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The Investment Case For Rio Tinto plc

rio tinto

Like its fellow FTSE 100’s miners BHP and Anglo American, Rio Tinto (LSE: RIO) (NYSE: RIO.US) has been grappling with the ending of the booming mining super cycle and demands from investors to prioritise shareholder returns over grand expansion projects. It has installed a new CEO, cut back on capital expenditure and exploration costs, sold peripheral assets, taken an axe to operating costs, and increased dividends.

That gives rise to two main strands in the investment case: firstly, a somewhat contrarian approach to buying into a softening market in the expectation that conditions will eventually improve, and secondly a play on how successfully Rio can increase productivity and financial efficiency.

Cycles

Though a diversified miner, Rio is primarily a play on iron ore, which contributed nearly 90% of 2013’s earnings. Aluminium and copper also make significant contributions and add stability to total earnings. Supply of iron ore is expected to exceed demand this year, as increased production put in place in earlier times overshoots slowing demand from China. That’s how commodity cycles work.

It means that Rio’s future profits will depend on the outturn for iron ore prices. But Rio’s strategic advantage is its low cost, quality mines, particularly the giant Pilbara site in Australia. When prices are under pressure, big low-cost operators have the advantage. Rio can see out difficult conditions better than most, with higher cost operators eventually forced out.

Slimming

Meanwhile, profitability has been boosted by a successful corporate slimming exercise. Last year capex was reduced by 25%, a target of $2bn of annual operating cost savings was comfortably exceeded, and cash flow increased by a fifth. That produced a 10% rise in underlying earnings and turned a net loss after impairments into a net profit. Debt was reduced and the dividend hiked by 15%.

More of the same is promised, including $3bn of operating cost cuts. Healthy cash flow should give Rio the flexibility to shed more debt and return cash to shareholders through increased dividends or share buy backs.

Dividends

Currently yielding 3.7%, Rio is a decent dividend-payer. But with the payout set to rise, in the short term from increased efficiency and in the longer term from a strengthening supply/demand balance, it’s an attractive stock for income seekers. Over the long term, it can be better to buy stocks with moderate but rising dividends than those which happen to be the biggest yielders at the time.

Reinvesting dividends grows wealth. Over the past 25 years, about 60% of the total return from the FTSE All share Index has come from reinvested dividends.

You can learn more about how to capture the wealth-boosting power of dividends in 'My Five Golden Rules for Building a Dividend Portfolio'.  It's an exclusive report published by the Motley Fool. You can get it by clicking here -- it's free.

 > Tony owns shares in Rio Tinto and BHP but no other shares mentioned in this article.