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Why Rio Tinto plc Could Plunge To 1,580p

Mining giant Rio Tinto (LSE: RIO) derives around 85% of its profits by producing iron ore.

The market price of iron ore plunged from a peak of around $187 per metric ton in February 2011 to today’s figure around $53 — a 72% fall.

Holding on

Rio Tinto is fighting back. In the good times of high commodity prices costs escalated due to supply and demand — the big miners wanted labour, machinery, equipment energy and other resources, so the price of those things went up in such a buoyant market. So to counter falling revenues, Rio Tinto has been pushing costs back down and increasing its operational efficiency for several years.

The firm is also ramping up production in a dash for market share. With these lower iron ore prices, that boils down to working harder for less. However, Rio has some producing mines with production costs less than half today’s iron ore market price and the firm reckons it can ride out the downward lurch of the price cycle. So far, Rio Tinto is keeping positive cash flow coming in, albeit at a reduced level.

The chart for iron ore shows that the price has not fallen beyond the low of around $50 it hit in April, so has the base metal found a floor? Maybe, but I wouldn’t count on it. The big worry I have with iron ore is the price history.

Just another bubble

On the price chart for iron ore over a 30-year period the high prices of the last ten years look like a bubble. For almost 20 years from 1985, iron ore traded in a range between about $12 and $15 dollars per metric ton. Then we saw the big bubble in the price, which peaked at about $187 in February 2011.

Today’s $53 or so is still almost twice the $28 iron ore stood at ten years ago in December 2005, and around four times the $13 or so from December 2002. To me, that price history means there is a lot of potential for iron ore to revert to the mean from here and, in that context, a halving of the price of iron ore does not seem like a wild expectation.

Still increasing the dividend

Meanwhile, Rio Tinto keeps up its progressive dividend policy. In August, the firm’s interim results revealed underlying earnings down (43%) compared to the equivalent period the year before, net cash from operations down (19%), but the firm lifted the dividend by 12%.

Earnings used to cover the dividend payout almost seven times in 2010, but 2016’s projected earnings will only cover the forward dividend once.  If iron ore falls further, it will affect Rio’s cash flow and earnings further, and the directors will likely reduce the dividend. It’s hard to imagine Rio Tinto’s share price holding up if the directors start slashing the dividend.

It is hard to estimate how far the share price might fall if this downside scenario plays out. However, a natural first stop is the firm’s net asset value around £28,976 million. If that figure becomes Rio Tinto’s new market capitalisation, the shares will stand at about 1580p each. In this potential outcome, investors stand to lose both capital and income. Once down, the shares could stay low, perhaps never returning to previous highs. That’s why I’m avoiding Rio Tinto, which I see as a gamble right now.

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Kevin Godbold 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.