In the last five years, Rio Tinto Limited's (ASX: RIO) shares have traded as high as $70 per share. Although the company's performance disappointed in 2014 and 2015, in 2016 it has recovered from a low of $37 to reach the current price of $51. However, in my view its future is uncertain and the chances of it returning to $70 per share are slim.
A rising market?
Rio Tinto's shares have risen sharply in 2016 due to an improved performance for iron ore. The steel-making ingredient has increased in price by around 30% since the start of the year. This has lifted the share prices of iron ore miners BHP Billiton Limited (ASX: BHP) and Fortescue Metals Group Limited (ASX: FMG). They are up by 28% and 158% respectively, which is ahead of Rio Tinto's 16% gain.
However, the outlook for iron ore prices is uncertain. Chinese demand for steel has increased by 7% versus last year. It is being driven by a revived housing sector in China which is forecast to remain buoyant until at least the end of 2017. However, this increased demand is expected to be more than offset by a rise in the supply of iron ore. For example, Brazil's Vale is expected to add 28 million tonnes of iron ore in 2017, while the 56 million tonnes per year Roy Hill mine is due to come on stream in 2017/18.
Diversity
The effect of a further imbalance between supply and demand could send the price of iron ore downwards. This could negatively impact Rio Tinto's financial performance because of its dependence on iron ore. It accounted for 60% of operating profit in the first half of the 2016 financial year.
Although Rio Tinto is investing in other divisions such as aluminium and diamonds, the rate at which it is likely to diversity is relatively slow. That's because it has cut back on capital expenditure. For example, in the first half of the 2016 financial year, Rio Tinto reduced capital expenditure by 47% to US$1.3 billion.
In my view, this hurts Rio Tinto's long term growth prospects since US$0.7 billion of the amount was sustaining capital expenditure. This leaves limited cash available to develop other assets and create new income streams in areas other than iron ore.
Outlook
Rio Tinto has sound finances. Its gearing ratio of 23% was 1% down on the previous year and remains within the lower half of the targeted range. Therefore, it is highly likely to survive a downturn in iron ore prices, should it arise.
However, its lack of diversity and the rapidly increasing supply of iron ore mean that I'm bearish on its future prospects. Given that Rio Tinto has a P/E ratio of 16.5 versus 12.5 for the materials sector, I think that its share price is unlikely to rise to $70.
