Swings and roundabouts in a Rio Tinto transition

Sam Walsh’s first real results as chief executive of Rio Tinto was always going to be measured more by his ability to deliver cost reductions and reduce capital expenditures than by the absolute performance he announced. He’s made a very reasonable start.

Rio’s earnings were always going to be down, given what’s happened to commodity prices since the corresponding half of 2012, and they were.

On an underlying basis they were 18 per cent lower at $US4.23 billion ($US5.2 billion previously) and on a statutory basis, which included $US1.85 billion of non-cash foreign exchange losses and the $US340 million cost of the landslide at the Bingham Canyon copper-gold mine in the US, down 71 per cent.

The drivers of the earnings decline were revealing of the new environment in which miners are operating.

As with most of the major miners Rio has been expanding production aggressively, particularly in its iron ore business, where records are being set. The impact of that increased volume on earnings was $US359 million. That was, however, swamped by the decline in commodity prices, which wiped $US1.3 billion from the results.

That’s why Walsh’s focus on costs and capital (and a similar mantra from Andrew Mackenzie at BHP Billiton) is so important.

Rio said today it had achieved $US1.5 billion of total pre-tax costs reductions, including $US977 million of operating cost reductions and $US483 million from cuts to exploration and evaluation spending. Walsh and his chief financial officer, Chris Lynch, are targeting $US2 billion of costs reductions for the full year and another $US1 billion in 2014 to bring the total savings to about $US5 billion.

It has reduced capital expenditure by 9 per cent and expects full-year spending to be around $US14 billion, or 20 per cent below last year’s peak of $US17.5 billion, and has also sold $US1.9 billion of assets.

Walsh said he was pleased with the momentum being generated in cost savings and the reductions in capital being deployed within the business as he targets a leaner and more focused business.

He would also have been pleased that cash flows from operations held steady at $US8 billion ($US7.89 billion previously), which has enabled Rio to increase its interim dividend by 15 per cent to US83.5 cents despite Walsh declaring himself less than comfortable with Rio’s debt levels.

He would have been even happier if Rio had been able to make a few more asset sales. It tried to sell its diamonds business but pulled it off the market because it couldn’t attract an acceptable price for what’s regarded as a good business.

It has also been forced to re-integrate its Pacific Aluminium business, which contained the aluminium assets it least likes, into the Rio Tinto Alcan group after concluding that it couldn’t deliver value from a divestment in the current environment.

Walsh said Rio needed to do more to improve the performance of the aluminium division which had, at least, positive earnings of $US123 million in the half. It has, however, an asset base of $US18.8 billion and, as it has been since that ill-fated Alcan acquisition, remains a drag on returns and a distraction for Walsh and his team.

The divestments strategy was a key plank of the task Walsh had set himself to make Rio a simpler and cleaner group with a stronger balance sheet. With about $US19 billion of net debt within what is a highly volatile environment he’s quite open about his discomfort about the balance sheet he has inherited and his intent to reduce its risk.

The relatively impressive aspect of the result was, as one would expect, the iron ore division’s performance where earnings held up quite well in the circumstances, helped by the rising volumes.

The iron ore businesses contributed $US4.3 billion to the group result – equivalent to the entire underlying result – compared with $US4.99 billion previously. The big decision for Walsh and his board, which they will confront later in the year, is whether to commit another $US5 billion or so to the next big expansion of their Pilbara production.

The copper business’ performance, where earnings fell from $US530 million to $US348 million, would have been reasonably solid if not for the Bingham Canyon event but the commodity that has been worst hit by China’s slowdown, thermal coal, helped push Rio’s energy businesses into the red. That division was also impacted by losses from Rio’s uranium businesses.

Given that Walsh and Lynch have really only had a very brief time in charge – Walsh was appointed chief executive in January and Lynch, previously a non-executive director of the group, in April – they’d be pleased with the start they’ve made towards re-positioning Rio for the post-boom environment.

It’s obvious from Walsh’s commentary and his open concern about the balance sheet, however, that they both believe they’ve got a lot more work to do to get the group from where it is today to where they want it to be.