In the last year, the share price of Rio Tinto Limited (ASX: RIO) has fallen by over 15% as the commodity rout has caused its financial performance to come under severe pressure. In fact, iron ore has dropped to a ten-year low during that time period and, with Rio Tinto's operations being dominated by its iron ore division, the company's top and bottom lines have fallen dramatically.
Looking ahead, it would not be a major surprise for further challenges to come along, since Chinese demand for steel (and the steel-making ingredient, iron ore) does not appear likely to pickup anytime soon. And, with Rio Tinto trading on a rather rich price to earnings (P/E) ratio of 14.9, many investors may be tempted to sell up before things get even worse.
However, doing so could be a bad move since it would mean selling at a low ebb for the business and in the commodity cycle. Clearly, the performance of the entire sector has been disappointing, but Rio Tinto may yet emerge in a stronger position relative to its peers.
That's because it has increased production, taken a knife to its costs and mothballed various projects so as to improve efficiency and keep its cost curve at the lower end of the industry. For example, in the first half of the current financial year alone, Rio Tinto has delivered cost savings of $641m and has increased its annual target of efficiencies for the full-year to $1bn.
This could mean that, while its peers fall by the wayside in the coming months, Rio Tinto increases its market share and puts itself in a stronger position to generate higher profitability when the commodity cycle turns.
In this regard, Rio Tinto continues to spend on long term growth projects where the economics make sense. For example, it has reached key milestones in three of its growth projects and, with capital expenditure standing at $1.2bn for the half year, Rio Tinto's operating cash flows of $4.4bn appear to be adequate. And, with dividends of $2.2bn added to this figure, Rio Tinto appears to be able to afford its current level of shareholder payouts, thereby making its yield of 6.1% (fully franked) seem relatively sustainable.
In addition, Rio Tinto has a debt to equity ratio of 50% and this low level of gearing not only allows for a generous dividend but also a share buy-back programme which is expected to purchase $1bn of shares in the second half of the current financial year. With Rio Tinto having a price to book value (P/B) ratio of 1.63, it seems to offer good value given its sound management, prudent strategy and income appeal.
Therefore, while life for its investors could get worse before it gets better, now does not appear to be the time to cut and run from Rio Tinto. Rather, it is an opportunity to buy in at an even more appealing price level for the long term.
