Equity analysts think it's both prudent and likely Rio Tinto (RIO) will cut its dividend given shrinking free cash flow. We now forecast flat dividends of $1.40 per share from 2016, down from 2014's $2.15 per share peak and our most recent forecast of $1.80 per year.
Falling commodity prices will be the arbiter of dividends, not management's will. This cut would see Rio Tinto generate total free cash flow after dividends of approximately $4 billion for the three years ended 2017. It is prudent some debt is repaid as financial leverage magnifies the impact of lower commodity prices on the value of the shares. Rio's balance sheet is only sound.
Destroyed Cost Advantages
The unchanged no moat rating reflects over-investment during the boom. Rio exemplifies the danger of high levels of investment during a boom and has destroyed its cost advantages, particularly in iron ore, by investing in high priced assets at the peak of the cycle. Our unchanged high fair value uncertainty rating reflects Rio’s operating leverage, cyclicality and reliance on iron ore.
Aluminium Prices to Fall
Aluminium prices are likely to fall in the next few years on weak Chinese demand, before a slight recovery to $1,450 per tonne mid-cycle, in real terms, by 2020. China supply is a concern with new low-cost supply likely to outstrip capacity curtailments. We expect China's uneconomic supply to be sticky.
We think aluminium will be caught in the downdraft from China's fixed asset investment peak and the end of their property boom and expect significantly weaker consumption growth in the future. We estimate fixed asset investment drove 64% of aluminium consumption in China in 2014 and China accounted for just above half of total global demand.
As in other commodities, once rapidly growing demand is sated and supply can more easily keep up, markets can quickly move to oversupply. We think Rio Tinto's decision to expand bauxite production is either a strategic mistake – the additional supply feeding China's competing alumina refineries and aluminium smelters, which adds to the oversupply – or an admission bauxite supply entry barriers are so low that it will either be supplied by competitors, if not by Rio Tinto. The combination of weak demand and growing supply means we think the outlook for the aluminium complex is likely to remain challenging for some time.
