is more balanced. A margin around 40% in our view is sustainable for an industry with the consolidation of that of mineral sands. Pigment inventory coming down The issue for the feedstock producers has been that pigment producers were seeing demand for their product drop off in late H1 12 and thus have been caught with high inventory levels. We understand pigment inventory levels rose to 120 days from normal being 60 days, but this has now reversed and is down to 90 days. The high inventory level is what is keeping Rio cautious on H2 12 and H1 13 TiO2 feedstock demand. Diamonds Not of Sufficient Scale While the diamond industry fundamentals are strong, and Rio's assets are of reasonable quality and do have some expansion/life extension options, the size is insufficient to provide Rio with a scale that would see them as a dominant player in the industry. Thus it remains for sale. A conclusion to the sale process unlikely this year though. In the interim, Rio will continue to progress the underground at Argyle which will see diamond production double to >20Mcts pa out to 2020 and there remains the possibility of a further extension to 2027 via a sub level cave extension. At Diavik, underground mining commenced in 2010 and open cut mining will cease within the next couple of weeks. Production is aiming to get back to 6-7Mcts pa.

5 Tinto Limited 13 September 2012 Glyn Lawcock Myles Allsop Jo Battershill EARNINGS & VALUATIONS Current Price Rating Mkt Cap NPAT (US$m) EPS (US$/share) 3 yr EPS P/E EV/EBITDA NPV P/NPV Company Price Target USDm 2011A 2012E 2013E 2011A 2012E 2013E CAGR 2011A 2012E 2013E 2011A 2012E 2013E Australia BHP Billiton A$32.85 A$42.00 Buy 182,992 20,925 13,884 15, % 8.9x 13.2x 11.9x 5.1x 5.8x 5.2x A$ x Rio Tinto A$55.09 A$93.00 Buy 106,448 15,549 10,828 13, % 7.1x 9.8x 7.9x 8.7x 6.4x 5.3x A$ x Global 13 September 2012 Anglo American Buy 37,049 6,120 3,379 4, % 8.9x 11.2x 8.6x 6.4x 6.8x 6.2x x BHP Billiton Plc Buy 171,215 20,925 13,884 15, % 8.0x 11.8x 10.6x 4.8x 5.4x 4.8x x Rio Tinto Plc Buy 97,148 15,549 10,828 13, % 7.7x 8.3x 6.8x 6.9x 5.6x 4.6x x Xstrata Neutral 46,718 5,785 3,967 3, % 10.0x 11.7x 12.6x 5.8x 7.0x 6.9x x Average -3% 8.4x 11.0x 9.7x 6.3x 6.2x 5.5x 0.79x GROWTH & RETURNS EPS growth 3 yr EPS Return on Equity Dividend per share (US$/share) Dividend Yield P/FCF Gearing Company 2011A 2012E 2013E CAGR 2011A 2012E 2013E 2011A 2012E 2013E 2011A 2012E 2013E 2011A 2012E 2013E 2011A 2012E 2013E Australia BHP Billiton 23% -32% 11% -3% 39% 22% 22% % 3.3% 3.4% 7.0x 8.7x 7.8x 25% 27% 25% Rio Tinto 15% -28% 24% 1% 28% 19% 21% % 2.8% 3.0% 5.7x 7.6x 6.8x 17% 18% 14% Global Anglo American 23% -47% 32% -5% 17% 8% 11% % 2.6% 2.5% 5.5x 6.7x 6.8x 2% 15% 15% BHP Billiton Plc 23% -32% 11% -3% 39% 22% 22% % 3.7% 3.8% 6.3x 7.8x 7.0x 25% 27% 25% Rio Tinto Plc 15% -28% 24% 1% 28% 19% 21% % 3.3% 3.5% 4.9x 6.1x 5.8x 15% 17% 13% Xstrata 12% -32% -6% -10% 11% 7% 7% % 2.7% 2.8% 6.4x 6.4x 6.4x 13% 18% 24% Average 18% -33% 16% -3% 27% 16% 17% 2.4% 3.1% 3.2% 6.0x 7.2x 6.8x 16% 20% 19% SENSITIVITIES (based on 2012 earnings) PERFORMANCE Al Cu Ni Zn WTI FeO St Coal C Coal A$ Current Price Upside Company +10c/lb +10c/lb +10c/lb +10c/lb +$10/bbl +$10/t +$10/t +$10/t +10c Company Price Target +1 wk +1 mth +3mth +6 mth +1 year Australia Australia BHP Billiton 1.4% 1.4% 0.1% 2.9% 6.8% 1.8% 1.4% 7.2% BHP Billiton A$32.85 A$ % 4.8% -0.3% 3.2% -6.1% -11.0% Rio Tinto 6.1% 0.9% 11.0% 1.5% 0.5% 6.1% Rio Tinto A$55.09 A$ % 9.8% -2.5% 1.1% -15.4% -19.4% Global Anglo American 3.0% 0.2% 1.3% 3.4% 6.0% 3.2% 7.7% Anglo American % 3.3% -5.7% -10.7% -27.4% -21.5% BHP Billiton Plc 1.4% 1.4% 0.1% 2.9% 6.8% 1.8% 1.4% 7.2% BHP Billiton Plc % 3.7% -3.6% 6.2% -6.1% -1.9% Rio Tinto Plc 6.1% 0.9% 11.0% 1.5% 0.5% 6.1% Rio Tinto Plc % 8.1% -3.5% 4.8% -14.0% -12.8% Xstrata 4.6% 22.4% 3.9% 6.4% 0.9% 12.0% Xstrata % 1.5% 6.3% 11.5% -14.9% -0.6% Average 31% 5.8% -1.3% 1.6% -15.2% -14.1% Note that BHP Billiton values have been calendarised Shareholder returns Source: UBS estimates UBS 61

6 Rio Tinto (RIO.AX) Analyst/s: Glyn Lawcock 12-Sep-12 MARKET INFORMATION COMPANY DESCRIPTION Rating: Buy Rio Tinto is one of the world's largest diversified mining companies with major interests in copper, Price (as of 12-Sep-12): A$55.05 iron PROFILE EN ore, coal, aluminium, mineral sands and borax, and with lesser exposure to diamonds and Price Target (12 months): $ gold. Major operations are world-class, mostly lowest-cost quartile and located in North and South Issued Capital: 1,851.9 America, Australia, Indonesia, Europe and Southern Africa. Key operations include Hamersley Market Capitalisation [US$m]: 106,398 Iron, QIT/RBM TiO2 feedstock, US Borax, 30% of Escondida copper, 40% of the Avg. daily turnover (US$m) Freeport/Grasberg expansion and Australian coal. Rio has recently acquired Riversdale Mining for Year end: December its Mozambique coking coal property, and is a major shareholder in Ivanhoe Mines of Canada Website: which owns the Oyu Tolgoi copper-gold deposit in Mongolia. A zero hedging policy for Major Shareholders: Tinto Holdings 37.6% commodities is maintained. Exchange rate AUDUSD 1.05 INVESTMENT SUMMARY OPERATIONAL ASSUMPTIONS (US$m) E 2013E 2014E H1 12 H2 12E E 2013E 2014E Net profit [reported] ($m) 5,836 11,559 13,473 13,550 Prices Net profit [adjusted] ($m) 15,549 10,828 13,473 13,550 Aluminium (USc/lb) EPS [reported] ($) Copper (USc/lb) EPS [adjusted, diluted] ($) Gold (US$/Oz) 1, , , , , ,400.0 EPS Growth (%) Iron Ore Fines (US$/t) PER [adjusted] (x) Steam Coal -JFY (US$/t) Dividend ($) A$:US$ Payout ratio (%) 18% 27% 24% 25% Dividend Yield (%) 2.5% 2.8% 3.0% 3.1% Production (Equity Basis) FCF Yield (%) 7% -4% 5% 8% Copper Production - conc (kt) Copper Production - cathode (kt) Shares [period-average, diluted] (m) Iron Ore - Hamersley (Mt) VALUATION Iron Ore - Robe River (Mt) Valuation per share ($) Thermal Coal (Mt) Price/NAV [10% disc rate] (x) 0.59x Semi-soft Coking Coal (Mt) Coking Coal (Mt) Operating Assets [JH 12] US$m A$m Alumina (Mt) Iron Ore 110, , Aluminium (Mt) Aluminium 16,616 20, Copper 10,173 12, DIVISIONAL BREAKDOWN [EBIT] Energy 5,414 7, (US$m) H1 12 H2 12E E 2013E 2014E Diamonds & Minerals 5,519 8, Iron Ore 7,278 8,005 19,727 15,283 15,940 16,501 Other 4,383 4, Aluminium ,021 1,655 Copper ,856 1,184 3,684 2,117 Energy , (389) Diamonds & Minerals ,528 1,792 Gross Assets 152, , Other (300) (199) (124) (499) (25) 274 Net Debt (13,892) (13,754) -743 Net Asset 10% discount rate 138, , PROFIT & LOSS (US$m) H1 12 H2 12E E 2013E 2014E Sales Revenue 25,336 27,561 60,537 52,897 60,404 62,540 Operating Cash Profit 10,557 11,843 29,637 22,400 27,416 27,353 Depn & Amortisation (2,244) (2,392) (4,231) (4,636) (5,232) (5,675) ENTERPRISE VALUE EBIT 8,313 9,452 25,406 17,765 22,184 21,678 (US$m) E 2013E 2014E Other (1,462) (1,128) (11,810) (2,590) (2,037) (1,718) Enterprise Value 110, , , ,723 EV/EBITDA (x) EV/Operating Free Cash Flow (x) Net interest (81) (51) (382) (132) (209) (191) Profit before tax 6,770 8,273 13,214 15,043 19,938 19,768 EPS SENSITIVITIES Tax expense (678) (2,255) (6,439) (2,933) (5,769) (5,657) Commodity Base 2012E 2013E 2014E Equity Associated NPAT 6,092 6,018 6,775 12,110 14,169 14,111 Change EPS Change Minority Interests (207) (344) (939) (551) (696) (561) Currency 5-2.2% -3.5% -3.5% Net Profit [reported] 5,885 5,674 5,836 11,559 13,473 13,550 Aluminium 10% 1.8% 3.5% 3.7% Abnormal Gain/(Loss) after Tax (731) 0 9,713 (731) 0 0 Copper 10% 1.0% 1.5% 1.2% Gold 10% 0.2% 0.2% 0.2% Net Profit [adjusted] 5,154 5,674 15,549 10,828 13,473 13,550 Coal 10% 0.9% 1.4% 1.4% Iron Ore 10% 5.0% 8.0% 7.9% EBITDA margin (%) 41.7% 43.0% 49.0% 42.3% 45.4% 43.7% Net Interest Cover [EBIT] (x) Tax Rate (%) 10.0% 27.3% 48.7% 19.5% 28.9% 28.6% CASH FLOW EBIT/Total Assets (%) 22.6% 14.9% 17.8% 16.2% (US$m) E 2013E 2014E NPAT/Equity (%) 9.9% 16.5% 16.6% 14.8% Operating income [EBIT, UBS] 25,406 17,765 22,184 21,678 EBIT/Avg Cap Employed (%) 35.6% 20.8% 23.5% 21.8% Depreciation & Amortisation 4,231 4,636 5,232 5,675 Net change in working capital (2,249) (3,928) (1,950) (1,378) Other (operating) BALANCE SHEET [Selected Items] Pre-tax op cash flow 27,388 18,472 25,466 25,975 (US$m) H1 12 H2 12E E 2013E 2014E Interest (paid) / received (613) (742) (709) (591) Net Working capital 6,883 4,943 7,020 4,943 5,364 5,461 Tax paid (6,197) (6,073) (5,769) (5,657) Fixed Assets 70,395 76,078 64,967 76,078 84,480 89,672 Other (548) (630) (630) (630) Net Other 2,181 4,467 (645) 4,467 4,467 4,467 Operating cash flow 20,030 11,027 18,358 19,096 Capital Employed 79,459 85,488 71,342 85,488 94,310 99,599 Capital expenditure (12,335) (15,386) (13,233) (10,567) Net Cash / (Debt) (13,892) (15,347) (12,134) (15,347) (13,325) (8,055) Exploration expenditure Total Equity [incl. minorities] 65,567 70,141 59,208 70,141 80,985 91,545 Free cash flow 7,695 (4,359) 5,125 8,529 Minorities (9,892) (9,892) (6,669) (9,892) (9,892) (9,892) Net (acquisitions) / disposals (3,811) Dividends paid (Common) (2,236) (3,017) (3,102) (3,259) Net Debt / Equity (%) 21.2% 21.9% 20.5% 21.9% 16.5% 8.8% Shares issued/(repurchased) (5,080) Book Value per Share($) Source: Company accounts, UBS estimates. UBS valuations are stated before goodwill, exceptionals and other spcieal items. Note: For some companies, the data represents an extract of the full company accounts. Source: UBS estimates UBS 62

7 Rio Tinto Limited Rio Tinto is one of the world's largest mining conglomerates with major interests in copper, iron ore, coal, aluminium and mineral sands, and with lesser exposure to diamonds and gold. Major operations are world-class, mostly lowest-cost quartile and located in North and South America, Australia, Indonesia, Europe and Southern Africa. Key operations include Hamersley Iron, QIT/RBM TiO2 feedstock, 30% of Escondida copper, 40% of the Freeport/Grasberg expansion and Rio Tinto Alcan. It maintains a zero hedging policy for commodities. Statement of Risk Investment risk inherent in the resource sector includes, but is not limited to movement of commodity price and currency which may differ materially from the assumptions used in this report. Furthermore the sector is subject to political, financial and operational risks, each of which has the potential to significantly impact industry performance.

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