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Rio Tinto (NYSE:RIO ) is paying a fat 11% dividend and investors have trashed it, assuming that the dividend is cyclically doomed to return to its mean. While the global environment is quite recessionary, governments all over the world are preparing to massively subsidize the industrial metals market by way of the electric vehicle revolution. Let's also insert growing tensions in the Pacific and Eurozone over Russia and Chinese military aspirations, you have another catalyst for industrial metals spending making for an industry that should be able to maintain its cashflows for years to come. This stock remains cheap up against almost any valuation metric, price/earnings, price/free cash flow, and a low PEG ratio to boot.

Rio Tinto has a market cap of $94 billion and is one of the bellwethers in this sector, by far my favorite play out of the major three that rule this mining segment with the others being Vale (VALE) and BHP Group (BHP). These are all multinational conglomerates that produce steel, copper, nickel and other metals for industrial use. All are big dividend players for passive income investors with Rio Tinto's financial performance and operating efficiency ahead of its peers. The fiscal year's profit margin for RIO was at 33% and return on invested capital was a whopping 33% as well. Rio's numbers are superior to their industry peers who are sinking into negative margins, dividends at 6.37% (RIO currently pays 11%), and return on invested capital at 20%, all well below the numbers Rio Tinto has been able to put up recently.

Let's take a dive into the safety of the dividend. The trailing dividend payout ratio for Rio Tinto is at 73% of earnings. This crosses the 50% threshold that dividend investors would like to see as their margin of safety, but not anywhere near the point where we would have to anticipate them borrowing to cover dividends with debt levels remaining conservative. Rio Tinto's debt to equity ratio is at 22%. Trailing 12 months of free cash flow, the vital element to look at when analyzing dividend stability, was $14.9 billion with a forward dividend of $10.34 billion, 69% of free cash flow. Thus at a granular level, the dividend payout to free cash flow looks a bit healthier than the dividend payout to earnings ratios.

Running this through a compound interest calculator with dividends reinvested, assuming a five-year holding period with Rio Tinto maintaining its 11% dividend and a 40% (8% a year) share price upside we get the following conclusions: For a $1,000 investment you would have an ending balance of $2433, annual average dividend income of $233 with a total dividend payment of $843 during that period. The total return potential would be 143.31% with an average annual return of 28.66%.

The above assumptions maintain that commodity prices remain strong during those 5 years. There is no shortage of analysts betting that inflation is here to stay, I'm also on the commodities super cycle boat and reiterate my strong buy opinion because of this.

Analyzing the valuation metrics of the company, this is certainly a value stock by several metrics. Rio Tinto on a price to earnings and price to free cash flow basis is trading at just 6x forward earnings and 4.3x cash flow. The company's trailing PEG ratio is roughly .3, taking into consideration the compound annual growth rate of the past 5 years EPS divided into the forward price to earnings ratio. Finally, if we look at the company's Graham number (square root of (22.5) x (TTM EPS) x (MRQ Book Value per Share)), we get 22.5 x 10.86 x 31.22 = $87.34, or a possible 47% upside in addition to the 11% dividend. The Graham number is effective when looking at companies that have value based on both their tangible assets and cash flows as compared to companies that are valued in a skew more toward their earnings growth potential in conjunction with intangible IP.

Morningstar analysts forecast 2024 EBITDA at $26 billion, with EBITDA being a good proxy for free cash flow, we can see that the dividend is expected to be covered at the current levels for the next 2 years based on estimated EBITDA retreating 13% off its full year 2022 guidance. Considering these fundamentals, this is one of the best dividends plays for this yield territory that you will find in the market. Normally when we stumble upon large dividend payers like this, there is either a payout ratio in excess of EBITDA and earnings that forces the company to either cut or borrow to satisfy the payout. In some instances like REITS, fresh equity is continuously sold to pay the dividend and expand because the payout exceeds earnings. This common scenario creates a false reality via dilution. Rio Tinto on the other hand is covering this dividend with a very strong balance sheet for backup if they need to raise additional debt for assistance.

We know charging stations are going to need massive amounts of copper wire, cars and vehicles need steel. One of the big enchiladas few people talk about is nickel, Elon Musk stated that battery making requires much more nickel than it does lithium. Investors, on the other hand, have been obsessed with the lithium play, driving lithium producer's price to earnings ratios well into the stratosphere. Rio Tinto is dipping its toes into both nickel and lithium with the Tamarack mine in Minnesota and a lithium mine in Serbia and Australia. This makes Rio Tinto an interesting play for the future of both critical battery minerals being hedged by amazing cash flows from all of their other mining segments.

Is this a standard boom and bust commodities cycle with the enormous profits, margins and returns on invested capital being short lived if the world falls into a recession or worse? Additionally, Rio Tinto and other industrial metals companies are being clobbered with the assumption that if China's residential and commercial real estate market collapse, a large portion of their profits derived from that sector would be nullified. Believing that Chinese construction is solely dependent on the residential market would also be a bit of a misnomer.

The Chinese government will most likely shift their focus from subsidizing residential developers. Much of their expansionary activity will be moved into commercial and infrastructure projects to stimulate the economy with greater control than being a majority partner with private residential developers, which was the typical order of business. Finally let's also not forget that while the rest of the world is increasing interest rates, China is one of the sole countries reducing them in order to rekindle construction activities.

The answer is yes. The leaders in mining and energy are all reconfiguring their future operations to protect their access to revolving credit and debt. Rio Tinto lays out their plan here from their annual 20-f filing:

In 2021, we launched our new business strategy, with the low-carbon transition at its heart. This makes priority the opportunity for growth in the materials that will enable the energy transition and accelerates the decarbonization of our assets. We brought forward our 15% reduction target for our own Scope 1 and 2 emissions from 2030 to 2025, and we more than tripled the target for 2030, seeking to reduce our carbon footprint by 50%.

The pivot that Rio Tinto is making to abide by ESG score rules is vital, and one that will help expand future operations by access to credit as well as provide share price stability by allowing more pension funds to invest. Both pension and some hedge funds are now instituting rules regarding ESG - basically, if you don't have a plan, they can't invest in you. While many plans that you see being instituted today might just be lip service, it will provide vital credit and equity stability for the time being.

In summary, with a possible 40%+ upside in price appreciation, an 11% dividend that is still sustainable, and industry-leading performance on all fronts, this is a good place to park for value investors looking for passive income or potential upside in a swing trade.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of RIO, SCCO, VALE either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.