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High Headroom Convinces Me Rio Tinto plc Is A Buy

The difficulties experienced by mining companies such as Rio Tinto (LSE: RIO) (NYSE: RIO.US) over the last year or so have left many investors feeling concerned.

Indeed, falling demand for metals such as iron ore (in which Rio Tinto is heavily focused) has led to deterioration in profitability across the mining sector.

In turn, a fall in profitability naturally brings to the fore the question of sustainability and, more specifically, whether mining companies will be able to see this rough patch through and come out the other side in (half) decent shape.

So, I’m pleased to report that Rio Tinto looks to be well placed to weather the storm.

Although its operating profit fell from $6.6 billion to $5.7 billion in its most recent half-year results, interest cover (the number of times that debt interest payments could have been paid by operating profit) were covered an impressive 28 times.

So, even if operating profit were to fall further, it is likely that Rio Tinto could continue to service its debt and it is, therefore, highly probable that the company can ride out the current storm.

Of course, sustainability is not the only reason I’m bullish on Rio Tinto. I’m also impressed by the renewed focus of its capital expenditure, making cuts in areas that were arguably more speculative in favour of parts of the business that are more likely to recover the quickest from challenging trading conditions.

This is, in my view, crucial because it is easy to slash capital expenditure across the board when times are tough. However, doing so could mean that the business struggles to grow once trading conditions pick up. Therefore, a more focused spend is, in my opinion, the perfect decision.

In addition, I’m highly optimistic about Rio Tinto’s prospects because, even though the company is experiencing a tough time at the moment, it is still able to deliver impressive returns on its assets.

Indeed, the return on assets in its most recent half-year results was 1.5%. On an annual basis, this is north of 3% and, although this figure is not among the highest in the wider stock market, it is still a great effort given the huge drop in metal prices (and demand for metals) seen this year.

So, I’m a Rio Tinto bull because I think it will ride out the current storm, as highlighted by its high interest cover, as well as delivering a relatively high return on assets and having sensible plan with regard to its capital expenditure.

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> Peter owns shares in Rio Tinto.