Rio Tinto: The "Stock to Own" in Mining

06/27/2017 2:52 am EST

Focus: COMMODITIES

Yiannis Mostrous

Editor, The Capitalist Times

The mining industry has tried for more than a year to improve its ways. The best companies have made real progress to effectively control production output and costs while being more disciplined with capital and increasing payouts to shareholders, observes global stock expert Yiannis Mostrous, editor of Capitalist Times.

These efforts will continue. Management teams that choose to ignore the new paradigm will drive themselves and the companies they lead to oblivion.

Geopolitical risks notwithstanding, mining equities seem to be in a consolidation phase after the recent sell-off. These stocks could see significant pick up in the third and fourth quarters and into the next year.

Cash flows are strong, deleveraging continues and demand remains stable. Profits have been improving, while shares outstanding remain unchanged or, in some cases, even shrunk.

The recent sell off has removed some “expensiveness” from commodity markets, making them more appealing to investors. And the sector trades at a discount to the market on almost every metric.

Rio Tinto (RIO) is the stock to own in this industry. The company is one of the world’s largest mining conglomerates, with major interests in copper, iron ore, coal, aluminum, mineral sands, borax, diamonds and gold. Iron ore contributes 57% of earnings.

China’s production cuts should be a positive for higher quality iron ore producers, including Rio Tinto. Note that 93 million tons of steel capacity closed in 2016, with another 50 million tons of closures planned for 2017. By the end of June, all facilities producing inferior-quality steel bars in China will be dismantled.

Rio Tinto has one of the strongest balance sheets in the industry. And it enjoys relative low gearing levels. As a result, and at current commodity prices, there could be an increase in dividends, a special dividend or more share buy backs–all of which are positives for investors.

The company doesn’t hedge its currency or commodity positions, yet consistently delivers high margins and cash flows. Rio Tinto has generated 7% free cash flow even during the low parts of the cycle. Currently, it’s generating around 10%.

This consistent and significant free cash flow yield isn’t a surprise. Management’s priority is cash flow growth instead of blind volume growth.

Operational productivity (i.e., producing more with flattish costs) is the main avenue to accomplish this goal. And right now, the company trades at a discount, with EV/EBITDA at less than four compared to the long-term average of seven.

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