Rio Tinto: Result 2012

Rio Tinto reported a statutory loss for the first time in its long corporate history. Lower commodity prices contributed to a 16% fall in revenue to US$51bn and previously flagged asset writedowns ensured the US$2.9bn loss recorded for the full year compared to a US$14bn profit last year. On an underlying basis, that is, excluding the asset writedown, net profit fell a mere 40% to US$9.3bn. As an act of penance, Rio increased dividends substantially, from 145 US cents last year to 167 US cents (fully franked, ex date 6 Mar).

Rio used the historic loss to declare changes in strategy. New chief executive Sam Walsh has pledged a renewed focus on costs, renounced excessive ambition and emphasised shareholder returns as a key measure in decision making. Acknowledging past misdeeds, Walsh appears to be returning the company to its conservative roots.

Hidden losses

The damage done by the Alcan acquisition is easy to understate because of booming iron ore prices. If poor judgement about aluminium’s future almost bought down the business, Chinese steel demand has saved it. Without the remarkable iron ore boom, Rio would surely have failed.

That boom is now subsiding. Falling iron ore prices tore US$3.6bn from the bottom line even though volume expanded considerably. Capital expenditure peaked this year at US$17.4bn as Rio completed Pilbara expansions and development of the giant Oyu Tolgoi mine.

With operating cashflow falling 40% to US$16.5bn, Rio was free cashflow negative for the year. As iron ore output expands to 360m tonnes in 2015 and capital expenditures fall away, free cashflow should rocket higher.

The iron ore division generated about 90% of profits while aluminium made a mockingly low $3m contribution and will be partly divested and wholly forgotten in time. Copper remains a key business but we have doubts about returns from both Escondida and Oyu Tolgoi, Rio’s primary copper mines. The first is aging, struggling to maintain output while the second is struggling for liberty from government control and is yet to be tested. Both are capital intensive and Rio may be reluctant to feed cash indefinitely.

Despite the poor result, the strategic change at the company is encouraging. Marginal output expansions, cavalier adventures and wild risks are being abandoned for cost control and efficiency gains. Shareholders will see the benefits of this approach over time as free cashflow rises which is why we’ve adjusted our recommendation guides up. We still, however, expect lower iron ore prices and hence are demanding a larger margin of safety before buying. The share price is up 7% since Resurrecting Rio from 18 Jan 13 (Hold – $65.98) and we’re sticking with HOLD.