I believe Rio Tinto (RIO) is undervalued due to a misconception of Chinese industrial production (IP) growth and lower than expected iron ore supply. While there is lower than expected aggregate supply, RIO just reported a 12% growth in their iron ore production as well as a 13% q/q increase in coal production. It is evident that RIO’s production is healthy and a stronger second half of 2011 is to be expected.

RIO is priced for an unmoved Chinese IP and GDP growth. With the June numbers in, it is apparent this is not the case.

RIO did mention that bad weather in Australia has affected the reliability of the country’s transportation infrastructure. This is actually a blessing in disguise as problems in infrastructure keep supply from running away.

Another development keeping supply levels in check are the countless production issues facing iron ore mines.

While management does realize iron ore is their bread and butter, they have been making changes to weather the impact of an iron ore supply glut by aggressively investing in other mining products.

Although the near term future looks bright for RIO, there are some long term concerns to be aware of, namely an unexpected Chinese slowdown, which would seriously affect the demand to supply ratio.

Using 5 year averages for valuation metrics (PEG, FPE, PB and PS) I came up with a three stage exit plan that accounts for the uncertainty in RIO’s future.

Incorrect Chinese-Growth Based Pricing

RIO’s current pricing is based too heavily on investors’ worries about Chinese growth due to Beijing’s current inflation-combative policies. Not only did June’s economic numbers put worries about potential negative growth to rest, they actually convinced analysts that China will not be having a hard landing. In fact, rather than shrinking, China’s IP grew at a rate of 15.1% in June and GDP growth came in at 9.5%. This means that China’s IP should continue to flourish, which is very good news for RIO’s iron ore business.

Recent Barriers to Iron Ore Supply Glut

According to a report by Citigroup, Australian exports account for about 42% of global iron ore production. Therefore, when worries arise about the ability of the country’s transportation system (seaports and trains) to keep up with production, it is natural to assume that supply won’t be a high as in normal working conditions. For this reason I believe that this development will actually help RIO’s profitability. If global supply is lower this year than last year, yet Chinese productivity increases, it’s easy to see that there is going to be a surplus of demand for iron ore in 2011.

Also a contributing factor to this barrier is the recent setbacks in global iron ore production due to bad weather and behind schedule mine installation. Some mines that were supposed to be producing by 2014 have now been rescheduled to 2015. Vale (VALE), the Brazilian mining company, lowered its iron ore 2015 production target due to these setbacks. The unseasonably bad weather this past year has also caused mines to stop production in the interest of workers’ safety. Without mines producing a full capacity, the chance of aggregate production reaching estimates becomes more unlikely.

Portfolio Diversification

Management has become aware of their exposure to iron ore and have been expanding their product segments that are not tied as tightly to global supply and demand. These divisions are aluminum, copper, diamonds & minerals and energy. Earnings from copper sales increased by $656 million from 2009 to 2010. Energy more than doubled its earnings contribution from $1.167B in 2009 to $2.432B in 2010. The Riversdale acquisition was proof an effort to increase this diversification, as Riversdale is an anthracite coal miner. Naturally a mining company is going to be exposed to any broad based commodities moves, but reducing their dependence on one commodity should moderate their sales volatility.

Inherent Risks

Even though the rest of 2011 looks promising for RIO, there are some risks that we need to be aware of. The most obvious risk is an unexpected slow down from China. If this happens, their appetite for iron ore could fall and due to their portion of the global demand, push prices down with it. Another supply-linked risk is iron ore mine production proceeding as planned. If the original level of production is met, a supply glut could form much more quickly than anticipated. Even with both of these factors not occurring, a future supply glut is a very real possibility. While these factors would save the demand surplus in the medium term, by 2015 at the latest, a supply surplus is expected. This is why I am pitching RIO as a medium-term investment and to get out before the supply glut is realized.

Valuation and Price Target

I used the 5 year averages of the PEG ratio, forward PE multiple, price-to-book ratio and price-to-sales ratio as basis for my price target. I felt the 5 year average is a valid price target because of the iron ore pricing pressures expected in the coming years. Investors pay up for future growth but RIO will have growth issues as iron ore supply outpaces demand. The PEG average implied a price target of $35.17, the forward PE average implied a price target of $106.49, the price-to-book average implies a price target of $129.43 and the price-to-sales average implied a price target of $92.78.

Even though the PEG ratio implication is scary at half the current share price, I felt its inclusion helped the final price target account for expected growth. However, weighting it equal to the other valuations is justified due my short time frame of 6 to 12 months, rather than the 5 year time frame used to compute a PEG ratio. Averaging the price targets from each metric gives an aggregate price target of about $90. Due to all the uncertainty surrounding iron ore’s future, I feel it’s necessary to sell off a position in three segments – one for each $5 increment, starting at $80. Therefore the exit plan would be to sell a third at $80, another third at $85 and the final third at $90. This way profits can be made all the way up to the price target and the entire investment doesn’t rest on RIO reaching $90. Naturally any developments in the iron ore industry or in China’s growth would need to be followed by a reassessment of my investment thesis.