At first glance, Rio Tinto (LSE: RIO) (NYSE: RIO.US) looks cheap, and offers an appealing dividend yield of 3.7%. However, as a shareholder, I’m concerned that Rio’s shares may be cheap for a reason.
I’ve recently taken a fresh, critical look at Rio Tinto, and have found a number of weaknesses in my investment case for the firm, which have made me consider whether I should sell my Rio shares.
It’s not that cheap
Rio Tinto shares currently trade on a forecast P/E ratio of about 9.8. This looks very cheap, until you factor in Rio’s $22bn net debt.
Rio’s enterprise value (net debt + market capitalisation) is a whopping £77bn, which equates to 13.4 times the firm’s forecast earnings for 2013. In comparison, oil giant Royal Dutch Shell has much less debt, and its enterprise value is just 9.6 times its forecast earnings.
Shell’s inflation-busting 5.4% yield is also more attractive than Rio’s 3.7% prospective payout, which makes me question whether Shell is a more appealing play on the natural resources sector than Rio.
Political risk
Rio’s iron ore business has always been largely free of political risk, as it’s in Australia, which has a stable tax regime and a mining-friendly political environment.
However, Rio’s investment in the giant Oyu Tolgoi copper and gold mine in Mongolia has been repeatedly delayed by political interference.
Rio has spent $6.2bn on Oyu Tolgoi so far, and has completed the open pit stage of the mine development. However, development of the second, underground, stage of the mine has been postponed indefinitely, after the Mongolian government delayed approval of financing for the project, having previously tried to renegotiate its financial interest in the mine.
Still a one-trick pony?
Although Rio bills itself as a diversified miner, in terms of profit, Rio is an iron ore miner with some side projects.
In the first half of this year, Rio’s iron ore business delivered net earnings of $4.2bn on sales of $11.8bn. Although the firm’s coal, aluminium, copper and diamonds businesses generated a further $13bn in sales, they contributed just $611m to Rio’s net earnings.
Rio’s big hope for true diversification is its growing copper business, especially the Escondida and Oyu Tolgoi mines.
However, the firm still has a very long way to go to reduce its dependency on iron ore, and I’m not sure whether Rio’s current valuation reflects this risk.