Rio Tinto is a direct play on the expected China rebound, as the Iron ore segment generates c.78% of the company’s EBITDA and c.95% of its free cashflow. Rio Tinto is also “doubling down on iron ore” with a fresh USD6.2bn investment in Simandou. The company’s FY23 results were broadly in-line with expectations, and while the dividend was a positive surprise some caution is still warranted in relation to its guidance for an increase in iron ore production costs. Iron ore prices are still above consensus and could lead to upward revisions over the next few months if the current spot price holds and the Chinese stimulus proves to be effective in reviving the country’s economy. We expect a higher upside risk to Rios 2024 earnings estimates vs. its peers, due to its considerable exposure to the iron ore market.
The ongoing uncertainty about China's economy and the effectiveness of the government’s stimulus to combat deflation have exacerbated investor concerns, which has led to a significant de-rating of the mining sector. The EuroStoxx Basic Resources index has been the worst performing sector both YtD (-10%) and YoY (-17%) compared to gains of 3.5% YtD and 7% YoY for the EuroStoxx 600. The sector’s P/B has also de-rated by c.6% vs. the broader market. Iron ore has been one of the worst-performing commodities so far in 2024 on the back of weaker Chinese demand, as the currently troubled property sector accounts for c.30%-35% of China’s steel demand. Consensus expects the iron ore market to be broadly stable in 2024 and we believe it should directly benefit from China’s efforts to support the property sector though stimulus. Iron ore prices would also benefit from rate cuts, as a 100bp decrease in US 2Y yields is expected to lead to c.4% increase in prices for industrial metals.
With the stock trading at a 10% discount to its long-term P/E and 6M ATM volatility at 2YPc5, we suggest buying 2x Sep 24 6000 calls financed by 1x Sep 24 4400 Puts at a net cost of 0.64% of underlying (spot ref: 5093). Should the spot price increase by 10% the value of the call leg would return c.2.2x on the premium employed, all other parameters remaining equal. Alternatively, you are left holding the stock at mid-2020 price levels implying a 7.2x PE at 25% discount to its long-term rating