Rio Tinto: Death Knell or Opportunity?

01/30/2014 8:00 am EST

Focus: STOCKS

Yiannis Mostrous

Editor, The Capitalist Times

Investor sentiment toward mining companies has soured considerably over the past few years, as growing production, and slowing demand in China and other emerging markets have weighed on commodity prices, recalls Yiannis Mostrous, editor at Capitalist Times.

With many pundits sounding the death knell for the commodities super-cycle, mining stocks have underperformed dramatically; the Bloomberg World Mining Index of 108 of leading mining stocks, has fallen 43% over the past three years.

However, history should give investors hope. Over the past two decades, mining stocks have delivered solid returns on two occasions when commodity prices declined.

The trick: Lower capital expenditures, and debt levels that enabled the industry's best-positioned players to expand their price-to-earnings multiples.

Mining companies have returned to this playbook during the most recent swoon, cutting capital expenditures aggressively, slashing costs, paying down debt, and avoiding expensive mergers and acquisitions.

Rio Tinto (RIO) should appear toward the top of investors' shopping lists. The company operates primarily in developed nations, a geographic footprint that ensures a more straightforward operating environment than in emerging economies.

The firm has worked diligently to decrease its debt levels and rationalize its capital expenditures, slashing US$2 billion in costs last year as part of an effort to deliver US$5 billion in savings. It reduced its exploration-related spending by US$800 million in 2013 and will likely maintain this level of expenditures in 2014.

The company has demonstrated a willingness to part with assets that don't fit its strategy, recently agreeing to sell its 50.1% interest in the Clermont thermal coal mine in Queensland to Glencore Xstrata for US$1 billion.

In 2013, the company divested about US$3 billion worth of assets. The majority of these sales will close in 2014, with the proceeds expected to reduce Rio Tinto's debt.

Iron ore accounts for about 43% of Rio Tinto's revenue and 70% of its earnings. Although the company boasts some of the world's best iron ore mines, this commodity's price suffered its weakest December in five years. If steel production contracts dramatically in China, the price of iron ore will decline even further.

We expect iron ore prices to slip once again in 2014; however, these declines won't live up to bearish calls for the commodity to sink to US$80.00 per ton this year. China's steel production will slow, but not to an extent that would push the iron ore market into a structural surplus.

Trading at 9.1 times forward earnings and offering a dividend yield of 3.3%, Rio Tinto's American depositary receipt (ADR) rates a buy up to $55.

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