Rio Tinto Group (RIO.N) is back in the news, having rebuffed a mega-merger offer from Glencore plc (GLEN.L) that would have created the world’s largest mining company. As the price of iron ore alternately falls and plummets, we take a look at the prospects for an independent Rio, one of the world’s largest low-cost producers.
While many analysts clearly welcomed the proposed deal, citing the synergies and other cost savings it would create, it reinforces the fin de siècle feel as mega-mergers and huge corporate spin-offs seem to be announced on a daily basis.
Source: Thomson Reuters Eikon, StarMine
Iron ore price fallout
The recent fall in the price of iron ore (see above chart) has different impacts from an industry standpoint. It will (of course) result in reduced cash flow and therefore cause a reassessment of capex and dividend policy. Over the medium term we will certainly see a reduction of industry players as some of the higher- cost producers are uneconomic at current levels. Indeed, the first Australian iron ore producer has already entered administration – as reported by Reuters here.
Looking at forward estimates for commodity companies is always challenging. For Rio Tinto, an Analyst Revisions Model (ARM) score of 12 indicates that sell-side sentiment and estimates continue to decline. These estimates will be led lower by the price of the underlying commodity and it isn’t yet clear whether prices have found a floor.
Over the last 15 years, RIO has averaged a P/E ratio of 11.7, compared to 9.2 currently. But with prices having fallen and the “commodity super cycle” apparently ending – valuation doesn’t appear to offer any type of support. Indeed, the company is trading around the highest P/E of the last three years, as evident in the chart below.
Source: Thomson Reuters Eikon, StarMine
Murky growth picture
Using the StarMine Dividend Discount Model (DDM) and the current share price, one can also calculate the market implied growth rate – and so far market pessimism has marked down the implied growth rate to -8.3% EPS growth each year for the next five. Perhaps that’s sufficiently compelling? The timing may be right for a large acquirer who can drive enormous cost efficiencies.
Source: Thomson Reuters Eikon, StarMine
Two more indicators
The concern is that the markets haven’t found a bottom, and that RIO’s share price hasn’t yet found a floor that fully represents the likelihood of further iron ore price declines.
The chart above shows both Chinese GDP and Shanghai steel production from Platts, highlighting the potential for the “new normal’”’ to have a longer life. If that’s the case, then perhaps RIO shareholders will be happier in the embrace of a large company capable of deriving monstrous cost synergies. I’d expect that to be the pitch of the investment bankers.
Receive stories like this to your inbox as they are published. Subscribe here and follow us @Alpha_Now on Twitter or check out the Thomson Reuters Eikon blog. If you are looking to access Thomson Reuters data or analytics, register for a free trial.
