Sam Walsh’s objective when he became chief executive of Rio Tinto was to restore the group’s reputation for financial and operational excellence and discipline. He’s running ahead of schedule.
Today’s half-yearly result is full of out-performance against benchmarks Walsh had set which had previously appeared quite demanding.
It wasn’t just that the overall result, with underlying earnings of $US5.11 billion, was higher than the consensus expectation among analysts of about $U4.9 billion. On all the key metrics Rio out-performed despite the significant deterioration in the price of its key commodity, iron ore.
Iron ore prices were 20 per cent lower in the June half relative to the same half of 2013, wiping $US1.4 billion off underlying earnings of a business that generates more than 80 per cent of Rio’s profits before unallocated costs.
What saved the result was the success of Rio’s cost reduction program and the surge in volumes to record levels, particularly in iron ore that has occurred as Rio, and the other majors, pursue productivity offsets to the price declines.
Walsh had ambitious cost reduction targets. Last year he took $US2.3 billion out of the cost base and foreshadowed another $US1 billion this year. He’s delivered more than that in the first half, with the group’s cost base now $US3.2 billion lower than in 2012. A further $US1 billion of savings has been targeted for 2015.
The combination of volume and cost improvements in Rio’s key iron ore division actually more than offset the decline in prices, a remarkable outcome.
Walsh has also promised to reduce the capital intensity of the business as part of the enhanced focus on returns and shareholder value. Capital expenditure was reduced to $US3.6 billion in the half and is now expected to total $US9 billion for the year -- $US2 billion below Rio’s previous guidance. It is then expected to be whittled back to $US8 billion a year from 2015.
With operational cash flows rising 8 per cent to $US8.7 billion and the reduction in investment, Rio also reduced net debt by $US1.9 billion in the half to $US16.1 billion compared to $US22.1 billion a year ago.
With a 15 per cent increase in interim dividend Rio also flagged “materially increased cash returns to shareholders” over coming years, underscoring its confidence that the improvement in its performance will continue even as the easier cost cuts dry up.
The performance of Rio’s low-cost, high-quality iron ore business wasn’t a major surprise, although the extent of the reductions in cash costs was impressive, but Walsh and his board would be encouraged by the big improvement in their copper and aluminium operations.
The much (and deservedly) maligned aluminium business increased its underlying earnings 74 per cent from $US214 million to $US373 million, and Walsh said the group was “beginning to get the shine back” on the division.
The same story of lower costs and less capital spending contributed to the division’s improvement despite a 9 per cent decrease in average metal prices, but the underlying fundamentals for the sector have been improving as sub-economic capacity, including Rio’s, is being driven out of the industry. As the low-cost producer, Rio is positioned to benefit from any improvement in a sector which, thanks to its ill-fated $US38 billion acquisition of Alcan just ahead of the financial crisis, has cost it the best part of $US30 billion of write-offs.
Copper earnings were 71 per cent higher at $US594 million thanks to the recovery of volume at Kennecott Utah Copper after last year’s pit wall slide and the ramp up of volumes at Oyu Tolgoi in Mongolia. The $US206 million of cost reductions and the big 20 per cent-plus increases in volumes contributed to the theme of the overall result.
Rio’s coal business, in common with most of its peers, lost money but, at $US19 million, it lost less than the same half of last year ($US52 million).
Walsh plans to stick to his strategy of ramping up volumes, particularly in iron ore, and continuing to reduce costs.
As he said, in iron ore it is already having the desired effects, driving out higher cost and lower-quality ore from China and among the junior miners elsewhere. Rio, as the low-cost producer producing high-quality ore, also has the best margins in the business.
If it, and BHP Billiton and Vale, continue to increase their volumes the impact on miners with higher cost and/or lower quality mines will intensify. Some smaller producers are receiving prices up to 20 per cent lower than Rio and BHP.
Walsh described today’s results as outstanding and it is hard to believe anyone will disagree. In appointing Walsh CEO and his right-hand-man Chris Lynch CFO the Rio board hoped that it was putting some safe and conservative hands in charge.
The board has got significantly better results from those decisions and the duo it installed than it might have hoped for and the returns from their focus on re-establishing the core qualities, capabilities and processes that served Rio so well in its pre-GFC past appears to have taken even Walsh and Lynch themselves slightly by surprise.