Best Ideas Newsletter portfolio holding Rio Tinto (RIO) has been under significant pressure as global macroeconomic weakness and challenges facing the mining industry have not been kind to the company. The iron ore giant is focused on cutting costs as never before amid the turmoil in the global commodities markets, where some commodity prices have fallen to levels not witnessed since the Global Financial Crisis. China’s equity market collapse and the uncertainty in the Eurozone as it relates to the Greece debt negotiations haven’t helped. Ongoing flawless cost control will remain vital for Rio, as we expect the global surplus of iron ore to continue to prevent a strong recovery in iron ore prices, at least in the near term.
When considering the challenging environment in which it is operating, management was pleased with its first-half results, released August 6, despite underlying earnings and pre-tax net earnings decreasing 43% (now $2.92 billion, was $5.12 billion) and 82% (now ~$800 million, was $4.4 billion), respectively. First-half operating cash flow fell 19% to $4.4 billion, but such a level was still sufficient in covering sustaining capital expenditures and dividend payouts in the period; significant cost control helped to offset the pain of lower prices. Rio’s net debt position grew nearly $1.2 billion to ~$13.7 billion in the first half due to continued investment in growth opportunities. Traditional free cash flow, operating cash flow less all capital spending, came in at $1.96 billion during the first half of the year, which was not sufficient to cover dividend payouts in the period.
Nonetheless, Rio Tinto remains focused on strategically controlling its spending. The firm raised its full year cost saving target (including exploration and evaluation savings) to $1 billion from $750 million after reporting first half cost savings of $641 million. Rio also lowered its capital expenditure guidance for the full year to ~$5.5 billion, levels that are expected to be below the $6 billion and $7 billion forecasted in 2016 and 2017, respectively. Though Rio maintains that its balance sheet is “in very good shape,” the firm is entertaining offers for its assets that it can offload at the right price. The company is banking on its “tier one assets and sound operating capability” to help it navigate the current market environment.
Rio Tinto continues to be our favorite idea in the metals and mining industry, but this is worth explaining. The company is a very small holding and represents our exposure to the sector primarily for diversification reasons. Price-taking, commodity-producing entities that are staring down a supply glut of the main commodities they produce shouldn’t be considered a “best idea” outside the context of diversified exposure. We choose Rio because its balance sheet is much healthier than those of competitors, in our view–BHP Billiton (BHP) and Vale (VALE) both have nearly twice the net debt position of Rio. Financial leverage is an area that we’re paying close attention to as commodity prices wane.
All in, we’re fans of Rio’s cost cutting strategies, and we’re even bigger fans of its ability to successfully execute those strategies thus far. Rio remains the best risk-adjusted exposure to the metals and mining industry, and the company continues to trade at a significant discount to our estimate of its long-term intrinsic value; we view its dividend payout as icing on the cake.