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Stock Of The Day - RIO TINTO (BUY)

RIO CEO Sam Walsh presented an update on 12 May 2015 in Bank of America Merill Lynch Global Mining and Steel conference; whose main highlights were improvement in balance sheet strength and reduction in costs due to improved operational efficiency. The company has delivered a 64% return to shareholders in form of dividend return and returns through share buy backs from the period 2013 to 2014.  


The company has identified six critical value drivers that have enabled it to deliver such results. 


Critical Value Drivers (Source  - Company Reports)

At the heart of Rio’s strategy is its world-class portfolio of assets. They also have a compelling pipe- line of near term and longer dated projects across the portfolio. RIO operates in the entire value chain from exploration and evaluation of minerals, development of sites, mining, marketing & delivering as well as closing and rehabilitation. The company adds value at every stage, in the way RIO develops and operates the assets, the way it markets the minerals it produces and the legacy it leaves at the end of the asset’s life. By reinforcing capital discipline and reshaping the projects the company has retained significant high quality growth despite significantly reducing the capital expenditure. The capital expenditure has reduced by $9.4 billion over the 2012 to 2014 period.



Dividend Growth (Source - Company Reports)

The improved balance sheet strength is reflected in cost reductions and expenditures. The company has reduced operating, evaluating and exploring costs by $4.8 billion by the end of 2014 as compared to 2012. The company’s net debt has reduced by $9.6 billion from its peak on 30 June 2013. The company has completed $3.9 billion of divestments since January 2013. The company has released working capital of $2.1 billion by the end of 2014 as compared to 2012.  In a cyclical and capital-intensive industry such as mining a strong balance sheet is essential in order to preserve optionality and generate shareholder wealth at all points in the cycle. 



Global Growth (Source - Company Reports)
 
Operational efficiency is also one of the key’s to achieve the company strategy. The company has maintained its EBITDA margins in the range of 44% to 75% over the last 15 months, with average EBITDA being 63%. The sustaining capital expenditure was down to $3.5 per tonne, while the average has been $5 per tonne, in the last four years. The company has maintained a lost time injury frequency rate of less than 0.5 per 200,000 hours worked for the last 7 years  (a well run operation is a safe operation).


Iron Ore Demand (Source - Company Reports)
 
The company has a consistent and disciplined approach to capital allocation. The first allocation is to essential sustaining capital for its operations. Next in priority is the primary contact with the shareholders – the progressive dividend. Finally RIO assesses the best use of remaining capital between alternatives of compelling growth, debt reduction, and further cash return to shareholders. The company has reduced net debt to 19% (net debt / (net debt + book value of equity)). The company maintains a low gearing ratio and high dividend growth ratio (as measured over the period 2011-2014) and is among the few companies in the peer set to do so. 


Key Highlights (Source - Company Reports)

The company has survived a period of economic adjustment that followed the 2008 financial crisis. There are signs of global recovery with World Real GDP Growth projected to be at 4% for the next few years (according to IMF estimates).  The demand for RIO’s products and services will come from emerging economies, which will more than offset a slowing demand from China (it will continue to grow at a slower rate on a larger base in China). China will still account for the majority of contestable iron ore demand, with replacement infrastructure offsetting the slowdown in demand for new infrastructure. The demand for manufacturing goods is also increasing in China and so is the demand due to exports. Rising steel output in ASEAN and Indian markets will lead to increase in demand of Iron ore.
 
The company is currently trading at a price of $56.750, at a dividend yield of 4.51% and a Price to Earnings (P/E) ratio of 13.18. Few of its industry peers are trading at such an attractive combination of low Price to Earnings and high dividend yield.


RIO Chart (Source - Thomson Reuters)

Given the strength of RIO’s balance sheet and strong operating results, the company is in strong position to take advantage of the long-term fundamentals in the sector. We believe that the stock is worth buying at the current price of $56.750.