Rio Tinto Reports Higher Profits On Lower Costs And Higher Volumes Despite Low Prices


Rio Tinto ( RIO ) released its annual results on Thursday, February 13. The company reported annual profits of $3.7 billion for 2013, compared to a loss of $3 billion in 2012. The loss last year was largely due to massive impairments worth $14 billion that the company took on its balance sheet. In 2013, Rio recorded impairments worth $3.4 billion. Since the net income figure can be skewed owing to impairments, a better metric to compare would be the underlying earnings figure. Underlying earnings in 2013 stood at $10.2 billion compared to $9.3 billion in 2012. This nearly 10% increase was due to lower costs and higher volumes which more than compensated for the negative impact of lower commodity prices.

The key priorities going ahead will be to achieve cost savings of $1 billion in 2014, invest in developing and operating long-life, low-cost expandable operations, strengthening the balance sheet and generating greater value for shareholders. The bulk of Rio's cost-cutting plans will be borne by the aluminum and coal operations.

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Higher Underlying Earnings

The underlying earnings in 2013 were impacted negatively by lower prices of coal, aluminum and copper. Surprisingly, the average price of iron ore was higher than last year despite a slowdown in China. We think that this was mainly due to an economically irrational expansion of steelmaking capacity in China, buoyed by state subsidies and encouragement from local government officials. While the central government has belatedly ordered a crackdown by forcing polluting facilities to shut down, the full impact of this move is yet to be observed. Our opinion is that Rio may benefit if low-quality iron ore fines in Chinese steel mills are replaced by iron pellets and lumps as efforts to control pollution get underway. However, that largely depends on whether the commitment of the central government persists going forward. After all, even in the past, the Chinese government has shied away from harsh measures in the face of economic slowdowns for fear of causing wider unrest.

The lower prices of coal and copper were mainly a result of oversupply. In case of aluminum, while stronger demand for aluminum in the physical delivery market drove up premiums, it was not enough to offset the decline in prices by 9% on the London Metal Exchange (LME). Lower commodity prices impacted underlying earnings negatively by $1.3 billion.

Among other factors, earnings got a boost from growth in volumes of iron ore due to higher sales resulting from a capacity expansion and growth in volumes of aluminum due to recovery from a lockout at Alma last year. Higher volume boosted earnings by more than $0.5 billion. Cost reductions impacted earnings positively by more than $1.5 billion.


Rio recorded total impairments worth $3.4 billion in 2013. Of these, $1.5 billion was related to the impairment of a previous non-cash accounting uplift on the first consolidation of certain assets of Turquoise Hill (including Oyu Tolgoi) in Mongolia. Basically, the goodwill recorded on Rio's balance sheets post acquiring control of Oyu Tolgoi is now being pared. In addition, $1.2 billion worth of impairments were recorded in the company's aluminum business. This includes $555 million worth of impairments at its Gove alumina refinery and $696 million worth of impairments for the Kitimat assets where a project overrun has diminished the value of associated intangible assets. Finally, there was a notable impairment worth $470 million in Rio's Mozambican coal business following a review of the company's development plan, discount rate and associated country risk premium.

Future Strategy And Outlook

Rio is betting on rapid urbanization to drive demand for steel and thus iron ore. It considers China to be a key market until the mid-2020′s. It already derives about 80% of its earnings from iron ore, the bulk of which is sold in China. It wouldn't be a stretch to say that Rio's fortunes are closely correlated to China's. Rio expects countries in South-East Asia and India to offset flat and then falling consumption in China after the mid-2020′s.

While Rio is upbeat on iron ore prices, we are skeptical that its optimism is well-founded. There is a lot of production capacity coming online over the next 2-3 years and China is consciously trying to reorient its economy to a consumption-driven model from an investment-led model. The combination of these factors is likely to cause iron ore prices to bottom out around 2018, thus adversely affecting Rio's cash flows and profits.

Rio also plans to reduce the aluminum division's cost by about $1 billion by the end of next year. It has already decided to shut down its Gove alumina refinery in Australia. Using a combination of cost reduction and increases in liquidity, Rio hopes to make its aluminum business strong enough for a potential sell-off once the market improves. It has been unsuccessful in selling the aluminum business in the past owing to weak aluminum prices.

Rio had set itself a cost reduction target of $3 billion over 2013 and 2014. Of this, savings worth $2.3 billion have already been achieved in 2013 against a target of $2 billion. The company aims to achieve the remainder in 2014 and has decided not to raise that target.

We have a Trefis price estimate for Rio of $55 which will be revised shortly now that the annual earnings results are out.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , Investing Ideas , Stocks , US Markets

Referenced Stocks: RIO , VALE , FCX , BHP , ABX



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