Is Now The Right Time To Consider Rio Tinto?

| About: Rio Tinto (RIO)
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Summary

In my view, RIO's stock is well positioned to achieve high capital gains when commodity prices start to recover.

The shift in RIO's dividend policy makes sense, and a yield of about 4% is pretty satisfactory while waiting to price appreciation when commodity prices start to recover.

Iron ore, which in December fell as low as $35, was at about $53 a tonne at the end of the quarter, which is a very positive development for RIO.

Despite a challenging environment of weak commodity prices, Rio Tinto (NYSE:RIO) delivered a strong performance in 2015. The company has responded to the commodity price downturn by cutting costs, selling non-core assets, and reducing capital spending. In my view, RIO is well positioned to return to growth when commodity prices start to recover. Commodity prices are moving in cycles, and lower capital expenditures on exploration and production will eventually cause commodity prices to rebound. While waiting for a significant capital gain along a rebound in commodity prices, investors can be satisfied with the dividend payment. Although the company has cut its future dividend payment, the forward yield is still pretty high at 4%.

Rio Tinto is one of the world's largest mining companies, and its products include iron ore, aluminum, coal, copper, borates, diamonds, and gold.

Data: Company report

Year to date, RIO's stock is down 6.2% while the S&P 500 index has increased 0.1%, and the Nasdaq Composite Index has lost 3.3%. Moreover, since the beginning of 2012, RIO has lost 44.2%, in this period, the S&P 500 Index has increased 62.6%, and the Nasdaq Composite Index has risen 85.9%.

RIO Daily Chart

RIO Weekly Chart

Charts: TradeStation Group, Inc.

On February 11, Rio Tinto reported its full year 2015 financial results. The company posted 2015 adjusted earnings of $2.49 per ADR, down 50% from $5.03 in 2014. Sales fell 27% from the prior year, driven by lower commodity prices.

In the report, Rio Tinto chief executive Sam Walsh said:

Against a highly challenging environment, Rio Tinto delivered a strong performance in 2015 with underlying earnings of $4.5 billion. We continued to take decisive action to preserve cash through further cost reductions, lower capital expenditure and the release of working capital. This focus on cash resulted in operating cash flows of $9.4 billion. At the same time, we have significantly strengthened our balance sheet and finished 2015 with net debt of $13.8 billion, which is $700 million better than the $14.5 billion pro-forma position at the end of 2014.

According to the company, the continued deterioration in the macro environment has generated widespread market uncertainty. However, in my view, the company is taking the right steps to deal with the challenging market. It is embarking on a new round of proactive measures to cut its operating costs by a further $1 billion in 2016 followed by an additional goal of $1 billion in 2017. RIO is also reducing its capital expenditure to $4 billion in 2016 and $5 billion in 2017, an overall reduction of $3 billion compared with our previous guidance. The company believes that these significant actions provide it with the confidence that it remains robustly positioned to maintain both balance sheet strength and deliver shareholder returns through the cycle.

Along with its full year 2015 earnings report, the company said that it would switch from its current progressive dividend policy to a more flexible payout based on actual earnings, business conditions, and the outlook for primary commodities. According to the company, over the past five years, it has returned more than $25 billion to its shareholders, underlining its commitment to shareholder returns. However, with the continuing uncertain market outlook, the Board believes that maintaining the current progressive dividend policy would constrain the business and act against shareholders' long-term interests. The company pays dividends twice a year, in April and September, and it announced that it will make its next payment of $1.073 per ADR on April 7 which corresponds to an annual yield of $7.86%, and switch to the new dividend policy in September. Also, RIO said that it intends that the full year dividend will not be less than $1.10 per share, which corresponds to an annual yield of 4.0% at the current stock price. All in all, the company returned $6.1 billion to shareholders in 2015 including the 2014 final dividend of $2.2 billion, the 2015 interim dividend of $1.9 billion and $2.0 billion of share buy-backs. As I see it, the shift in the company's dividend policy makes sense, and a yield of about 4% is pretty satisfactory while waiting to price appreciation when commodity prices start to recover.

Iron Ore

Iron Ore is RIO's largest business unit, accounted for 41.6% of 2015 group revenues and 59% of EBITDA ($7.9 billion). China is by far the biggest iron ore consumer. China's GDP growth slowed moderately to just below 7% in 2015. This weaker Chinese demand led to a further deepening of the cyclical downturn in most commodity markets in 2015. The iron ore price dipped below $40 per dry metric tonne towards the end of the year, representing an 80% fall from the peak of the market in 2011. According to RIO, given China's exposure to property and investment trends, domestic finished steel consumption there decreased by between four and five percent. China's iron ore requirement proved more stable due to a combination of record steel exports and a declining share in scrap use. Nevertheless, this was far from sufficient to absorb the growth in low-cost seaborne supplies. Price pressures led to about 130 million tonnes in high-cost production cuts from China and non-traditional seaborne suppliers, in addition to the 125 million tonnes of exits in 2014. However, Iron ore price was up almost 25% at the end of the March quarter. Iron ore, which in December 2015 fell as low as $35, was at about $53 a tonne at the end of the quarter, which is a very positive development for the company. The rally in iron ore prices, reflecting strengthening Chinese steel prices and increased production ahead of the country's key construction season.

Source: barchart.com

Valuation

RIO's valuation is very good, the forward P/E is low at 11.63, and the PEG ratio is also low at 1.03. Furthermore, the Enterprise Value/EBITDA ratio is very low at 6.04. According to James P. O'Shaughnessy, the Enterprise Value/EBITDA ratio is the best-performing single value factor. In his impressive book "What Works on Wall Street," Mr. O'Shaughnessy demonstrates that 46 years back testing, from 1963 to 2009, have shown that companies with the lowest EV/EBITDA ratio have given the best return.

Summary

Despite a challenging environment of weak commodity prices, Rio Tinto delivered a strong performance in 2015. The company has responded to the commodity price downturn by cutting costs, selling noncore assets, and reducing capital spending. Iron ore price was up almost 25% at the end of the March quarter. Iron ore, which in December 2015 fell as low as $35, was at about $53 a tonne at the end of the quarter, which is a very positive development for the company. RIO's valuation is very good, the forward P/E is low at 11.63, and the Enterprise Value/EBITDA ratio is very low at 6.04. Moreover, the company returns substantial capital to its shareholders by stock buyback and dividend payments. In my view, RIO's stock is well positioned to achieve high capital gains when commodity prices start to recover.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.