3 Key Takeaways From Rio Tinto's Earnings Report

Under pressure from the iron ore bear market, commodity blue chip Rio Tinto turned in a disappointing 2015. Because commodity prices have declined so markedly, Rio Tinto's consolidated revenue fell 27% to $34.8 billion for the full year, and its underlying earnings retreated 51% to $4.5 billion. Rio Tinto management also scrapped the company's progressive dividend and enacted plans to ensure that the company remains strong for the long haul. Following are three key takeaways from Rio Tinto's latest earnings report.

Flexible dividend

Although Rio Tinto's 2015 underlying profit of $4.5 billion more than covered its annual dividend cost of $4.1 billion, the company's estimated underlying earnings in 2016 of $2.7 billion at current iron ore prices won't be enough to cover the dividend. Given that paying more in dividends than making in profits is unsustainable, Rio management took the long view and scrapped its progressive dividend policy to preserve the company's balance sheet.

A progressive dividend is a payout policy in which the dividend rises at least in line with the rise in underlying earnings, and the dividend doesn't decline if earnings declines. Rather than paying a progressive dividend, Rio management has instead committed to paying a flexible dividend with which the board decides the appropriate dividend payout at the end of each financial period. The board's goal is to pay 40% to 60% of the company's underlying earnings through the cycle by way of the ordinary dividend, special distributions, and stock repurchases.

Rio Tinto's new dividend policy has its advantages. If commodity prices recover, Rio Tinto can pay special dividend distributions that make up for the dividend cut. If commodity prices don't recover in the near term, the payout flexibility ensures that Rio Tinto survives the commodity bear market with its assets and balance sheet intact.

Capital expenditures are lower, but production can hold steady

Although it's getting harder and harder to cut costs, management still plans to trim $2 billion in expenses and another $3 billion in capital expenditures over the next two years. The lower planned capital expenditures mean Rio Tinto's capital expenditure budget will be $4 billion in 2016 and $5 billion in 2015, down from the previously guided $5 billion-plus and $7 billion in the two years. Although management is cutting costs, Rio Tinto's production won't decline much because the company has Tier 1, high-quality, long-life assets.

Rio Tinto's debt is manageable, and the company could make someacquisitions

Rio Tinto has a strong balance sheet. The company has a gearing ratio (a measure of the degree to which an organizations' activities are funded by owner vs. creditor capital) of 24%, well within management's 20%-30% target range, and the company's net debt of $13.8 billion in debt is $700 million better than that of 2014. On a relative basis, Rio Tinto's balance sheet is miles better than that of its smaller competitors such as Freeport-McMoRan , which is substantially more leveraged and has exposure to crude.

Rio could potentially use its stronger balance sheet to acquire assets of distressed commodity companies such as Freeport-McMoRan. Although it hasn't pulled the trigger on any purchases yet, Rio management has said that it expects quality accretive assets to be put on the market as the commodity bear market rolls forward.

Investor takeaway

While the dividend cut is painful, management made the right choice for long-term investors. Rio Tinto will survive and will have the balance sheet to acquire distressed companies if the right opportunities present themselves. Although the slowdown in China might worsen and a recession might occur in the United States, demand for iron ore, copper, and other commodities that Rio Tinto produces will rise in the long run as emerging markets develop and Rio Tinto will deliver substantial value to its shareholders.

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