Rio Tinto And Its Grave Future Outlook

Mar. 6.14 | About: Rio Tinto (RIO)

Summary

China contributes about 35% to the total revenue base of Rio Tinto and its urbanization projections are too optimistic to be realized.

The company previously raised considerable debt to make acquisitions; however, due to ill-advised acquisitions, the company’s balance sheet weakened with enormous debt and fluctuating profits.

Considering that 77% of the company’s EBIT is dependent upon iron ore, the expected metal price dip will significantly effect the bottom line.

The mineral and mining industry is a highly cyclical industry with little or no differentiation between the companies involved in exploration, extraction, and refinement of various metals and minerals. The following discussion is intended to explore several arenas that impact the financials and future of Rio Tinto Group (NYSE:RIO).

Recent Performance

As of 2013, the company reported an improvement of 10% compared to 2012's earnings. The boost in earnings is largely a function of increased iron ore prices over the year even though the earnings were weighed down to some extent due to a decrease in imports from China. Further, the positive impact in the bottom line was caused by enhanced cost efficiencies and increased production volume of iron ore. The cost savings from exploration and evaluation surpassed the target by 33% yielding $1 billion in savings compared to the target of $750 million. The total cost savings target was set at $2 billion while the company generated savings of $2.3 billion. Over 2013, the company's cash flows from operations surged by 22% to $20.1 billion due to operating cost reductions and increases in the company's production volume by 9%. The company has also brought down its debt to $18.1.

Where earnings received a positive boost from iron ore prices they were dented from reduced copper, aluminum, and coal prices. Copper and coal prices suffered a downward pressure as supply exceeded the demand. With regards to aluminum, although the metal's sales volume increased and its respective net margin stood around mid-single digits the overall prices in the London Metal Exchange (LME) declined by 9% and negatively impacted the total net earnings of the company.

To enhance the company's ability to pay off its outstanding debt Rio significantly cut down its capital expenditures over the past two years and is expected to cut it down further by about $20 billion. The company previously raised considerable debt to make acquisitions; however, due to ill-advised acquisitions, the company's balance sheet weakened with enormous debt and fluctuating profits. The following bar chart indicates the company's expected capex profile.

Source: Company Presentation

The investors are not happy with Rio's recent performance and fallacious acquisitions. The company probably increased its dividends by 15%in an effort to please the investors.

Industry and Future Outlook

Throughout the recent history, growth in the company's margins and revenues has received a major boost from developing countries as indicated by the company's financials. Approximately 67% of the company's revenues in 2013 are attributable to Asia. China alone contributes about 35% to the total revenue base of Rio Tinto. The company believes that further growth in this region is expected as countries move rapidly towards urbanization and this will further boost the company's iron ore profitability. However, this projection seems unrealistic because the Chinese government is making an effort to move the country's focus from an investment led model towards one that is driven by domestic consumption. The GDP of the country is gradually edging towards stability; the GDP growth in the last quarter of 2013 was 7.7%, slightly lower than the GDP growth of 7.8% in the previous quarter. Note that China alone is responsible for procuring 60% of total seaborne iron ore.

Although iron ore has been a core driver of the company's revenues this year, the commodity's prices may dip in the future even as the demand increases by 60 million tons. Considering that 77% of the company's earnings before interest and taxes (EBIT) are dependent on iron ore, Rio's bottom line is heavily reliant on the fluctuation in iron ore prices. Both demand and supply functions are expected to hurt the future prices of iron ore.

Chinese steel mills have been stocking up on iron ore to use as collateral for raising loans from the state-owned enterprises. This activity previously drove up the demand and prices of iron ore. Now, since the Chinese economy is slowing down, construction activity is expected to weaken as well. Weakening construction activity means that demand for iron ore will be lower going forward and this will lower the prices of the metal. The falling prices will induce margin calls from the lenders who gave out loans against the collateralized iron ore. However, with the slowing economy, steel mills may not be able to meet those margin calls thus making it more likely that the collateralized iron ore will be dumped into the market. This will be in addition to Rio Tinto's and BHP Billiton's (NYSE:BHP) iron production volumes. An oversupply will indeed push the prices down thus hurting the top and bottom lines of Rio Tinto. To add to that iron ore prices are expected to continue to drop until 2017 according to a Bloomberg forecast.

Conclusion

The company's assumption concerning the rapid urbanization of economies seems overly optimistic. Considering that 77% of the company's EBIT comes from iron ore, the projected drop in its prices will significantly decrease its revenue and margins. The company maintains a heavy debt level in its balance sheet. With revenue expected to plunge significantly the situation is expected to become graver for Rio. Cutting down the capital expenditures means no further growth in the company's operations. Rio's previous acquisitions have not been very smart either. Moreover, the company's decision to raise dividends to please its investors does not seem very sustainable in the future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.