Rio and the $115bn capital return | FT Alphaville

Rio and the $115bn capital return

Sam Walsh, the new Australian boss of Rio Tinto has probably never heard of Tony Pidgley, the chairman of upmarket UK housebuilder Berkeley Homes.

Which is a pity because Pidgley, adopted from Barnardo’s at the age of four by travellers, could give him some tips on how to run a cyclical business and maximise returns to shareholders. (Something, of course, his predecessor conspicuously failed to do).

Specifically, the plan hatched by Pidgley back in 2011 was to return Berkeley’s entire market cap in dividends over a ten-year period. (And given he’s pulled off something similar before you wouldn’t bet against him doing the same again).

Anyway, we digress. Citigroup reckons this strategy could work in the mining industry.

No, really ,it could.

So what would happen if Walsh did a Pidgley and returned Rio’s market cap ($115bn) in dividends over ten years?

One could argue that there are similarities in the cyclical nature of buying and developing land as to buying and developing resources. It also removes timing issues which is a frustration of many investors, as the peak of cash generation occurs at the peak of the cycle and so do peak capex and M&A prices.

Interestingly the company has spent $110bn on capex and net M&A (acquisitions less divestments) over the past ten years and this compares to the company’s current market cap of around $115bn. Rio has paid around $18bn in dividends and buy backs less the rights issue is positive $4bn. At least in theory the company could have adopted this strategy in the past and perhaps avoided ~$35bn in impairments.

We already forecast dividends of around $76bn and capex of $76bn, which on our conservative long-term forecasts (copper $6,500 and iron ore $81 real) would interestingly still leave the company in a net cash position of around $79bn by 2023. In our view the numbers work, and Rio could commit to returning around $115bn in cash to shareholders with minimal shrinkage to its business (although this is a separate debate).

Right then Rio could, in theory at least, do a Pidgley.

But what would be the upside for shareholders?

Over to Citi again.

The valuation impact in our view would be pronounced. Rio Tinto’s market cap ~$115bn is currently trading at a 15% discount to our calculated NPV of $133bn; we calculate a value of $167bn or 45% upside on a cash return strategy. If Rio Tinto paid out its current market cap ($115bn in dividends) over the next ten years we calculate that it would be worth $66bn in today’s money (using a dividend discount model at a cost of equity of 12%) and would result in our expected payout ratio increasing from around 50% to 86%. We have then calculated a residual value of Rio Tinto in 2023 and present valued that back to today of $101bn, this is based on a conservative ~5x earnings and a 20% discount to the residual NPV.

Of course, this isn’t going to happen. But as any exercise in fantasy corporate strategy its useful. And that’s because after the past few years of writedowns and bungled acquisitions mining executives really do need to think harder about how they deploy capital.

For no other reason than this:

As an example Rio Tinto historically traded at a ~20% premium to NPV, arguably up until the Alcan acquisition, rights issue, and unprecedented capex spend. This resulted in a step change on how the company traded relative to our calculated NPV and over the past three years it has traded at a discount of around 30%.

Mr Walsh will present Rio’s annual results on Thursday.

Related links:
Oh, Rio, Rio…. – FT Alphaville
Rio chief quits after $14bn writedown - FT
The Rio Tinto domino – FT Alphaville
New Rio chief challenges miner stereotype – FT.com