19.08.14 - 10:27 Uhr
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Rio Tinto (Price: 3406p | Target: 3552p | Rec: Hold)

Rio Tinto’s single commodity exposure is often portrayed as a weakness, yet the exaggerated operating margins that its iron ore division enjoys affords it the capacity to withstand high price volatility. Barring a collapse in iron ore prices, this provides it with a great deal more earnings surety than more diversified peers, which rely on commodity divisions with smaller operating margins and therefore greater earnings volatility. Rio is capable of delivering a class-leading dividend yield, bolstered by buy-backs.

* Iron ore EBITDA margins have been running at 60-70% this decade, twice that of the other commodity divisions. As iron ore prices decrease, we expect EBITDA margins to fall to c.50%, in par with levels before the Supercycle, but the division is still expected to remain the most profitable, supporting Rio Tinto’s current growth strategy.
* This enables the company to confidently predict “markedly increased cash returns” to shareholders. In this regard, we assume a lift in the progressive dividend policy, with the pay-out ratio increasing 20% from recent levels of c.35% to a c.42%, which we believe can be maintained under even bearish commodity price assumptions. With net debt now at targeted levels, we expect excess cash to be applied to buy-backs, potentially resulting in a 4% lift in EPS and DPS from FY17E onwards.
* Our target price is based on an equally-weighted average of five metrics: NPV, dividend yield, 12-month PE, a 10% forward free cash flow yield and 13x sustainable EPS. With the roll forward of our model post the 1H14A results and therefore the increased weighting towards higher-earning future periods, our TP has increased from 3,220p to 3,552p. The iron ore price remains the key risk to the achievement of this TP.

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Analyst: Hunter Hillcoat +44 (0)20 7597 5182

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