One Reason Why I Wouldn’t Buy Rio Tinto plc Today

Today I am looking at why a weak iron ore market threatens to derail Rio Tinto’s (LSE: RIO) (NYSE: RIO.US) earnings prospects.

Lack of diversification strangles earnings prospects

Mining giant Rio Tinto’s extensive operations around the world allow it to produce a variety of commodities including copper, aluminium, diamonds and coal. However, these areas account for only a small percentage of the firm’s total earnings, leaving it at the mercy of worsening oversupply in the critical iron ore market.

Broker Investec notes that “iron ore pricing is going through a tumultuous period as the market digests ever increasing seaborne supply against a backdrop of weakening demand growth from China,’ commenting that ‘we do not expect the iron ore price to return to previous highs” even as high-cost production from the Asian commodities giant is cut.

While iron ore takes care of the lion’s share of Rio Tinto’s earnings, aluminium and copper — the mining company’s second and Rio Tintothird most critical markets respectively — accounted for just 8.4% and 7.7% of earnings before interest, tax, depreciation and amortisation (EBIDTA) in 2013. By comparison, the iron ore sector was responsible for more than three-quarters of the group’s EBITDA last year.

And with industrial activity in the world’s factory floor of China continuing to struggle, the outlook for the iron ore supply imbalance looks set to worsen. Latest HSBC manufacturing PMI came in at 49.4 for May, the fifth successive month below the index benchmark of 50 which separates contraction from expansion.

Sucden Financial expects global iron ore supply to advance 6% to 2.12bn tonnes in 2014, comfortably outpacing a 3.7% rise in steel production. And the broker notes that “high stocks of steel, tight credit conditions and government clampdowns on surplus [steel production] capacity” in China further cast a pall over iron ore demand forecasts in the near term — the country produces almost half of the world’s steel.

The tentative state of the global economic recovery means that surging production across all of Rio Tinto’s core markets looks set to outstrip demand for some time to come. Still, the iron ore market is undoubtedly one of the worst-hit commodity sectors in terms of market imbalance, making the mining firm particularly susceptible to severe earnings weakness in the near term and in all probability well into the future.

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> Royston does not own shares in Rio Tinto.