With the iron ore price falling to a 10-year low, it is little wonder that iron ore producer Rio Tinto (LSE: RIO) (NYSE: RIO.US) is going through a challenging period. In fact, the company’s share price has sunk by 22% in the last five years, with many investors now believing that its next move could be further down.
However, now could be a great time to buy a slice of Rio Tinto, with gains of 27% being very achievable over the medium term. Here’s why.
Increasing Output
As the saying goes, “when the going gets tough, the tough get going”, and that’s exactly how Rio Tinto is treating the present low price in iron ore. It is using it to its advantage by increasing output and decreasing costs so as to limit the impact of a falling iron ore price on its bottom line, but also to hurt its sector peers. In fact, Rio Tinto has one of the lowest cost curves in the iron ore sector, and so can survive longer than most iron ore producers while commodity prices are low. And, in the long run, this could work out well for Rio Tinto as it increases its market share.
Profitability
Still, the short term is set to be very tough. For example, Rio Tinto’s bottom line is expected to fall by a whopping 63% this year but, interestingly, the market appears to be sufficiently pricing in such a fall. For example, Rio Tinto currently trades on a price to earnings (P/E) ratio of 15.4 even when taking into account its forecast profit fall. This compares very favourably to the FTSE 100‘s P/E ratio of 16, and indicates that an upward rerating could be on the cards for Rio Tinto.
And, looking ahead, Rio Tinto’s focus on cutting costs and improving efficiencies is set to allow it to increase its bottom line by 21% in the next year. This means that, if it were to remain on its present P/E ratio of 15.4, shares in Rio Tinto would be trading at around £35.21, which is 21% higher than the company’s current share price of £29.09. Furthermore, if Rio Tinto can continue to increase output and cut costs, which is very possible, then there is little reason why it should not trade on the same P/E ratio as the FTSE 100, which could mean an increase of 27% from its current price level.
Looking Ahead
Furthermore, Rio Tinto currently yields 5.3%, and this means that even if there is no uplift to its rating, the total return over the medium term could be well in excess of 27%. And, while the chances of a bid from Glencore now seem less likely after the Australian government said they would block such a deal, Rio Tinto’s long term future appears to be very bright.
As such, and while the short term may see the company’s share price weaken somewhat as political pressure for output cuts increases (which it is believed would stabilise the iron ore price and boost the Australian economy), the medium- to long-term potential for Rio Tinto remains very attractive.
