Rio Tinto: Q4 Production Report Analysis (NYSE:RIO)

Here at the Lab, when we initiated Rio Tinto coverage (NYSE:RIO, OTCPK:RTPPF, OTCPK:RTNTF) with a title called If It Aint Broke, Don’t Fix It, where we assigned a neutral rating. However, during the year, despite a few negative comments on China and iron ore development, we increased the company to overweight. It was a good call and since then, Rio Tinto’s stock price performance (including dividend payments) delivered a return of more than 40% compared to an S&P 500 of just 5%. Aside from our buy rating target on M&A optionality, our internal team closely followed Rio’s development with an analysis of Q1, Q2, and Q3 production releases. Last week, the company announced its Q4 production report and today, we are back to provide our insights. The next company catalyst will be FY 2022 results on 22 February.

Q4 Production Results

The Q4-2022 production report was broadly in line with Mare Evidence Lab’s expectations. In detail, iron ore shipments were 1% above Wall Street consensus, but copper and soft aluminum performance missed estimates by 1% and 8% respectively.

Source: Rio Tinto Corporate Website

On a positive note, iron ore output was particularly strong thanks also to the Gudai-Darri ramp up. Given that Rio’s EBITDA margin is 70% made of iron ore, this is the single most important data to look at. Aside from that, Oyu Tolgoi’s first production of copper is expected in the first quarter and not in the first half of 2023. This is again a supportive catalyst for the giant mining company. The Mongolian site reached 19 draw bells out of the 21 needed for the first output.

On a negative note, the fiscal year 2022 alumina production output missed guidance by 7.5mt (versus the expectation of 7.7-8.0mt). This was due to plant stability at QAL and unplanned maintenance requirements. More important to report was the iron ore unit costs which are now forecasted at close to $22 per ton (versus the expectation of $19.5-$21 per ton). This is due to labor wages, some year-end inventory movement in inflation, and higher diesel prices. However, the company declared that the 2023 outlook for iron ore unit costs is left unchanged at $21-$22.5 per ton, implying that 2022 costs were a one-off. Still negative is Kennecott furnaces maintenance which will lead to weak copper guidance in the Q1 2023 production report.

Other minor notes are:

1. We are now including new copper guidance at 650-710mt to include Oyu Tolgoi on a full-scale basis;
2. We are implying higher liability with an impact of Rio Tinto EBITDA for approximately $200 million;
3. Given the Turquoise Hill minority acquisition, a $2.9 billion investment happened in December;
4. The company paid A$613 million for a litigation settlement with the Australian Taxation Office;
5. We are estimating sale proceeds for Cortez royalty for $525 million in cash.

Conclusion and Valuation

Here at the Lab, we believe that Wall Street analysts’ expectations have been rebased. Our internal team is now forecasting a 70% payout ratio for the second half-year compared to the consensus of 73%. We believe that given the recent TRQ acquisition coupled with the possible incremental CAPEX for Simandou, FCF estimates are on the downside. However, considering iron ore development with the Gudai-Darri ramp-up, better relationships with traditional owners, and copper growth from Oyu Tolgoi, we reiterate our supportive buy rating, maintaining our preference for Rio Tinto over BHP. After carefully analyzing the Q4 production report, we decided to update our estimate to reflect Rio Tinto’s new production volumes, considering iron ore cost sensitivity and higher aluminum and alumina cost. Our fiscal year 2022 EBITDA guidance falls by just 1% as a result. However, Mare Evidence Lab’s target price of £72 per share is unchanged and on the Australian line is set at A$140 per share. Regarding the valuation, we continue to value Rio with a 5x EV/EBITDA, and despite the upcoming months should be pretty volatile, 2023 production guidance is unchanged and China is reopening.

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