Raining on Rio's Parade

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SYDNEY -- Australia's second-largest miner by market capitalization, Rio Tinto (ASX: RIO.AX), reported its half-year results to June 2012 yesterday, beating analyst expectations -- or did it?

At a first glance, the company reported a net profit of $5.9 billion, above analyst expectations for a profit of around $5 billion. But included in that $5.9 billion was a deferred tax credit of $1 billion related to the recent introduction of the Mining Resource Rent Tax. Take that figure out, and the results may have fallen short of analyst expectations.

Analysts, commentators, and investors alike also appear to have missed the real point: The company has reported a massive drop in profit due to falling commodity prices, which show no sign of reversing course yet.

Rio's shares are up more than 3% today, despite a reported 13% fall in total revenue to $25.3 billion and a drop in profit of 22.4%. Most of the blame can be laid at the feet of falling commodity prices.0 The company received $1.9 billion less in revenue than in the previous year, despite increased production. Prices declined for nearly all of Rio's major commodities except for gold, some minerals, and thermal coal.

The primary concern for the company and investors is how much lower commodity prices could fall. With more than 80% of Rio's revenue exposed to iron ore prices, any further falls in the price could have major implications for the company's profitability. Rio plans to ramp up production of iron ore from 91 million tons this half-year to 283 million tonnes per year by the end of 2013. To reach that target, Rio plans to spend an additional $6 billion in capital expenditure in the remainder of the year, on top of the $7.6 billion it has already spent. Total capex for 2012 is expected to come in at $16 billion.

As a consequence, net debt blew up from $8.5 billion as of Dec. 31, 2011, to $13.2 billion as of June 30. One can only imagine how much debt the company will have by the time it has ramped up production to the target 283 million tons.

Unlike BHP Billiton (ASX: BHP.AX), which appears to be taking a conservative approach to future projects, Rio looks to be rushing into its iron ore expansion plans with little or no slowdown planned. Yet the company doesn't appear to think it has much choice. For years it has been ramping up its iron ore production; it's not about to turn back now.

The problem for Rio is that a 10% fall in iron ore prices reduces the company's underlying earnings by $1 billion, and this could have a greater effect in future years as the company increases its reliance on iron ore.

Pure-play iron ore miners Fortescue Metals (ASX: FMG.AX) and Atlas Iron (ASX: AGO.AX) are also aggressively ramping up production but may face an equally uncertain future if prices fall much further.

Rio increased its dividend by 34%, declaring a AU$0.685 cent fully franked dividend for Australian shareholders -- still a fairly low yield for investors.

The Foolish bottom line
Rio stated that China's GDP continues to grow at about 8% and that it expects China's policymakers to stimulate their economy to ensure it continues at that pace, should it show signs of slowing further. I'm not sure that's the same as a guarantee, and it appears to me that GDP growth could moderate still more.

The other issue is the supply of iron ore. With all the big iron ore miners expecting to significantly increase their production, we could see an oversupply of the commodity. Basic economics will tell you that when there's more supply than demand, prices will fall.

Rio appears headed into a storm at full steam.

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Motley Fool writer/analyst Mike King owns shares in BHP. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

The Motley Fool's purpose is to help the world invest, better. Take Stock is The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, while it's still available. This article contains general investment advice only (under AFSL 400691). Authorized by Bruce Jackson.

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