3 ways Rio Tinto Limited shares could go higher in financial year 2017

In the last five years, shares in Rio Tinto Limited (ASX: RIO) have fallen by 40%. Sure, much of that is due to falling commodity prices, with the likes of BHP Billiton Limited (ASX: BHP) falling by 55% and Woodside Petroleum Limited (ASX: WPL) declining by 35% during the same period.

However, I think that Rio Tinto’s strategy has also been partly to blame. As such, here are three areas that I would change if I were in charge of the business.

Slash dividends

In the last financial year, Rio Tinto paid out over $4 billion in dividends. In my view, this was overly generous and represented an increase of 9.9% over 2014’s payment, which in itself was an increase of 11.7% over 2013’s level. This is at a time when the outlook for resources companies is uncertain and I feel that Rio Tinto, while having excellent operating and free cash flows, is simply overspending on dividends.

For example, net operating cash flow was US$9.4 billion in 2015 and out of this Rio Tinto spent US$4.7 billion on capital expenditure, leaving US$4.7 billion as free cash flow. Therefore, while dividends are affordable at their current level, I think that spending 85% of free cash flow on them when the risks to the business from further commodity price falls are high is unwise and makes Rio Tinto a riskier investment.

Acquisitions and disposals

With such strong net operating cash flow and a balance sheet which is only modestly leveraged, Rio Tinto has the scope to make major acquisitions in my opinion. For example, it has a debt to equity ratio of only 54% and with a cash balance of US$9.4 billion, this figure falls to just 32% on a net debt to equity basis.

In my opinion, Rio Tinto is in need of diversification and undertaking M&A activity is one means of effecting this. Although previous acquisitions have turned sour (such as Alcan in 2007), Rio Tinto relies on iron ore too much to my mind, with it accounting for 64% of net operating cash flow in 2015.

Therefore, the company’s decision to shelve its iron ore project in Africa recently was a wise move in my opinion, while its divisional reorganisation could lead to asset disposals. Such a move could leave Rio Tinto leaner, more efficient and better diversified.

Further investment

Of course, Rio Tinto continues to invest in growth. Capex represented half of net operating cash flow in 2015, but I feel that this amount could be increased. That’s because some capex is more like opex in terms of it being required in order to keep assets in production state. I’d like to see Rio Tinto invest more aggressively for the long term, since its through the cycle earnings are likely to be higher than those currently being experienced, while iron ore and other commodities are at a low ebb.

If dividends were cut then this would free up as much as US$4 billion to spend on developing Rio Tinto’s world-class asset base. I would argue that while investors in the company may miss their dividends, the potential for greater profitability from higher investment in the long run would make a lack of income return well worth it.

Discover the 'new breed' of blue chips that could take your portfolio higher in 2016

Forget BHP and Woolworths. These 3 "new breed" top blue chips for 2016 pay fully franked dividends and offer the very real prospect of significant capital appreciation. Click here to learn more.

The report is free! No credit card required.

Motley Fool contributor Robert Stephens has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

Two New Stock Picks Every Month!

Not to alarm you, but you’re about to miss a very important event! Chief Investment Advisor Scott Phillips and his team at Motley Fool Share Advisor are about to reveal their latest official stock recommendation. The premium “buy alert” will be unveiled to members and you can be among the first to act on the tip.

Don’t let this opportunity pass you by – this is your chance to get in early!

Simply enter your email now to find out how you can get instant access.

By clicking this button, you agree to our Terms of Service and Privacy Policy. We will use your email address only to keep you informed about updates to our website and about other products and services we think might interest you. You can unsubscribe from Take Stock at anytime. Please refer to our Financial Services Guide (FSG) for more information.