If Rio Tinto’s interim result looked familiar, it’s because it has followed a pattern for several years; lower commodity prices cut profits but lower costs and currency offset the decline. Yes, this was an utterly predictable result (summarised in Table 1).
Lower commodity prices slashed US$1.9bn from underlying earnings, a sum offset by currency and energy savings worth US$300m and cost cuts worth another $400m. Rio has now accumulated US$6.8bn dollars of savings since it started looking for them in 2012.
Iron ore still the star
Astonishing cost reductions
One change came from mining volumes which, after rising for several years, were flat, suggesting the strategy of using higher volumes to offset lower prices has ended. That could mean industry wide supply cuts are coming, a positive for prices.
Another key change, a welcome one, is stricter capital allocation. The great boom was wasted on most miners who frittered cash flows away on expensive expansions and awful acquisitions. Rio has increased internal hurdle rates for capital allocation and recent spending does appear better.
Three large projects have been approved: expansion of the splendid Oyu Tolgoi copper mine, development of the Silvergrass iron ore mine and an expansion of bauxite output in Northern Australia. All three projects are high quality and will generate generous returns of over 20%; Silvergrass should generate returns over 100%.
|Op cash flow||3,240||4,435||(27)|
|U'lying EPS (cents)||87||159||(45)|
All about iron ore
Rio’s iron ore division remains dominant, generating over 60% of EBITDA and all its net profit.
Despite well publicised price declines, iron ore still generates remarkably stable EBITDA margins of 58%. We still expect prices to ease and, while Rio’s Pilbara mines are the world’s best, the persistent reliance on iron ore remains a weakness.
The rest of the portfolio performed poorly with energy (mostly coal) generating an interim profit of just US$80m on an asset base of over US$6.7bn. Aluminium posted decent cash flow but woeful profits of US$377m, about half as much as last year. On an asset base of over US$16bn, that’s still an abysmal return and, even after writing off about US$20bn, aluminium could yet attract further impairments.
The copper division recorded a loss but should improve as expansions of Escondida and Oyu Tolgoi are completed. This remains the best hope for diversification from iron ore.
Strong cash flow
On a cash flow basis, results were better with Rio generating US$3.2bn for the half year, with all commodity groups contributing.
The cash results are a decent indication of performance because Rio is depreciating an asset base that was expanded massively and expensively over the boom. Maintaining that asset base should be cheaper now so depreciation likely overstates capital expenditure, although this is a theory we will test again when full accounts are released later this year.
Rio’s next focus will be on debt reduction. At US$13bn, debt isn’t an immediate concern but the miner is fortifying its balance sheet and no one is complaining. A focus on debt repayment explains why dividends were miserly at just US$0.45 per share, less than half of what was paid last year.
Despite that decline, this was a decent result with Rio continuing to show astonishing levels of cost reductions and better than expected iron ore margins. The other divisions haven’t performed as well, however, which is why our buy price is some way from the share price. All up: not bad, Rio. HOLD.