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Should you buy Rio Tinto?

Foolish investors know the hallmarks of a good buy in any market, even one as competitively priced as the S&P/ASX 200 (ASX: XJO) (^AXJO). As indexes climb, investors sometimes begin to make exceptions to their investing strategies. You know this is happening when even the worst stocks are climbing higher and higher.

Rio Tinto (ASX: RIO) is not a stock that has climbed higher for no good reason. It could be CEO Sam Walsh’s drive to stamp out extraneous costs, the increasing likelihood of the Pilbara 360 expansion or a resilient iron ore spot price that has kept pushing the share price higher. Let’s take a quick look at company and see whether or not it’s a good place to put your money.

Rio is the world’s second largest iron ore miner and is listed on both London’s FTSE and the ASX. Its products include aluminium, copper, diamonds, thermal and coking coal, uranium, gold and a number of industrial metals. The company divides these into five product groups – aluminium, copper, diamonds and minerals, energy and iron ore.

In recent times, Rio suffered one of the biggest write-downs ($14 billion) in history after the company made numerous poorly thoughtout acquisitions, including the purchase of Canadian aluminium producer Alcan for $38 billion. This is still having repercussions today and cost former CEO Tom Albanese his job. When the purchase was made in 2007, Rio’s share price was rising to a peak of nearly $150.

Although Rio produces multiple products, some might consider it a ‘pure play’ iron ore miner thanks to the commodity accounting for around 80% of earnings, dwarfing copper, aluminium and coal sales. The lack of diversity, compared to rival BHP (ASX: BHP), make the downside risks much larger but the potential upside, if the price of iron stays firm, amplified.

Earnings per share have been falling since 2008’s high of 981 cents. In the half to June 30, 2013 EPS came in at 93.1 cents. Over the same period dividends have grown slightly, raising the payout ratio from 16% to 33%. Between 2010 and 2012, long-term debt ballooned from approximately $13 billion to over $23 billion, shareholders equity reduced by around $12 billion and return on equity dropped from 24% to 19.8%. During that time, the spot price of iron ore averaged above US$124 per tonne but the aluminium price trended downwards.

Growth

Rio’s future, not past, is what’s important. We need to objectively assess it for future growth given its price and expected returns, but also understand the potential pitfalls to its success.

In November this year, the board will meet to decide whether or not the company will ramp up production to 360 million tonnes of iron ore annually – currently its production rate is 265 million tonnes. For those that have a bullish outlook on China, ramping up production is a no brainer, especially if the price of iron ore remains above $100 per tonne. In addition the company has now officially opened its gold and copper Oyu Toigoi project in Mongolia.

Morningstar forecasts EPS for 2014 and 2015 at 549.6 cents and 712.7 cents, respectively — 16% and 50% higher than its predicted 2013 earnings of 473 cents. At those earnings it will trade on a ratio (based on a current price of $64.20) of 11.69 for FY14 and 9.00 for FY15.

Foolish takeaway

Bear case: In the near to medium term, if the iron ore price doesn’t hold up above US$110 per tonne, Rio’s earnings will come under pressure but could still be considered somewhat cheap, although not a bargain. A conservative investor would wait for a lower entry point.

Bull case: At current prices and allowing for a 50% increase in earnings between now and 2015, Rio’s shares are cheap, provided the iron ore price remains strong between $115 and $135 per tonne. In this instance, I wouldn’t be surprised if Rio’s share price goes higher in the coming years.

There is a lot of uncertainty surrounding Chinese demand for steel and a looming oversupply will put downwards pressure on the iron ore price. For those willing to take on the risk, Rio could warrant a buying opportunity. For those of us who would rather sit on the sidelines and wait for a lower entry price or look for other investing ideas, it’s important to remember that patience will not lose you money.

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Motley Fool contributor Owen Raszkiewicz does not have a financial interest in any of the mentioned companies.

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