Australia's biggest exporter of iron ore, Rio Tinto (ASX: RIO), has made a meal of investors equity over the past five years. Writing down billions of dollars as a result of poorly timed acquisitions and slumps in commodity prices has many investors concerned – justifiably so.
What was once a takeover target for the world's biggest miner, BHP Billiton (ASX: BHP), for an approximate value of $147 billion, Rio shares have fallen hard. Since the GFC and subsequent fall in many commodities, Rio's Alcan purchase and Mozambique coal business have cost the company (therefore its shareholders) dearly.
Pre-GFC Rio had a massive return on equity (ROE) of 53.9% but now it sits around 19.8% and its return on capital has fallen to just 14%.
However despite recording a net profit down 70% for the half year to June 30, it appears investors believe the company has turned a corner. In the past few months a number of key milestones have been reached, including the opening of its massive Oyu Tolgoi copper and gold mine in Mongolia, its Pilbara 360 expansion has been approved, costs are down $1.8 billion since the start of the year, there will be a 20% reduction in capex for each of the next three years and a number of non-core assets have already been divested.
In hindsight if BHP was to make an offer for Rio, it would have been six months ago. The bottom for Rio's share price, before its 33% climb.
Buy in the trough, sell at the peak
In order for Rio to return to its former glory it needs two things. Firstly, it needs to cut costs and divest non-core assets such as its aluminium and coal businesses (it has started to do this but failed on a number of occasions). Secondly and, perhaps most importantly, it needs its earnings to remain strong to pay down debt, continue exploration, pay a dividend and make sensible investments.
Currently, iron ore accounts for over 80% of earnings thanks to resilient iron ore price and subdued prices on many of the groups other commodities such as aluminium, coal and uranium.
A bull case
The two real risks for Rio are a slowdown in the Chinese economy or an oversupply of iron ore. Both of which will result in much lower prices for the steel-making ingredient. However, it's unlikely we'll experience such a dramatic and rough landing in the near future because global economies are rebounding and growth in trade to and from China will be coming off a larger base. Meaning that even if the Chinese government decide to cut back on infrastructure spending, its huge manufacturing industry and private investment will continue to drive demand.
In addition, other booming Asian economies will continue to have a need for steel. Rio's huge Pilbara 360 expansion will make it not only the most conveniently located iron ore mine in our region but also the biggest in the world. Enabling it to supply cheap high grade iron ore to its targeted markets.
A bear case
Rio's reliance upon iron ore markets and the Chinese economy are huge risks that investors need not necessarily subject themselves to. We're already seeing government officials become concerned over the level of pollution emitted by many factories in China and they're unlikely to continue the massive investment in fixed infrastructure like railways, ports and buildings at the same pace in the long run. Investors could look for more diversified companies with less debt that pay higher dividends but still have exposure to iron ore, BHP is one example.
Foolish takeaway
If iron ore prices remain strong, Rio, Fortescue (ASX: FMG) and juniors like BC Iron (ASX: BCI) and Atlas Iron (ASX: AGO) will pay off any debt and grow earnings. However, long term the iron ore price is likely to fall (just like every other commodity) because more mines are coming online and look set to outweigh the demand from Asian economies. An upside for Rio remains with a high iron price but to minimise your downside risk, BHP is enough exposure – it also pays a better dividend!
