Rio result fails to live up to expectations

-- | 03/08/2018

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Mathew Hodge: I think the key thing is that inflation is really starting to kick in again on the input cost side. We've had a really very favorable period for the mining companies where commodity prices have been rising and costs have been pretty steady. So, they have got nice margin expansion. The market is still expecting margins for Rio Tinto to continue to expand from here. I think this result will put some questions in the minds of investors and of some analysts as to whether that's a reasonable expectation for the future.

What they have done is paid down a lot of debt. But in that sense, they are not alone. The majors globally have all done the same thing. Everyone got a big fright in 2015 when commodity prices turned down and there were concerns that China's structural issues were finally, kind of, coming to a head. China economy has since been stimulated by government spending and infrastructure spending. So, that's kind of been kicked down the road a bit. But in the interim, all the mining companies have cleaned up their balance sheets. So, it's not an issue really for any of the majors. They've all got a lot of cash and a lot of financial capacity at this point in the cycle.

The hardest thing is finding something productive to do with that money. Asset prices are pretty high. If you are looking to make acquisitions, you are making acquisitions pro-cyclically. If you are buying back shares, you are doing that at a time when earnings are good and that's reflected in the share price. So, that's kind of how I see the world.

The other thing that the markets are kind of interested in is the $4 billion of asset sales proceeds that are going to be returned to shareholders where it hasn't decided how it's going to do that yet. It could be special dividend, it could be more buybacks. And I guess, we will wait and see. But there's pros and cons to all of that. As an Australian shareholder, dividends are great if they are fully franked. The shareholders get the benefit of the franking credit. But that's not necessarily the case for the London-listed stock. If they have buybacks, they are buying back the London-listed stock a bit cheaper than the Australian stock. But you are still buying back at a time when external conditions are very good. Ideally, you want to buy back when the markets are – what's baked into the share price is probably pessimistic, and I think, at the moment, we are probably on the optimistic side.

This report appeared on 2021 Morningstar Australasia Pty Limited

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