Back to the grindstone for Rio Tinto

Rio Tinto's solid report shows wins in iron ore, optimism on copper and losses in thermal coal and aluminium. It shows China concerns and debt doubts. Basically, it's back to business after the super profits era.

At face value the Rio Tinto result for the June half is reflective of a sector under pressure, which to a degree it is. That’s only the case, however, if it is compared to the extraordinary "super profits" the industry generated for 18 months or so while China’s economy was charging along and the demand for commodities outstripped supply.

With China’s economy having slowed dramatically since then, and more supply having entered the market, the environment has changed dramatically and prices for most of the major commodities have slumped heavily.

In those circumstances, while the 34 per cent fall in underlying earnings might appear quite nasty, Rio actually significantly outperformed market expectations and appeared more than satisfied with its performance.

If that period of industry super-profitability were excised from memory, and in an environment where prices have tumbled and costs soared, it was actually a pretty solid performance given that the falls in prices alone stripped almost $US2 billion from those earnings.

Rio did generate an extra $US366 million from volume increases as its massive expansion of its Pilbara iron ore operations continued, but that was more than offset by $US584 million of volume losses related largely to its copper and gold businesses.

The result highlighted again just how good Rio’s iron ore business is, but also how dependent the group is on them, a dependency that will only increase as Rio continues its multi-phase expansion program within the Pilbara.

The iron ore operations contributed $US4.75 billion of the $US5.1 billion of underlying earnings – about 93 per cent -- and about 80 per cent of earnings before interest, tax, depreciation and amortisation. Given the quality of the business that’s not a bad thing, and it does explain why Rio has focused a large part of its investment program on expanding it. But it does highlight the relatively poor performance of the rest of the group.

The copper business, whose earnings slumped from $US1.2 billion to $US556 million, suffered from lower grades and volumes that Rio says is temporary. The fundamentals for copper – the supply-demand equation -- are strong and Rio also has the giant Oyu Tolgoi copper-gold project in Mongolia coming on stream later this year. Rio is quite bullish about copper.

Its energy business, primarily thermal coal, saw its product group profitability fall from US$433 million to $US196 million and with prices falling and costs rising it will remain under pressure.

The real issue for Rio, however, and it is no secret to anyone, is that even after a $US8.9 billion writedown it still has about $US27 billion tied up in an aluminium division that contributed only $US24 million ($US344 million previously) to the result.

Rio continues to restructure the division, shedding assets, cutting costs and even investing selectively – and plans to hive off the Pacific Aluminium business if it can – but that ill-fated decision to bid$US38 billion for Alcan ahead of the financial crisis still haunts it and will for the foreseeable future. Tom Albanese talked about his willingness, if there are parts of that division deemed unviable, to take tough decisions. He may well have to.

Despite the conditions Rio is investing heavily and is encouraged that the Chinese authorities have responded to the slowdown in their economy by initiating some stimulatory measures, including approving, by Rio’s estimates, more than 500 new projects. That could put a rising floor under China’s economy which Rio believes will recover to a growth rate of around 8 per cent by the end of the year.

Rio has a committed capital expenditure program of $US16 billion, although its share is "only" $US13.6 billion. It supplemented the $US7.8 billion of cash generated from its operations in the half (US12.9 billion previously) with borrowings to fund the $US7.6 billion it invested in the half and its other commitments, including its dividends and the tail end of a share buyback.

It will probably have to add to its debt to complete this year’s investment program, although it does have some assets on the market (including its diamond operations) and does have some flexibility that would enable it to wind the program back a bit if necessary. It certainly won’t do anything to jeopardise its credit rating.

Next financial year its committed spending will fall – unless it green lights some new projects – which will give it even greater financial flexibility if conditions don’t improve.

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