What Management Would Prefer You Didn’t Know About Rio Tinto plc

Rio Tinto

In 2007 and 2008, I worked with an Australian company that specialised in providing capital for small mining companies. Many of those companies were actually looking to raise funds via an initial public offering (IPO).

I spoke to a representative from the stock exchange many years later and he told me that 2006, 2007 and 2008 had actually seen a record number of company listings.

At the time, China’s annual economic growth rate was north of 10%, and the mining sectors of both Australia and south America were booming.

That boom has now ended. The question remains though, what will Rio Tinto’s future look like without the high commodity prices investors have become used to? It’s a picture of Rio Tinto (LSE: RIO) (NYSE: RIO.US) I think management would prefer you didn’t look at .

Getting into trouble

Rio Tinto is proud of the fact that, year on year, its underlying earnings have increased. This, however, is largely due to some heavy-duty cost cutting, according to last year’s annual report. At what price though? According to unions, Rio Tinto is increasingly turning to contract and subcontracted workers to cut costs. Last month five miners were killed in two separate incidents at a copper mine in Indonesia. Three out of the four miners who died in one of the incidents were subcontracted workers.

There’s another problem, too. Also included in the annual report was a concession that Rio’s cost-cutting efforts were offset by lower prices in all of the Group’s main commodities other than iron ore, inflation and increased tax charges. In other words, Rio was already hurting financially prior to the sizeable correction we’ve seen in the price of iron ore.

The ugly truth

Iron ore alone accounts for more than 90% of Rio’s profits. According to the good people at Goldman Sachs, prices of iron ore have tumbled 29% in 2014. Are your eyes watering yet? Well, how about this: analysts at Sanford C. Bernstein say their models show that for every dollar fall in the price of iron ore, Rio’s assets lose $1.5 billion in value.

Why Rio’s plan won’t work

Here’s some basic economics: if the price falls, the firm must increase its ‘quantity supplied’ in order to maintain ‘equilibrium’. The world’s two biggest miners have done exactly that. Rio Tinto and BHP Billiton have increased output, counting on those higher volumes to make up for lower prices.

The problem though is that as Rio’s biggest market (China) slows, the miner will not be able to make up for falling prices with volume. Dr Nouriel Roubini is forecasting that China’s economy will slow to an annual growth rate of between 6% and 6.5% next year. Moreover analysts say Chinese steel production is expected to slow further next year, putting even more downward pressure on prices and margins (as supply swells). In short it means Rio Tinto is facing a once-in-a-generation profit squeeze.

I found no solace in the miner’s annual report. In fact, the slowing Chinese economy is top of mind for the company. Rio says it’s heavily reliant on the Chinese market. It says a sudden economic disruption could substantially decrease China’s demands for the Group’s commodities, which would adversely affect the Group’s profitability and cash position.

Glencore thought it would throw a spanner into the works this week, suggesting a merger with the miner. Rio said “no”. Analysts though say that Glencore will remain interested in a deal while the iron ore price remains depressed. It’s this Fool’s understanding that a deal is unlikely to go ahead, but the fact that Glencore made a move at all is a symptom of an industry that’s in the throws of significant change.

Party’s not over yet

Last year Rio Tinto reported a dividend of USD$1.92. That was a 15% increase on 2012. City analysts expect a USD$2.15 payout this fiscal year, which is an increase of 11.93%. That’s not a bad return for now.

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David Taylor has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.