An aluminium blip on Rio's radar

Rio Tinto's annual results were disfigured by the massive new impairment charges relating to its aluminium businesses, which have led to the very principled decisions of Tom Albanese and his chief financial officer, Guy Elliott, to forego any bonuses because of their roles in the disastrous $US38 billion acquisition of Alcan in 2007.

While one can speculate about the roles Albanese, then a new and youthful CEO, and Elliott actually played in that ill-fated decision, relative to the group's former, powerful, executive chairman Paul Skinner, the executives' request to their remuneration committee not to be considered for bonuses was, as Rio's current chairman Jan du Plessis said today ‘'absolutely right.''

The latest $US8.9 billion charge against the value of the aluminium business brings the total write-downs of the value of the business since the Alcan acquisition to almost $US19 billion. That deal, made in the knowledge that BHP Billiton was stalking the group, was probably the worst resources acquisition in history.

The aluminium division is profitable in what remains a very difficult corner of the resources sector, but its earnings of $US442 million last year are being generated on a devalued asset base of $US26.2 billion and revenues of $US12.2 billion and distracting from what would otherwise be regarded as a very strong performance. The impairment charges turned a solid 11 per cent increase in underlying earnings into a net profit of only $US5.83 billion, a 59 per cent fall from the previous year.

Had it not been for the charges, the result would have compared more than favourably with the first-half earnings BHP reported earlier this week.

BHP announced an eight per cent increase in underlying earnings but a 5.5 per cent decline in reported profits, largely as a result of production disruptions at its Escondida copper mine, its Gulf of Mexico petroleum operations and its Queensland metallurgical coal business.

With its significantly bigger iron ore business, Rio has a greater exposure to the sweet and high-margin spot within the resource sector. While iron ore prices did fall away somewhat as last year progressed, Rio lifted the earnings of that business from $US10.2 billion to $US12.85 billion. It was iron ore that generated all the group's growth, with lower profit contributions from all the other product groups.

That disproportionate exposure to iron ore relative to the far more diversified BHP is a mixed blessing. In the near term it ought to drive relatively greater profitability and growth for Rio, which is investing furiously to expand the business.

In the longer term, if BHP's view that the growth rate in demand for steel-making materials from China will eventually mature, it could leave Rio over-exposed. The massive investment in aluminium was supposed to provide another major product group to go with iron ore and, to a lesser extent, copper and perhaps might yet play a stronger role in the longer term.

There are, however, concerns that the changes occurring in the aluminium sector aren't transient but reflect structural changes as the Chinese producers shift into a different phase of their development and as the markets for alumina and aluminium diverge.

An unremarked aspect of the BHP result, and one that explains, perhaps, the more cautious tone adopted by Marius Kloppers and his defence of a flat dividend and no capital management announcements – BHP had to ‘'live within our means'' – was that the run-rate for its cash flow generation dived in the latest half.

While it was flat relative to the previous corresponding half, at $US12.3 billion, net cash from operations fell more than 31 per cent from the $US17.9 billion BHP generated in the immediate preceding half, when it was experiencing record prices and volume growth. That kind of abrupt reduction in the amounts of cash flowing through the business would tend to cause a re-thinking of the pace of expansion and a bigger focus on cash conservation.

Rio's net cash from operations grew nicely over the year, from $US18.3 billion to $US20 billion, and grew solidly between the first and second halves, which presumably reflects its focus on iron ore and fewer disruptions to its core assets.  That has enabled it to continue to increase its dividends.

The tone of the commentary around the result was, like Kloppers', cautious, with Albanese, too, worried about cost pressures and the cloudy short-term outlook created by the problems in the eurozone and their implications for China.

That isn't stopping Rio from driving ahead with its Pilbara expansion, which Albanese said would increase capacity by more than 50 per cent by the end of the first half of 2015. He also has the Oyu Tolgoi copper-gold project coming gradually on stream and the giant Simandou iron ore project in Guinea in his pipeline of new projects.

Despite the continuing issues within the aluminium business, which is operating within a market in over-supply, Rio, having cleared a few decks, is in a very strong position as long as its iron ore volumes and prices hold up.