Rio Tinto Financial Analysis: Ratios, WACC & BHP Comparison

Introduction

Rio Tinto is an Australian mining company and FTSE 100 component. Based in London and Melbourne, Rio Tinto is involved in the exploration for and mining of aluminium, copper, iron ore, diamonds, and energy resources. Rio Tinto is one of the largest mining companies in the world and is dual-listed in Australia and London (RioTinto.com, 2011). It ranks #68 on the Forbes Global 2000 list of companies (Forbes, 2010). The company has seven divisions: Aluminium, Copper, Diamonds & Minerals, Energy, Iron Ore, Exploration, and Technology & Innovation. Operations are global, depending on the product. Most non-mining activities are conducted in Western nations, while mining activities are conducted on site around the world, in both developed and developing nations.

This paper analyzes Rio Tinto in the context of its recent financial performance. The objective is to make a determination with respect to the company's financial health. The analysis includes a discussion of strategy, trend analysis, ratio analysis, and a calculation of the firm's weighted average cost of capital (WACC). The main sources of information are the company's annual report and financial figures from Yahoo! Finance UK. Recent news reports are also used to gain independent perspective on recent changes at the company and in its operating environment.

The paper also includes a comparative analysis of Rio Tinto against a main competitor. The competitor chosen is BHP Billiton. BHP is also dual-based in London and Melbourne and is also a member of the FTSE 100. In addition, the two companies are comparable in size and global scope. BHP operates in iron ore, aluminium, coal, manganese, base metals, uranium, and other categories, making it slightly more diversified than Rio Tinto, but in general there are many product-line similarities. The two companies are natural comparables. Based on this comparison and the prior financial analysis, an overall assessment of Rio Tinto is made in the conclusion.

Company Overview and General Financial Analysis

Rio Tinto's vision (2011) is "being the global mining leader…sector leadership…operational excellence, sustainable development, exploration and innovation." While this provides only minimal specific guidance for stakeholders, the company envisions itself as having strong growth potential as global demand for minerals continues to increase, largely due to population growth and economic development around the world. The company sees China in particular as a strong source of future growth and has embarked on a number of joint ventures there to support this element of its strategy (Walsh, 2011).

The company has also enjoyed strong financial results recently, driven by increases in the price of base metals. Profits in the most recent year were £14 billion, fueled by a doubling of copper prices and a 50% increase in iron ore and aluminium prices. The company has also begun to recover financially from going into debt with its $40 billion purchase of Alcan, the Canadian aluminium giant, two years prior (Wachman, 2011). In general, mining companies tend to benefit from increases in commodities prices, as they are able to earn higher margins on their products in the face of rapidly escalating demand. It is worth noting that over the long run, the mining business tends to be cyclical in nature, as commodities prices are highly volatile (Bank of Montreal, 1997). The earnings of mining companies are therefore highly exposed to fluctuations in commodities prices. This is important to bear in mind throughout this analysis, because to some extent the relative success or failure of Rio Tinto is driven by commodities prices rather than internal competencies. Over the long run, however, Rio Tinto should outperform its peers as a result of its strategies.

Rio Tinto currently trades at 4,243.5p per share, on the lower side of its 52-week range. The company earns 7.26p per share, giving it a price-to-earnings multiple of 584.34, which is very high for a company its size, even one that is rapidly growing. Rio Tinto's market capitalization at this level is £83.26 billion. The company's high stock price implies a forward P/E of 4.44, so the market expects earnings to increase significantly in the coming year.

According to Rio Tinto's 2010 Annual Report, the company has a relatively even geographic split: 21% of sales are in the Americas; 19% in Europe, the Middle East and Africa; 28% in China; and 32% in Asia/Australia. The firm's dependence on the Chinese market is already high and is expected to grow further. The contributions to earnings by group are as follows:

This table illustrates that despite offering a wide range of products, Rio Tinto's business revolves around the health of the iron ore market. Iron ore prices have increased significantly of late. Since August 2010, iron ore prices rose 28.7% from $145.34 per ton to $187.18 per ton in February 2011.

Based on this understanding of Rio Tinto's business, the company should have enjoyed an improvement in its results over the course of the past year, roughly in line with improvements in the price of iron ore and other key commodities. Rio Tinto's revenue from continuing operations for fiscal 2010 was $56.5 billion, compared with $41.8 billion in 2009 and $54.2 billion in 2008. The weakness in the global economy in 2009 resulted in depressed commodities prices. As those prices recovered in 2010, particularly in China, Rio Tinto saw its revenues rebound. Net profit also improved significantly in 2010: $15.3 billion, compared with $5.3 billion in 2009 and $4.6 billion in 2008.

These results derive primarily from the increase in commodities prices, as evidenced by the sharp uptick in revenues that was not matched by an equally sharp uptick in costs. Revenues from continuing operations increased 35% last year while net operating costs increased just 8.4%. There was also an element of cost containment in the profit improvement, as operating costs as a percentage of revenues fell to 64.8% in 2010 from 69.3% in 2008 — a year with similar revenue and cost figures. Thus, Rio Tinto improved its efficiency while also benefiting from higher commodities prices.

Ratio Analysis

A trend analysis of the statement of financial position shows that Rio Tinto reduced its degree of gearing in the past year. While total assets increased 15.5% in 2010, total liabilities declined 8.1%. Along with the improvement in net income, this reduction of debt is indicative of a company strengthening its financial position. A ratio analysis can complement the trend analysis by identifying more specific elements of the financial statements.

With respect to liquidity, the decrease in the gearing ratio from 2009 to 2010 should be taken as a positive sign. The total gearing ratio is 41.9%, down from 52.7% in 2009. This sharp move reflects Rio Tinto's desire to reduce its debt following the Alcan purchase. The company committed to paying down that debt, and the reduction in gearing in 2010 demonstrates that it has made good on that commitment. The current ratio for Rio Tinto is 1.82, compared with 1.56 in 2009. The quick ratio is 1.41, compared with 1.05 in 2009. The cash ratio is 0.84, compared with 0.44 in 2009. Each of these ratios showed dramatic improvement from 2009 to 2010.

All of these ratios were notably poor in 2008 (current ratio: 0.66) and 2007 (current ratio: 1.12), because the current portion of long-term debt was very high in both years. The company needed that debt to help finance the Alcan purchase, but sought to pay it down rapidly in order to restore its capital structure. The company still carries a substantial portion of long-term debt ($13.2 billion), but if high commodities prices are maintained, Rio Tinto is expected to continue reducing this debt, thereby improving liquidity and solvency and reducing the gearing ratio further.

Rio Tinto's profitability ratios show an operating margin of 34.8% in 2010, a significant improvement over 2009 (17.9%) and 2008 (18.8%). The net margin was 26.8%, compared with 12.7% in 2009 and 8.5% in 2008. These margin improvements relate primarily to the increase in iron ore and other commodities prices, which improves the top line while allowing the company to maintain relative stability in its cost structure.

Rio Tinto recorded an inventory turnover of 7.6 times in 2010, compared with 6.4 times in 2009 and 6.8 times in 2008. This indicates that part of the company's improvement came from moving more inventory, not just from higher commodity prices. The receivables turnover ratio was 11.8 in 2010, compared with 8.0 in 2009 and 8.6 times in 2008. The asset turnover was 0.54 times in 2010, compared with 0.44 times in 2009 and 0.57 times in 2008. These figures, alongside the operating expense ratio, indicate that Rio Tinto became a more efficient operation over the past year. Intuitively, this is expected as the company gains efficiencies from integrating Alcan into its other aluminium operations. The broad-based improvement in efficiencies points to a company focused on its strategic vision of operational excellence.

What the ratio analysis of Rio Tinto indicates, therefore, is that the company's dramatic financial improvement last year was not solely the result of a cyclical rise in the price of its key commodities, but also the result of its commitment to internal improvements and better integration of Alcan. Rio Tinto is putting itself in a positive position going forward, using a period of relative strength to improve its operations so that when the next down cycle arrives, the company is better prepared.

Conclusion

3.44 + (1.49)(7) = 13.87%

The weighted average cost of capital for Rio Tinto is therefore calculated as follows:

(13.87)(0.581) + (4.077)(0.419) = 8.05 + 1.71 = 9.76%

The purpose of this financial analysis was to deliver an assessment of Rio Tinto's financial health, reflecting both short- and long-term considerations. On a purely strategic level, it is evident that Rio Tinto is benefiting from a recent surge in commodities prices. The company is outperforming 2009 in most respects, although in some measures 2008 was still a stronger year. For the most part, Rio Tinto's performance reflects broader industry strength; however, Rio's financial performance shows more consistent improvement than that of key rival BHP Billiton. In this respect, Rio Tinto appears to have outperformed over the past couple of years.

There are two main considerations with respect to that performance, beyond the improvement in iron ore prices. The first is that Rio's balance sheet was negatively impacted by the debt taken on to purchase Alcan in late 2007, and the company has spent the past few years restoring its balance sheet health. That Rio was able to reduce its gearing during the down year of 2009 — not only during the strong year of 2010 — indicates that the company is committed to balance sheet health and is not solely reliant on a strong iron ore market to achieve it. For an investor, that is a very good sign.

The second consideration is that approximately $5 billion of Rio Tinto's profit improvement appears to have come from internal improvements. While margin gains driven by commodity prices account for the bulk of the profit increase, the company has also worked hard at internal cost containment, producing improvements that should persist over time.

There is some cause for concern that too much of Rio Tinto's recent success is tied to iron ore prices. Compared with BHP Billiton, Rio is not well diversified and is therefore likely to experience greater earnings volatility. The company is more geographically diversified, however, which is cause for optimism. While Rio should focus on building its asset base outside of iron ore, the company has demonstrated that this is part of its long-term strategy.

For an investor, Rio Tinto represents a strong mining company that has demonstrated good internal competencies and a commitment to maintaining a prudent level of gearing. There are some mild reasons for concern, but in general Rio is a good performer and compares well financially to major rival BHP. Rio's stock is in the middle of its 52-week range and is not overpriced for investors seeking a blue chip mining stock. Based on the trend, ratio, and comparative analysis of the firm's financials, a buy or hold recommendation is most appropriate for Rio Tinto at this point in time.

Bank of Montreal. (1997). Hedging commodity price risk. Bank of Montreal/Harris Bank/Nesbitt Burns. Retrieved March 27, 2011 from http://www.bmocm.com/common/scripts/getfile.aspx?fileID=68

BHP Billiton 2010 Annual Report. Downloaded March 27, 2011 from

Forbes. (2010). Forbes global 2000. Forbes Magazine. Retrieved March 27, 2011 from http://www.forbes.com/lists/2010/18/global-2000-10_The-Global-2000_Rank.html

IndexMundi.com (2011). Iron ore monthly price. IndexMundi. Retrieved March 27, 2011 from http://www.indexmundi.com/commodities/?commodity=iron-ore&months=12

Rio Tinto 2010 Annual Report. Retrieved March 27, 2011 from http://www.riotinto.com/annualreport2010

RioTinto.com website, various pages. (2011). Retrieved March 27, 2011 from http://www.riotinto.com/

Wachman, R. (2011). Rio Tinto magic turns base metals into gold. The Guardian. Retrieved March 27, 2011 from http://www.guardian.co.uk/business/2011/feb/10/rio-tinto-profits-from-commodity-boom

Walsh, S. (2011). China iron ore 2011. Rio Tinto. Retrieved March 27, 2011 from http://www.riotinto.com/documents/110324_New_opportunities_for_industry_growth_Sam_Walsh.pdf

Yahoo! Finance: BHP Billiton. (2011). Retrieved March 27, 2011 from

Yahoo! Finance: Rio Tinto. (2011). Retrieved March 27, 2011 from