Rio Tinto Set For The Next Mining Cycle Upwards

Aug.11.14 | About: Rio Tinto (RIO)

Summary

Past the industry bottom, investors in cyclical mining stocks like Rio Tinto have the best opportunity for share price gains by buying early in the cycle.

Cost cutting, lower capex and the lowest operational costs yet support earnings. Debt can be paid down and a capital return via special dividend or share buyback becomes more possible.

Long-term, market leaders with the best profit margins and deepest pockets for future growth have the best chance of raising share prices and paying decent dividends.

Since Rio Tinto (NYSE:RIO), as big as it is in iron ore mining, is still in a cyclical industry, the best way to get the most out of share price gains is to buy it at or just past cyclical lows. As you can see in the chart, two major buy points would have been mid-2003 and late 2008 when the stock was $20. Investors could have more than doubled their investments.

Rio Tinto plc Click to enlarge

Source: Yahoo Finance

From 2003 to now, the share price has almost tripled from about $20 to its current $57.48, for a compounded 10% annual increase.

After the GFC and mini-mining boom driven by Chinese iron ore imports, the "above the mean" price movement has been equalized. Now I think the worst of the mining cycle is over- the excess has been wiped away- and with a stable bottom established, long-term investors should be positioning themselves for the climb up to the next cyclical peak.

The reasons can be found in the 2014 half year results media release released this month.

Operational costs

Rio Tinto revealed that its operational unit costs, excluding royalties and freight, were about $20 a tonne for the half year. Although the iron ore spot price weakened, Rio Tinto had a better buffer as the lowest cost producer. Its average realised sale price was $99 per wet metric tonne.

With all the cost cutting they are doing, I don't see much more room to go below that unit price, though the spot price could sink based on regular supply-demand issues. The main driver of that issue is Chinese iron ore demand.

Rio Tinto estimates that Chinese iron ore demand will rise generally about 3% - 4% annually. China may not be exporting as much steel as it did several years ago, but according to a World Bank report by 2030 approximately 25% of its population is projected to move from rural to urban areas. That comes out to about 300 million people.

Demand for steel, aluminum and copper will steadily rise to construct roads, buildings, housing, service industries, etc. to meet the needs of these new city dwellers. This could put a floor on iron ore prices, and underline the bottom of the cycle. Rio Tinto produces all three of the materials needed, but about 90% of its underlying earnings come from iron ore.

(As a personal note, I recently visited Beijing and Xi'an, and the expansion of construction was pervasive. Yes, there could very well be a construction glut of new residential buildings, but as I rode in the taxi from Xi'an's city centre to the airport, there were areas that had block after block after block of either newly constructed or under construction buildings. This gave me the perspective of how much construction material would have to be used in the future to prepare for such a mass move into the cities.)

Increased iron ore production and export supply-demand

Rio Tinto was able to hit its target of producing capacity to 290 million tonnes annually, and is pressing on towards the next target of 360 million. Other mining majors like BHP Billiton (NYSE:BHP) and Fortescue Metals Group (OTCQX:FSUGY) are also on a mad dash to raise their production volumes as well.

Logic might say that they are cutting their own profits by flooding the export market, of which about 60% - 70% goes to China as it is. As someone who has experience in property investing and development, I saw it similar to towards the end of a property boom, with developers just trying to produce as many houses as they can to keep up earnings, even if profit margins suffer.

Also, like a supermarket dealing with discounted items, the company can still make the same profit if higher volumes offset lower unit prices.

Rio Tinto's advantage here, similar to BHP Billiton, is that its iron ore is of a higher-grade, which can attract a premium price compared to lower grades. Surprisingly, the premium is coming somewhat from the fact that pollution in China's major cities is so bad, that lower-grade iron ore, which has more impurities that cause pollution, is becoming frowned upon.

So what's happening is the extra 150 million tonnes that the big three companies above have pumped into the market recently is driving lower-grade miners out of the market. Rio Tinto expects about 125 million tonnes of lower-grade ore will exit the market in 2014, some of it actually from small, less-efficient domestic miners in China (see half year results release, page 5).

In a two-fold strategy, Rio Tinto can maintain and even boost its own earnings by increasing production and at the same time squeeze small competitors out by making them less profitable. This is a classic long-term investing characteristic you look for in market leaders- being able to survive with decent profits when smaller competitors with now thin margins get marginalized.

Capex and capital returns

Along with its cost cutting programs to cut away the fat in the system, capex costs are also coming down because the output expansion programs are nearing their targets, so they are moving from development to the production phase.

This can either open up funding for other projects or widen earnings margins, but the possibility of capital returns and special dividends is now better than ever. With the 21% increase in interim underlying net earnings achieved, Rio Tinto has raised the interim dividend 15% from US 83.5 cents per share to 96 cps.

After reducing its net debt by $1.9 billion to $16.1 billion, there is still capacity to have a capital return. It could be a special dividend, yet a share buyback would be better appreciated by shareholders. At this time the company hasn't stated which it will be, but has expressed an intention to return capital at some point. This could be seen as a way to appease investors while the share price goes sideways.

What I see from here…

Taking the long-term investor view, we're past the low point of the cycle, so the biggest share price appreciation opportunities are now. Iron ore and copper, two materials China will definitely need over many, many years are the biggest money earners for Rio Tinto.

Higher production will support earnings levels and further squeeze out smaller competitors. If share prices don't rocket up over this, don't be surprised. However, growing dividends plus a potential capital return could boost portfolio income for years to come.

In the short-term, I think Rio Tinto's share price could get back up to about $65 before being really challenged. It has come close to the $60 mark already two times since early 2012, with higher lows along the way. The market is seeing the worst is in the past, so further earnings improvements will justify pushing it up.

This is a buying opportunity for both the short- and long-term.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.