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Rio Tinto plc (ADR) (RIO), BHP Billiton Limited (ADR) (BHP): One Bullish Argument and 2 Bearish Arguments on This Miner

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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.

Rio Tinto plc (ADR) (NYSE:RIO)

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.

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