By Paul Rickard

While Rio Tinto largely remains a “bet” on the strength of the Chinese economy and more directly the iron ore price, you cannot but commend management for getting it in the right shape. And, the market has recognised this, providing shareholders with a strong return this year.

In 2016, Rio shareholders have enjoyed a return of 13.9%. The share price has risen from $44.71 at the start of the year to $49.42 at yesterday’s close, plus, they have received a dividend of $1.519. Comfortably higher than BHP, which has returned 8.1% over the same period, but a drop in the bucket compared to pure-play iron ore producer Fortescue, which has returned 137.4%.

Last night, Rio released its results for the first half of 2016 (it has a 31 December balance date). The good news for shareholders is that management is continuing to take actions to improve the bottom line. 

Rio’s first half

Rio reported first-half underlying earnings of US$1.56bn, down 3% on the second half of 2015, and 47% on the corresponding half in 2015. This was marginally above the consensus analyst forecast of US$1.47bn.

Cash generated from operating activities was US$3.2bn, down US$1.2bn on the corresponding period. In accordance with the new dividend policy, shareholders will receive a dividend of US 45c per share (approx. AU 59.2c). This was higher than analysts had forecast. Rio says that it intends to pay a dividend for the full year of no less than US 110c per share.

Lower commodity prices were the main drivers for the fall in underlying earnings. Comparing 1H 2016 to 1H 2015, price reductions cost Rio almost $1.9bn. Interestingly, the Aluminium product group was impacted by almost $700m, causing underlying earnings to plummet 52% from $793m to $377m. Iron Ore, on the other hand, only saw a decline in earnings of 17% from $2,100 to $1,743m.

Offsetting the impact of price changes were further productivity and costs improvements, which Rio says added $580m to earnings.

Strengths and outlook

While the Pilbara iron ore business continues to be the main driver for Rio’s earnings, contributing 83% in the first half, Rio says that it has tier 1 assets in each of its three other product groups - aluminium, copper and diamonds, and energy materials. With the Pilbara, cash unit costs fell to US $14.30 per tonne in the first half compared to $16.30 in the corresponding half, which helped Rio generate an incredible EBITDA margin of 58%. 

As a result of productivity improvements and disciplined capital investment, the balance sheet continues to strengthen. In the half, Rio reduced net debt by US$0.9bn to US$12.9bn. Gearing now sits at a very comfortable 23%, towards the lower end of Rio’s “through the cycle” range of 20% to 30%.

In terms of productivity improvements, the company says that it has already taken out costs of US $6.8bn against its 2012 cost base, including US $580m in the current half. It reconfirmed guidance for further savings in 2016 and 2017, which will take this total to $8.2bn.

Despite these actions to take out costs, and the fact that the current spot price for iron ore of US$60 per tonne is well above the average price for the half year of US$48, the Rio Management team aren’t celebrating. If anything, the tonality of the report is a little downbeat, with management remaining cautious about the outlook for commodity prices (and the Chinese economy). They note that a strong credit boost at the start of 2016 revived a moribund property sector in China and increased demand for commodities, and that the medium-term outlook for global growth is continually being revised down.

The brokers

Over the next couple of days, the brokers will update their forecasts. As the profit result was reasonably in line, there probably won’t be too much change to their targets. Going into the result, they were positive on Rio, with 4 buys and 4 holds among the major brokers. The consensus target price is $52.68, a 6.5% premium to the closing price on Wednesday.

Bottom line

The Rio Management team has done a good job to get Rio into shape. It is a tier1, word class mining company. However, it is hard to ignore Management’s obvious caution about China (and iron ore prices). Maybe a long-term buy if you can ride out further weakness in commodity prices, or firmly believe that the cycle has bottomed. Otherwise, underweight.

Sourced feature image: Copyright © 2016 Rio Tinto