Rio Tinto: Result 2015

'We cant just wait for prices to recover. Hope is not a strategy'. With those words, Rio Tinto at once dismantled its cherished progressive dividend while confirming what everyone already knew: there will be no quick recovery for trashed commodity prices.

For many miners, this downturn has morphed from a cyclical funk to an existential crisis: Anglo American, Glencore, Vale, Fortescue and countless smaller producers have all been threatened by too much debt. Not so Rio. The miner announced a full year result that was, under the circumstances, impressive.

Underlying earnings fell 50% to US$4.5bn but that doesn't adequately capture commodity price carnage. Falling prices alone wiped US$7.7bn – more than 80% - from last year's profit. Favourable exchange rates and energy prices clawed back US$2.3bn and a combination of volume growth and lower costs added another US$1bn.

Currency losses on debt and derivatives and asset writedowns, mainly from an African iron ore project and uranium assets, resulted in a statutory loss but the outcome could easily have been worse.

An iron base

As always, this was a result underwritten by the iron ore business. Profits from the Pilbara may have halved to US$3.9bn but iron ore still generates operating margins of 60% and a return on assets of over 20%. Considering most of the industry is under strain, this is remarkable. Cash costs have now fallen to about US$14 a tonne, the lowest in the industry.

The coal and copper division generated negligible profits of just US$274m, down almost 70%, an ROA of just 2%. With the giant Oyu Tolgoi copper mine now in production, profits should increase but the poor result does raise questions about the quality of Rio's copper mines. We will be watching this division closely for better returns.

The coal business is no longer making losses but a tiny profit of just US$45m is little to celebrate, equating to an ROA of about 2%. We expect ongoing asset sales in this segment.

The aluminium business has been written down savagely but still contains US$16bn worth of assets. Profit of just over US$1.1bn, a mild decline on last year, represents ROA of about 7%, a huge improvement on recent years despite lower aluminium prices. Productivity gains, cost cuts and a soaring market for bauxite all aided the result.

Lower costs, capex

Costs cuts have been a consistent feature of Rio's results: over the past three years US$6.2bn of costs have been stripped and management have outlined a further US$2bn of cost cuts over the next two years. This is an impressive outcome but further cuts will be harder to find.

Capital expenditure has followed costs dramatically lower. In 2012, Rio spent over US$17bn on capital expenditure which last year fell to just US$4.7bn. Net debt now stands at US$13.8bn. With Rio still generating operating cash flow of over US$9bn a year and free cash flow of about US$5bn, there are no balance sheet concerns here.

Despite balance sheet strength, we are pleased to see changes to the dividend policy. Rio will pay at least US$1.10 in full year dividends this year but payments will then target 40-60% of underlying earnings throughout the cycle, a description that allows plenty of flexibility to raise and lower payments over the cycle. BHP Billiton will almost certainly announce something similar.

Careful now

Our final note is cautionary. Enthusiasm for lower capital expenditure is understandable, even admirable, under current market conditions but we shouldn't become over-enthusiastic about cuts.

Both Rio and BHP are now paying less in capital expenditure than they are depreciating. As both firms engaged in an orgy of spending at elevated prices over the boom, this is acceptable but mining is still a capital heavy business and there is a limit to how much expenditure can be cut. We suspect we are approaching those limits now.

This was an excellent result under difficult circumstances. We would take another look at Rio below $38 but, for now, HOLD.