In previous articles, I've shown investors how Rio Tinto Limited (ASX: RIO) could one day prove to be a bargain at current prices, and I've hinted at the idea of it being a turnaround story. However, it's becoming more and more obvious with every passing day that Rio is facing a number of headwinds.
The problem: iron ore prices
Iron ore earnings accounted for a large portion (more than 90%) of Rio's underlying earnings in FY13. Although iron ore affords miners like Rio and BHP Billiton Limited (ASX: BHP) strong profit margins, their dependence upon it is also their number-one weakness. That's because, if the price of iron ore drops, so too will their earnings.
I believe the value of a resources company is a function of the cost of production, because trying to accurately predict or forecast commodity prices is anyone's guess.
However it's important to have an appreciation of the current market forces at play and the best way to garner an insight into future commodity prices is to try and gauge the market's general consensus. By doing so, what I've concluded is it doesn't look good for iron ore investors, particularly those with their money tied up in higher cost producers. I'm steering clear of smaller miners such as Arrium Ltd (ASX: ARI), Mt Gibson Iron Limited (ASX: MGX) and Atlas Iron Limited (ASX: AGO).
Iron ore, like all commodities, will maintain a certain price while demand keeps pace with supply. Australia's three biggest miners – Rio, BHP and Fortescue Metals Group Limited (ASX: FMG) – along with Brazil's Vale Inc (NYSE: VALE) are ramping-up production considerably. Although increased production is generally perceived as a positive, the catch for investors is that China, which accounted for 99% of the growth in seaborne iron ore between 2005 and 2013, isn't likely to increase demand as quickly as hoped for.
Since it accounts for 67% of seaborne iron ore it has to be asked how the current price could be sustained if production increases continue.
Rio's other businesses
Rio isn't just an iron ore miner. Its copper business is profitable and operates on an underlying EBITDA to revenue margin of 29%. However it simply doesn't have the scale to offset the likely falls in iron ore earnings. Its aluminium business has, in recent years, been a worry for investors as management continuously wrote down assets following sustained low spot prices. These prices are likely to continue into the near future. Diamonds and energy are also unlikely to offset any fall in earnings.
Foolish takeaway
While Rio appears cheap using a number of simple valuation techniques such as price-earnings (currently around 8.5) and dividend yield (3.3%), I believe a number of stars will need to align before we'll witness any meaningful appreciation of the share price.
However, I'm not going to rule out earnings growth in 2014. If Rio can surprise the market with growing earnings from its aluminium and copper divisions (whilst keeping write downs to a minimum), and the average realised price of iron ore stays as high as $US110 per tonne, then there is a chance it could outperform the S&P/ASX200 (ASX: XJO) (^AXJO). However the question is: Is it worth the risk?
