Cast iron case for Rio

Pulled back from the brink of disaster thanks to a $15bn (£9.5bn) rights issue last June, major mining group Rio Tinto has all but repaired its balance sheet. It has renewed its focus on expansion and looks well-placed to deliver long-term earnings growth.

Rio is exposed to commodities markets that should continue to flourish over the medium term, driven by demand from developing economies. Commodities prices will inevitably fluctuate short term in response to economic data and currency movements, but it's difficult to see how demand from developing countries, followed by eventual recovery in the developed world, can fail to sustain longer-term demand.

The rapid urbanisation of China has almost single-handedly propelled the current commodities boom. Possibly over 600m Chinese have already left the fields for cities and joined the ranks of the global consumer. Yet consultants at McKinsey Global Institute estimate that 300m more (roughly the population of the US) will urbanise by 2025.

If China is to accommodate this human sea, it will need to build new cities and infrastructure at a fantastic rate - constructing a city the size of London every year - to house these new urbanites, then provide employment and goods for them.

China is already the most voracious consumer of many materials - iron ore, copper and coking coal (used in steelmaking), for example - and second only to the US in its consumption of oil. Demand for these and other commodities will grow further as urbanised Chinese become wealthy enough to buy cars and consumer durables. All this requires huge quantities of commodities, many of which are supplied by Rio.

Much of Rio's potential is based on iron ore and copper, two of the metals most fundamental to industrialisation. Rio has significant opportunities in its project pipeline, although these are generally long-term projects that require substantial capital investment. The group has approved $3bn of capital spending so far in 2010. Full-year capital spending is expected to approach $6bn, and could rise to $9bn in 2011 if investment conditions remain stable.

Around 60 per cent of Rio's profits come from iron ore, which is used predominantly to make steel. This makes iron ore a vital commodity for powering the industrial revolution in China and other developing countries, and Rio is well positioned to take advantage of the anticipated resumption of Chinese steel capacity next year.

After calling off its planned iron ore joint venture with BHP Billiton in Pilbara, Western Australia, in the face of regulatory opposition, Rio confirmed further investment of $3.1bn (Rio's share - $2.1bn) to expand Pilbara's infrastructure. Rio plans to increase mining capacity to 283m tonnes a year by 2013, although more investment will be needed before it can mine at this rate. Rio has also advanced to the next stage of developing its world-class Simandou iron ore project in Guinea and restarted expansion of Iron Ore Company of Canada's concentrate capacity.

Meanwhile, Rio's Oyu Tolgoi copper-gold project in Mongolia should start production in 2013. The project is held as a joint venture with a Canadian firm, Ivanhoe Mines, and Rio has increased its interest to 29.6 per cent. Construction of the Eagle nickel-copper mine in the US will begin this year, with first production also expected in 2013.

Broker Oriel Securities estimates that, even after spending $6bn on capital projects this year, operating cash flow ($9.9bn in the first half of 2010) and asset sales ($3.6bn in the first half of 2010) will leave Rio with over $8bn of cash at the year-end, reducing net debt to around 13 per cent of shareholders' funds. This would leave plenty of ammunition for acquisitions, although these will be smaller than the $38bn Alcan deal of 2007. This deal left the group in dire financial straits and with a large exposure to aluminium, whose price looks likely to stay weak, holding back profits growth in the near term.