Rio Tinto (NYSE:RIO) is a multi-national resources company focusing on iron ore, aluminum and copper mining and has operations in over 40 countries. The share price of Rio Tinto has been severely lagging its peers; mainly because of Rio Tinto's dependence on China's commodity demand (especially iron ore). The lagging share performance, however, gives Rio Tinto significantly more upside potential than its competitors should China continue to recover.
5-year share performance
Rio Tinto has only gained 42% over the last five years which is mainly due to weak Chinese demand for its core commodities such as iron ore and copper. Other companies fared much better: BHP Billiton (NYSE:BHP), one of Rio Tinto's closest competitors, has gained 120% and Freeport-McMoRan (NYSE:FCX) more than 200%. Only Vale (NYSE:VALE), the Brazilian mining corporation with a market cap of $83 billion, produced an equally disappointing return: The shares increased a mere 39%.
China's urbanization trend will drive commodity demand
Rio Tinto operates a global mining network, but remains heavily dependent on China. Chinese construction and manufacturing activity took a beating over the last quarters as it became apparent that the economy was on the brink of overheating due to misguided, speculative and debt-financed real estate investments. Naturally, growth slowed so that resources in the economy could be redirected to their most productive use. Despite short-term challenges I believe the fundamental trends in China are intact: A migration of rural populations to the cities and wide-ranging infrastructure updates to accommodate the flow of people and goods. The China in 20 years will look very different from the China today. The rural population still dominates China but constant migration and the hopes of better economic prospects in Chinese cities will drive more rural workers out of their agricultural jobs. Rio Tinto will have a front seat in playing the reinforcing urbanization trend and is well positioned with its iron ore operations in the Pilbara, Australia, to supply China with the necessary commodities to expand and upgrade its economy.
Given the strong, secular growth trend in China, Rio Tinto's forward P/E ratio does not fully reflect the earnings prospects that come with it. Rio Tinto trades just below 10 times forward earnings. The average company in the peer group, consisting of large-cap mining conglomerates with large-scale operations, only trades at 10.67x forward earnings indicating that the entire sector trades at a discount to its cash flow- and earnings prospects.
Mining companies, especially the ones with a focus on iron ore, have been beaten down after the Chinese economy began in 2011 to grow at a rate below its long-term growth rate of around 10-11% per year. Lower valuations also lead to higher dividend yields, assuming of course, payouts aren't reduced. The dividend yields in the sector are now quite attractive and an improving Chinese economy could turbo charge cash flows and earnings, particularly in Rio Tinto's iron ore unit. Higher earnings driven by China also increase the likelihood of rising distributions in form of dividends in the future. Rio Tinto has a dividend yield of 3.16%.
Rio Tinto currently trades at a 6% discount to the peer group average P/E ratio of 10.67 which by itself is a very low valuation. A low P/E ratio provides investors with limited downside risk while strong future earnings power can be bought at a discount.
Rio Tinto's core iron ore assets have strong rebound potential once Chinese demand catches up. Rio Tinto's Pilbara operations are likely to show their full value only when the mines operate on full capacity and commodity prices increase as well. Rio Tinto's share price has the potential to double in that scenario: Strong EPS growth, operating cash flow improvements from a mean-reverting iron ore price, multiple expansion, a low valuation and a lagging share performance compared to peers could all help to propel Rio Tinto to higher valuation levels. I believe that once the market has fully absorbed that China has returned to its long-term growth path, iron ore prices will have already rebounded. Given the current low valuation with an earnings yield above 10%, a decent dividend yield of 3.16% and strong upside potential from its iron ore business, I believe Rio Tinto is a Strong, anti-cyclical BUY for investors who want to play a China rebound.
Disclosure: I am long VALE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.