Drilling down into Rio’s debt obsession

Rio Tinto’s sensitivity toward debt levels is understandable given its vulnerability to changes in iron ore demand. Don't expect another dividend boost.

The market’s response to Rio Tinto’s 2013 earnings and the unexpectedly large increase in dividend was, quite rightly, very enthusiastic. Sam Walsh delivered on almost all the metrics that are within his control.

The big question mark, however, going into 2014, relates to the things beyond his or Rio’s control.

He and his chief financial officer, Chris Lynch, can control costs to some degree and have significant discretion in relation to how much capital they deploy.

They are ahead of their guidance on both counts, having pulled $US2.3 billion out of the cost base and $US3.5 billion from capital spending. There’s another $US700 million of cost reductions to go to meet this year’s guidance and capital expenditure is expected to fall from $US14 billion to $US11 billion this year and $US8 billion in 2015.

The 15 per cent increase in dividend was something of a surprise because Walsh and Lynch are very focused on reducing net debt, which is about $US4 billion lower than its peak levels last year.

There is no guarantee that this year’s dividend will rise, or at least rise to the same extent because, despite Walsh’s commitment to improve shareholder returns, Rio still believes it has too much debt and that its $US18 billion of net debt remains a source of potential vulnerability. Much of the free cash flow released by the big cuts to spending will inevitably be devoted to strengthening the balance sheet.

The sensitivity towards debt levels is understandable. Rio has total operating assets of about $US64 billion but generated about 97 per cent of its earnings last year from only a third of them – its fabulous iron ore business.

Rio is acutely aware of its reliance on, and exposure to, iron ore prices and demand. A 10 per cent movement in the iron ore price can add or subtract $US1.2 billion from its earnings. Rio can, and has, partly offset lower prices with surging production volumes but price has a much bigger impact than volume.

In the longer term the expansion of its copper business and (now that it is solidly, albeit not satisfactorily profitable) the potential of aluminium to make a larger contribution off its lower cost base and heavily rationalised asset base may help Rio diversify its exaggerated exposure to a single commodity.

The near term, however, does pose some challenges and potential threats because of that over-reliance on iron ore, an exposure that will continue to rise as the massive expansion of Rio’s Pilbara business continues. Hence the dash to reduce debt.

The iron ore price has softened this year to trade around the $US120-a-tonne level but not too much can be read into that because there are seasonal factors that affect China’s demand and generally a build-up a build-up of stocks that precedes a destocking cycle at this time of year.

With all the big seaborne iron ore producers having significantly lifted their production capacity in the post-crisis period, and Rio and BHP and Fortescue still continuing to increase their output, the supply of iron ore is rising quite rapidly.

China’s somewhat more volatile economy and the shift in its focus from infrastructure and exports to domestic consumption complicates assessments of demand, but most analysts believe the iron ore market is moving rapidly into surplus, probably this year, and will be heavily in surplus in 2015.

Rio is the low-cost producer in the sector and therefore, provided it gets its balance sheet in order and maintains its fierce focus on cash costs, ought to be the last producer standing if the market were to really fall apart. Its profitability would, however, take a major hit if forecasts of prices as low as $US100 a tonne this year and $US80 a tonne next year are borne out.

In theory, if the market moves into over-supply the high-cost producers ought to be displaced first, creating room for the low-cost operators like Rio, BHP and Vale to continue to sell their output, albeit at lower prices.

What no-one knows until the theory is tested by the actual outcomes, is whether China’s domestic iron ore industry will respond to lower prices by closing down unprofitable or sub-economic production. There is a social dimension to China’s economic activity that sometimes produces outcomes that don’t fit conventional economic theories.

Rio’s iron ore division is the best in its class but it is an awareness that its over-reliance on that business also creates potential vulnerabilities that is colouring and will continue to colour Walsh and Lynch’s agenda.

Walsh’s first year in charge of Rio has delivered surprisingly strong results and momentum but getting the debt down and continuing to improve the fundamentals and contributions of the non-iron ore businesses within their portfolio, even as Rio continue to build Pilbara production volumes, remain urgent works-in-progress.