Questor share tip: Rio Tinto's iron ore is at the bottom of the cost curve

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Rio Tinto (Berlin: CRA1.BE - news) cost cutting should boost profitability. Questor says buy.

Mining (Euronext: SMI.NX - news) giant Rio Tinto said last week that it has targeted $5bn (£3.1bn) of cost savings by the end of 2014. Agreed spending on exploration and evaluation projects would be cut by $1bn. Miners heavily invested in new projects when basic material prices went through the roof, but prices have plunged as investors became worried about a slowdown in China and as supply of certain commodities increased.

At the same time, costs escalated, crimping margins further. Rio plans to simultaneously boost production at its iron ore, copper and aluminium operations.

Rio has focused on iron ore, which now makes up almost 70pc of operating profit and so is heavily exposed to China infrastructure spending. Although the pace of growth has slowed, urbanisation is likely to continue for some time.

Rio benefits from being at the lower end of the costs curve, particularly in iron ore. Prices of the steel-making ingredient fell to about $86 a ton in September due to Chinese destocking, but Rio is profitable at this level. Other miners are not.

Iron ore prices have since rebounded to almost $120, however.

Rio is likely to rein in investment in commodities such as coal, but has not reduced spending on iron ore. Rio also has a substantial copper business, which has one of the best supply-demand fundamentals of all metals. Prices have been rising lately and the metal is up 4pc this year.

Global (Chicago Options: ^RJSGTRUSD - news) demand for aluminium is also expected to double by 2025. Rio owns Alcan, the Canadian aluminium business it bought at the height of the commodities boom. The group is also mining mineral sands and some analysts reckon these could make up 14pc of earnings by 2014.

Cost savings and the reduction of capital-intensive expansion projects is likely to lead to an increase in free cash flow. This means more share buybacks are likely, but there will also be pressure from investors for special dividends.

Iron ore prices are also off lows and are unlikely to fall back as Chinese stocks are close to year lows and there are signs of an economic improvement. The shares are trading on a 2012 earnings multiple of 9.7, falling to 8.6. The average price target of City analysts monitored by Bloomberg is £38.08, some 23pc above the current price. Buy.