Rio Tinto takes a walk on the safe side

Confirmation that Rio Tinto has smashed its operating cost reduction target is exactly what the market wants to hear.

Bringing down operating costs and paying off debt is reducing the company's risk. Already eclipsing the $2 billion of cost savings this year, the target for the year ahead is another $1 billion. Rio is putting returns to shareholders ahead of the future growth profile of the company for now.

It is likely investors will pressure Rio Tinto to return more capital beyond standard dividends from the cash chest, but Rio’s focus for 2014 is reducing debt on the balance sheet. The full-year dividend in 2012 increased by 19 per cent after a 20 per cent increase in 2011. Expectation is the dividend will increase again this year, pleasing investors.

Of the capital allocation priorities, progressive dividends are second only to sustaining essential capital expenditure. That's a reflection that Rio is in tune with what shareholders want.

Despite having slashed operational costs, Rio has set new production records. The close of the mining boom has forced miners to readjust and become more efficient, something Rio has managed well. While surplus supply of iron ore is a realistic threat in the year ahead, Rio Tinto has taken measures to ensure operations are maximising efficiency, keeping  cost-per-tonne as low as possible. 

Beyond operational cost savings, Rio plans to continue cutting capital expenditure. Consequently investors can’t expect the same levels of growth in the near term or even in the years ahead. Decisions need to be made today to provide growth in the medium and long terms. A change in market conditions or demand would force Rio to respond and either leverage on this growth opportunity or let it slide. 

While there is often scepticism around China’s future growth potential, it is important to keep in mind China has continued to churn out GDP growth in excess of 7 per cent for some time, even as global economic conditions have created a weaker environment.

For investors, now it comes down to a matter of valuation and time frame. Global growth is improving, despite news headlines and market commentary often giving a negative slant. For Rio, China’s fixed-asset investment makes up the lion's share of iron ore revenues. There is a wager with this – less-than-expected government stimulus will offer downside risk. Conversely, a better-than-expected outcome will present an upside opportunity.