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How Rio Tinto Limited (ASX:RIO) could lift its US$12bn capital return by 30%

It’s not a good day for mining stocks as the sector has the unenviable task of leading the market lower today, but Rio Tinto Limited (ASX: RIO) may be close to announcing a surprise 30% increase to its capital return program.

This bullish speculation from Citigroup comes at a time when the iron ore giant is about to offload its Grasberg copper mine.

The market isn’t paying attention though as the share price of Rio Tino tumbled 0.8% to $79.20 in after lunch trade while the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) is down 0.5%.

It’s not a bad idea to buy the dip given the cashed-up miner could see another US$3.5 billion added to its coffers from the sale of the Indonesian mine.

While the final terms have yet to be worked out, the amount has been agreed by the parties concerned and it’s materially above the valuation that Citigroup has put on Grasberg.

“Using our long-term copper price assumption of $3.18/lb, our DCF value of Rio’s interest is at $2.6bn. Therefore, a price of $3.5bn would be above the NAV estimate we have in our model, and hence completion would be a positive step,” said the broker.

“We believe any cash proceeds from the deal will add to the ~US$12b (Citi est.) cash return to the shareholders in 2018.”

But returning the proceeds from the sale of Grasberg is not guaranteed. Rio Tinto could use the cash for acquisitions even though management has said repeatedly that it isn’t shopping around and remains focused on improving its existing business.

However, Citigroup believes that it would make sense for Rio Tinto to acquire the minority interest in Canadian copper miner Turquoise Hill Resources Ltd, which 51% owned by Rio Tinto.

There’s long been speculation that it was only a matter of time before Rio Tinto swallowed the miner and Citigroup believes it could pay a 30% takeover premium for the Canadian and US-listed miner, which would come up to US$3.6 billion.

Either way, the outlook for Rio Tinto is good and Citigroup has a “buy” recommendation and $86.00 a share price target on the stock. The capital upside is supplemented by Rio Tinto’s circa 5% dividend yield. This gives the stock a total upside of around 16% from its current share price if you included the franking credits.

Rio Tinto isn’t the only one flush with cash. BHP Billiton Limited (ASX: BHP) is also close to sealing a more than US$10 billion deal to sell its on-shore shale oil and gas assets in the US and the market is expecting the Big Australian to be handing back most of the proceeds to shareholders.

The amount of surplus cash makes large cap miners the new defensive sector in my opinion. While investors are wondering how well the big banks like Commonwealth Bank of Australia (ASX: CBA) and Australia and New Zealand Banking Group (ASX: ANZ) can withstand a housing downturn, there’s little doubt about the health of the major miners even if commodity prices were to turn lower.

Our two mining heavyweights are also arguably more defensive than utilities and infrastructure stocks like Transurban Group (ASX: TCL) and AGL Energy Ltd (ASX: AGL) as these sectors are facing regulatory pressure that could put their earnings under significant pressure.

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Motley Fool contributor Brendon Lau owns shares of AGL Energy Limited, Australia & New Zealand Banking Group Limited, BHP Billiton Limited, and Rio Tinto Ltd. The Motley Fool Australia owns shares of and has recommended Transurban Group. 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 Scott Phillips.

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