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10 iconic UK shares: Rio Tinto

The next in our series of articles using fundamental analysis to examine the prospects of 10 iconic FTSE companies.

Rio Tinto Group's West Angelas iron ore mine in Pilbara, Australia
Source: Bloomberg

Reasons to watch

  1. Strong dividend payouts, higher than the sector average
  2. Undemanding PE ratio
  3. Potential for consolidation in the sector as miners look to cut costs

History

Rio Tinto is a global metals and mining firm with a listing in Australia and the UK. It traces its history back to 1873 when it purchased its first mine on the Rio Tinto river in Spain.

Its main focus is the discovery and extraction of raw materials, including iron ore, bauxite, alumina and copper, but it also has key refining operations for bauxite and iron ore.

The key event of recent years was the purchase of Canadian aluminium firm Alcan in 2007 for over $38 billion. At the time, the merger was hailed as a triumph but the timing was poor – just before a global financial and economic crisis that saw mining stocks hit hard.

Since 2008 Rio has sold a number of assets in a bid to focus attention on its core operations, including those in iron ore, in which it is the second-largest producer in the world. 

Fundamental analysis*

An investor buying Rio Tinto shares at any point in 2009 until around October would still be sitting on a small profit. Those who bought at the top in 2011 or at almost any other time in the period since 2009 will have not done so well. The shares have struggled for direction in recent years and, although they have not slumped to 2008 lows, their current performance, down 12% versus a 2.3% drop for the FTSE 100 this year, leaves a lot to be desired.

Given that Rio Tinto makes most of its money from iron ore, a 40% drop in the price in 2014 will have hit the company hard. Iron ore prices are below the levels seen in 2012. Then Chinese production shut down and provided a base for prices, but this is not happening this time around.

Rio’s current strategy relies on low-cost mines that can turn a profit, regardless of the current state of the iron ore market. It worked in the 1990s, when flat commodity prices failed to dent earnings growth and a good stream of dividends. Now, this looks more difficult to achieve. Costs have already been cut back, with little room for additional reductions, and if prices fall further the miner’s dividend – which is still on a healthy yield of 4% – could be the next to go.

Rio’s problems do not stop at iron ore. Demand from China is not seeing any significant uplift and a rerun of 2008’s massive stimulus programme does not seem to be on the cards at the moment. Other emerging markets are stuttering too, leaving the firm exposed to additional drops in the iron ore price. Supply of iron ore is expected to continue to rise, an event that is hardly likely to be bullish for the price trajectory.

Value-hunting in mining stocks is always tricky, given that apparently solid fundamentals can be undermined by a rapid shift in commodity prices. However, Rio trades at a much less demanding PE than its UK-listed peers, currently 9.3 versus 15.3 for the broader sector, and it still has the dividend advantage, on a current yield of 4.96% versus 3.92% for the sector as a whole.

A share prices of £35 has proved too high a valuation for the time being, having been tested twice this year, but for the time being buyers are stepping in above £29. With commodity prices still falling however, Rio Tinto shares are not for the faint-hearted.

The attempted bid by Glencore for Rio puts the spotlight on potential consolidation in the sector. Rio has fought off the bid for now but Glencore could easily come back for another try, since Rio’s iron ore division would plug a gap in Glencore’s otherwise strong breadth of production. However, Chinalco, the Chinese firm, would need to agree, and it seems highly likely that national considerations would play a part. China would not be keen to see one foreign firm gain such increased power in the sector, while the differing cultures of Rio and Glencore, one conservative and the other far more swashbuckling, would also be a tricky fit. Nonetheless, with a bid now public knowledge, the possibility of another firm making an approach cannot be ruled out.

*What is fundamental analysis?

Fundamental analysis seeks to examine a security by measuring its value through the use of financial and qualitative factors. Essentially, fundamental investors believe that each share is a piece of a company, and that the company can be analysed to determine whether the current share price indicates whether the company itself is undervalued (trading at a discount) or overvalued (trading at a premium).

The overall objective is to determine the underlying value of a company, and use comparisons with similar companies to determine if the business is likely to be successful or otherwise. Crucially, a company cannot be overvalued or undervalued in isolation. Instead, fundamental analysis compares a company to its peers in the sector, to the broader market, and to past valuations, to determine whether the current valuations are appropriate. 

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