Rio Tinto (ASX: RIO), like many other iron ore stocks, has rebounded in share price in the past two months, held high by a resilient iron ore price despite very bullish predictions on its ability to remain at such levels. Here are four reasons that help explain why the short to medium term future of Rio's share price remains contentious.
Source: Google Finance
#1: Spot price of iron ore
As is evident from the two graphs (above and below), the share price of iron ore stocks like Rio and Fortescue Metals Group (ASX: FMG) is dictated largely by the spot price of iron ore. For Rio, iron accounts for 43% of earnings. Demand stems largely from China, where manufacturing is growing steadily despite that country's transition from manufacturing to a more service based economy.
There are also enormous environmental concerns that could have an effect on manufacturing in the long run. However in the short to medium term, many commodity experts and investment banks have predicted massive supply increases will put downwards pressure on the spot price until at least 2017.
Source: Indexmundi.com
#2: Aluminium
Aluminium is the company's second biggest earner, but a big loser. In 2007 Rio bought Canadian aluminium producer Alcan for $38 billion. This has proven to be the biggest mistake for Rio Tinto management in the past 10 years. Buying something at its most expensive point is never a good idea, and since then the aluminium price has dropped and the companies been forced to take huge write-downs. If iron ore prices favour the bears, Rio's recent decision to expand its iron ore operations might have the same effect as the aluminium purchase in the medium term.
#3: Diversification
Currently Rio is putting assets on the chopping block. Recently it sold French aluminium assets, a copper mine in the US, put its Mozambique assets up for sale, couldn't find a suitor for its diamond business and currently is in the process of selling its Iron Ore of Canada operations. In this Fool's opinion, focusing on its core operations and selling off its non-core operations opens it up to a much bigger downside if iron prices go south. BHP (ASX: BHP) would be a better stock for investors wanting a more conservative resource company in their portfolios – although it too is not a bargain at current prices.
#4: Debt and fundamentals
Since the purchase of Alcan, Rio's debt has been bloating uncontrollably. Operating margin, net profit margin and return on equity are nearly half what they were in 2006. The downwards trend of the operating margin is particularly concerning and, like every miner, paying higher dividends when profits are dropping is only an attempt to prevent a fall in share price.
Foolish takeaway
It's hard to understand how an investor would justify spending their hard earned cash on an investment in Rio regardless of whether it's boosting production or paying out a slightly better dividend. Rio's share price has only been buoyed by the current iron ore price and if that goes down then the share price will certainty follow. Learn from Rio's mistakes and don't invest in something when it's expensive. Waiting on the sidelines for Rio's share price to come down could save you money.
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Motley Fool contributor Owen Raszkiewicz does not have a financial interest in any of the mentioned companies.
