Rio Tinto (LSE: RIO) is a leading producer of iron ore along with other materials. Because Rio Tinto is a commodity producer, its financials are subject to the boom/bust commodity cycle. Although the good times can be really good in terms of earnings and growth, the bad times can be pretty difficult.
Given the current information on the commodity cycle, what’s ahead for the dividend? Here’s what I think.
Dividend trends
Iron ore is used to make steel. Given that countries need steel to build new cities and maintain old ones, iron ore is quite essential. This is especially true for nations that are still developing like China.
Although iron ore prices fell sharply from 2011 to the early part of 2016 due to a slowdown in China’s economy, the price of the commodity has since rallied from the 2016 lows. Given the rally, one could say we’re in the boom phase of the commodity cycle.
Because the exact future price of iron ore is unknowable, however, I believe the company’s dividend will continue to fluctuate over time. Management themselves have adopted a rather flexible approach to capital returns.
In terms of their dividend policy, management’s intention is for “total cash returns to shareholders over the longer term to be in a range of 40 to 60 per cent of underlying earnings in aggregate through the cycle”.
Rio Tinto’s dividend has fluctuated in the past. In the year ended 31 December, 2016, for example, Rio Tinto’s total normal dividend fell to $1.70 per share from the previous year’s $2.15 per share.
The dividend has also increased in other years. Assuming management doesn’t pay a special dividend, Rio’s dividend yield is around 4.67% at current prices with a total normal dividend of around $3.86 per share.
In terms of the next few years, I think the dividend could grow given that its largest customer, China, has rebounded rather strongly economically. I also reckon that emerging markets could outperform expectations given the amount of stimulus going around and the vaccine rollouts.
What I think of Rio Tinto
There is a lot to like about Rio Tinto. Given its scale and asset quality, the company is one of the low cost producers of iron ore. As a result, it can handle the commodity cycle better than many of its rivals. With good management, the company has the potential to expand with opportunistic acquisitions when the industry is in the bust parts of cycles.
In terms of execution, management has done well over the past five years. Since early 2016, the stock has more than tripled and the company has also paid plenty of dividends along the way. The company’s management has also smartly avoided investing substantial sums in oil and gas assets, many of which aren’t as valuable as they were before given the lower prices of Brent crude oil.
As Rio Tinto’s long-term chart shows, however, commodity cycles can be tough to judge. As a result, I think the stock is riskier than a lot of leading stocks in other sectors that are less volatile.
Because I think iron demand will increase in the future given the development of many emerging markets, I’d buy Rio Tinto shares. But, because the commodity cycle is inherently unpredictable, I’d give it the same weighting in my portfolio as it has in the FTSE 100.
