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200 MILLION reasons why I think Rio Tinto Limited and Fortescue Metals shares will fall

I don’t mean to sound like a doomsayer BUT…

…I think the Rio Tinto Limited (ASX: RIO) share price and the Fortescue Metals Group Limited (ASX: FMG) share price will fall.

Source: Yahoo! Finance

Source: Yahoo! Finance

Indeed, the five-year chart above may look bad — but it could get worse.

The reason I’m bearish on the Rio Tinto share price and the Fortescue Metals Group share price is this: iron ore. Specifically, the dwindling profit margins of the miners.

Margins? What margins?

In its most recent annual report, Fortescue said its ‘C1 cost’ at the end of the 2015 financial year was $US19 per tonne. They are targeting $US18 per tonne in FY16, and with these improvements, the miner said it’d be in the “low cost end of the industry curve with targets in place to drive our competitive position further.”

Unfortunately, it’s hard to say exactly where Fortescue sits in the industry’s cost curve because the goal posts are constantly moving. The industry as a whole is reacting to the continual slump in commodity prices by pushing every conceivable cost out of their operations.

By the way, a ‘C1 cost’ includes just “operating costs of mining, processing rail and port” according to the Fortescue Annual Report glossary.

Personally, I like to think of C1 costs as ‘the direct costs associated with running a mine, excluding anything else which may or may not be important but may make the company look bad.’ That’s not a swipe at Fortescue, by the way. It seems every miner, from iron ore to gold and uranium reports ‘C1 costs’.

Unfortunately, to run a successful business there is a whole heap of other costs that are important. Investing for the company’s future is a necessity, for example — that’s called capex (capital expenditure). Corporate overheads and debt servicing are but some of the other added costs associated with any successful business, including miners.

As PricewaterhouseCoopers Mining Consulting Leader for the Americas, Calum Semple, wrote in an industry cost review early in 2014 “cash costs alone do not capture many of the expenses required to maintain a long term sustainable mining operation.”

Earlier this year, Rio Tinto CEO Sam Walsh was quoted by Fairfax Press as saying his company had average cash costs of $US17 per tonne of iron ore produced.

Fortescue and Rio Tinto’s cash costs are world-class and generate excellent cash flows for their parent companies to pay down debt and fund corporate activities. But the share market, and the world of business more generally, is forward-looking.

Demand AND Supply concerns

Unfortunately for shareholders, the market price of iron ore is plunging. The steel-making ingredient accounts for 97% of Fortescue’s revenue and 63% of Rio Tinto’s segment-level net earnings. According to The Metal Bulletin, at the weekend, iron ore prices plunged below $US40 per tonne – a decade low.

Rising supply from major producers, including Rio Tinto, BHP Billiton Limited (ASX: BHP) and Brazil’s Vale SA, are fuelling the downward pressure on market prices at a time when China’s demand for steel is falling sharply. Indeed, steel exports from China, the world’s largest producer, fell 3% in the month of October year-over-year, according to the World Steel Association.

Further, Vale SA expects iron ore exports to reach 1.6 billion tonnes in 2016, according to an article in the Wall Street Journal. Meanwhile, demand is expected to be between 1.35 billion tonnes and 1.4 billion tonnes.

Buy, Hold or Sell?

In fairness, I’ve only run a basic valuation of Fortescue shares because I think the whole sector is at risk of further downgrades. However, I believe it is overvalued given the outlook for iron ore prices and should be avoided.

As I showed here, I think Rio Tinto shares are worth around $35 per share. Their shares currently trade at a price of $44.75, or 28% more than what I think they are worth.

In summary, if you and I sell out of or avoid iron ore stocks for the foreseeable future, we may miss a subsequent rally — as a result of some unknown catalyst — but just think of all the safer and cheaper stocks on the ASX, which are waiting to be bought.

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Motley Fool writer/analyst Owen Raszkiewicz has no position in any stocks mentioned.

Owen welcomes your feedback on Google plus (see below), LinkedIn or you can follow him on Twitter @ASXinvest.

Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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