US Edition Rio Tinto
£43.75 -75p
Questor says BUY
Analysts at RBS were clear on what they wanted Rio to do with all the money coming through the door. "Our preferred method of deploying cash would be through a material and sustainable increase in dividends," they said. The analysts calculated that the group could find itself with cash balances in the order of $28bn (£17.5bn) next year.
Current consensus figures forecast a material dividend increase when the full numbers are released on February 10. It is expected that the dividend will more than double this year to $1.03 from 45c last year. However, this is from a low base as the payment was skipped during the downturn when the company sought to repair its balance sheet.
It is clear that many want a sharp increase in the dividend – but for companies in cyclical businesses this is a risk. Markets, especially the UK market, punish companies when the dividend is cut. The payment has to be sustainable even in difficult times, and that is why Questor thinks it is more likely that Rio will employ a slow-but-steady share buy-back approach rather than opt for large increases in the payout.
The company also has a substantial capital investment programme, in which it plans to spend about $13bn this year investing in mines. Rio also has a massive five-year programme of investment in the Pilbara region of Western Australia to increase production of steel-making ingredient iron ore.
Iron ore prices have soared since the pricing mechanism was changed to a quarterly system and it is now expected to contribute 65pc of operating profits when the full 2010 numbers are released. Copper is forecast to be about 17pc, aluminium at 8pc, coal 7pc, with diamonds, uranium and other minerals making up the remaining 3pc or so.
This means that Rio, the third-largest diversified miner in the world, is not quite as diversified as it could be. It has major exposure to iron ore. Because of high prices, a substantial amount of investment in new iron ore supply has been announced all over the world. Once this production comes on stream, prices are likely to retrench.
However, it takes a long time for new projects to come on stream, so the company can make hay from iron ore for some time. There is also some scepticism in the industry as whether all the projects are feasible.
Copper, however, has been a concern. Rio has been suffering from falling grades – and 2010 copper production fell by 16pc on a year-on-year basis – but it is working to rectify this.
Issues at Oyu Tolgoi in Mongolia with partner Ivanhoe are slowly resolving themselves, after it announced a funding deal in December. Rio has taken on the management from Ivanhoe – but no copper production is expected until at least 2012.
One other risk for the mining sector – one that is unquantifiable at this point – is the threat of emergency taxation in Australia following the devastating floods in Queensland. A massive reconstruction project will have to be funded from somewhere – and there are precedents for taxing miners more heavily at times of crisis.
Following the devastating earthquake in Chile last year, miners have agreed to a new royalty scheme that will link tax payments to margins to cash in on high copper prices.
However, the development of China and India will keep demand for Rio's products high and the company will throw off cash for some time to come.
The shares are trading on a December 2011 earnings multiple of 7.9 times and yielding 1.3pc. They were tipped on May 4 last year at £33.79 and they have risen 29pc compared with a FTSE 100 up 10pc.
Buy.
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