This is the biggest challenge facing Rio Tinto Limited

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The biggest challenge facing Rio Tinto Limited (ASX: RIO) is not the outlook for the iron ore price, but rather its reliance on iron ore.

Undoubtedly, the future performance of iron ore could disappoint. China is continuing its shift away from capital projects and towards consumer goods and this means that global demand for iron ore is unlikely to return to previous highs. Iron ore focused companies such as Rio Tinto (for whom iron ore represented 87% of underlying earnings in 2015) therefore need to diversify away from iron ore so as to provide their financial outlook with greater resilience.

Although Rio Tinto is investing elsewhere in its asset portfolio (which, by the way, is world-class), I fear that past mistakes on the M&A front are holding the company back when there is a stunning opportunity on offer.

I’m of course referring to Rio Tinto’s decision to pay US$38bn for aluminium producer Alcan in 2007, with the deal being viewed by some investors as one of the worst in the history of the mining industry. Naturally, the failure of Rio Tinto to make a success of Alcan in the intervening years is a major disappointment.

However, it was not helped by the falling price of aluminium in the two years following the deal. In fact, aluminium fell by as much as 50% between 2007 and 2009, thereby making the task of successfully integrating the business exceptionally challenging.

While that deal didn’t work out, today’s mining sector valuations are a whole lot different from where they were nine years ago. For starters, they are a lot cheaper and this provides Rio Tinto with not only greater choice to invest and diversify its operations, but to also benefit from a wider margin of safety. In other words, buying high quality assets at discounted prices provides a lower risk acquisition opportunity.

Further, Rio Tinto has an excellent financial outlook which means that it has the financial capacity to conduct M&A activity. It is the lowest cost major iron ore producer in the Pilbara, with a cash unit cost of just US$14.90 per tonne in 2015. This means that Rio Tinto can afford to invest in its long term growth outlook through making acquisitions since it seems likely to be able to out last the vast majority of its iron ore peers.

Therefore, with asset prices being low and Rio Tinto having the means to engage in M&A activity, now could be the perfect time for Rio Tinto to diversify its income stream. This seems to be the logical step for its new CEO to take, or else investors may be somewhat disappointed as China and global demand for iron ore gradually slip away.

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Motley Fool contributor Robert Stephens has no position in any stocks mentioned. 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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