It’s a well known fact that mining and metals industry has been bleeding severely, and investing in the sector is not advisable. During fiscal year 2012, Rio Tinto plc (ADR) (NYSE:RIO) posted a loss of $3.01 billion because the demand for iron ore was weak. As a result, its shares lost nearly 30% over the last year.
Since industrial production isn’t expected to skyrocket anytime soon, Rio Tinto plc (ADR) (NYSE:RIO)’s organic growth prospects are are still glum. But despite Rio Tinto’s towering debt and unending macroeconomic headwinds, Citigroup is bullish on the company with a price target of $72 per share.
Why is the Street bullish?
One of the main reasons for this bullishness is that Rio Tinto plc (ADR) (NYSE:RIO) is finally working towards reducing its towering long-term debt of $26.82 billion. Its management recently came forth with a cost savings plan that’s expected to save $5 billion over the next 2 years. This will be done by improving operating efficiency and cutting redundant costs.
Additionally, Rio Tinto plc (ADR) (NYSE:RIO) recently called off the sale of its dozen diamond assets in Australia. It had planned to raise around $1.3 billion from the divestitures, while their collective fair value was estimated to be around $2 billion. This is apparently good news for investors, as Rio Tinto won’t be selling away its diamond business at a 35% discount.
Besides that, its management also proudly announced the expansion of its Pilbara mines. The project, worth $5 billion, is expected to add 70 million tonnes of annual iron ore production capacity. This should allow Rio Tinto plc (ADR) (NYSE:RIO) to boost its overall revenue and eventually offset its shrinking topline.
Why you shouldn’t be bullish
But there are broadly two reasons why investors should be bearish on Rio Tinto plc (ADR) (NYSE:RIO).
The European miner is primarily involved in the production of iron ore, which accounts for 90% of its overall revenues. Since iron ore prices have declined by nearly 20% year to date, the miner will most likely post a severe margin compression in the coming quarters. Its net margin of 5.5% is already low, as compared to BHP Billiton Limited (ADR) (NYSE:BHP)’s 14.5% and Vale SA (ADR) (NYSE:VALE)’s 10%, and falling iron ore prices (unrealized) will further shrink its operating cash flows.
Apart from that, Rio Tinto’s Pilbara expansion also seems to be mistimed. This is because iron ore demand isn’t expected to increase anytime soon, which suggests that its expanded iron ore capacity will most likely remain dormant. If Rio Tinto chooses to run its Pilbara mines at a high utilization rate, analysts fear that the oversupply will cause iron ore prices to tank and further strain margins of the entire mining industry.
As a result, several investors have asked its board to reconsider the expansion plan, and instead use its $5 billion cash to reduce its outstanding debt.
How do its peers fare?
As of now, both Rio Tinto and its competition seem to be debt ridden. Vale SA (ADR) (NYSE:VALE) is operating with a debt/equity ratio of 42% with total long-term debt of $29.93 billion. Its shares have tanked by nearly 35% over the last year, and analysts estimate its annual EPS to shrink by 4.46% over the next year. This is because most of its debt is external, and the depreciating Brazilian Real is inflating its interest payments.
Meanwhile BHP Billiton Limited (ADR) (NYSE:BHP) is operating with a debt/equity ratio of 53% with total long-term debt of $28.33 billion. But unlike its peers, BHP Billiton Limited (ADR) (NYSE:BHP) is actually showing signs of a turnaround.
Instead of expanding capacity, the company has scrapped its coal projects which were due for FY13. The company also announced the sale of its $1.5 billion stake in Jimblebar iron ore mine along with its coal mines in Australia to reduce its debt. The company has sold $6.5 billion worth of assets over the last 2 years, which have played a vital role in arresting its inflating debt. And to top it all off, BHP Billiton Limited (ADR) (NYSE:BHP) also has a $1.9 billion worth of annual cost saving plan to solidify its turnaround story.
Final words
To be frank, I don’t see how rising capital expenditures and capacity expansions can bolster Rio Tinto’s short to medium-term profitability. It may turn profitable over the long run, but I believe BHP Billiton Limited (ADR) (NYSE:BHP) offers more value as compared to Rio Tinto or Vale SA (ADR) (NYSE:VALE).
Piyush Arora has no position in any stocks mentioned. The Motley Fool owns shares of Companhia Vale Ads. Piyush is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article 1 Bullish Argument and 2 Bearish Arguments on This Miner originally appeared on Fool.com is written by Piyush Arora.
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