3 Top Dividend Stocks in Iron Ore

Iron ore is one of the main raw materials used to make steel. In fact, 98% of the iron ore mined each year is for steel production. Given the importance of steel to our global economy, iron ore is one of the most valuable metals produced by miners.

Because of that, companies that mine it tend to make a considerable amount of money. That's why the world's three largest iron ore miners, which combined to control more than 40% of the market, pay very generous dividends:

Data source: YCharts. Dividend yield as of June 20, 2017.

Here's a closer look at the top dividend paying stocks in the iron ore industry.

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Iron ore and so much more

Rio Tinto is the third largest iron ore producer in the world thanks to its network of 15 mines in the Pilbara region of Western Australia. That business produced robust earnings last year, generating $8.5 billion of underlying EBITDA, up 11% from the prior year, helping the company more than offset weakness in its aluminum, copper, and diamonds businesses so that it delivered $13.5 billion in EBITDA for the full-year, up 7% from 2015. Overall, Rio Tinto generated $8.5 billion in operating cash flow for the year and returned $3.6 billion to investors, including $3.1 billion in dividends.

Those payments should continue flowing to investors since a crucial part of Rio Tinto's value proposition is paying out 40% to 60% of its cash flow in dividends each year. Given that policy, Rio Tinto has the potential to pay higher dividends as cash flow rises, which is highly likely since it has several initiatives underway geared to increase earnings. One of those is its Silvergrass expansion project, which will deliver 20 million tonnes of iron ore per year when it comes online later this year, a nice increase for a company that produced 263.3 million tonnes in 2015. It's an incredibly high-return project, with Rio Tinto expecting to earn a more than 100% internal rate of return on the $500 million invested in the project. In addition to that, the company is working to increase the productivity of its mines, which should release an additional $1.5 billion of cash flow per year by 2021. Add in the fact that Rio Tinto has the best balance sheet in its peer group, and it should continue making dividend investors happy.

The global iron ore leader

Brazil's iron ore giant Vale is not only the largest iron ore producer in the world but that one commodity supplies more than 75% of its revenue. While that means it's as close to a pure play on iron ore as income investors will find in the sector, its lack of diversification and weaker balance sheet makes it higher risk during periods when iron ore prices are low. That was the case last year when the company only paid $250 million in dividends, which was a huge drop from the $1.5 billion it paid out in 2015 and the $4.2 billion it shelled out in 2014. That said, with iron ore prices rising over the past year, and a major growth project ramping up, the company's dividend has followed suit in 2017.

That growth project is the $14 billion S11D mine, which will add 90 million tonnes to the company's annual capacity as output ramps up. The mine will eventually enable Vale to produce 400 million to 450 million tonnes per year, which is a pretty big jump for a company that produced 346.1 million tonnes in 2015. Even better, cash costs of that mine will be 40% below those of its legacy mines, positioning the company as the low-cost leader in the industry. Because of that, Vale should generate tremendous cash flow in the future, likely enabling it to pay higher dividends.

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An iron giant and then some

Like Rio Tinto, BHP Billiton benefits from controlling several iron ore mines in Western Australia. That said, BHP is much more diversified since iron ore only contributed 42% of its underlying EBITDA in the back half of last year, while petroleum, copper, and coal each provided about 20% of underlying EBITDA. That diversification enabled the company to benefit from an improving iron more market as well as stronger demand for coal and copper. As a result, cash flow from operations jumped 46%, giving BHP Billiton the money to pay 150% more in dividends than it did in the prior period.

One of the drivers of that dividend increase is BHP Billiton's payout policy, which dictates that it return 50% of cash flow after maintenance capital to investors via dividends, with the rest allocated toward growth projects, share buybacks, debt reduction, and additional dividends. As a result of that policy, when cash flow rises so does the dividend. 

While improving commodity prices will play a significant role in boosting earnings in the future, another driver will be growth projects. One such expansion is in its Western Australia iron ore business, where the company plans to boost annual capacity up to 290 million tonnes per year during 2019, which is a healthy increase from the 273.8 million tonnes produced in 2015. That future capacity increase, when combined with rising commodity prices, has the potential to fuel healthy dividend growth in the years ahead. 

Investor takeaway

Because iron ore is an essential component for steelmaking, it tends to be quite profitable. As a result, the largest global iron ore producers generate substantial cash flow, which gives them plenty of money to pay generous dividends to shareholders when prices are high. Further, these companies have a history of reinvesting their iron ore cash flows into high-return growth projects, which should push profits higher even if prices don't follow suit, increasing the likelihood that their dividends will rise over time.