Rio Tinto Limited (ASX: RIO) has risen by 10% in 2016. That's behind the gains of BHP Billiton Limited (ASX: BHP) and Fortescue Metals Group Limited (ASX: FMG) which have increased by 16% and 153% respectively.
However, Rio Tinto's gain masks problems which may lie ahead for the iron ore-focused miner. Its business model and strategy could act as negative catalysts on its share price over the medium to long term.
Diversity
Rio Tinto cut dividends for the first half of the 2016 financial year by 58% versus the comparable period. Although this is a sensible step, it does not go far enough to allow the company to become more diversified. For example, capital expenditure was cut by 47% in the first half of financial year 2016 and it is only through investment in its non-iron ore divisions that it will build a more diversified and lower risk business.
Instead, Rio Tinto has sought to balance the near term income prospects of its investors alongside some investment, rather than diversify away from iron ore as quickly as it should. It relied upon iron ore for 64% of its EBITDA in the first half of 2016. While the price of iron ore increased from US$40 per dry metric ton to as much as US$60 per dry metric ton during the first half of the 2016 financial year, its outlook is uncertain due in part to lacklustre demand from the world's biggest importer, China.
Cost reductions
Rio Tinto has been successful in cutting costs. For example, in the first half of the 2016 financial year it reduced operating cash costs by US$0.6 billion and is on target to reduce them by a total of US$2 billion by the end of the 2017 financial year. However, cost cutting can only do so much to improve Rio Tinto's profitability. It needs to generate a higher income alongside reduced costs and it is not making full use of its low gearing to achieve this.
For example, Rio Tinto has net debt of US$13.6 billion on its balance sheet, which equates to a net gearing ratio of 31%. Interest payments were covered 4 times by operating profit, which indicates that it is able to borrow to make acquisitions. This would not only diversify the company away from iron ore, but could also improve its income performance. Assets in the resources segment are cheap and Rio Tinto should take advantage of this to generate higher returns.
Outlook
Rio Tinto is a financially sound business which has an enviably low cost curve within iron ore. However, its focus on cost reductions and not on expanding income as well as its decision to pay out over half of underlying earnings as a dividend instead of investing in its asset base could hurt its performance. A further dividend cut may be unpopular and an acquisition may be risky, but the status quo leaves Rio Tinto with a high risk profile and an unhealthy dependence on iron ore.
