Seeking Alpha
Long only, research analyst, portfolio strategy, media
Profile| Send Message| ()  

As anticipation of the first shipments from Oyu Tolgoi, the giant copper and gold project in Mongolia, builds, Rio Tinto's (RIO) CEO Sam Walsh offered his input on the strategy of the company overall, and where things stand with Oyu Tolgoi specifically, at the Bank of America Merrill Lynch conference in Barcelona recently.

Walsh said all the right things, and it's worthwhile taking a look at them as the strategy of the company is one that should be considered a bellwether for the mining industry in general. If you're looking at miners, the actions and ideas presented by Walsh should be taken into account in the analysis of other mining companies. If they aren't taking similar actions, they could be in real trouble in the current economic environment.

Walsh is focusing on four basic areas: cutting capex, lowering operating costs, selling non-core assets, and boosting production. At this time that's the game that must be played by miners.

(click to enlarge)

Exploration and Evaluation Expenditures

Although not the largest area of cuts, the shrinking of exploration and evaluation expenditure is an important one for Rio Tinto and for any mining company. If mining management isn't aggressively reducing costs, it doesn't see or is in denial of the forces working against it under existing conditions.

Miners need to get lean and focus on existing operations rather than spend big on exploration. To that end Rio Tinto says it has the goal of cutting exploration and evaluation expenditures in 2013 by $750 million. In the first quarter, the giant miner has already slashed $275 million off of those costs.

Some may question this strategy, thinking Rio may be sacrificing the future in order to produce better short-term results. But in the mining industry it's different than in, for example, the tech industry, where research and development cuts can destroy a company because of the lack of products in the pipeline, or at minimum improvements in existing products. The natural resources industry is different, as companies are able to operate under proven reserves while waiting for economic conditions to change to their favor. This is especially true when reserves are in place that can carry the company for a number of years.

Overall capex will be cut by $4 billion this year, coming in at about $13 billion.

Operating Costs

Rio also continues to work on driving down its operating cost base, with the goal of cutting it by $3 billion by the end of 2014, according to Walsh. At the rate it's going now, the company should have those costs down by $2 billion at the end of 2013.

One move that is important but also symbolic is the reduction in the size of its major corporate centers. For Rio Tinto that means downsizing in Sydney, Melbourne, London and Johannesburg. That is already happening at the Australian offices, and will extend to London and Johannesburg going forward.

Walsh says in those four centers about 40 percent will be cut.

Selling Non-Core Assets

The name of the game for miners is to focus on core assets and get rid of non-core assets. For Rio Tinto, it has sold over 20 non-core assets over the last five years, generating just under $14 billion as a result.

Not only does that get rid of distractions, but it adds significantly to the cash position of a company. That's important for helping miners weather slow times, and also to have cash-on-hand when future acquisition opportunities present themselves.

Walsh says the company continues to look at selling more non-core assets in 2013.

Projects and Production

Production growth for Rio Tinto looks solid, as Oyu Tolgoi is close to going online and the company is adding 53 million tons of extra capacity at Pilbara. That will bring production at Pilbara to 290 million tons annually, with production capacity potentially reaching 360 million tons a year. A decision on whether or not to boost Pilbara production to its highest level will be made this year or in 2014.

The first concentrate at the giant Oyu Tolgoi copper and gold property is scheduled to begin in June. Rio Tinto is already processing about 60,000 tons of ore daily, and will bump that up to 70,000 tons a day by the latter part of June.

"We already have concentrate bagged and ready for shipment, and are on track to make our first shipment in June," Walsh said.

As the company shrinks down its capital investment, Walsh says the company should boost production through 2016 at a pace of 8 percent annually in copper-equivalent terms.

Securing funding for the next phase of development at Oyu Tolgoi is also going well.

Mongolian Government Risk

The inexperience and changing outlook of the government of Mongolia in regard to Oyu Tolgoi is well documented, and is already priced into the stock.

What is relatively new is the Foreign Investment Law has been amended, and the government has made it a priority to work hard to ensure commercial production at the mine meets its target of starting in June. Past government indecision has led to disruption in a way that has led to uncertainty concerning seemingly endless delays, resulting in the share price of Rio Tinto and partner Turquoise Hill Resources (TRQ) to come under pressure. (here)

Travis Hamilton, Managing Director of Khan Investment Management, said this:

"Mining Minister Gankhuyag was tasked to urgently resolve all outstanding obstacles preventing timely production of OT (Oyu Tolgoi). The previously proposed controversial draft minerals law introduced by Mongolia's President has now been withdrawn. The Deputy Minister of Economic Development announced a new investment law designed to give investors more assurance about the rules governing their investments has been drafted and will be proposed in Parliament before the end of the spring session."

The overall problem is the government of Mongolia over-promised the timing of results to its people, and was also frustrated when the costs of the project continued to rise, which it saw as a threat because of deferred expectations.

Now that it is learning throughout the process, it appears most if not all of the governmental risk concerning Oyu Tolgoi has been resolved. We'll have that confirmation next month based upon commercial production at the mine launching.

Conclusion

Rio Tinto is taking the right steps in light of the economic conditions it faces, and assuming the company executes its strategy efficiently, it is positioning itself for solid performance in the near future.

Understanding the tightrope it must walk now, it is also a good idea to cut back on its exploration and evaluation expenditures, which don't make sense at this time. When demand picks up, the leaner company should boost its margins to more attractive levels than they're at now, creating more profit for shareholders even if revenue declines some.

Retaining and focusing on core assets is also a must that the company has proven it's committed to, seeing it has been taking actions in that regard for the last several years.

Finally, production at the company looks good, and it will be hard for Rio Tinto to miss when it starts commercial production at one of the largest mines in the world.

Once all of this settles, the major downside risk will be deflationary pressures on some of the commodities it produces.

After commercial production at Oyu Tolgoi begins, the company should get a nice boost, as a lot of attention will be paid to the highly anticipated event. That should result in goodwill and a positive outlook for the company, as investors are reminded of the value of the extraordinary reserves represented in the project over the next several decades.

Source: Rio Tinto Getting Lean And Mean As First Oyu Tolgoi Shipments Approach