Investment Comment Overlooking Rio Algom’s pluses could mean

From a high of $28 last spring, the shares of Rio Algom have recently dropped to under $20. Over the past month or so, the market has focused on the company’s negatives — its abandonment of the East Kemptville tin project and the need for additional expenditures on the Potash Co. of America’s potash mine in Saskatchewan. In doing so, the market has overlooked Rio’s strength but at the same time, it has presented a buying opportunity to investors.

So writes Wood Gundy’s Electa Aust in a recent research report. “We believe,” she says, “that Rio Algom shares offer good value at current price levels and we recommend purchase.” At the time of the report Rio shares were trading at $20. At presstime the shares were trading at about the $20.63 level. Tin troubles

Describing the company’s troubles with tin as “not unexpected,” Ms Aust notes Rio’s transfer of ownership in the East Kemptville project to the banking group which financed the majority of the capital cost of the project will likely result in a writeoff of $20 million in the company’s year-end statement.

This writeoff will actually have a positive impact on the Wood Gundy forecast of earnings and return on equity for Rio, says Ms Aust, as it had been assumed the tin property would contribute an earnings loss this year and next.

To the argument that this move by Rio will damage the company’s relations with the banks, Ms Aust has a 3-fold response.

* The $155-million project loan was syndicated to include several banks, the largest exposure being taken by Bank of America. Little, if any, damage will be done to Rio’s relations with the Canadian banking community. The backing of Rio’s parent, Rio Tinto Zinc, will likely provide Rio Algom with access to international markets in any event.

* The failure of the tin pro ject was a result of the tin cartel collapse and the ensuing tin price decline. Although technically there were some start-up problems, these were well on the way to being resolved, says Ms Aust. In lending money to finance commodity- backed projects, banks have always assumed a degree of risk predicated on the price movements of the commodity in question. The collapse of tin prices caused this particular project to go sour for the banks. “To single Rio out as the villain in this case ignores the realities of the world of commodities,” says Ms Aust.

* In financing the $170-million capital cost of the project with the $155-million limited recourse debt, Rio’s managment took the burden of risk off the shoulders of the common shareholders and placed it on those of the banks. “A company that protects its shareholders against the risk of a high-risk business such as mining is only being prudent, in our estimation,” she says.

Potash is long-term

Ms Aust describes Rio’s purchase of the outstanding shares of Potash Co. of America as a long- term investment with the potash price continuing to be the most critical variable in the profit equation for PCA.

PCA’s assets are a potash mine in Saskatchewan and another in New Brunswick. Rio’s purchase of these assets was based on two assumptions: that the potash market would ultimately improve and that the New Brunswick operation could be turned around. The company has been successful in improving the New Brunswick operation, a fact that the market is overlooking, says Ms Aust, adding that the improvement in the potash market is yet to come.

However, even with low commodity prices, the New Brunswick mine is expected to report breakeven operating profits, after depreciation, this year, she says.

The Saskatchewan operation has been reporting a small profit despite low potash prices. Some $15 to $20 million is slated to rectify water problems at the operation. The required expenditure will be largely made this year and will be capitalized and amortized over roughly 20 years. This will result in a decline in Rio’s earnings of 1 cents per share, a minimal impact, she notes. Company is strong

Rio has strengths which are being overlooked, stresses Ms Aust. One strength is its ownership in Lornex Mining Corp., which shares with Cominco its ownership of the Highland Valley Copper mine in B.C.

By 1988 this mine will be the largest North American copper producer with production in the order of 400 million lb per year at an average cost of under 55 cents per lb. Rio’s leverage to copper, through its Lornex interest, will be very significant at 45 cents per share for each 10 cents (US) per lb change in the copper price.

Rio’s uranium operation will continue to generate $65 to $70 million in operating profits for the company. The uranium market is now in supply/demand balance and the spot price has been firming, albeit slowly, she writes. As a major uranium producer, Canada may generally benefit if South African uranium purchases are reduced as a result of economic sanctions against this country, she adds.

Over the past two years, Rio has made two investments in the steel area, both proving profitable and contributing to sustaining Rio’s earnings in times of weak commodity prices, she says. Healthy financials

Rio is a company of vigorous financial strength, with a debt-to- common equity ratio of 0.45:1 by year-end. After capital expenditure and debt repayment, the company’s free cash flow should be in the order of $100 to $120 million or $2.35 to $2.80 per share per annum. At the end of September Rio had $5.44 per share in cash.

The most compelling argument for the purchase of Rio shares is that the company as of the end of September had $16 per share in working capital. Of that amount, $5.44 is in the form of cash, the remainder is in inventory.

In addition, Rio shares are trading at 9.5 times the 1986 earnings per share estimate of $2.10, 10.3 times the 1987 estimate of $1.95 and 9.3 times of the 1988 estimate of $2.15.

These are low multiples relative to the market at 13 times, relative to other mining stocks at 15 times and relative to Rio’s historical 10- to 15-year average P/E multiples of over 12 times.

Rio is expected to earn a 12% to 14% return on equity and the stock is trading at 1.2 to 1.3 times its book value. This is in line with the historical valuation of Rio shares but these figures currently render the shares undervalued relative to the market, which is trading at 1.5 times its book value and earning only a 9.5% return on equity.

On a price-to-cash-flow basis, Rio’s shares are trading at about 4.5 times cash flow estimates for the 1986 to 1988 period. This figure compares with an average of 8 times for most base metal mining shares and the company’s 10- and 15-year average of over 5 times, says Ms Aust.

“We believe Rio’s shares should trade at a price-to earnings multiple of 12 to 13 times, a price to book value ratio of 1.5 times and a 6 times multiple of cash flow,” says Ms Aust. These valuations make Rio’s shares more comparable with the market, other mining shares and Rio’s historical value. They yield a target on Rio shares of $24 to $25.