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Is There A Buying Opportunity In Rio Tinto plc?

Valuation and quality of earnings: these are two of the most prominent factors that any value investor pays attention to when looking at an investment, and Rio Tinto (LSE: RIO) (NYSE: RIO.US) is absolutely no different. Let’s dig a little deeper (pardon the pun) and see what’s really going on behind the scenes at Rio…

It’s been a bit of a turbulent time for the mining sector as a whole – China’s slowing growth coupled with its growing internal production of raw materials has hampered global demand on the markets, and prices have compressed as a result. At the beginning of July 2013, the mining sector was pretty much a consensus short. Any contrarians out there with convictions in their ideas that bought at maximum pessimism would have seen a near-20% price appreciation for Rio Tinto since then, versus 12% for the FTSE 100.

If we first get our heads around the fundamental business aspects of Rio, perhaps we can better understand it and see if we have a viable investment opportunity.

Valuation

The valuation aspect of Rio Tinto is easier to get to grips with, so let’s first consider that. It’s currently trading on around 26x current earnings. There is a wealth of research on the fallibility of forecasts, so instead I prefer to focus on current earnings for valuations; there’s too much variation in using forecasted earnings.

Now, a P/E ratio of 26x isn’t exactly cheap and may have many value investors scoffing; however, there’s more to it than that. Rio is currently yielding 3.97%. This may not be anything to write home about, but the dividend cover is sensible at almost 2x so even if earnings took a turn for the worse, they might not need to cut the dividend to keep the lights on.

Quality Of Earnings

Rio Tinto is synonymous with iron ore. It’s the world’s second largest producer – behind Vale – so when times are good for iron ore, times are good for Rio and shareholders. So just what is happening with iron ore?

Iron has just dipped below $90 per tonne, which is not a pretty sight. In fact, it’s never been that low since 2012. When 96% of your earnings come from iron ore, then the price you can sell it for becomes incredibly important. Even more so when you pay your miners in Australian dollars and sell it to the market in US dollars.

In fact, a 10% change in average price of iron ore would affect Rio’s earnings by $1.2 billion. Fantastic news for rising prices; not so fantastic news for falling prices.

There is no doubt about the need for iron ore. Iron is a highly useful commodity and everyone, everywhere needs it. However, the demand for it is cyclical, and China has had enough for the moment. Perhaps other emerging-market nations are just about to step up and take the place of the great iron consumer – India? – but no one knows for the moment.

The Verdict

With a reasonable-looking dividend, perhaps that’s enough to tempt some into investing in Rio Tinto. For the moment, with iron prices in a slump and a former chief of the iron ore department, Sam Walsh, as CEO, I’m not confident in Rio’s ability to deliver sustainable shareholder value. It’s a bumpy ride in mining and Rio does have some excellent mines; if you have the patience to wait it out and not react to market noise, then maybe Rio Tinto is worth a second look.

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Alistair does not own shares in Rio Tinto.