Rio Tinto: A Smart Play On Iron Ore Market Growth In 2013

Feb.27.13 | About: Rio Tinto (RIO)

With the increase in iron ore price from $115 to $145 in December 2012, the share price of Rio Tinto (NYSE:RIO) also increased from about $49 to $56 per share (in December 2012), a 14.3% increase. Rio Tinto is currently trading around $53.30 per share. The key reasons behind this jump were the panic due to the expected cyclone in the Pilbara region of Western Australia leading steel mills to replenish their stock, speculation that China would import huge amounts of iron ore in 2013, and political factors which led to many mines shutting down in India. This panic will likely not last long and the prices will come down to a more reasonable level fairly soon.

More Stable Future

70% of Rio Tinto's revenue is generated from the iron ore segment. Rio Tinto is the second largest iron ore supplier in the world. Looking at the global production of iron ore (about 253 million tonnes), Rio's contribution was nearly 80%. Interestingly, Rio Tinto is also the world's largest producer of industrial salt for the chemical industry.

With the increasing demand for steel in China and India due to increasing urbanization, Rio Tinto should benefit significantly, as the company has a strong foothold in these markets. Furthermore, as prices return to "normal," Rio Tinto should benefit significantly.

CEO Tom Albanese recently stepped down, and the person replacing him is the company's iron ore segment CEO, Sam Walsh. Tom Albanese stepped down due to a $14 billion reduction in the book value of assets bought during his tenure. These assets include $3 billion relating to Rio's Mozambique project and $11 billion relating to the Alcan project. This is significant for long-term investors as this move shows the company has no tolerance for poorly thought out business decisions.

Shedding the Fat

Rio Tinto has entered into an agreement with the Industrial Development Corporation of South Africa Limited and Hebei Iron & Steel Group to sell its 58% stake in Palabora Mining for $373 million. I welcome this move, as I believe it no longer fits with the company's portfolio.

Rio Tinto is planning to either sell off or take in a new partner for its coal unit in Mozambique. This plan is the result of infrastructural problems that are causing issues in the delivery of materials to port. The company has incurred a write down for its Mozambique assets, which are worth $3 billion and were acquired in 2011 from an Australian miner, Riversdale Mining Limited.

Conducting Efficiency Audits

At a time when commodity prices are weak and mining costs are up, the company has initiated a move to cut down spending by $7 billion and add about $5 billion in savings. I question whether such a move is possible, given the rising commodity prices alongside increasing costs of ongoing mining activity.

Rio Tinto has given a rough estimate of about $16 billion worth of investment in projects this year. The company increased its dividend by 34% to 72.5 cents per share at the end of the first half of 2012. The dividend has been contributed to mainly by virtue of the increase in its earnings from the iron ore business alone. As a result, with an expected improvement in volume, I do believe the effect of price depreciation should be outweighed by an increase in volume.

Investors looking for income should realize that Rio Tinto is not expected to deliver significant returns anytime soon. Ore prices are expected to stabilize and several of the company's projects are in early stages. The company is also in the process of several transitional moves. However, with prices remaining in the $53 to $60 per share range, returns are not going to be poor either. Rio Tinto, with a 39% dividend payout ratio, is marginally better than its competitor BHP Billiton (NYSE:BHP) at 38% and GoldCorp (NYSE:GG) at 29%.

With a 9% return on assets, Rio Tinto is a far better bet than competitors, Goldcorp at 4.7%, and Vale (NYSE:VALE) at 8.5%. This ratio will likely improve once loss-incurring operations are removed.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.