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Should you buy Rio Tinto Limited?

Increased productivity, lower costs and a commanding market position is usually enough to make a share price rally. Well, that is, unless you’re in the resources sector.

In recent years, resources heavyweight Rio Tinto Limited (ASX: RIO) has, along with fellow miner BHP Billiton Limited (ASX: BHP), failed to impress the market and its shareholders. Since the company decided to acquire its Aluminium business, Alcan in 2007/2008 for $US38 billion, shareholders have been unable to benefit from what’s surely to be one of the biggest mining booms in our lifetime.

Even in the company’s most recent annual report, write-downs plagued the balance sheets. However with what seems to be the worst of it all well-and-truly behind us, now could be the time to take a second look at this recently troubled miner.

First of all before even considering adding Rio to your portfolio you’ll have to be bullish on the price of iron ore as its makes up over 90% of its earnings. Secondly, with 66.3% of gross revenues coming from Asia – including China, Japan and others – you’ll have to be content with the fact current economic growth rates in Asia are sustainable.

What’s more, increased production from the three biggest iron ore miners in the world is also important. Not only is Rio in the process of ramping up production – from a current 266 million tonnes per annum (Mtpa) to 360Mtpa by 2017 – so too are its rivals BHP Billiton and Vale SA (NYSE: VALE).

If you combine all three factors and still believe the risks are worth it, you should look to add Rio to your portfolio when the commodity prices themselves experience exceptional volatility (which they always do!). We have recently witnessed how the share prices of iron ore miners such as Rio, Fortescue Metals Group Limited (ASX: FMG) and Atlas Iron Limited (ASX: AGO) can be sold-off significantly as a result of relatively minor falls in the spot price of iron ore.

The sell-offs have resulted because of investors’ bearish concerns over the Chinese economy and the government’s spending on infrastructure projects like railways, roads and skyscrapers. All of which require steel.

If Rio was a pure iron ore business its share price would command a considerable premium to what it is today. That’s because outside of iron ore, Rio’s Aluminium and Energy businesses continue to be unimpressive (to say the least) and drag on profitability. Both operate on an EBITDA to underlying earnings ratio of 16% or less, while the diamonds business is even lower at only 8%!

This doesn’t leave much margin for error but it should be acknowledged the commodity prices of aluminium, uranium and coal are at historically low levels. Despite this however, a turnaround story for both coal and aluminium is unlikely in the medium term although uranium prices could lift if Japan shifts back to nuclear energy.

Foolish takeaway

Rio Tinto shares trade on 8.5 earnings for a reason. If you’re thinking of adding it to your portfolio, you’ll have to contend with many potential headwinds which a majority of analysts, commentators and investors believe are likely to eventuate in the future.

However, the new management in place at Rio are competent and willing to do the hard yards. Something former management struggled to do, instead opting for a philosophy of growth at all costs. If the market for commodities such as gold, aluminium and uranium picks-up and the spot prices for both iron ore and copper stay strong then it wouldn’t be surprising to see Rio’s profit trend much higher in the near-term and, as a result, its share price should follow.

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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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