Shares in Rio Tinto (LSE: RIO) have fallen by 25% in the last year, which is clearly hugely disappointing for its investors. Inevitably, after such a large decline in value, many investors may be considering the purchase of Rio Tinto at what appear to be distressed levels. However, before doing so, these three weaknesses need to be taken into account.
Firstly, Rio Tinto lacks diversification. It is almost a pure play iron ore miner, with over 90% of profit in 2014 being derived from the mining of the steel-making ingredient. This was a major plus for the company in previous years, when China was growing by more than 7% per annum and was demanding steel hand over fist. However, now that global demand for steel and, consequently, iron ore, has dropped, Rio Tinto is in a difficult position since it does not have a significant representation among other commodities to potentially offset the challenges faced within its iron ore division.
Secondly, Rio Tinto has attempted to diversify in the past through M&A activity, but this has not always gone to plan. For example, the 2007 takeover of aluminium producer Alcan is now viewed as nothing short of a disaster, with Rio Tinto completing the purchase at what is now deemed to be an overly generous price. As such, investors may be wary of Rio Tinto’s ability to make successful acquisitions since it has a relatively poor track record of doing so. This could hamper its progress if, as expected, consolidation occurs within the resources space.
Thirdly, Rio Tinto will always be a price taker as opposed to price maker. This means that it has little control over its margins or profitability, thereby making it highly cyclical and dependent upon the performance of the wider economy. Of course, the same is true for all mining stocks but for investors seeking bargains after the FTSE 100’s fall from 7100 points to just over 6000 points, it may be possible to find good value stocks in other sectors with wider economic moats than Rio Tinto.
Despite these three weaknesses, investing in Rio Tinto still appears to be a prudent move to me. It remains a financially sound business which appears to be pursuing the right strategy at the present time in terms of increasing production so as to boost profitability and also squeeze out rivals with higher cost curves. Furthermore, its focus on improving efficiencies is also likely to be beneficial should the price of iron ore fall further, since it means that Rio Tinto will remain among the lowest cost producers in the world.
Meanwhile, Rio Tinto offers excellent value for money at the present time, as highlighted by its price to earnings (P/E) ratio of 13.2. And, with a yield of 6.8%, it continues to be a highly appealing income play – even if dividends are cut over the next few years.
