Robert Sutherland Smith Uncovers Value at Rio Tinto

By Robert Sutherland Smith

The results just published for BHP Billiton (BLT) came as a bit of a surprise.

They are interesting in that they demonstrate what management can do to counter poor trading conditions. Equity investment is crucially about that ability of human management to anticipate and confront challenges. Conversely, if you own a bond it is generally the victim of circumstances including inflationary expectations and general macro-economic changes.

In the case of BHP, iron ore prices fell by 38% but BHP restricted the fall in earnings to 31% – evidently better than the market expected because the share price rose on the results. Unit costs were reduced by 29% and capital spending is being cut significantly. The aim is to generate cash with which to pay dividends and hopefully, if possible, keep shareholders happy by returning cash through buying back shares to enhance earnings per share in future. BHP has responded to the downturn in mineral and oil prices by getting more efficient at what it does and restricting its activities to the most profitable and promising.

Rio Tinto (RIO) has achieved similar goals by investing to make its production the most efficient and cost effective in world mining. Its Pilbara mining complex in Australia has reduced unit operating costs and generated more cash flow. It was these attractions which prompted Glencore, which does not seem to have this investment-led model of business, to recently attempt a cheeky bid for Rio. Partly for that reason, the Rio share price has increased by more than a fifth from its low point of 2,600p which it hit as recently as December 2014.

The pertinent question now is to ask if Rio is still a share to buy.

There are a number of reasons for thinking it is. First, the company appears to have enough cash flow to sustain a progressive dividend policy. That may be in greater doubt for BHP because the mature, non core businesses it proposes to divest are also cash generative. In any event, the consensus of market forecast estimates is for Rio dividends to increase around 10% this year to an estimated 152p and a further 7% next year to an estimated 162.7p. Unlike BHP, Rio also has the cash for share buy backs. Consequently, the consensus of market forecasts is for an annual dividend yield of 4.7% for this year and 5% for next year.

Second, the share price chart still looks to be trending north. Although the market is factoring in a 25% decline in earnings this year it is also looking for an 18% recovery in earnings next year, valuing the equity on 11 times estimated earnings per share of 292p and a PEG (price to earnings growth ratio) of an attractive 0.6. Investors should take on board the fact that the market is looking for recovery as soon as next year.

Third, this is an investment in the international economy and not the UK. Thus, it sidesteps probable political and constitutional problems in the UK late this year and next year as we presumably pass into an era of weak coalition government and perhaps the huge uncertainty over the UK’s membership of the European Market.

Finally, and not to be forgotten, in a year when the FTSE 100 has scaled an all time peak, Rio has actually underperformed the index by 33% in the last five years – thanks to weakness in the share price since the peak in 2011. That implies plenty of room for recovering lost ground against the index, which will be attractive to long term investing institutions. These shares look attractive to me.