Rio Tinto: Result 2013

It’s more than half a decade since Rio Tinto made its infamous decision to acquire Alcan at the top of the cycle. The move still haunts the company. Although Rio’s full-year profit of US$3.6bn was better than last year’s loss, it was again riddled with impairments (US$3.4bn) and currency losses (US$2.7bn).

The result was far better on an underlying basis – profit rose 10% to US$10.2bn – and cash flow was particularly strong at US$20bn, up 22%. From underlying earnings per share of US$5.53, up 10%, a full-year dividend of US$1.92 was declared (ex date 5 Mar), 15% higher than last year.

The strong underlying result in the face of lower commodity prices adds to the sting. Rio should have been a magnificent success over the decade. Instead, it has destroyed value and come close to death. This result shows that it was poor capital allocation, not lower prices, that hurt this business.

There are signs, however, that the pain may be over. Although lower prices slashed US$1.3bn from the bottom line, Rio stripped US$1.6bn of costs and registered higher volumes. The magnificent iron ore business produced 290m tonnes for the year, the latest expansion coming below budget and ahead of schedule.

More iron to come

Chief executive Sam Walsh confirmed that production would increase to 360m tonnes by 2015, although the increase will come from operational tweaks rather than new construction. In an ominous sign to mining services firms, more than US$3bn will be saved this way. Rio appears a more cost-focused business than it was five years ago; it saved 4m litres of fuel from its truck fleet, for example, by recalibrating engine idling speeds.

As promised, capital expenditure was cut by 26% to US$13bn and will fall to US$8bn next year. This reflects not merely prudence but a new found humility. Sam Walsh pledged not to engage in silly investment, to act like an owner and to focus on return on capital. These are not just idle words: management is acting on its promises.

Another US$3bn of asset sales were announced and will contribute to lowering debt which, at US$18bn today, is perhaps too high for a business that relies on iron ore for 90% of profits. Copper is a particular focus for rationalisation, with the company divesting smaller mines and focusing on six major ore bodies.

Improving low returns

Of the lamentable aluminium business, there was less clarity. The business generated US$550m in operating profit compared to just US$50m last year. Operating margins rose from less than 1% last year to 4.4%; pitiful, yes, but increasing amidst falling prices. Rio must decide whether the US$18bn worth of assets tied up in the aluminium business will ever make acceptable returns. Right now, aluminium generates a return on assets of just 3% compared to returns of 47% from iron ore. Liberating aluminium may allow higher returns to be earned elsewhere.

Management suggested that returns would improve as China restructured its heavily subsided aluminium industry. They might be right, but irrationality with state support can last a long time. All the while, Rio is earning a pittance. The quality of Rio is being obscured by a poorly performing division. Rio should remove it.

This was a strong result from a business that is getting better. Although we are negative on iron ore prices, Rio will generate sensational returns at almost any realistic price, due to its position as the world’s lowest cost producer.

With asset sales and lower capital expenditure lifting free cash flow, Rio looks better today than it has for many years. A more detailed look beckons. With the price up 11% since Rio Tinto: Interim result 2013 (Hold – $62.20), we’re sticking with HOLD.