Falling Demand for Steel Likely to Reduce Rio Tinto's Variable Dividend

Last week iron ore prices tumbled 20%, marking the worst week for the mineral since the financial crisis in 2008. The sell-off was stamped by China implementing production limits for steel, the primary use for iron ore, to help ensure blue skies for the upcoming winter Olympics in Beijing.

However, global steel demand had already begun to wane, led by the cooling housing market in China, the world's largest consumer of steel.

Concerns around the price of iron ore dropping over 50% since last May continue to accelerate. Evergrande, one of China's largest property developers, is teetering on insolvency, signaling a continued slump in demand for building materials in what has been the world's hottest market.

Share prices of mining companies have followed suit. Rio Tinto, which generates around 75% of its earnings from iron ore, has seen its stock drop over 30% since its May peak.

Not only is iron ore the most significant piece of Rio Tinto's business, but China is its primary market for the mineral.  

As a result, Rio's earnings will inevitably pull back from the stellar results reported since the onset of the pandemic. And with it, the variable-rate dividend payer will likely see its payout reduced in the year ahead.

Rather than commit to a fixed dividend payment that remains stable or increases annually, Rio's dividend policy targets a 40% to 60% earnings payout ratio through an economic cycle.

When commodity prices are booming, dividend growth can be substantial as earnings swell.  Rio's ordinary dividends over the past year are up nearly 80%, and the firm has distributed special dividends as well.

But this variable payout policy is a double-edged sword.  With China's declining demand taking iron ore prices down with it, Rio's earnings will likely settle back in line with historical levels.  And its dividend will follow to keep the payout ratio in line with management's target.

In the first half of this blockbuster year, Rio paid out 50% of its earnings as an ordinary dividend.  As iron ore prices revert to their long-term average and cause Rio's earnings to contract, we estimate the firm's dividends could fall as much as 50% over the next few years to maintain Rio's payout ratio target.

In other words, investors looking at Rio should probably expect a full-cycle dividend yield closer to 5% rather than the 10% yield Rio has sported this year.

As a result, we are downgrading Rio Tinto's Dividend Safety Score from Borderline Safe to Unsafe.  Until iron ore prices stabilize, investors should brace for some volatility around the dividend.  

Despite the looming impact on the dividend, our downgrade of Rio's Dividend Safety Score doesn't imply owning Rio is a bad investment.

Mining companies serve an essential role in supporting global economic growth, and Rio Tinto is a well-run firm with low-cost production and an A credit rating.  The company is positioned to capitalize on boom periods while ensuring it can ride out periods of contraction such as now.

Investors dependent on predictable income would be better served looking elsewhere for income, but those comfortable with volatility may find Rio Tinto a good opportunity to gain exposure to commodities and global economic growth while also generating some income.