Why I think this blue-chip share is best avoided

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Rio Tinto Limited (ASX: RIO) has a historic yield of 4.4%, which is 20 basis points higher than the ASX’s historic yield. This is not as high as the yields on popular income stocks such as Telstra Corporation Ltd (ASX: TLS) and Westpac Banking Corp (ASX: WBC). They have yields of 5.7% and 6.2% respectively. Nevertheless, it holds appeal at first glance for income seeking investors. However, buying Rio Tinto for its income prospects could be a bad move.

Price taker

A key reason for this is Rio Tinto’s status as a price taker. It is highly dependent upon commodity prices for its revenue and profitability. During the course of 2016, it has enjoyed favourable conditions in this respect. For example, the price of iron ore has risen from around US$40 per dry metric tonne to as much as US$60 per dry metric tonne this year. This has aided Rio Tinto’s financial performance, but there is significant uncertainty regarding the future price of iron ore.

For example, iron ore is forecast to be priced at US$60 per dry metric tonne in 2020. This offers limited scope for a major increase in Rio Tinto’s sales during the next four years. Further, the risk of a fall in the price of iron ore is real. Evidence of this was in Rio Tinto’s first half results, where it stated that ‘growth in China is on a long transition path of slower and less commodity-intensive growth’. This is significant for Rio Tinto because China is the largest iron ore importer in the world. It imports six times as much as the second highest region, which is the EU.

Lack of diversity

In the first half of the current financial year, Rio Tinto generated 60% of its underlying EBITDA (earnings before interest, tax, depreciation and amortisation) from iron ore. This shows that it is highly dependent upon the price of just one commodity, which increases its risk profile versus more diversified resources peers.

Further, all of its iron ore operations are located in Australia. Although it is a politically and economically stable environment, Rio Tinto lacks geographical diversity for the bulk of its business. This increases its risk profile yet further and makes its dividend outlook less robust.

Dividend policy

In February 2016, Rio Tinto announced a new dividend policy. It will now seek to pay out a proportion of profit as a dividend each year. The percentage is expected to be between 40% and 60% over the long run and Rio Tinto will aim to pay out special dividends during more profitable years.

Although this strategy is sensible given its uncertain outlook, it means that Rio Tinto’s dividends are due to fall over the next two financial years. EPS is forecast to decline from $4.15 in FY 2015 to $2 in FY 2017. Based on this forecast and a best-case 60% payout, it means that Rio Tinto’s dividend could fall to $1.20 per share in FY 2017, which works out as a yield of 2.4% at its current share price. Combined with its lack of diversity and its status as a price taker, this means that Rio Tinto is best avoided by income-seeking investors.

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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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