S&P Lifts Outlook on Rio Tinto plc (RIO) to Stable; Ratings Affirmed
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S&P Global Ratings said it has revised its outlook on global diversified mining company Rio Tinto PLC (NYSE: RIO) to stable from negative.
At the same time, we affirmed our 'A-' long-term corporate credit rating on the company and raised the short-term rating to 'A-1' from 'A-2'.
The outlook change indicates that in our view Rio Tinto's supportive financial flexibility and some improvement in prices will allow the company to generate stronger positive DCF (free cash flow after capital expenditure [capex]) and dividends in 2016 and 2017, and maintain its credit metrics within the range we consider commensurate with our current ratings.
Furthermore, we now assess Rio Tinto's liquidity as exceptional, taking on board the company's limited maturities after its recent $6 billion liability management and debt maturities; hefty cash on the balance sheet; and positive DCF in the next few years. As a result, we raised our short-term rating on Rio Tinto to 'A-1' from 'A-2'.
We believe that the tailwind from the recent iron ore rally (recovering to $60 per ton today compared with prices below $40 per ton earlier this year), coupled with further cost cutting initiatives and a moderate capex program, have resulted in a better debt position and credit metrics than previously expected. Going forward, Rio Tinto's new dividend policy should provide an additional layer of flexibility, allowing the company to manage its leverage more dynamically through periods of low prices. For example, we now project Rio Tinto's funds from operations (FFO) to debt to be between 35%-40% in 2016, compared to our previous forecast of about 32%-33%. We view FFO to debt of 35%-45% to be commensurate with our 'A-' long-term rating.
We recently revised upward our price assumption for most commodities, including some of the key commodities in Rio Tinto's portfolio (iron ore, aluminum, and gold). The change in our assumption for iron ore to $50 per ton for the rest of 2016 and $45 per ton in 2017, reflects the current positive momentum in China's steel sector and some delays in the ramp-up of new capacity. That said, we believe that iron ore prices should remain subdued, as we don't see any fundamental change in the industry supply and demand dynamics.
Under our base-case scenario, we project that Rio Tinto's S&P Global Ratings-adjusted EBITDA will be $10.6 billion-$10.8 billion in 2016 and $10.7 billion-$11.1 billion in 2017, compared with $11.7 billion in 2015. In the first half of 2016, Rio Tinto reported a better-than-expected adjusted EBITDA of $4.3 billion. A further upside is expected over the short term if prices, especially iron ore, remain at the current level.
The following assumptions underpin our estimation:
- Iron ore prices of $50/ton for the rest of 2016 and $45/ton in 2017 (versus a spot price of $61/ton). According to our calculation, a change of $5/ton in the price of iron ore would result in a change of $1.2 billion in the EBITDA, leaving other assumptions unchanged.
- Copper price of $2.1 per pound (/lb) for the rest of 2016 and $2.2/lb in 2017 (versus a spot price of $2.14/lb)
- Exchange rate of the Australian dollar against the U.S. dollar of $1.39 in 2017.
- Production broadly in line with the company's guidance.
- Relatively minor contribution from the company's ambitious cost-cutting program. According to the company, it achieved savings of about $0.6 billion in the first half of 2016 out of a framework of $1 billion in 2016 and another $1 billion in 2017.
- Capex of about $4 billion in 2016 and $5 billion in 2017, in line with the company's guidance.
- Dividends (including dividends to minorities) of about $2.2 billion in 2017, compared with announced dividends of $2.7 billion in 2016. Starting in 2017, the dividends will reflect the newly adapted flexible dividend policy, targeting total cash returns over the longer term to shareholders of 40%-60% of underlying earnings.
These assumptions translate into positive reported DCF of around $1.5 billion in 2016 and 2017 and adjusted FFO to debt of close to 35%-40% in 2016, improving further in 2017. As of June 30, 2016, the company's reported net debt was $12.9 billion, comfortably below the debt levels of its immediate peers. Based on our projections, the company is going to be close to the lower end of its gearing ratio of 20%-30% through the cycle. This, in our view, may provide the company with the necessary comfort to distribute higher dividends.
We continue to assess Rio Tinto's business risk profile as strong, supported by a low-cost, long-life asset base; a large scale; and operational diversity. Tempering this strength is the impact of the ongoing cyclical weakening of the resource industry. Rio Tinto's major operations are well-positioned in the first or second quartiles of the global industry cost curve. We take a positive view of management's ability to maintain its very competitive position in the iron ore business.
The stable outlook on Rio Tinto reflects our expectations that the company will be able to maintain adjusted FFO to debt of about 40% in the next few years, based on our assumption of iron ore prices of $45/ton in 2017. This ratio is in line with the range of 35%-45% that we consider commensurate with an 'A-' rating. In addition, we expect the company to generate positive DCF.
We expect Rio Tinto's financial flexibility to improve further at the start of 2017 as the company has no commitments to onerous dividends or new expansion programs. In our view, this would allow the company to manage its leverage more dynamically through periods of low prices.
We might consider lowering the ratings if Rio Tinto's adjusted FFO-to-debt ratio were to fall below 35% on a persistent basis. This scenario could occur if the Chinese economy experienced a more-pronounced slow-down, compared to our base case, and that had a direct impact on the prices of key commodities (iron ore, aluminum, and copper).
We do not currently anticipate an upgrade as commodity prices are likely to remain sensitive to the investment cycle in China. Any upgrade would depend on Rio's track record with its new financial policy, its commodity diversification, and supportive FFO to debt sitting comfortably above 45%.
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