Jefferies upgrades Rio Tinto to 'buy', praises strong cash flows

Analysts at Jefferies upgraded mining giant Rio Tinto to 'buy' on Friday, stating the group's strong free-cash-flow through the cycle should lead to a supportive dividend in weak markets and leverage to the upside in stronger markets, which in turn should provide a floor for the shares.

Jefferies noted that while iron ore prices could go lower, Rio shares can deliver strong returns over extended periods of commodity price weakness.

"Rio's [free cash flow] can be relatively cyclically resilient as its capex varies greatly through the cycle and it has low-cost assets that are cash-generative even in weak markets," analysts Christopher LaFemina and Timothy Ward said in a research note sent to clients.

While Jefferies acknowledged that investors were concerned about downside risks to Rio Tinto's capital returns if iron ore price did fall, its analysis suggested the firm's FCF yield would be roughly 5% at a cyclical trough on its current share price, and its dividend yield would be in the 2.5%-5% range.

"In a world of low rates, a divi yield of >4% should support Rio shares in downturns, and downside risk to these shares should be limited from here," said Jefferies, which also issued the group with a 4,700p target price.

The analysts also added that seasonal demand strength and an easing of trade wars also skewed near-term risk/reward "to the upside".

While Jefferies earnings estimates for 2019-20 were about 7% below consensus as it conservatively modelled volumes, costs and metals prices, the broker's projections thereafter were more than 10% above consensus on higher iron ore price forecasts.

"We also think the market greatly underappreciates the importance of Rio's dividend as its shares effectively behave as a high-yield bond proxy with a growing coupon, and history shows that these shares have delivered spectacular returns even in bear markets for commodities," said Jefferies.

"We downgraded Rio on Aug 6 because of escalating trade wars, near-term seasonal demand factors, and our view that Rio was a consensus long. We upgrade today based on our detailed capital returns analysis."