Why is Rio Tinto’s Stewardship rating untouched?

Morningstar’s analyst discusses his stance on company amid a whirlwind of controversy.
By Morningstar Analysts |  01-10-20 | 

Rio Tinto is one of the world's biggest miners, along with BHP Billiton, Brazil's Vale, and U.K.-based Anglo American. Above-average assets relative to peers mean Rio Tinto is one of few miners profitable through the commodity cycle. Most revenue comes from operations located in the relatively safe havens of Australia, North America, and Europe, though the company has operations spanning six continents. By customer, Rio Tinto's largest customer by far is China.

In Rio Tinto shows us why ESG cannot be ignored, we looked at the various repercussions of the mining giant’s act of blasting archaeological sites.

Sustainalytics, a leading independent global provider of ESG (environmental, social, corporate governance) research and ratings, categorizes its company ratings across 5 risk levels.

  • Negligible
  • Low
  • Medium
  • High
  • Severe

Rio Tinto is High Risk. You can view it here. The top material ESG issues for Rio Tinto are:

  • Corporate Governance
  • Community Relations
  • Emissions, Effluents and Waste
  • Resource Use

Mathew Hodge, director of equity research at Morningstar and Rio Tinto analyst, share their views on Rio Tinto.

Impact on supply

The area around the caves which they're talking about potentially excluding from production, we're talking about 10 million tons or less of reserves. The reserves in the Pilbara are extensive. Rio Tinto is drawing from a whole bunch of mines and sending it to China to make steel. If they are not mining it here, they are going to mine it somewhere else. There are lots of other areas where they can explore and develop and build up new resources and reserves.

Overall, I do not think we are talking about a large impact to the business. There might be some additional costs, but we are talking an infinitesimally small and insignificant number relative to the kinds of money that Rio Tinto is making out of iron ore currently.

Management

This is not like owning a building or a toll road or something like that. Mining is an asset-heavy business. Drilling and blasting and moving stuff around. There are risks with that. And the industry on the whole does a pretty good job of doing that efficiently and safely, but it's not a risk-free activity. And from time-to-time you do have areas that kick up.

Early 2019, we saw mining company Vale have the tailings dams failures that cost them billions of dollars.

This is an industry that can do things when it understands the need and is motivated to do so. I think part of the answer is making sure that it's understood in the culture and that the incentives are appropriate to make sure those things are happening.

Rio Tinto is a very high-quality company, full of very smart individuals. In terms of ESG (environmental, social, governance), the investing community has sent a clear message to Rio Tinto, and Rio Tinto has sent a clear message to its organization, and I think the message is pretty clear to the industry as well that this requires full focus.

The feedback from institutional shareholders to Rio Tinto is pretty clear that having trust in your community is vital to your social license to operate. It's really important for Rio Tinto to re-establish that trust with the parties involved - key stakeholders, traditional owners, and a community.

Stewardship

With the departures of the CEO and other key executives, we retain our Standard stewardship rating for Rio Tinto. We think new management will do what it takes to avoid a recurrence of the Juukan Gorge mistake and preserve social licence.

The Stewardship rating has various components:

  • Balance sheet

Rio Tinto’s balance sheet is sound, and we expect the company to run a relatively conservative balance sheet for the foreseeable future. This reflects painful lessons from the global financial crisis when the company undertook a value-destructive discounted equity issue after taking on too much debt for acquisitions during the preceding boom.

We think they're going to continue to have a strong balance sheet in the future regardless of who the managing director is. If someone else came in and had a completely different strategy, then we might reassess. But that would be highly unlikely. I think the business understands the need to have a strong balance sheet.

We like the focus on returning excess cash to shareholders and think the company’s approach to shareholder distributions is appropriate.

  • Shareholder distributions

The management has made it pretty clear that whenever the company has excess capital, it is going to go to shareholders. I think that is the correct approach.

So, on both of those elements, I score Rio Tinto quite well. The bit that I find challenging is the investment part. Investment is likely most important for Rio Tinto’s future shareholder returns.

  • Investment

They are in a cyclical and capital-intensive industry. What that means is I think it's quite difficult to gain confidence that over that kind of 10-year period or longer that Rio Tinto will be able to continue investing in projects and not invest in projects that destroy shareholder value.

And we saw through the China boom, the acquisition of Alcan, and the acquisition of Riversdale Mining that you can have these occurrences where you do invest, and in mining, we're generally talking quite large sums of money, and capital can be destroyed. So, that is just the one area where I don't have sufficient confidence to say, "OK, they're going to invest well and add value reliably, and therefore be exemplary."

We think Rio Tinto's investment is likely to remain relatively disciplined in the near- to medium term. However, mining is a cyclical and capital-intensive business where significant capital can be misallocated to value destructive projects and acquisitions. In the long term, we lack sufficient confidence that the firm will remain disciplined, consistently invest to add value and avoid value-destructive mistakes. Exposure to cyclical commodity prices, presents a risk of materially value-destructive investment, such as the acquisition of Alcan in the past. And high capital intensity means future investments are likely to be the primary long-run driver, along with commodity prices, of total shareholder returns. We think the outlook for investment for Rio Tinto is fair overall, which dictates a Standard stewardship rating.

We think it will be difficult for the company to consistently make value-adding investments and avoid mistakes, hence the Standard rather than Exemplary rating.

If we thought Rio Tinto’s new investments would reliably be above the firm’s cost of capital and significant shareholder value was likely added as a result, then an Exemplary stewardship rating would be warranted given we think the balance sheet will remain sound and shareholder distributions will be appropriate.

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