Rio Tinto: A haunted house
Recommendation
After years as a frigid conservative, in 2007 Rio Tinto surrendered to pressure and, right at the peak of the cycle, purchased Alcan for US$40bn. Having already written off asset values, raised billions in equity and sacked thousands of employees, the decision continues to haunt the company. The pain was again evident in Rio’s full year results for 2011, released last week.
Although revenue rose 10% to over US$60bn, net profit after tax fell 59% to US$5.8bn. That caused a similar fall in earnings per share to US$3.03, although a dividend of $1.45 per share was declared (ex-date Feb 29th), 34% higher than last year.
The massive profit fall was due to a near US$9bn writedown of aluminium assets related to the Alcan acquisition. Those assets, which were bought for more than US$40bn, are worth a mere US$25bn today.
Key Points
- Profits hit by asset writedowns
- Structural woes affect aluminium
- Dependency on iron ore rising
When it stumped up the cash to buy Alcan, Rio argued it was buying a business with a fortified competitive advantage. The massive pool of cheap hydroelectricity accompanying Alcan would insulate it from a glut of Chinese aluminium production that threatened to swamp the market. Rio expected that Chinese production, exposed as it was to higher energy prices, would be forced to shut as power costs across China rose. The Chinese production glut, Rio posited, was temporary and would eventually wane. That hasn’t happened. To understand why, we need to appreciate the crucial role of energy prices in aluminium production.
Turning alumina into aluminium requires running massive electric currents through it, a process known as electrolysis. This means that quantities of available power must be immense and, to make the process economic, prices must be low. With more than 30% of total production costs coming from power, electricity prices generally determine how competitive production will be.
31-Dec-11 | 2011 | 2010 | Change (%) |
---|---|---|---|
Revenue (US$bn) | 61 | 55 | 10 |
EBIT (US$bn) | 14 | 20 | -30 |
NPAT (US$bn) | 6 | 14 | -59 |
EPS (c) | 304 | 731 | -58 |
DPS (c) | 145 | 108 | 34 |
Net operating cashflow (US$bn) | 20 | 18 | 9 |
Capex (US$bn) | 19 | 6 | 245 |
Instead of shutting, however, Chinese smelters, aided by cheap capital, moved to western China to access vast, cheap coal-fuelled energy. The dominance of Chinese producers in the aluminium market has actually increased and, with Chinese aluminium prices higher than elsewhere, Chinese smelters can operate even as the rest of the industry struggles. Alcan has been left out in the cold.
Despite the structural turmoil, Rio has approved almost US$8bn in new spending on aluminium projects. By adding yet more cash to a totem of past failures, Rio management may well be compounding a past mistake.
We’ve argued that the aluminium sector is undergoing the type of structural change that steel and iron ore have already experienced (see Alumina: lousy business, hot opportunity from 05 Oct 11 (Speculative Buy – $1.44)). This time, however, rather than being a beneficiary of Chinese involvement, Rio will be a victim of it.
Iron awe
If aluminium stands as Rio’s gloom, iron ore is its star. Compared to BHP iron ore’s return on assets of 50%, Rio’s figure stands at an astronomical 95%. This is easily the best iron ore business in the world, the profitability of which is at once Rio’s greatest strength and its greatest frailty.
The company’s dependence on iron ore is frightening; it alone earned more than US$20bn of earnings before interest tax depreciation and amortisation, 75% of the company’s total.
Rio’s capital expenditure program isn’t as aggressive as BHP’s but, for a company on the brink just a few years ago, it is daring. Having helped resurrect Rio from debt and despair, the iron ore division is about to enjoy a huge cash injection.
Right now, the company produces less than 200m tonnes of iron ore per annum. By 2015 it will produce more than 350m tonnes. A dangerously high dependence on iron ore is only going to grow. And then there’s the operating leverage.
For every 10% change in iron ore prices, underlying profits change by more than US$1.7bn. This kind of operating leverage works wonderfully in the midst of a boom but the concerns highlighted in Iron ore: It’s (not) different this time on 15 Nov 10 still stand; supplies of iron ore are growing. Even without a slowdown in China, additional output alone could depress prices by a further 30%.
That means that more than US$5bn in underlying earnings is at risk if all is well in China. If it isn’t, the consequences could be catastrophic.The share price has fallen 8% since 05 Aug 11 (Sell – $76.58) but the risk of real share price damage has only increased. SELL.