As I showed here, Rio Tinto Limited (ASX: RIO) derives 47% of its revenues from iron ore – a steel-making ingredient.
At the divisional profit level – which Rio calls segment underlying earnings – its dependence on iron ore becomes even more apparent.
In financial year 2014, iron ore accounted for 79.4% of Rio's total underlying earnings.
Meanwhile, sales of iron ore account for 98.79% of revenue over at Fortescue Metals Group Limited (ASX: FMG), a 'pure-play' iron ore miner.
Not only are Rio and Fortescue heavily dependent on iron ore, they're also heavily dependent on one customer: China.
For Fortescue, 96.27% of all sales are made to China, whereas at Rio that figure stands at 38.2%.
Here's why I'm avoiding Rio and FMG
Deriving a big proportion of your profits from any one product or customer is not a problem… until it becomes one.
Over the past two decades, dependence on Chinese steel mills has been great for businesses in West Australia's Pilbara region and Brazil's Carajás Mountains.
In fact it's been so good that as Motley Fool analyst, Mike King, showed yesterday, each of the biggest mining companies in the world have ramped up combined production from around 510 million tonnes in 2007 to over 900 million tonnes today, just to keep up with China's demand.
However, looking ahead, annual production from these giants is expected to exceed 1,300 million tonnes by 2018.
As the following snapshot from the World Steel Association shows, China accounted for 22.9% of global crude steel production in 2003 but over 48.5% in 2013.
With massive increases in iron ore production and huge increases in steel output, the question on every miners' lips is: when does the party end?
Some commentators have suggested, with the iron ore price falling 70% over the past five years to average just $US51 per tonne in April, the point of peak profits has already passed. Personally, I couldn't agree more.
For some years now, pundits have been cognisant of China's decision to transition to a "consumer-led" economy. That is, away from its "infrastructure-led" economy. Last time I checked, not nearly as much steel goes into consumer goods as compared to railways, freeways and skyscrapers!
A sign of China's waning demand can also be found in the Resources and Energy Quarterly report from the Australian government's Department of Industry and Science. In its March 2015 update it said, "China's steel prices fell throughout most of 2014 as an increase in supply entered a market with weak growth."
"After a decade of growth driven primarily by fixed asset investment the Chinese government is planning to rebalance the economy, through market reforms, to increase domestic consumption," the report added. "The successful implementation of these reforms will alter the allocation of resources through the economy, boosting the more productive sectors like manufacturing and force cuts in sectors that are over producing, such as steel."
Rising output of the steel-making ingredient coupled with lower demand means further falls in the iron ore price are likely. In turn, that means lower profits for iron ore miners and, ultimately, lower share prices.
Buyer beware.
Should you buy, hold, or sell Rio and FMG shares?
For the above reasons, and more, I'm avoiding Rio and Fortescue shares at today's prices. Sure, they might look cheap from a price-earnings or dividend yield perspective. But are they worth the risk? I don't think so.
