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Is Rio Tinto Limited undervalued?

Rio Tinto Limited (ASX: RIO) is one of Australia’s premier mining stocks. With operations all over the world, it’s notching production records every year. To some investors, its current price could be a bargain.

So why is it trading so cheap? The answer: forecast lower iron ore prices.

With huge production increases from the world’s major iron ore miners such as Vale SA (NYSE: VALE), Rio, BHP Billiton Limited (ASX: BHP) and Fortescue Metals Group Limited (ASX: FMG) expected to hit Chinese markets soon, it is anticipated demand won’t keep pace with supply, thus forcing down the average price.

With iron ore accounting for over 90% of Rio’s underlying earnings in FY13, investors have reacted to the possibility of iron ore dropping to $US80 per tonne by selling down its shares. Last year, Rio realised an average sales price of $US126 per tonne.

Although Rio is one of the world’s lowest cost iron ore producers, the falling spot prices will significantly affect the top and bottom lines of the iron ore giant. This means, cash flows will drop and its debt repayment schedule could be significantly delayed. Currently Rio has $US18.1 billion in debt, down from $US19.2 billion in FY12.

Even though the miner is expected to produce 295 million tonnes of iron ore in the 2014 calendar year (2013: 265mt), if the price drops to below $US100 per tonne in coming months, it will be exceedingly difficult for it to match its earnings last year.

Outside of its iron ore business, cost cuts and divestments are beginning to have a positive effect on earnings. The group’s struggling aluminium division experienced a hefty upswing in profit in FY13 and although the commodity remains under pressure, management will be hoping for more of the same in the current financial year. However, the increased earnings from other divisions are unlikely to come even close to completely offsetting a significant fall in the iron ore price.

Foolish takeaway

Some analysts are forecasting iron ore to remain around $US110 per tonne for the remainder of 2014, while others are expecting $US80 per tonne in the second half of the year. If it stays at the higher end of this range for the next 24 months, Rio’s current share price could prove to be undemanding. However if iron ore falls to the $US80 per tonne in that time it’s going to put Rio shareholders in a prickly situation.  One which I wouldn’t want to be caught in. Therefore unless you’re extremely bullish on the price of iron ore, you may want to hold off making a purchase until we get its half-yearly results later in the year. 

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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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