The Long and Short
Limited upside in Rio Tinto at tight spreads
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Rio Tinto (RIOLN: A2/A/Au) continues to trade at some of the tightest spreads in the metals and mining segment, second only to the slightly higher-rated BHP Group (BHP: A1/A-/Au). It also trades tight to the broader basic industry sector. The name offers limited upside at current valuation with better opportunities to add spread elsewhere. Glencore (GLENLN: Baa1/BBB+) is one example with better relative value despite risks related to its proposal to buy part of Teck Resources.
As the largest global producer of iron ore, RIOLN is highly leveraged to the growth trajectory of China. While the near-term outlook for steel production in China has already raised questions for the mining industry, projections become even murkier over the intermediate-to-long term for holders of longer-dated RIOLN securities.
Year-to-date, the basic industry sector has delivered a Top 3 performance with an excess return—a credit return net of Treasury impact—of 2.44% on around 35 bp of OAS tightening. By comparison, the investment grade index has delivered a 2.08% excess return on around 29 bp of OAS tightening. RIOLN 20- to 30-year maturity notes have mostly delivered comparable performance over the same period, largely generating similar excess returns as the broader sector. Going forward, some of the lower-rated ‘BBB’ credits within basic industry are more likely to outperform the highest-rated names, such as RIOLN.
Exhibit 1. IG Metals & Mining Sector
Source: Santander US Capital Markets, Bloomberg/TRACE BVAL indications only
Bid-side indications for long-dated RIOLN securities:
Source: Santander US Capital Markets
RIOLN on July 26 also reported weaker operating results for the first half of 2023, with a significant year-over-year drop in profits and an even greater drop from record results in the first half of 2021. Underlying earnings were $5.7 billion, down 34% from $8.9 billion in the prior period and down from the record-setting $12.2 billion in the first half of 2021. Underlying EBITDA declined 25% and free cash flow dropped 47% year-over-year as well. Iron ore prices, which contributed over three quarters of EBITDA throughout the first half of the year, were down 14% versus the first half of 2022, while Copper and Aluminum were down 10% and 24%, respectively.
While RIOLN is a conservative credit, management commits a large percentage of cash flow to shareholder payouts, limiting the cash available for debt reduction and improvement to the company’s overall credit profile. The company typically pays out between 40% to 60% of underling earnings on average through the cycle to shareholders, through combined high dividends and share repurchases, with the remainder going toward growth initiatives. For the first half of 2023, $2.9 billion of dividends were declared or about a 50% payout. RIOLN makes fairly frequent small, strategic acquisitions, but investors should not rule out the prospect of a larger, more transformational deal over the longer-term given some of the more prominent consolidation attempts in the industry in recent years.
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