Iron Ore and Copper Drive Value at Rio Tinto

Over two thirds of our Rio Tinto RIO valuation derives from just two commodities: iron ore, and copper. If you add aluminum, you've effectively covered 85% of the value. We stick to these in our commentary on fourth-quarter fiscal 2010 output. Forget diamonds and industrial minerals. Simply forecasting prices for iron ore and copper gets the bulk of the job done. That's not to say there won't be periodic swings and occasional roundabouts in uranium, molybdenum and other products, but these are more generally of passing concern. They are more important for near-term earnings, but less important to overall value.

Iron ore production rose 5% to 50.1 million metric tons, a good result, and better than expected. Rio Tinto has expanded output by around 25% from levels three years ago--similar to BHP, but in a more roller coaster fashion--and has sizeable ongoing expansion programs. It proposes a 30% increase in installed Western Australian capacity from current 220 million metric ton per annum levels, to 283 million metric tons by the end of 2013. Its share is around 79%, and further expansion to 333 million metric tons per annum is slated by the end 2015.

Like BHP Billiton BHP, Rio Tinto has enthusiastically pushed expansion since the collapse of the proposed Pilbara iron ore joint venture. Its plans are comparatively less aggressive, though they originate from a larger base, and represent a greater share of group earnings. All things considered, expansion plans are probably similarly meaningful for each, despite BHP's comparatively more optimistic growth target.

Rio Tinto increased fourth-quarter copper production by 16% to 185,000 metric tons, ahead of expectations. It had warned of weaker near term output at Escondida in Chile due to scheduling issues and declining head grades. The strong gain overall is off the back of a very weak third quarter from Grasberg in Indonesia, but heartening nonetheless. Rio Tinto's U.S. Kennecott operations enjoyed improved grades. Escondida though is still likely to see a 5%-10% decline over 2010 due to grade.

Lethargy in copper production is in stark contrast to iron ore's expansion. Declining head grades and prohibitively expensive up-front development temper production growth. It has also made sense to limit new production as the plus $4 per pound copper price can attest. Rio Tinto has held its ground, seemingly happy to let copper revenue grow in the face of stagnant volumes. New production will eventually come via Oyu Tolgoi in Mongolia from 2013. The mine could deliver the equivalent of 15% of Rio's current copper output.

Rio Tinto's fourth-quarter aluminum production grew 2% to 962,000 metric tons, the highest in the year, and in line with expectations. In essence, aluminum output has run below 1 million metric tons per annum capacity levels - boosted by Alcan's purchase in late 2007 - since the global financial crisis. Prices are improving and the decoupling of alumina prices from aluminum is a strong tailwind. This explains why aluminum comprises such a large share of our valuation, despite generating losses in 2009, and contributing only 5% of 2010 group earnings before interest and tax. Aluminum is the sleeper division that could very quickly contribute very meaningfully should recent positive trends continue.

We are marginally lowering our fair value estimate for these shares. We're incorporating higher capital expenditure expectations to better reflect cost pull from higher commodity prices--chiefly iron ore, copper and oil. Partial offsets are the same higher iron ore and aluminum prices. Our fiscal 2010 earnings forecast is marginally improved, thanks to strong fourth-quarter production performances in iron ore and copper. Fiscal 2011 grows more meaningfully, reflecting stronger iron ore pricing.