Firms in commodities-driven industries are notoriously difficult to value–not only is there execution risk related to their cost structures but the price they receive for the respective commodities that they produce is cyclical—and driven by external factors beyond their individual control. For example, BHP Billiton (BHP) can’t necessarily raise its prices on standard-grade iron-ore at a high-single-digit pace unless the market colludes (others follow along with its price hike). This is unlike a company such as Hershey (HSY) that can hike prices almost at will to offset rising cocoa costs. That’s why commodities firms can only carve out competitive advantages by being the low-cost provider (their prices are set by the marketplace).
Though it is more difficult for a commodities-producing entity to carve out a sustainable competitive advantage, there are a number of commodities companies that we like on a fundamental basis. For example, Compass Minerals (CMP) has an enviable position in rock salt, Potash (POT) has historically benefited from a rational oligopoly in potash (though this has recently been upended), and DuPont (DD) and Dow Chemical (DOW) have put together impressive franchises across the chemicals arena. Perhaps our favorite fundamental idea in the commodities space is PPG Industries (PPG), though we note its valuation is not as tempting as others…which brings us to Rio Tinto.
Rio Tinto (RIO) is one of the largest providers of iron ore, and we’re fans of its low-cost position at Pilbara (where unit cash iron-ore costs are ~$20). The company recently reported first-half 2014 net profit that more than doubled thanks in part to aggressive cost-cutting and improved production (its underlying earnings jumped more than 20% during the first half of 2014). As with many of the company’s mining peers, Rio Tinto is focused on disciplined free-cash-flow management, particularly with respect to new capital projects. Free cash flow surged during the first half of the year thanks to an 8% increase in cash generated from operations and a near-50% decline in capital expenditures (traditional free cash flow = cash generated from operations less capital expenditures). Rio expects capital expenditures to fall to $9 billion in 2014 and $8 billion in 2015, less than half of levels of just a couple years ago.
Strong profit growth generated during the first-half of the year revealed the company’s ability to offset roughly a 30% decline in iron-ore prices with stronger production and strict cost controls. Management prudently used the strong free cash flow production to reduce its net debt load to $16.1 billion from $18.1 billion at the end of December. There’s nothing better to report than a doubling of profits, flawless execution and prudent use of cash flow in an update. We were also very pleased to hear that management has identified another $1 billion in annual operating costs it can shed by the end of 2015 to bolster profitability. Fundamental momentum is moving in the right direction.
Valuentum’s Take
Rio Tinto is underpriced on a discounted cash-flow basis relative to our point fair value estimate. The company also pays a decent dividend, though we wouldn’t view it as a dividend growth idea on the basis of its commodities-driven operations, despite a progressive year-on-year policy. We generally like what we see at Rio Tinto and believe it is one of the best ideas in the mining space at this time as a result of its valuation, strong execution and low-cost position at Pilbara. New investors in Rio Tinto should monitor economic growth (and steel production) in China closely, but we like internal improvements at the company quite a bit. The mining giant is a holding in the Best Ideas portfolio, and shares are worth $68 each in our view.
What is considered a ‘Best Idea’ at Valuentum?
A best idea in Valuentum parlance is a holding in the Best Ideas portfolio and/or the Dividend Growth portfolio. We typically add shares to the Best Ideas portfolio when they register a high rating (a 9 or 10 = a “we’d consider buying” rating) on the Valuentum Buying Index and hold them until they register a low rating (a 1 or 2 = a “we’d consider selling” rating) on the Valuentum Buying Index. We don’t add all firms that register a high score on the Valuentum Buying Index to the actively-managed portfolios due to sector weighting or overall market valuation considerations, among others. The Valuentum Dividend Cushion is a key factor behind adding companies to the Dividend Growth portfolio and is used in conjunction with a company’s annual dividend yield, its price-to-fair value ratio and Valuentum Buying Index rating.