In the past few months shares in Rio Tinto Limited (ASX: RIO) and fellow Australian miner BHP Billiton Limited (ASX: BHP) have grown stronger on the back of a patchy year in 2013, but it appears the bullish run can continue.
Over the past 10 years Rio Tinto shareholders have kept their faith in the miner whilst the market punished poor management and falling commodity prices with steep sell offs in its share price – in 2008 shares were trading more than double what they are today!
The good news is…
Many will still be feeling the effects of Rio's constant write-downs and complete destruction of shareholder value which has resulted in tens of billions of dollars being wiped off the balance sheets. However, the good news is, it could soon come to an end.
Net debt is dropping, cash flow is increasing and its aluminium business has shut smelters and reconditioned others – it has been the division worst affected by falling commodity prices.
The Mozambique coal business – which was purchased around the same time as Rio's aluminium business (2007/2008) from Riversdale Mining for $4 billion – has been severely discounted with impairments in the last two years totaling more than $3.2 billion – the latest $470 million reflects the country and development risks facing the operations. Don't be surprised if they keep this one on the chopping block this year.
The company's newest gold and copper mine, Oyu Tolgoi, is unlikely to experience any significant write-downs in coming years since production is now in full swing.
Strength in numbers
Continued ramp-up of production in the companies Pilbara iron ore business is also underway. This is management's major strategy for growing shareholder wealth in the short and medium terms. With production set to reach 360 million tonnes per annum by 2017, Rio's top and bottom lines could be expected to be boosted by as much as 25% in that time.
A thorn in its side
Rio's reliance upon iron ore is not only its greatest asset but also poses the biggest risk. The Australian Bureau of Resources and Energy Economics (BREE) in 2013 said it expects the iron ore price to drop as low as $US90 per tonne by 2018. Since Rio realised an average spot price of $126 per tonne in 2013, the ramp-up in production may, at best, only counteract the effect of falling prices.
Although there's no denying Rio will make money at those prices, because it claims to be able to dig up, transport and ship its high grade ore for as little as $US50 per tonne. The point is Rio's iron ore division may not be the saviour long-term shareholders are hoping it will be. In 2013, Rio's iron ore division made $9.858 billion profit whilst the group's total net earnings came in at $10.2 billion.
Foolish takeaway
In the short term Rio's upward trend looks very likely to continue. Rising production, growing cash flow, falling debt and bigger dividends all appeal to investors. As a result of its transformation, don't expect the miner to announce any acquisitions or significant investments in 2014 (with the exception of its Simandou project), since it is still in damage control and strengthening its balance sheets. For short term investors/traders, Rio could be a worthy bet.
In the medium term, shareholders must be mindful of the price of iron ore and management's ability to diversify away from the steel-making ingredient. This will be crucial to its long-term sustainability.