When it comes to buying shares in mining companies, it is impossible to escape the fact that their profitability depends to a large extent on the price of the commodity that they sell. So, in Rio Tinto’s (LSE: RIO) (NYSE: RIO.US) case, over 90% of its profit comes from the sale of iron ore, so clearly the price of iron ore is a major driver of its bottom line. And, with the largest buyer of iron ore in the world, China, enduring a soft landing at the present time, the near term outlook for the steel-making ingredient does not appear…
When it comes to buying shares in mining companies, it is impossible to escape the fact that their profitability depends to a large extent on the price of the commodity that they sell. So, in Rio Tinto’s (LSE: RIO) (NYSE: RIO.US) case, over 90% of its profit comes from the sale of iron ore, so clearly the price of iron ore is a major driver of its bottom line. And, with the largest buyer of iron ore in the world, China, enduring a soft landing at the present time, the near term outlook for the steel-making ingredient does not appear to be particularly bright.
However, with China in the process of cutting interest rates so as to try and stimulate its flagging economy (which is still growing by over 7% per annum, by the way), the longer term outlook for iron ore may be much more positive. In fact, it could surprise on the upside compared to gold, which has delivered a much more robust performance than iron ore in recent years and is a key reason why gold mining stocks such as Centamin (LSE: CEY) have easily outperformed Rio Tinto in the last year, with the former’s shares up 17% and the latter’s down 2% during the period.
Of course, there is more to a mining company than the price of the commodity that it sells. For example, the financial standing of a company can have a major influence on how well it copes with the downturns that are somewhat inevitable in the long run.
On this front, Rio Tinto scores particularly well. Not only does it have one of the lowest cost curves in the iron ore sector, it also has superb cash flow and a very modestly leveraged balance sheet – both of which allow it to increase production during challenging periods so as to strengthen its position relative to peers.
For example, Rio Tinto’s operating cash flow has averaged £8.6bn per annum during the last three years and, while it has spent almost this entire amount on capital expenditure during the period, much of this is non-essential spending that can be avoided moving forward. And, with a debt to equity ratio of just 46%, Rio Tinto could leverage its balance sheet to make acquisitions, should it wish to do so.
Meanwhile, Centamin has no debt and also has strong cash flow. However, it does not have the size or scale of Rio Tinto and, as such, may not be in as dominant a position as its sector peer within its respective marketplace. That said, it remains financially sound and able to withstand a downturn in the price of gold, should that occur over the medium term.
Clearly, the future prices of iron ore and gold are known unknowns and, with the unease surrounding mining stocks at the present time, both Rio Tinto and Centamin trade on very appealing valuations. For example, Rio Tinto has a forward price to earnings (P/E) ratio of just 13.7, while Centamin’s is even lower at just 9.8.
This may lead investors to conclude that Centamin is the more appealing of the two companies. And, for less risk averse investors, it appears to be due to its lower valuation and the better outlook for gold than iron ore at the present time (for the short to medium term at least). However, for investors who are concerned about downside risk, Rio Tinto remains one of the biggest mining companies in the world with a vast balance sheet, huge cash flow and tremendous size and scale. As such, it is a safer bet and could prove to be a superb buy at the present time.
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Peter Stephens owns shares of Rio Tinto. 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.