Morningstar's Mat Hodge on Rio's fortunes
The destruction of an indigenous cave shelter was unforgiveable but there are other reasons why the iron ore heavyweight is overvalued.
Mentioned: Rio Tinto Ltd (RIO)
Emma Rapaport: Hi, I'm Emma Rapaport. Welcome to Morningstar. I'm here today talking with our Rio analyst, Mathew Hodge. We're here to talk about the recent resignation of the CEO and what risks remain for investors in the market.
Matt, thanks for joining us today.
Mathew Hodge: Thanks, Emma.
Rapaport: We learned last week that the CEO of Rio had resigned after controversies surrounding their actions in WA, Western Australia, for our global viewers. The company apologised and decided to cut the executive bonuses, but that didn't seem like enough. Why is it that that wasn't enough for the market?
Hodge: Yeah. I think it's a really unfortunate set of circumstances to start with, and I think if the executives at Rio had their time again, they would just wish to have this back. So, it's been a terrible incident. I think it's been a series of miscommunications that have led to that. I think the feedback from institutional shareholders to Rio Tinto is pretty clear that having trust in your community is vital to your social license to operate. So, I think it's really important for Rio Tinto to re-establish that trust, and I think it's probably going to be easiest with the parties involved, you know, the key stakeholders, the traditional owners, and a community if that's done with some new people.
Rapaport: You said that you think the company has made a mistake and that they've rectified, or at least trying to rectify what's gone on. Why do you have this sense of trust in management that everything is going to work its way out. What makes you really believe in management?
Hodge: Yeah, I think Rio Tinto is a very high-quality company, full of very smart individuals and I think they just dropped the ball in this area. This sends a clear message from the chairman all the way down that this is an area that requires full focus, and I'm sure that when the organization turns its focus to this that it will get the appropriate attention.
Rapaport: Do you feel like there's a real shift amongst the investor community to respond in this way when things go like this in the market? Has the mood changed in how investors are willing to respond?
Hodge: I think the bar continues to move onwards and upwards in terms of ESG, and I think this sends a clear message – the investing community has sent a clear message to Rio Tinto and Rio Tinto has sent a clear message to its organisation, and I think the message is pretty clear to the industry as well that this requires full focus.
Rapaport: Investors in Rio – are there still risks that remain in the market? Are you worried about any sort of legislative actions that might be taken in response?
Hodge: Yeah. This is not like owning a building or a toll road or something like that. Pre-covid I might have said airport as well. There's a bit more risk in airports than perhaps we thought before. Mining is an asset-heavy business. It's drilling and blasting and moving stuff around and there are risks with that. And the industry I think on the whole does a pretty good job of doing that efficiently and safely, but it's not a risk-free activity. And from time to time you do have areas that kick up. I mean, early 2019, we saw with Vale where they had the tailings dams failures and that has cost their company billions of dollars. So, I think this is an industry that can do things when it understands the need and is motivated to do so. So, I think part of the answer is making sure that it's understood in the culture and that the incentives are appropriate to make sure those things are happening.
Rapaport: You said in your report that you don't think there will be a big impact on supply. Can you explain why you think that?
Hodge: Yeah. I think the area around the caves which they were talking about potentially excluding from production, we're talking about 10 million tons or less of reserves, right? And the reserves in the Pilbara are extensive. Rio Tinto is drawing from a whole bunch of mines, and they're sending it down their rail and port to go to China, usually to make steel. So, if they're not mining it here, they're going to mine it somewhere else. And I think if there are more areas that need to be carved out of reserves and resources and that's what's needed for social license, then that will happen. But I think there's a lot of other areas where they can explore and develop and build up new resource and reserves. But overall, I don't think we're talking about a large impact to the business. There might be some additional costs, but we are talking an infinitesimally small and insignificant number relative to the kinds of money that Rio Tinto is making out of iron ore at the moment.
Rapaport: In your report you said that this action hasn't changed a view on their on their stewardship rating. Can you explain a little bit about what Morningstar's stewardship rating is and why this hasn't affected it at all?
Hodge: Yeah. So, by stewardship, we're talking about capital allocation. So, there's three key components to that. One is balance sheet, another is investment and another is shareholder distributions. So, Rio Tinto has got a very strong balance sheet. We think they're going to continue to have a strong balance sheet in the future regardless of – basically regardless of who the managing director is. If someone else came in and had a completely different strategy, then we might reassess. But that would be highly unlikely from the position that we're in. I think the business understands the need to have a strong balance sheet.
Shareholder distributions – they've made it pretty clear that whenever the company has excess capital, it's going to go to shareholders, and I think that is the correct approach. So, on both of those elements, I score Rio Tinto quite well.
The bit that I find challenging is the investment part. They are in a cyclical and capital-intensive industry. What that means is I think it's quite difficult to gain confidence that over that kind of 10-year period or longer that Rio Tinto will be able to continue invest in projects and not invest in projects that destroy shareholder value. And we saw through the China boom the acquisition of Alcan, the acquisition of Riversdale Mining that you can have these occurrences where you do invest and in mining, we're generally talking quite large sums of money and capital can be destroyed. So, that's just the one area where I don't have sufficient confidence to say, okay, they're going to invest well and add value reliably, and therefore exemplary.
Rapaport: You've currently got a fair value that puts the company in a really overvalued place. You have a fair value of $69. I think the company is trading around $100 today. It's quite a big gap.
Rapaport: Why is there such a big gap for you? And what is the future for Rio Tinto?
Hodge: Well, because I don't think $130 a ton iron ore is sustainable. At that rate, for every dollar that Rio has invested in iron ore, it's basically owning $1 per year, 100 per cent return on invested capital. So, it's a better-than-average iron ore business, but it's not that good. And basically, if you're an iron ore producer, you're making money currently. So, it's a long way above the cost curve. It's a long way above the price that you need to incentivise new supply. And longer term, we think demand from China is likely to fall because they've passed the peak of urbanisation, they're relatively well developed as far as infrastructure. So, the amount of infrastructure per capita is in excess of many OECD countries like the UK Their spending is vastly greater, and we don't think that that's going to be sustained.