Rio Tinto bullish after mine green light

In a world where a supply glut has suffocated the price of most commodities and destroyed industry valuations, the approval of Rio Tinto's 22.8 million tonne per annum (Mtpa) Amrun bauxite project has been well-received in the City. However, the miner is struggling like the rest, and predicting when the plunge in its share price will end has been very much like catching the proverbial "falling knife".

The project, previously named South of Embly, will cost Rio $1.9 billion to get off the ground - but broker Deutsche Bank values it at $3.5 billion on a stand-alone basis, with a 19% internal rate of return as long as bauxite prices stay about $50 a tonne (currently $58 per dry metric ton (/dmt)). That's a cash profit margin of 60%. Analyst Rob Clifford reckons this adds around £17.7 billion to Rio's market value and has upgraded his price target by 50p to 3,446p. The shares are currenty at 2,161p, near a six-year low.

With annual production of 22.8 million tonnes, Amrun's output will offset depletion at the East Weipa deposit. Around 44Mtpa of bauxite, which is used in aluminium production, is extracted from the Gove, Weipa, Boke and MRN mines, with around 27Mtpa shipped to third parties in China.

Therefore, Rio's total bauxite production will increase to 55Mtpa, with 36Mtpa being exported to third parties. Clifford reckons bauxite exports will contribute 10-15% of Rio's earnings going forward, so the Cape York Peninsula-based project is important.

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Initial production is set for early 2019, but the project's design allows management to ramp-up output by 50Mtpa when the market allows by extending the jetty and developing the Southern Norman Creek.

Clifford also expects Rio's OT UG copper project and Silvergrass iron ore project to be approved in the first half of 2016. And the analyst remains confident: "Even with Amrun approved, we still see the seaborne bauxite market moving into deficit by 2020, despite our assumption that some Malaysian exports remain in the market and exports increase from Guinea and Brazil."

Barclays analyst David Butler is similarly upbeat, despite the difficult backdrop: "Aluminium prices are on their knees are the moment. However, if you produce good quality bauxite, and Weipa is very good quality, then you remain relatively unaffected and can generate a high margin throughout the cycle. This is partly because China, where all the growth is coming from, has not got good quality bauxite and is forced to import both bauxite and alumina.

"It is no wonder that when Rio Tinto proposed the sale of asset stakes to Chinalco in 2009, Weipa was one of the main assets Chinalco went for. However, it does raise broader questions as to whether Rio should be incentivizing more Chinese aluminium capacity, cannibalizing their own smelting margins in the process, or increasing capex (and reducing dividend coverage) at this point in the cycle?"

Rio 'undervalued on most metrics'

Deutsche's Clifford is also impressed by Rio's cash flow and balance sheet: a cash flow yield of 8.7% is complemented by a 27.1% net debt:equity ratio.

Management have been working to a clear strategy this year, prioritising cost reduction, growth, paying down debt, rebasing the dividend and buying back stock. It's been working, too. Costs are down by over $5 billion and its aluminium division is outperforming the market.

"The new strategy is a dramatic (positive) change for Rio Tinto and management are delivering on their promises," explains Clifford.

"We expect the stock to re-rate in 2015 and into 2016 as commodity markets rebalance. We believe Rio Tinto is undervalued on most metrics (price/earnings (PE) multiples, [discounted cash flow] valuation), and we rate the stock a 'buy', trading at a discount to our [net present value]."

Of course, further deterioration in commodity prices could cause more pain. And the market is still factoring this in. Rio's shares have plummeted by a third since February and are more than two-thirds below 2008 highs of 6,969p. A break above technical resistance on the downward trend line (see chart above) - currently around the 2,430p level - would be highly significant.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.