The volatile mining sector is not usually the first place you would look for income investments. However, I believe that over the past five years, the industry has transformed itself from a sector dominated by volatility to an industry with stable, reliable cash flows.
Redesigning the business
Rio Tinto (LSE: RIO), is a great example. Over the past five years, this miner has overhauled its business model. Nearly $17bn of disposals have been announced since 2013. Coal assets have been disposed of, and the company has double down on what it knows best: iron ore and aluminium. Production of these two commodities now makes up more than three-quarters of revenue.
By selling off assets, Rio has been able to pay down most of its balance sheet debt. At the end of 2015, the company reported net debt of nearly $14bn or 1.3 times earnings before interest tax depreciation and amortisation (EBITDA), which was hardly troubling by any standards (a net debt-to-EBITDA ratio of two or more is a red flag), but management wasn’t comfortable returning capital to investors without a fortress balance sheet behind the business. Today, net debt stands at just $5.2bn or 0.3 times EBITDA.
As well as paying down debt, the company has been returning cash from operations to investors. So far this year, management has announced $5.2bn of share buybacks, and analysts believe another $3.5bn could be paid out to investors when Rio completes the sale of its stake in Indonesia’s Grasberg copper mine next year.
On top of buybacks, the company has also been paying out record amounts of cash to investors. Analysts believe the business is on track to return a total of 226p to investors via dividends in 2018 giving a dividend yield of 6.4%. The payout is expected to fall slightly next year, although analysts are still forecasting a yield of 6.1%.
Just like Rio, over the past few years, BHP has been cutting costs and selling assets, using the cash generated from both of these initiatives to reduce debt. The rest has been returned to investors.
After slashing its distribution by more than 70% to just $0.29 in 2016, analysts are forecasting a total full-year dividend of $1.65 (129p) per share for BHP’s current financial year. Like its peer, BHP has adopted the strategy of returning all excess cash to investors. Unfortunately, this means that unlike a progressive dividend policy, where management tries to increase the payout every year, dividends will be more volatile because they are linked to earnings. Next year, analysts are expecting a 6% decline in BHP’s earnings per share, which will translate into a 25% reduction in the company’s full-year dividend they believe. Still, even after this reduction, the shares are on track to yield 6.5%.
With high single-digit dividend yields on offer, I think both BHP and Rio are both bargains after recent falls.