A leaner Rio is primed to capitalise

Rio Tinto’s decision to turn to two old hands to navigate the very different course imposed on it by the more challenging resource sector environment is paying off.

Sam Walsh and his chief financial officer Chris Lynch promised to pull slabs of capital out of the group and carve into costs in response to the sharp decline in commodity prices. They are on track to create a significantly less capital-intensive business with a substantially thinner cost base.

At today’s investor seminar Walsh, appointed chief executive at the start of the year and Lynch, who switched from a non-executive role to the chief financial officer post in April, gave an update on their progress.

They’ve lopped $US1.8 billion ($A1.97 billion) from the group’s cost base already, and they say they are on track to deliver their target of $US2 billion by the end of the year. Capital expenditure of less than $US14 billion is 20 per cent lower than it was in 2012 and is expected to be reduced by 20 per cent in each of the next three years. They’ve made or announced $US3 billion of divestments.

Next year, capital expenditure of $US11 billion is being targeted and in 2015, $US8 billion. This is less than half the $US17.6 billion Rio invested in 2012.There will be more cost cutting next year; the goal is to lower costs by at least another $US1 billion to bring cumulative cost reductions to about $US5 billion.

The focus on capital intensity is producing some surprising outcomes.

The market has been waiting on Rio’s expansion plans in the Pilbara, anticipating a commitment to spending as much as $US5 billion to lift iron production from the current 290 million tonnes a year to as much as 360 million tonnes.

Instead, Rio announced last week that it would expand production by at least 40 million tonnes a year, to 330 million tonnes – at a capital cost of $US120 to $US130 a tonne, or at least $US3 billion lower than expected. The focus on brownfields expansion and productivity has produced a plan that generates growth but at a far lower cost than the original and more ambitious proposal for new mines.

With iron ore prices holding up at historically high prices and the Australian dollar finally sliding, the apparent tensions between reducing investment while pushing ahead with expansion plans can be reconciled by a more creative approach to generating growth.

What Rio is doing is what all the major miners are doing as they reshape their portfolios for the post-boom environment. The relative outcomes will be determined by the quality of their execution. The ability of Walsh and Lynch to deliver the savings they promised on or ahead of schedule is very encouraging.

In copper, Rio has been re-positioning itself, exiting higher-cost projects and taking $US350 million out of its continuing operations to focus on its higher quality assets with first quartile cost potential.

There is a consensus in the sector that copper’s long-term fundamentals are strong – with demand continuing to increase – but existing supply coming from increasingly lower grade and higher-cost mines.

The more challenging task for Walsh and Lynch lies within the albatross they inherited: the aluminium business unhappily bulked up by the ill-timed and mispriced $US38 billion acquisition of Alcan just ahead of the financial crisis. There were structural changes in the industry that have significantly and probably permanently impacted the integrated Western producers.

Unable to sell or spin off the worst of the assets within the portfolio, Rio has focused on cost-cutting ($US450 million to date) and the closure of sub-economic production. It plans no significant new investment in alumina or aluminium for the foreseeable future, but appears cautiously positive about the outlook for bauxite.

Like his peers, Walsh remains optimistic about the long-term outlook for commodities. However, he concedes the near term could be fragile and volatile as the major developed economies continue to deal with the aftermath of the financial crisis.

The re-basing of the big end of the industry towards lower cost and less capital-intensive assets and a shift in philosophy from breakneck expansion to shareholder value ought to mean that those groups that execute their strategies well will be in good position to capitalise on a stronger and more stable global economic environment. At the very least, they will survive in reasonable condition and generate reasonable returns to shareholders.