Rio Tinto: Buying An Undervalued 10% Equity Yield (NYSE:RIO)

Thesis

If you feel that a stable equity yield of close to 10% is a good investment opportunity given the current market conditions, then buying Rio Tinto (NYSE:RIO) stock might be an excellent idea. In my opinion, there is little reason to assume that Rio Tinto’s future dividend is in danger — I view it as unlikely that the structural demand for iron ore and other raw material fades, and almost equally unlikely that increased industry competition redistributes Rio’s current market share.

Moreover, reflecting on a likely demand boom on the backdrop of the China COVID reopening, paired with an already somewhat stretched demand/ supply balance, I argue there is upside in Rio Tinto’s current valuation.

Personally, I value RIO stock with a residual earnings model and calculate a fair implied share price of $104.37. ‘Buy’.

A Track Record Of Steady Value Accumulation

Rio Tinto has strong track record of steady business expansion and value accumulation, ignoring cyclical fluctuations. During the period from 2012 until 2022 (TTM reference), Rio Tinto grew revenues at a compounded annual growth rate of close to 2%. Admittedly, this is not much. But investors should consider that over the same time period, operating income expanded at about x4 this rate: growing from about $11 billion to $23.8 billion.

Notably, despite strong results, the TTM reference may very well be considered as a ‘bad’ year for the firm–referencing various macroeconomic challenges, including a year-long lockdown for the world’s greatest iron ore importer and consumer China. Still, for the trailing twelve months, Rio Tinto generated earnings from continuous operations of about $18.9 billion and operating cash flow of $22.2 billion.

As an additional consideration regarding Rio’s finances, investors should also take note of the mining giant’s exceptional balance sheet: By end of Q3 2022, Rio Tinto recorded $13.9 billion of cash and short term investments7 cash equivalents, as compared to total financial debt of ‘only’ $12.9 billion, resulting in a $1 billion net cash position.

Anchored on strong profitability and a solid balance sheet, Rio Tinto was able to distribute as much as $12.6 billion of cash (dividends) to shareholders–an annualized equity return of close to 10%.

A Solid Market Backdrop

Although it is true that demand for raw materials such as iron ore is cyclical, there is little reason to assume that the market for iron ore and other metals will not continue to grow–even if the growth is only in line with the global nominal GDP growth. In addition, Rio Tinto also boasts a solid copper division, positioning itself as one of the top producers globally. Copper is a vital component for electrical and transportation industries, and might thus see increased structural demand due to the increasing usage of renewable energy and electric vehicles.

In any case, demand problems should not be Rio Tinto’s major concern, according to research by Goldman Sachs. In a detailed 54 page note, analyst Jeffrey Currie and his team argue …

… from a fundamental perspective, the setup for most commodities next year is more bullish than it has been at any point since we first highlighted the supercycle in October 2020 …

… citing a material supply/ demand imbalance in many commodities due to structural global underinvestment in mining capacity.

The China Reopening Tailwind

If the supply/ demand in commodities is indeed stretched already, as Goldman Sachs’ commodities research team argues, then the demand tailwind coming from the China COVID reopening is likely to push the market out of balance — with commodity prices appreciating and producers’ profit margin expanding.

Likely in anticipation of such a scenario, Rio Tinto stock has already appreciated sharply since the COVID lockdown in China ended. For reference, for the past two months, RIO stock is up by slightly more than 50%, as compared to a loss of less than 20% for the S&P 500 (SPY).

Residual Earnings Model

To estimate a company’s fair implied valuation, I am a great fan of applying the residual earnings model, which anchors on the idea that a valuation should equal a business’ discounted future earnings after a capital charge. As per the CFA Institute:

Conceptually, residual income is net income less a charge (deduction) for common shareholders’ opportunity cost in generating net income. It is the residual or remaining income after considering the costs of all of a company’s capital.

With regard to my Rio Tinto stock valuation model, I make the following assumptions:

• To forecast EPS, I anchor on the consensus analyst forecast as available on the Bloomberg Terminal ’till 2025. In my opinion, any estimate beyond 2025 is too speculative to include in a valuation framework. But for 2-3 years, analyst consensus is usually quite precise.

• To estimate the capital charge, I anchor Rio Tinto’ cost of equity at 10%–in line with the dividend yield

• For the terminal growth rate after 2025, I apply a 2.25% estimate, which is slightly below expected long-term nominal GDP growth, reflecting some level of conservatism.

Given these assumptions, I calculate a base-case target price for Rio Tinto equal to $104.37, which implies that Rio Tinto could be undervalued by approximately 30.5%.

My base case target price does not calculate a lot of upside. But investors should also consider the risk-reward profile. To test various assumptions of Rio Tinto’ cost of equity and terminal growth rate, I have constructed a sensitivity table.

Conclusion

Rio Tinto stock is valued at a FWD EV/EBIT of approximately x6, and likely close to 30% undervalued–according to my estimates. And while investors wait for the stock to trade in line with fundamentals, a (in my opinion) safe 10% equity yield makes patience worthwhile.

Reflecting on a likely demand boom on the backdrop of the China COVID reopening, paired with an already somewhat stretched demand/ supply balance, I argue the risk/ reward for investing in Rio Tinto is simply too attractive to ignore. ‘Buy’.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.