Iron ore giant Rio Tinto recently reported underlying earnings for CY16 of US$5.1 billion, beating Ord Minnett’s forecast of US$4.8 billion and consensus expectations of US$4.9 billion, mainly driven by cost savings and a lower tax rate.
A full-year dividend payout of US$1.70 a share also bettered Ord Minnett and consensus forecasts of US$1.60 and US$1.33, respectively. The dividend, combined with a surprise US$500 million buyback, took the full-year payout ratio to 70%. However, we expect this is just the beginning.
Based on our forecasts, Rio Tinto will generate excess cash for the foreseeable future and we forecast CY17 gearing at 7%. On this basis, and due to the likelihood of limited project approvals, we believe the share buyback will be topped up progressively over the medium term.
Net debt of US$9.6 billion was slightly higher than our US$9.3 billion estimate. A gearing level of just 17% prompted Rio Tinto to initiate the US$500 million on-market buyback of its UK-listed shares, an amount we expect will be increased with the first-half results due in August.
We continue to think the mining sector can continue to re-rate, with the consensus upgrade cycle ongoing, valuations not being stretched and China macroeconomic data remaining positive.
In our view, Rio Tinto continues to be one of the stand-out stocks in the sector, offering a CY17E dividend yield of circa 7%, and trading on low valuation metrics – a price to net present value ratio of 0.94 and a CY18E enterprise value to operating earnings multiple of 5.9 times. We reiterate our Accumulate recommendation and raise our target price on the stock to $71.00 from $70.00.