Shares in Rio Tinto Limited (ASX: RIO) have soared since the start of the month, with the iron ore major posting a rise in its valuation of 9%. A key reason for this has been improved investor sentiment towards the mining sector and, despite the share price rise, Rio Tinto still yields a fully franked 5.3%. That's 70 basis points higher than the ASX's yield and means that many investors are considering buying the mining company for its income appeal.
Clearly, though, the company's profitability is under considerable pressure. For example, it declined by almost 20% last year and, looking ahead, Rio Tinto's earnings are forecast to fall on a per share basis from $6.19 last financial year to just $3.45 in the current financial year. That's a fall of 44% and means that the company's dividend is covered 1.1 times by net profit; down from a coverage ratio of 2.4x last year.
Of further concern for the company's investors is the outlook for iron ore. The Chinese economy seems destined to grow at a lower pace than in recent years as it transitions from a capital expenditure-led economy towards a more consumer-focused economy. With it becoming increasingly mature, double-digit growth could prove to be a thing of the past and, while further infrastructure projects are a certainty, the demand for steel (and its key ingredient, iron ore) may not return to previous high levels.
As a result, and with iron ore contributing the majority of Rio Tinto's profits, earnings growth may be rather subdued in future years. Of course, Rio Tinto appears to have a sound strategy. For example, it has made excellent progress on its cost reduction programme, with $5.4bn in total operating cash cost improvements and reductions in exploration and evaluation expenditure being delivered since 2012.
Furthermore, Rio Tinto is attempting to grow its non-iron ore operations via targeted exploration and evaluation spend. For example, just 5% of expenditure in the first half of 2015 was incurred by its iron ore group, with 37% incurred by the copper and coal division and 22% by diamonds and minerals. As such, Rio Tinto's dependency on iron ore may gradually recede over the long run.
Meanwhile, Rio Tinto's cash flow remains strong, and with net cash generated from operating activities of $4.4bn in the first half of 2015, the company's dividend payments of $2.2bn and $1.2bn of sustaining capital expenditure were easily covered. As such, it appears as though the company's shareholder payouts are relatively robust. And, with a strong balance sheet, as evidenced by a net gearing ratio of just 21% and interest cover of 9x, its future outlook seems to be relatively stable.
So, while Rio Tinto is enduring a challenging period where profitability is falling dramatically, its price to earnings (P/E) ratio of 15.5 means it appears to be a reasonable long-term play.
