Why I Wouldn’t Buy Rio Tinto PLC At These Prices

Mining colossus Rio Tinto (LSE: RIO) has enjoyed a handsome relief rally in end-of-week business, with the stock recently dealing 6% higher from Thursday’s close.

This late spurt means the diversified digger is only fractionally down from levels seen at the start of the week, a somewhat-impressive result given the climate of intense fear currently washing over financial markets.

Still, I for one cannot view this bounce as anything more than a blip in Rio Tinto’s enduring downward spiral. The company’s shares have haemorrhaged four-tenths of their value over the last year alone, as a rapidly-cooling Chinese economy has worsened already-chronic supply/demand imbalances across each of the Rio Tinto’s major commodity classes.

With worries over emerging market cooling continuing to intensify — and concerns over the global banking system and the prospect of a US recession coming into play more recently — I fully expect Rio Tinto to be dragged even lower as the dash from ‘riskier’ assets heats up.

Earnings under pressure

A steady erosion in metals prices saw underlying earnings at Rio Tinto more than halve in 2015, the company advised yesterday, falling to $4.5bn. And the firm swung to a net loss of $866m from a profit of $6.5bn in 2014, thanks in part to a mighty $1.8bn write-down of its Simandou iron ore asset in Guinea.

The City expects Rio Tinto to endure a third successive earnings slip in 2016 as difficulties in its core markets persist, this time by a chunky 14%. This figure leaves the business dealing on a P/E rating of 14.2 times, a decent reading on paper but a figure that fails to properly reflect the company’s high risk profile. I would consider a multiple closer to the bargain benchmark of 10 times to be a fairer reading given the worsening state of commodity markets.

A subsequent re-rating in Rio Tinto’s share price would leave the business dealing at £14.75 per share, representing an 18% drop from current levels.

Dividend poised to dive

And Rio Tinto’s increasingly-perilous earnings outlook has forced the company to put paid to its progressive dividend policy in a desperate bid to conserve cash.

Although the firm kept the dividend frozen at 215 US cents per share for 2015, Rio Tinto advised that “with the continuing uncertain market outlook, the board believes that maintaining the current progressive dividend policy would constrain the business and act against shareholders’ long-term interests”.

Rio Tinto advised that it would try to keep the dividend for 2016 above 110 cents per share, a shocking admission given company’s history of offering market-smashing dividend yields, and further illustrating the growing stress on the firm’s balance sheet.

Net debt at Rio Tinto advanced 10% last year to $13.8bn, while gearing rose by 500 basis points to 24%. And while the London-based business vowed to extend cost-cutting measures, and cut capex budgets by a further $3bn through to the end of 2017, similar measures have already failed to steady the ship in a climate of tanking commodity prices.

With rampant supply levels set to continue outstripping demand in 2016 beyond, I expect things to become a lot tougher at Rio Tinto before they improve, a terrifying prospects for share values.

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