Why you’d love to buy this share, but shouldn’t

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During the course of 2016, commodity stocks such as Rio Tinto Limited (ASX: RIO), BHP Billiton Limited (ASX: BHP) and Fortescue Metals Group Limited (ASX: FMG) have risen sharply. In fact, they are up by 10%, 7% and 135% respectively year-to-date and while Rio Tinto’s half-year results which were released this week show that it has a number of merits, it may not prove to be a sound buy.

Financial standing

Clearly, Rio Tinto has a sound balance sheet and strong cash flow. This was evidenced in this week’s results, with the iron-ore focused miner generating net cash from operating activities of US$3.2 billion during the period and having a net debt to equity ratio of 31% after reducing net debt in the last six months to US$12.9 billion.

These figures show that while a commodity downturn has left a number of Rio Tinto’s peers in dire financial circumstances, Rio Tinto has a sound balance sheet and net operating cash flow which allowed it to invest US$1.3 billion in capital expenditure and pay out US$1.9 billion in dividends during the first half of the year. Although this level of dividend payout amounted to 100% of free cash flow, Rio Tinto continues to generate sufficient cash to balance investment in long term growth with rewarding shareholders via payouts in the near term.


Rio Tinto’s strategy is also sound, with this week’s update highlighting the success of its cost cutting and efficiency improvements. For example, Rio Tinto achieved US$0.6 billion of sustainable operating cash cost improvements in the first half of the year, with it being on-track to achieve its full year target.

Furthermore, its EBITDA (earnings before interest, tax, depreciation and amortisation) margins have remained relatively high in recent years, with them being 33% in the most recent half year compared to 34% in 2015. And with it recording $0.6 billion in divestments plus a further $0.2 billion expected before the end of the year, Rio Tinto continues to become increasingly streamlined and efficient.

Price taker

Despite its sound strategy and financial strength, buying Rio Tinto may not be a sound move. A key reason for this is its dependence upon commodity prices and the uncertainty surrounding its future performance which this creates. In other words, Rio Tinto is a price taker and while it is making significant improvements to its business model and cost base which has maintained its financial strength, ultimately its future profitability and share price depends to a very large extent upon the performance of commodity prices.

For example, in the first half of the current year iron ore increased in price from a low of under US$40 per dry metric tonne to as much as US$60 per dry metric tonne. This aided Rio Tinto’s results, but with China on a path of slower and less commodity-intensive growth, iron ore could endure further challenges ahead which would hurt Rio Tinto’s financial performance.


In addition, Rio Tinto continues to lack diversity. It generated US$5.7 billion in underlying EBITDA in the first half of the year and US$3.4 billion of this was from iron ore. This shows that the company is dependent upon iron ore for the vast majority of its profit. This increases its risk profile yet further versus other commodity stocks such as BHP Billiton which have a much more balanced and diversified portfolio of assets.

So, while it has a sound strategy and excellent finances, Rio Tinto’s lack of diversity and its status as a price taker mean that it may be best to check out these three blue-chips instead.

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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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