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Raining on Rio’s parade

Australia’s second largest miner by market capital, Rio Tinto Limited (ASX: RIO) reported its half year results to June 2012 yesterday, beating analyst expectations – or did it?

At a first glance, the company reported a net profit of US$5.9 billion dollars, above analyst expectations for a profit of around US$5 billion. But included in that US$5.9 billion was a deferred tax credit of US$1 billion related to the recent introduction of the Mining Resource Rent Tax (MRRT). Taking that figure out and the results may have fallen short of analyst expectations.

Analysts, commentators and investors alike also appear to have missed the real point and that is the company has reported a massive drop in profit due to falling commodity prices, which show no sign of reversing course just yet.

Rio’s shares are up more than 3% at lunchtime today, despite the company reporting a 13% fall in total revenues to US$25.3 billion and a profit that was down 22.4%. Most of the blame can be laid at the feet of falling commodity prices, with the company receiving US$1.9 billion less in revenues than the previous year, despite increased production. Prices declined for nearly all of Rio’s major commodities, except for gold, some minerals and thermal coal.

The worry for the company and investors is how much lower commodity prices could fall. With more than 80% of Rio’s revenues exposed to iron ore prices, any further falls in the price could have major implications for the company’s profitability. Rio plans to ramp up production of iron ore from 91 million tonnes this half year to 283 million tonnes per year by the end of 2013. To reach that target, Rio plans to spend an additional US$6 billion in capital expenditure in the remainder of the year, on top of the $US7.6 billion it has already spent, and total capex for 2012 is expected to come in at US$16 billion.

As a consequence, net debt blew out from $8.5 billion at 31 December 2011 to US$13.2 billion at 30th June 2012. One can only imagine how much debt the company will have by the time it has ramped up production to 283 million tonnes.

Unlike BHP Billiton Limited (ASX: BHP), which appears to be taking a conservative approach to future projects, Rio looks to be rushing into its iron ore expansion plans with little or no slowdown planned.

The company doesn’t appear to think it has much choice. For years it has been ramping up its iron ore production, it’s not about to turn back now.

The problem for Rio is that a 10% fall in iron ore prices reduces the company’s underlying earnings by US$1 billion, and this could have a greater effect in future years, as the company increases its reliance on iron ore.

Pure play iron ore miners, Fortescue Metals Group Limited (ASX: FMG) and Atlas Iron Limited (ASX: AGO) are also aggressively ramping up production, but may also face an uncertain future if prices fall much further.

Rio increased its dividend by 34%, declaring a 68.5 cent fully franked dividend for Australian shareholders, still a fairly low yield for investors.

The Foolish bottom line

The company stated that China’s GDP continues to grow at around 8%, and that it expects China’s policy makers to stimulate their economy to ensure it continues at that pace, should it show signs of slowing further. I’m not so sure that’s the same as a guarantee, and it appears to me that GDP growth could moderate even further.

The other issue is the supply of iron ore. With all the big iron ore miners expecting to significantly increase their production, we could see an over-supply of the commodity. Basic economics will tell you that when there’s more supply than demand, prices will fall.

Rio appears headed into a storm at full steam.

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Motley Fool writer/analyst Mike King owns shares in BHP. The Motley Fool‘s purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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