Rio Tinto's Profits Rise As Higher Volumes And Cost Savings Offset Impact Of Lower Commodity Prices

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Rio Tinto ( RIO ) released its half-yearly results Thursday, August 7. The company reported net income of $4.4 billion in the first half of 2014, as compared to $1.72 billion in the corresponding period last year. However, the net income figure can be distorted by items such as impairments, gains on disposal of assets and non-cash exchange and derivative gains. The underlying earnings metric, which excludes the impact of these items, is a better reflection of the company's operating performance. Rio's underlying earnings rose 21% from $4.23 billion in the first half of 2013, to $5.12 billion in the first half of 2014. The improvement in underlying earnings was driven by higher volumes, lower cash costs and favorable exchange rate movements, which offset the fall in commodity prices.

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Lower Commodity Prices

Lower prices of major commodities, particularly iron ore, coal, copper and aluminum, negatively impacted Rio's results in the first half of 2014 as compared to the corresponding period a year ago.

Iron ore and metallurgical coal are major inputs in the steelmaking industry. Thus, demand for iron ore and metallurgical coal by the steel industry plays a major role in determining their prices. Prices for these commodities are largely determined by Chinese demand since China is the largest consumer of iron ore and metallurgical coal in the world. Weak demand for these commodities from China, in the wake of an economic slowdown earlier on in the year, put downward pressure on iron ore prices. A Chinese government crackdown on polluting steel plants has forced many of them to shut down. In addition, tightening of credit by Chinese banks to steel mills that are not performing well has negatively impacted these mills' prospects. Furthermore, the Chinese leadership has proposed structural reforms of the economy, shifting the emphasis from investment and export driven growth to services and consumption led growth. Such a transformation of the Chinese economy may negatively impact Chinese demand for steel in the long term. Chinese steel demand growth is expected to slow to 3% and 2.7% in 2014 and 2015 respectively, from 6.1% in 2013. Weak demand for steel has indirectly resulted in weak demand for iron ore and coal.

On the supply side for iron ore, expansion in production by majors such as Rio Tinto and BHP Billiton has created an oversupply situation. Combined with weak demand for iron ore, prices of the commodity have tumbled. Weak demand, coupled with an oversupply situation due to expansion in production by major mining companies, has resulted in plummeting coal prices. The average Platts price for 62% iron Pilbara fines was 20% lower on average in the first half of 2014, as compared to the first half  of 2013. Hard coking coal benchmark prices were 22% lower and thermal coal spot prices averaged 16% lower. Thermal coal prices were lower primarily due to oversupply. (( Australian coal industry caught in 'perfect storm' , Financial Times))

Copper prices were down 9% on average in the first half of the year, as compared to the corresponding period last year. With a wave of new projects adding to global output, a supply glut has put pressure on prices. In addition, weak demand due to a slowdown in Chinese growth in the first half and fears over unwinding of Chinese copper financing deals, led to a fall in copper prices .

London Metal Exchange (LME) aluminum prices were 9% lower on average in the first half of the year. Slower Chinese economic growth translated into lower demand for the metal. In addition, persistently high aluminum inventory levels relative to demand kept LME aluminum prices depressed. This inventory has built up partially as a result of aluminum being tied up in financing deals, which were made possible due to low interest rates. (( Aluminum Price Premiums: Disconnect Between LME and Reality Continues , Metal Miner))

Lower commodity prices lowered underlying earnings by $1.39 billion in the first half as compared to the corresponding period last year. ((Half Year Results 2014, Rio Tinto Media Release))

Higher Volumes

Higher volumes boosted underlying earnings by $911 billion, as compared to the first half  of last year. This was primarily because of higher iron ore and copper shipment volumes.

Iron ore production in the first half of the year at Rio's facilities stood at 139.5 million tons, of which Rio's share was 109.9 million tons. Production was 10% higher year-over-year. The sharp increase in volumes was primarily due to the ramp up of production to a run rate of 290 million tons per year (Mt/a) at Rio's Pilbara operations in May, which was two months ahead of schedule. The Pilbara iron ore mines represent nearly 95% of Rio's global iron ore production. Global iron ore shipments stood at 142.4 million tons in the first half of the year, up 20% year-over-year. Shipments exceeded production, as inventory built up ahead of the expansion of port and rail infrastructure at the Pilbara system of mines was drawn down.

Copper production rose to 323,000 tons in the first half of the year, 23% higher compared to the corresponding period last year, excluding the impact of asset divestments in 2013. This was driven by higher grades and concentrator recoveries at Rio's Kennecott Utah Copper operations and the ramp up of production at the Oyu Tolgoi mines. ((Second quarter 2014 operations review, Rio Tinto Website))

Lower Cash Costs

Rio Tinto's cost reduction initiatives boosted the company's underlying earnings. In the first half of 2014, the company realized $929 million pre-tax ($661 million post tax) in operating cash cost savings. This was in addition to the $2.28 billion pre-tax ($1.56 billion post-tax) cost savings achieved in 2013. ((Half Year Results 2014, Rio Tinto Media Release))  Thus, Rio has achieved its target of $3 billion in operating cash cost savings with respect to the base year of 2012. Further, exploration and evaluation spending was reduced by $187 million (on a consolidated, pre-tax basis) in the first half. The company has prioritized evaluation spending on projects which have the greatest potential to deliver value in the medium term, with spending on some longer dated options reduced.

The appreciation of the U.S. Dollar against the currencies where the majority of the company's businesses are located, favorably impacted underlying earnings. The U.S. Dollar, on an average, rose by 10% against the Australian Dollar, by 7% against the Canadian Dollar and by 14% against the South African Rand in the first half of 2014, as compared to the corresponding period of last year. The combined effect of these currency movements increased underlying earnings relative to the first half of 2013 by $505 million. ((Half Year Results 2014, Rio Tinto Media Release))

Outlook

The company intends to continue with its strategy of cost reduction and disciplined capital allocation. In addition to the $3.2 billion in operating cost savings achieved by the first half of 2014, as compared to 2012, the company is targeting an additional $1 billion in cost savings by the end of 2015. Out of the target of $1 billion, $250 million in savings is targeted for the second half of the year, with the balance to be realized in 2015. Further, the company has lowered its capital expenditure guidance for 2014 by $2 billion to $9 billion. The company intends to maintain capital expenditure at $8 billion for the medium term starting in 2015. This approach to disciplined capital allocation will help Rio Tinto operate competitively in a subdued commodity pricing environment.

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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 , CLF , MT , FCX

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