MINING MARKETS & INVESTMENT NEWS — INVESTMENT COMMENTARY — Industry contraction helps the big get bigger

London-based analysts Emil Morfett and Nigel Kieser of J.P. Morgan Securities expect that Rio Tinto (RTP-N) will use its financial muscle to acquire quality assets now available at reduced prices.

“In a contracting universe, you cannot ignore the galaxy with the largest gravitational field,” the analysts write in a recent research report.

Already one of the world’s largest mining companies, Rio Tinto has a sizable war chest that could be used to acquire smaller companies struggling to survive the present bear market.

But the analysts concede that Rio Tinto, too, has also been battered, though not beaten, by the sharp fall in metal prices.

“One look at the share price performance of Rio Tinto relative to the U.K.

market gives a clear indication as to why institutional investors have been shy of the [resource] sector,” they write. “It has fallen 47% from its high last summer and underperformed the market by 50% since then.” A 10% share buyback program announced earlier this year has done little to shore up the declining share price.

However, the analysts hint that some relief might come from a major acquisition, which would “refocus attention” on Rio Tinto’s “rock solid strategy,” strong balance sheet and robust operating cash flow. And the timing is right, they point out, with the cycle in a downturn.

While there is little doubt that Rio Tinto has the resources to be a major player in acquisitions, other large majors plan to grow by swallowing smaller fish, which means competition for quality assets may be more intense than originally envisioned. Notwithstanding the paucity of top-tier acquisition targets, Morfett and Kieser submit that Rio Tinto is “well-placed to spend up to US$4 billion on new businesses.” Accordingly, they rate the shares a buy, with a 23% upside to their target price of US$49.90 per American depository receipt.

The analysts also say metal prices have fallen “too fast and too far.” They expect a muted recovery over the next 12 months and an even stronger recovery within two years. But even at current prices, they add, Rio Tinto provides relatively low-risk exposure to the resource sector for generalist investors. “Rio Tinto is the world leader in this sector and one of the few natural resources companies with a long-term track record of success and superior returns to investors.”

The analysts also see upside in Rio Tinto’s “undervalued” portfolio of long-term development projects, including Diavik Diamonds, Yandi Iron Ore, the Comalco Alumina project, Hail Creek Coal, and expansions at the Escondida copper mine in Chile. “We estimate that the net present value of these projects should increase to at least US$3 billion by 2002 from US$1.9 billion this year.”

More immediate growth is expected to come from Indonesia, reflecting Rio Tinto’s equity stake in Freeport-McMoRan Copper & Gold (FCX-N), operator of the huge and rapidly expanding Grasberg gold-copper mine in Irian Jaya.

Rio Tinto’s exposure to low gold and copper prices has been offset somewhat by its recently strong performance from iron ore and aluminum, as well as strong earnings from industrial minerals. But looking ahead, the analysts suggest that while the risk of further falls in base metals is limited, “industrial minerals could begin to suffer,” reflecting concern over the sustainability of continued growth in Europe and the U.S. These would include borates, titanium dioxide slags, talc, salt and industrial diamonds.

The analysts expect Rio Tinto to report a 13% decline in profits this year and a small 7% increase in 1999. “For this reason, the stock is unlikely to inspire investors looking for earnings momentum, but we believe it should appeal to those investing in stocks with long-term value.”