Here at The Motley Fool Australia, I write about a number of the best S&P/ASX200 Index (INDEXASX:XJO)(ASX: XJO) stocks on a day-to-day basis.
One of the companies I frequently write about is Rio Tinto Limited (ASX: RIO). The world's second largest iron ore miner and owner/operator of some of the biggest mining projects in the world.
Whilst Rio is often considered a diversified miner, in recent years, it has not been as diversified as many think. With over 90% of FY13 earnings from the iron ore division alone, it's not what I'd call, "a diversified miner".
Aluminium
One of the reasons why the iron ore division dominates group earnings can be put down to Rio's $US38 billion purchase of Canadian aluminium producer, Alcan, in 2007. This was intended to provide much needed diversification but instead resulted in $US25 billion of writedowns and the acquisition (among other things like falling coal and uranium prices) has resulted in a 26% drop in the company's share price, from then until now.
However, now, seven years on, the writeoffs appear to be slowing and management are finally taking the action necessary to turn the aluminium division around. Between FY12 and FY13, the division increased underlying profits from a meagre $54 million to a meaningful $557 million. It's a figure that some analysts believe the company could nearly double in the next five years.
What's more, with some commentators suggesting that we could witness aluminium demand surpass supply in the near future, the price of the commodity is expected to improve modestly.
Iron ore
Whilst the most obvious reason shares in Rio Tinto trade at a significant discount to the broader market is falling iron ore prices, it's important to remember the Pilbara iron ore operations are extremely low cost and produce a high-grade ore. Even at a spot price of under $US70 per tonne, which is the price some analysts suggest lower grade producers like Fortescue Metals Group Limited (ASX: FMG) is currently receiving, Rio will make money.
While margins will compress as a result, total group underlying earnings in the upcoming half-year report are expected to jump over 10% year-on-year, despite the iron ore spot price falling from over $US135 per tonne at the beginning of 2014 to a low of just $US91.80 in June. Longer-term, higher-cost producers will be pushed out of the market which, as any seasoned investor or first-year economics student will tell you, could lead to higher prices, over time, as older projects end and new supply drys up.
It's important to note however, commodity super cycles last for many years and depend largely on project lead times, mine construction and the amount of feasible reserves. Unless a miner, like Rio, BHP Billiton Limited (ASX: BHP) or Vale SA (ADR) (NYSE: VALE) can expand operations with low capital intensity, new operations grow increasingly unlikely to come online, in times of depressed spot prices.
Other divisions
Whilst iron ore and aluminium are Rio Tinto's newsworthy divisions, the copper business is quietly kicking goals for shareholders. The addition of production at the Oyu Tolgoi project in Mongolia, higher grade ore and a recovery at the Kennecott Utah Copper project enabled the group to a 23% increase in mined copper for the first half of FY14. Meanwhile bauxite production remained largely flat but prices are expected to remain strong in the near future. Lastly, uranium production will increase in the second half of the year and, in my opinion, its use will grow overtime and as the world seeks alternatives to dirtier fuel sources such as coal.
To buy, or not?
I recently bought call warrants on Rio Tinto (i.e. I think the share price will increase, over time) because I'm confident the company will be a stronger and more prosperous one many years in the future (to learn more about ASX warrants, click here).
Under recently installed CEO Sam Walsh I expect debt to fall, cashflows to increase and, generally, more conservative management than what was exhibited from its predecessors. However I am, by no means, guaranteeing it'll be a smooth ride from here (for resources stocks, it never is) nor am I suggesting Rio is a one-way ticket to riches. But I believe, if you truly consider yourself a long-term investor (10 years plus) and want exposure to Australia's resources sector, Rio is a solid buy at today's prices.
