Rio Tinto Will Reward Investors

Summary

• Rio Tinto has decided to sell its Australian coal assets to Chinese buyers for $2.69 billion.
• The sale should further solidify the company's financial health.
• The company is now well positioned to return excess cash to shareholders by increasing dividends or ramping up buybacks.

Rio Tinto (NYSE:RIO), one of the world's largest diversified miners, has moved closer towards selling its Australian coal assets. The Anglo-Australian company looks well positioned to boost shareholder value in the short term. I believe this might be a good time to load up on this high-dividend stock.

Rio Tinto shareholders have recently given an overwhelming approval, with 97.2% votes, to sell a large chunk of the company's thermal coal assets, located in Australia's Hunter Valley, to Yancoal Australia (OTCPK:YACAF), a Chinese state-backed miner, for $2.45 billion in cash and $240 million in royalty payments.

Yancoal will get its hands on high-quality thermal coal, which is used in electricity generation. But the real beneficiary will be Rio Tinto which will be successful in unloading a major asset at a great price. Rio Tinto has been trying to sell its Australian thermal coal business, which was valued at around $2 billion by analysts, since at least 2015. The company was able to attract two major buyers – Yancoal and the commodities trader Glencore (OTCPK:GLCNF, OTCPK:GLNCY). A bidding war ensued which pushed the price to well over analysts' estimates. Rio Tinto ended up selling to the highest bidder Yancoal which not only offered $15 million more than Glencore but also promised to pay a $225 million break fee if the deal fell apart. Yancoal can also close the deal by as soon as 3Q17, which is sooner than the expected 1H18 closure with Glencore.

The transaction will finally bring an end to the uncertainty surrounding the fate of Rio Tinto's thermal coal business. In addition to this, the asset sale will further solidify the company's already strong financial health.

Last year, Rio Tinto managed to significantly improve its financial health by net debt (total debt minus cash reserves) falling to $9.59 billion from $13.78 billion at the end of 2015. This improved the company's leverage, measured in terms of net debt-to-EBITDA ratio, from more than 1x in 2015 to almost 0.7x in 2016, which is one of the lowest in the industry. Its debt has already dropped further by $2.5 billion (gross debt) after the company closed its bond tender and redemption exercise in June. At the same time, the sale of Australian coal assets will push its cash reserves, which were $8.56 billion at the end of last year, higher. That should further improve the company's leverage metric.

Rio Tinto also generates strong levels of cash flows. Even in 2015, when the price of iron ore and other commodities plunged, the company generated $622 million of cash flows in excess of capital expenditure and dividends. That excess increased to $2.73 billion in 2016, thanks in large part to improvement in iron ore prices. I believe the company is well positioned to continue reporting strong levels of excess cash flows due to the strength in iron ore prices, cost-cutting efforts (planned $2B of cost savings for 2016-17) and mine-to-market productivity initiative.

Remember that iron ore prices have fallen to almost $65 per tonne at the time of this writing, as per data from Metal Bulletin, after peaking at $95 in February. The drop has been triggered by the mounting concerns regarding increase in supplies from low-cost operators, particularly the Brazilian mining giant Vale (VALE). Vale, which is the world's largest iron ore producer, aims to increase production by 6.1% this year to the range of 360 million to 380 million tonnes. The increase will be driven by the company's S11D mine, one of the world's largest and lowest cost mining projects, which came online last year. Increase in low-cost supplies could keep a lid on any price appreciation.

That being said, the current price level of around $60 is still substantially higher than last year's average FOB price of $53.60. The iron ore price for 2017 will likely end up being higher than last year's average, which should have a positive impact on the Rio Tinto's cash flows. That should offset the negative impact of higher capital expenditure which is forecasted to climb from around $3 billion last year to $5 billion in 2017. Consequently, the company will likely continue reporting strong levels of excess cash flows. This, coupled with reduction in debt levels, should allow Rio Tinto to return cash to shareholders by increasing dividends. The company already offers an attractive dividend yield of 4.1%, which is substantially higher than the industry's average of 1.8%, as per data from Thomson Reuters. In addition to this, Rio Tinto can also use its strong financial health to ramp up the existing $500 million buyback program which ends in December. Either way, the company looks well positioned to reward shareholders.

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Analyst’s 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.