Rio Tinto: Result 2014

In a year that saw iron ore prices fall 50%, expectations for Rio Tinto's full-year result were low. Rio commands the best iron ore mines in the world, its aluminium business is world class and its copper orebodies are outstanding. Yet a business dominated by iron ore couldn't report anything but lousy results amid plunging prices. Right?

Wrong. Rio has delivered a ripper. The numbers themselves may not appear too flash: underlying net profit fell 9% to US$9.3bn and operating cash flow fell 5% to US$14bn. In the context of steep commodity price falls, however, modest falls in profit are an outstanding outcome.

Lower commodity prices wiped US$4.1bn from the bottom line, partially offset by volume gains of US$1.4bn and cost cuts of US$1bn. The lower Australian dollar added a further US$700m.

Iron ore

It is iron ore, however that will determine the company's future. The strategy of increasing volumes in the face of tumbling prices – a tactic derided by rivals, politicians and some investors – has paid off.

Production grew from 266m to 295m tonnes, adding US$1.3bn to underlying earnings and offsetting US$3.8bn lost as a result of lower prices. Next year, Rio should produce 330m tonnes of iron ore, ultimately rising to 360m tonnes. Each round of volume hikes should also deliver lower costs.

Amazingly, operating margins remain above 60%. Rio's cash costs of production are just $17 a tonne and total costs still come to less than $30 a tonne. No other miner apart from BHP comes close.

As a result, Rio generated a return on assets of 38% from the iron ore business, a number that confirms that this is the finest asset in the resources world.

The iron ore result was good but it wasn't the highlight. Almost unbelievably, that came from aluminium.

Aluminium and coal

Rio has already written off US$30bn in assets from the foolish purchase of Alcan at the height of the boom. Yet after years of bleeding cash, this much-maligned division is starting to improve. Two years ago, aluminium generated just US$50m in earnings. Last year, it made US$1.2bn, a stunning turnaround from a division Rio couldn't even sell 12 months ago.

Those gains have been hard fought. Rio has spent half a decade ruthlessly cutting output and stripping costs; more than US$800m in costs have been cut and 700,000 tonnes of output scrapped. By next year, 80% of output will come from the lowest quartile of the global cost curve. Rio has not only been ruthless, it has been smart.

The company has identified that bauxite returns are higher than those from alumina or aluminium and has increased sales of unprocessed bauxite. This makes a big difference to profit. Bauxite sales generate a return on assets of over 30%; aluminium's ROA was just 5% and alumina currently makes $200m of losses each year.

As the global supply of aluminium shrinks and Rio gets better at tweaking its production mix, returns from the division should increase further. Although profits have soared, aluminium still generates a miserly ROA of just 6%, among the lowest in the Rio empire.

If aluminium was the star, coal was the disappointment. As recently as 2012, coal was generating profits over US$1bn. Last year, the Australian coal business reported profit of just US$20m on an asset base of US$3bn. As we argued in Coal: a dark future ahead, there are structural problems in the sector and, without large production cuts, we don't expect better results.

Buyback

Whereas big miners used to boast of their gargantuan spending plans they now trumpet their thrift. Over the past two years capital expenditures have shrunk from US$18bn to US$8bn and debt has halved to US$12.5bn.

That has allowed Rio to raise dividends to US$2.15 per share and announce a US$2bn share buyback, a move gleefully received by a market that adores yield.

At current prices, Rio yields 3.4% (and 4.2% if you use today's exchange rates), not bad for a supposed cyclical pig. Much like our case for BHP, Rio is adapting to lower iron ore prices and its aluminium division is improving.  Unlike BHP, however, Rio is reliant on iron ore for 90% of its earnings and we need a cheaper price before considering an upgrade.

This was an outstanding result that should wake up the sceptics. Clearly, the big miners have more control over their fate than many seem to think. A deep dive into the business, as we did for BHP (see Biting into BHP part 2), beckons to establish a clear valuation. For now, HOLD.