Big iron is again outperforming on the stockmarket today even as its business dissolves. Let’s take a look at how this magnificent fiction is achieved. Deutsche has just cut its iron ore prices to $51 for 2015 and $60 for next year and today recommended RIO as a buy (not picking on it especially):
After incorporating the commodity and currency revisions our Rio earnings have decreased by 15% in 2015 and 9% in 2016. The largest impacts were the drop in the Fe price. Despite the downgrade to earnings, we still have Rio generating around US$690m of free cash flow in 2015 prior to the US$2b buyback. We think cost decline is keeping good pace with price decline. In the Pilbara, we think Rio can drop C1 unit costs to around US$14/t in 2016. Our Rio valuation has decreased by c. 5% to A$78.35/sh. Despite the downgrades we still forecast a free cash flow yield (post capex, pre dividends and debt payments) of 6% in 2015 increasing to 9% in 2016. Expect more impressive cost out with the interim results in August and some project approvals. With a strong balance sheet we are now confident Rio can buy back stock and approve growth (South of Embley bauxite, Silvergrass, Hunter Valley, OT underground when approved) for years to come, even at lower iron ore prices.
So then, the elements of the RIO “buy” are:
- ignoring profit falls in favour of
- free cash flow and yield while assuming that prices will rebound shortly and
- that slow and steady cost out can keep pace with the tearaway iron ore price crash, as well as
- assuming that further investment in already massively oversupplied sectors will generate earnings growth (as opposed to further price collapses).
That’s about as glass half-full an analysis that I have ever read but, hey, it works, at least until it runs into the brick wall of zero profits, deflating assets and writeoffs.