Rio Tinto Fights Weather to Push Production

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Rio Tinto reported strong second-quarter production volumes despite some poor weather and mechanical mishaps. Near-record quarterly group iron ore production of 66 million tonnes on a 100% basis came despite a major conveyor belt breakage which saw one of five Pilbara ship loaders out of action for three weeks. Flooding in June added to difficulties. Workarounds and higher Canadian iron ore production mean full-year guidance is maintained at 265 million tonnes, capturing Pilbara expansion projects. Iron ore accounted for 83% of Rio Tinto’s 2012 earnings and 265 million tonnes this year is a 5% increase on 2012 volumes.

Output is then expected to grow 26% in 2014 to more than 330 million tonnes, before a further 11% increase in 2015 to 370 million tonnes. Rio says expansion projects remain on track despite challenging weather. Our 2013 and 2014 earnings forecasts are little changed at AUD 5.36 per share and AUD 5.64 per share respectively. Rio Tinto has maintained 2013 production guidance for all major commodities, except copper where it has increased guidance by 25,000 tonnes, taking a less hawkish stand on the negative impact of the pit-wall failure at Bingham Canyon in April.

Incorporating second-quarter production does not change our positive opinion of Rio’s prospects and its narrow-moat rating. Low-cost assets, such as the Pilbara iron ore operations in Western Australia, enjoy low sovereign risk and proximity to key Asian markets. Low production costs ensure profitability throughout the commodity cycle.

For example, Rio says it’s on target to achieve USD 750 million in exploration and evaluation savings in 2013, and that’s in the context of USD 5 billion in cumulative cash cost savings targeted by 2014. The fair value estimate employs an 11% cost of equity, reflecting high cyclicality and a medium level of operating leverage, tempered by Rio’s relatively high margins, lowcost position and low financial leverage. This gels with Rio’s medium fair value uncertainty. That drives a 9.0% weighted average cost of capital, assuming a long-run 30:70 debt-toequity split, appropriate for a mining company of Rio’s form.

Our fair value estimate equates to an enterprise value to EBITDA (EV/EBITDA) exit multiple in 2017 of 7.0 times. By way of comparison, peers BHP Billiton and Vale attract EV/ EBITDA multiples of 7.5 times and 6.5 times respectively. The end of the second quarter saw a restart to copper mining from the lower sections of Bingham Canyon pit. Recovery is advancing better than previously expected.

Rio will record a non-cash charge in the 2013 interim results for equipment damage and write-offs of historical waste stripping balances. It hasn’t said how much this will be, though it is excluded from our underlying earnings forecast. As an offset, Rio agreed to sell its Eagle nickel project in the U.S. for USD 325 million.

The transaction won’t close until the third quarter so won’t appear in the interim results. In addition, subsequent to end of the quarter, Rio shipped its first batch of copper concentrate from the Oyu Tolgoi mine in Mongolia. Rio projects a more than 13% compound annual growth rate in group copper production to 2015, with higher grades at Escondida and Oyu Tolgoi’s average annual production of 425,000 tonnes in addition to 460,000 ounces.

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