Rio Tinto deserves re-rating, says JP Morgan

Rio Tinto (LON:RIO) remains one of broker JP Morgan’s top picks among large diversified companies despite the company having suffered an ‘aggressive de-rating’ of its shares since its giant £9.5 billion rights issue in 2009.

Analysts at JP Morgan calculate that Rio has lost roughly three price/earnings points since the rights issue compared to the three years previously, leaving it trading on a multiple of 7 versus 10 before.

The broker reckons a doubling in iron ore prices coupled with a move to quarterly/spot pricing, which removed some of the earnings certainty for any given year, are partly to blame for the fall in valuation.

“Given Rio's dependence on iron ore it suffered the worst in terms of de-rating”, says the broker. While this dependence on iron ore does come down a bit over time, according to its forecasts, it still remains stubbornly above 50% going forwards.

Having said that, the broker feels a rerating for Rio is on the cards thanks to some “prudent and clever capital allocation” over the last six months.

JP Morgan believes the company has secured “a very interesting portfolio” of emerging market assets in what it expects to form some of the most important mineral supply basins. These include exposure to Mozambique coking coal, Mongolian copper and Guinean iron ore.

The analysts says Rio is the only large mining company to have been so active and successful recently in this regards, with the assets worth $19bn in net present value terms today. They promise to deliver “significant long term production growth as well as numerous options for regional consolidation in the future, especially in the bulk commodities arena”, they say.

Further restructuring of its aluminium business will also help with the process of re-rating, with management formally targeting an increase in aluminium EBITDA margins from 20% in 2010 to 40% ‘over the medium term’.

While the shakeup of the aluminium side will take time, most likely most of 2013, success on this front would deliver around a 15% uplift in group earnings uplift and at the same time reduce the group’s reliance on iron ore.

Another positive for the stock is that Rio does not plan to embark on any big, dilutive M&A programme. It is also in the process of buying back shares.

The analysts’ upbeat assessment of the group’s prospects mean they are retaining their ‘overweight’ rating on the stock, with a price target of £63, at which Rio would trade on a price earnings multiple of 10, in line with history.