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Summary

  • Goldman Sachs has forecasted the price of iron ore will reach $80 per ton within the next two years.
  • This decline in the price of iron ore will hurt Rio Tinto’s top line in the coming years, causing an adverse effect on the company’s earnings as well.
  • Rio Tinto does not seem to be able to sustain its dividend increases in the coming years; especially since it already has a very high dividend payout ratio.

Rio Tinto Plc (NYSE:RIO) is a global mining group engaged in exploring, mining, and processing the earth's mineral resources. While many analysts are optimistic about Rio Tinto's outlook, I want to share some headwinds for the company's prospects and my critique of the company's financial position and dividend policy in this article.

I will begin my article by shedding some light on the major headwinds for the company's upcoming financial performance and position.

Headwinds

Among the minerals extracted by the company to generate income, iron ore is the major revenue and income-generating product of the company. Rio Tinto generated 47.6%, 76.9% and 87% of its products group total revenue, EBITDA and net earnings, respectively, from its iron ore business during FY 2013. In terms of geographic region, China is the company's biggest customer, as shown in the chart below.

Source: 2013 Results Media Release

Heavy reliance on these two factors is likely to bring headwinds for the company's financial performance in the coming years. The following paragraphs will discuss details on the reliance on iron ore and China.

Oversupplied Iron Ore Market

Goldman Sachs has forecast the price of iron ore will reach $80 per ton within the next two years. Record iron ore output from mining giants like Rio Tinto are causing supply increases that are likely to surge the global seaborne surplus of iron ore to 90 million metric tons in 2014 from a balanced market in 2013, as estimated by UBS AG.

The analysts are forecasting the iron ore price of $113 per ton for 2014 will drop to $90 per ton in 2015, and then down to $80 per ton in 2016. This decline in the price of iron ore will hurt the company's top line in the coming years, causing an adverse effect on the company's earnings as well.

Demand from China is the pillar of global iron ore demand, and it considerably impacts iron ore's price. Another major reason behind the iron ore market being oversupplied in the coming years is the slowdown in the Chinese economy triggering a decline in demand for iron ore.

Chinese Economic and Iron Ore Demand Slowdown

After witnessing a strong performance during 2013, iron ore prices have dropped to an eight-month low in the past few weeks due to declining demand from Chinese steel mills. The Chinese steel mills are being impacted by credit tightening in the country. A planned cut in government subsidies and a phase-out of interest-rate controls will raise costs for the companies operating in China. These initiatives were taken by the Chinese government in order to transform a state-guided economy into one that is market-oriented. These measures will slow down the Chinese economy's average annual growth to as low as 3% by the year 2022, from 10% in the year 2010. As a result, industrial activities will slow down.

In the short term, healthy Chinese steel production rates may maintain iron ore prices, but ultimately, both the demand from steel mills and prices of iron ore will decrease.

Another factor that will decrease the demand for iron ore from China is the fact that the Chinese scrap supply is also likely to surge until the end of the decade as metal that was consumed in the early 2000s will be recycled.

These are the external factors that are likely to adversely impact the company's financial performance in the coming years. In addition to this, the company's dividend policy does not seem sustainable, along with a high level of gearing.

Critique on High Dividend Payout and Financial Position

The company recorded a 15% rise in its dividends for FY 2013 in comparison to FY 2012. This has led to the company's dividend payout ratio reaching 96.83%, compared to the industry average of 1.64% and sector average of 28.83%. Such a high ratio of dividend payout is not sustainable for the future, especially when the company's top line is facing serious headwinds for its major drivers, as I have discussed above. As far as cash flows are concerned, the company is overvalued based on its price-to-cash flow ratio. The company has a price-to-cash flow ratio of 17.94 times in comparison to the 12.53 times cash flow ratio of the industry and 12.52 times cash flow ratio of the sector.

The company has a 53.67 long-term debt-to-equity ratio that is well above the industry average. This means the company is carrying high financial risk. Additionally, the company falls short on return on assets in comparison to the industry and sector. The company generates 0.94% TTM return on its assets, while the industry and sector generate returns on assets of 4.11% and 13.40%, respectively.

Analysts' Forecast and My Take

Analysts are forecasting a 9% decline in the company's earnings from 2014 to 2016, taking into account the lower iron ore prices that will offset increased production and cost cuts made by the company. The headwinds for the company's financial performance come from the oversupplied iron ore market and slowdown in demand from the company's largest customer, China in the coming years. Declining top and bottom lines will impact the company's financial position in the coming years, as the company is already carrying a large debt. Considering these factors, the company does not seem to be able to sustain its dividend increases in the coming years; especially since it already has a very high dividend payout ratio. Additionally, the company's stock price is likely to maintain its historic relation with iron ore prices, as shown in the chart below.

(click to enlarge)

Source: YCharts

Source: Rusty Outlook For Rio Tinto