Rio Tinto Stock: Attractive Dividend Play, But Certain Short-Term Risks (RIO)

As the equity market makes new all-time highs and the implied risk for equities is hovering near record-highs as well, it is prudent for investors to reduce risk.

There are different ways to achieve that – from portfolio rebalancing and focusing on more defensive areas of the market to better diversification and investing in high quality dividend stocks.

When it comes to reducing risk, the basic materials sector rarely comes to mind as it is a highly cyclical area of the market that tends to underperform during market downturns while also offering limited upside when compared to high growth areas of the market.

Rio Tinto Group (NYSE:RIO), however, seems to be an exception as the stock has kept-up with the broader equity market in recent years.

As we see on the graph above, this was the case at least until the beginning of 2024, when a handful of large companies within the S&P 500 have caused the index to significantly outperform its equal-weighted counterpart. Therefore, it was extreme concentration in companies, such as Nvidia (NVDA), Microsoft (MSFT) and Amazon (AMZN), that caused the market to outperform RIO in recent months.

More importantly, Rio Tinto offers a current dividend yield of 6.6% which is above its historical average and highly attractive when considering the dividend yield of the S&P 500 of around 1.3% and the yield on 10-year Treasuries of 4.3%.

Rio Tinto’s dividend yield is also the highest within:

• its main peer group, consisting of BHP Group (BHP), Glencore (OTCPK:GLNCY) and Anglo-American (OTCQX:NGLOY);
• and the Top 10 holdings of The Materials Select Sector SPDR® Fund ETF (XLB).

The only peer with a higher dividend yield is Vale (VALE).

At these levels, Rio Tinto’s dividend yield does not necessarily need to be increased in the immediate future in order to remain attractive. What that means is that the safety of the dividend remains the only concern for dividend investors at this point in time.

Is The Dividend Safe?

On a free cash flow basis, Rio Tinto’s dividend does not appear to be at any immediate risk. If we ignore the special dividends paid in fiscal year 2021 and 2022, we could see that annual dividend payments have been gradually increasing since 2016, and they have been well-covered by the company’s free cash flow. In recent years, however, the gap between the dividend payments and free cash flow has narrowed-down.

For most of these years, Rio Tinto’s management has been spending significant amounts on capital expenditure relative to the company’s annual depreciation expense. The ratio has been hovering around 140% since 2018 which highlights the high levels of reinvestment back into the business in recent years.

This has happened at a time when Rio Tinto’s EBITDA margin fell to multi-year lows, and thus caused the narrowing of the aforementioned gap between free cash flow and dividends paid.

Although Rio Tinto’s management has been making a significant push to diversify operations in recent years, the company’s profits are still largely dependent on Iron Ore business in Australia, which makes up nearly 78% of profits.

The Iron Ore business is also by far the most profitable at the moment with EBITDA margin in excess of 60%, while Aluminium, Copper and Minerals are nowhere near this level.

The iron ore produced in Australia is predominantly exported to China, which makes Rio Tinto’s dividend yield largely dependent on the health of the Chinese economy. That is why the share price of Vale – the other large iron ore producer which exports its ore to China – has been performing in line with that of RIO.

As we see on the graph below, however, RIO has been performing far better than its Brazilian competitor as of late, with a wide share price performance gap opening in recent months.

One of the main reasons for that is the fact that Vale’s profits are almost entirely driven by the company’s Iron Ore Solutions segment.

As we saw above, around 22% of Rio Tinto’s EBITDA in FY 2023 came from the company’s Aluminium, Copper and Minerals segments.

More importantly, however, Rio Tinto’s management is pivoting towards the strategic copper segment. We can see that on the graph below, where I compare the share of revenues versus the share of capital expenditures in FY 2023. While only 12% of Rio Tinto’s revenues come from copper, the company is spending roughly 30% of its Capex budget on expanding its operations within this segment.

Another very important distinguishing factor for Rio Tinto is the company’s extremely conservative debt levels. As a consequence, the annual interest expense is hardly an issue for the company, even in the case of iron ore prices falling sharply in the future.

The net debt level also stands at around $3.3bn at the end of fiscal year 2023 which is about a third of the reported net income figure for the period.

With all that in mind, Rio Tinto’s dividend does not appear to be at risk at the moment from an operational point of view. As we established earlier, the main risk factor remains demand from Asia and more specifically – China.

With that in mind, short to medium-term investors willing to hold RIO in their portfolio should consider any macroeconomic developments regarding the steel industry in China. Although there are notable risks in that regard as steel inventories in the country are piling up, Rio Tinto’s management is addressing them by diversifying its operations away from iron ore and keeping debt levels low.

Conclusion

Rio Tinto’s dividend yield is among the most attractive within the basic materials sector, and the stock has been performing mostly in-line with the broader equity market in recent years. In terms of dividend safety, Rio Tinto’s management seems to have taken all the right steps towards reducing the risk and moving the business in the right direction in the long-run. Reliance on steel production in China remains the key risk factor for Rio Tinto’s shareholders, however, this is gradually being reduced as the company is pivoting to copper mining and keeping debt levels low.