Rio Tinto Plc’s Greatest Weaknesses

Two standout factors undermining an investment in Rio Tinto plc (LON: RIO).

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When I think of global mining company Rio Tinto (LSE: RIO) (NYSE: RIO. US), two factors jump out at me as the firm’s greatest weaknesses and top the list of what makes the company less attractive as an investment proposition.

1) No pricing power

To arrive at a base selling price, most businesses would tot up the costs of raw materials, direct labour and other direct expenses, add a bit for fixed costs, and add a bit more for a profit margin. It’s a sensible way to approach things because the whole point of being in business is to make a profit over and above costs.

Rio Tinto can’t do that. Generally, commodity companies sell their product into the market at whatever the prevailing commodity price happens to be. They could try to get more, I suppose, but without any product differentiation Rio simply has no pricing power — no ability to raise its output prices high enough to provide a decent margin above the cost of production.

rio tintoAll Rio can really do is produce like mad when commodity prices are high and put the brakes on production when commodity prices are low. That way, cash builds up in the good times and the firm doesn’t lose too much in the bad times.

It’s not an ideal business model, but one redeeming feature is that Rio is in a small group of very large commodity producing companies, which together enjoy a certain amount of power over the supply side of the supply and demand equation. If they all chose to choke off production together, it is conceivable that such a group action in itself could influence commodity prices and cause them to rise again.

2) Cyclical demand

The trouble with the demand side of the supply and demand equation is that it is cyclical. We’ve seen recently what havoc it can cause when a large industrialising nation such as China catches a cold on growth. When a big commodity-buying customer like China stops buying commodities as fast as it has been the prices slide and, suddenly, firm’s like Rio Tinto fall off their purple patches.

A look at Rio’s recent financial trading record tells the story:

Year to December 2009 2010 2011 2012 2013
Revenue ($m) 41,825 55,171 60,537 50,967 51,171
Net cash from operations ($m) 9,212 18,277 20,030 9,368 15,078
Adjusted earnings per share (cents) 357 713 808 503 553

Rio’s trading is volatile because of the cyclicality inherent in the industry. That’s an important point to consider whenever the firm starts to look attractive for its immediate growth or dividend-generating prospects.

What now?

Rio Tinto recently raised its dividend by 15% and new investors will enjoy a forward yield predicted to be around 3.6% at current share-price levels.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Kevin does not own shares in Rio Tinto.

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