This is not a straw hats in winter story that recommends counter-cyclical buying on the dips in mere hope. Rio Tinto Limited (ASX: RIO) has fallen to levels that suggest for a number of reasons there is potentially significant upside.
Yes, I hear you say, but what about the falling iron ore price and the weakening Chinese economy? These are not mere trifles, but they are potentially already factored into the share price. Also, China has massive reserves with which to bolster growth rates should that become necessary. Let's consider below whether the positives are outweighing the negatives for arguably the world's premier iron ore company.
The Aussie dollar effect:
In recent days the currency has plummeted from a high of US$94.85 to a low of US$90.01 this morning. This represents a depreciation of over 5%. The potential effect on full-year 2014 underlying earnings of a 10 % fall in the Aussie dollar would be $515 million.
The reporting season effect:
Additionally, in my opinion, Rio was the standout during the August reporting season by convincingly beating consensus expectations. The majority of brokers subsequently lifted the target price for the stock to an average of around $80. This represents just under 30% upside from Friday's closing price of $61.89.
The dividend support effect:
The company has all but promised higher capital returns after the full-year 2014 result and is fast becoming a yield play with projected dividend yields for FY2014 and FY2015 of around 3.8% and 3.9% respectively. In the current environment this yield effect is not to be understated and should provide a base level measure of support.
Survival of the fittest effect:
Deutsche Bank's broking division has done a review of spot cash margins for iron ore. Taking into account all-in costs and product discounts for FY2015, Rio still has a 45% cash margin. While large expansions are underway at Rio's mines (which will further reduce unit costs) other smaller companies with lower grades and higher costs are falling by the wayside. Recently both Sherwin Iron (ASX: SHD) and Western Desert Resources (ASX: WDR) have become casualties and many more small-to-medium size iron ore companies are expected to fall. This will benefit Rio by reducing supply from other sources.
