Where Next for Rio Tinto's Dividend?

LONDON -- Many investors focus on earnings per share when judging a company's performance. However, earnings can be manipulated and adjusted in all sorts of ways, meaning they don't tell you a lot about how much spare cash a company has generated. Similarly, since dividend cover is calculated using earnings, a good level of dividend cover doesn't necessarily mean the payout is actually being funded from a company's profits.

A company's cash flow can tell you a lot about a firm's financial health. Is the company burning up its cash reserves on interest payments and operating expenses, or does it generate spare cash that can fund dividends or be retained for future investment? If a dividend isn't funded by cash flow, then there is a greater chance the payout will become unaffordable and be cut, which is bad news for shareholders like you and me.

In this series, I'm going to take a look at the cash flow statements of some of the biggest names in the FTSE 100 (UKX), to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I'm looking at mining giant Rio Tinto  (LSE: RIO  ) (NYSE: RIO  ) .

Does Rio Tinto have enough cash?
As private investors, we want to back businesses that are able to pay their dividends out of free cash flow each year. I define free cash flow as the cash that's left over after capital expenditure, interest payments and tax deductions. With that in mind, let's look at Rio's cash flow from the last five years:

Year

2007

2008

2009

2010

2011

Free cash flow ($m)

(34,251)

8,702

5,855

16,566

3,192

Dividend payments ($m)

1,507

1,933

876

1,754

2,236

Free cash flow/dividend*

(22.7)

4.5

6.7

9.4

1.4

Source: Rio Tinto company reports. *A value of >1 means the dividend was covered by free cash flow.

A look at these figures shows that something dramatic happened in 2007, resulting in Rio experiencing a vast cash flow shortage. So what was it?

In 2007, Rio spent an eye-watering $38 billion buying Alcan, an aluminum producer. The cash flow statement for that year records $39 billion in new borrowings, so it's a safe assumption that Alcan was bought with borrowed money. Unfortunately, Rio paid vastly over the odds for Alcan, and has since been forced to writedown the value of the acquisition by many billions of dollars.

In the meantime, it's been forced to repay the $38 billion it borrowed to buy Alcan. Perhaps predictably, this proved too much for its battered finances to handle and in 2009, Rio was forced into a $15 billion share issue, the proceeds of which were used to repay a big slice of debt.

This story highlights one of the restrictions of only focusing on one metric -- such as free cash flow -- when assessing a company. No one metric can tell the whole story, although a look at Rio's full cash flow statements for the last five years provides most of the clues you need to understand this story.

Is Rio's dividend safe?
On the face of it, Rio has a history of strong free cash flow generation each year, with only 2007 proving an exception. Rio's overpriced Alcan acquisition is a mistake the company probably won't make again, as like most of its peers, it is now focusing far more carefully on managing and justifying major capital expenditure in order to cut costs and boost profits.

Rio Tinto's dividend yield of 2.9% is not bad for a big miner -- BHP Billiton offers 3.2%, while Anglo American offers 2.6% -- and the firm's dividend payments have been well covered by free cash flow over the last four years.

Although Rio's half-year results for 2012 show that its heavy capital expenditure commitments have continued this year, leaving it cash flow negative at the end of June, capital expenditure is set to fall next year, and the company has taken advantage of the current boom in corporate bonds to refinance some of its debt at very low interest rates. Rio also has just over $7 billion in cash and cash equivalents, enabling it to smooth over short-term cash flow shortages.

Overall, I think that Rio's dividend looks quite safe at current levels, but I don't expect to see dramatic growth over the next couple of years.

Top income tips
One man who really understands how to assess the quality of a company's dividends is legendary City fund manager Neil Woodford, whose High Income fund grew by 342% over the fifteen years to October 2012, during which time the FTSE All-Share index managed a gain of only 125%.

Mr. Woodford selects stocks that he believes are undervalued and likely to deliver strong dividend growth. His record is one of the best in the City and at the end of October 2012, he had £21 billion of private investors' funds under management -- more than any other City fund manager.

You can learn about eight of Neil Woodford's largest holdings and how he generates such fantastic returns in this exclusive Motley Fool report. It's completely free, but is available for a limited time only. I strongly suggest you click here and download the report today to avoid missing out.

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