Rio's iron will should crush its critics

With Glencore's Ivan Glasenberg stalking it, Rio Tinto needed to defend its strategy of expanding its iron ore production into a falling market at today's investor briefing. It did.

Glasenberg, after his merger/takeover proposal was rebuffed by the Rio board earlier this year, has been critical of Rio and BHP for continuing to ramp up their iron ore output, even as prices have been sliding below $US70 a tonne. He is positioning himself as a more capital and price-conscious manager, with a greater focus on near-term shareholder returns.

Rio, while deferring a decision on the development of its greenfield Silvergrass mine until at least the third quarter of next year, recommitted itself to increasing its iron ore production from 290 million tonnes a year to 330 mtpa in 2015 and 350 mtpa by 2017, with the additional tonnes generated by brownfields expansion, de-bottlenecking and increased productivity.

And why wouldn't it? The first 40 mtpa comes with a capital cost of about $US9 a tonne and, combined with the anticipated 26 per cent reduction in unit costs in the Pilbara from 2012 to 2020, will help support earnings before interest, tax, depreciation and amortisation above 50 per cent.

With cash costs of around $US20 a tonne in the first half of this year (11 per cent lower than in the same half of 2013) Rio, which generates premium prices for its ore relative to the rest of the industry, is the low-cost producer and the most profitable producer.

Rio says its “Pilbara 360” expansion program will deliver internal rates of return of about 40 per cent and a five-year payback. It is difficult to argue against an expansion that promises those sorts of returns, although Glasenberg will inevitably have to do so if he wants to continue to present himself as a superior and more capital-conscious manager.

The longer-term logic of expanding volumes when that increased output generates those sorts of IRRs and supports margins above 50 per cent is, however, irrefutable. It will help drive out higher-cost and lower-quality production from elsewhere and accelerate a re-balancing of a market currently significantly oversupplied.

As Sam Walsh said today, the long-term outlook for Rio remains sound -- and is built on its pre-eminent position in iron ore -- even if the near term is more challenging.

As with its peers, Rio has been slashing costs and rationing capital. Capital expenditure this year will be 34 per cent lower than in 2013 despite an overall 5.2 per cent increase in volumes, while operating and exploration costs are expected to be $US5.4 billion lower at the end of 2015 than they were in 2012.

The near-term uncertainty, however, is producing a more conservative approach. Rio has reduced its once-destabilising net debt levels by another $US6 billion this year, to about $US16 billion.

It is, however, shifting from a focus on absolute debt levels to a net gearing range of between 20 per cent and 30 per cent to “protect investors and provide flexibility”. Its current ratio is about 22 per cent, and Rio said it expected it to remain at the lower end of the target range in the near term. Given the plunge in commodity prices, conservatism was to be expected.

The market appears to be interpreting that as a dashing of expectations of imminent capital returns or special dividends, with Walsh declaring that the commitment to shareholders was to deliver “sustainable” cash returns through the cycle. Walsh said that over the next five years Rio expected to generate strong free cash flows and remained committed to materially increasing cash returns to shareholders “in a sustainable way”.

Rio, like BHP, appears to be looking to a progressive dividend policy rather than big one-off capital management initiatives as its way of rewarding shareholders, at least within the immediate future.

The apparent deferral of the prospect of capital management could represent an opportunity for Glencore to try to exploit the institutional hunger for short-term cash returns, although any attempt to take over the larger Rio would inevitably involve an already leveraged Glencore taking on a lot more debt (as well as Rio's) and offering a lot of its own scrip to Rio shareholders. That would be a tough proposition to sell.