Chinese Iron Ore Demand And Debt Reduction Will Support Rio Tinto

Feb. 6.14 | About: Rio Tinto (RIO)

Increasing volume to serve Chinese market

Steel demand in China is expected to be strong this year due to increasing urbanization in the country. With growing demand for steel, China's iron ore import is expected to increase by about 6.25%, or 50 million metric tons, this year. To meet China's demand, which accounts for about 65% of the global iron ore import, Rio Tinto (NYSE:RIO) is increasing iron ore production in its Pilbara Region mines. In 2013, the company produced 266 million metric tons, and will increase its annual production capacity to 290 million metric tons by the first half of this year.

Another major Australian miner set to ramp up production this year is Fortescue Metals Group Limited (OTCQX:FSUGY). The company has projected to increase its annual production capacity by 40 metric million tons by March of this year. In addition, many small and mid-tier Australian miners are expected to increase iron ore production this year. Due to the production volume increase of these companies, analysts are expecting that supply may surpass iron ore demand by the second quarter of this year.

Despite the increase in supply from other miners, Rio is confident about selling its incremental production. To increase its sales, the company is entering long-term contracts with its customers. In 2013, the company renewed or entered new contracts for long-term supply of 80 million metric tons. With the addition of these contracts for 2014, 60% of the company's iron ore volume is committed under existing long-term supply contracts. Also 15% of 2014's iron volume is expiring this year, but the company expects it will be renewed. Through these contracts, most of the company's production volume this year is already committed.

Along with the company's initiative, the following macro factors could help the company increase its sales:

  1. China demands higher grade iron ore consumption:
    To create less air pollution during steel production, Chinese steel producers prefer to buy higher grade ore over low grade ore. This initiative could cut rising export volumes from smaller exporting countries like Iran, Indonesia and Mexico due to higher sulfur content in their ores because sulfur generates higher levels of pollutants when it is removed during processing. Iron ore from these countries contain about 1.5% to 2%. In comparison to iron ore from these countries, sulfur content in Rio's ore is just 0.05%. With incremental production, the company can displace the lower quality iron ore supply from other countries.
  1. Depleting exports from India:
    India, which was the third biggest iron ore exporting country a few years back, has reduced its exports volume by 85%, or 100 million metric tons, in the last two years due to the ban on iron ore mining in its few states. To curb the exports further, India is imposing 5% duty on iron ore pellet export. Last year, India's iron ore export to China was reduced by 68% to 10 million metric tons, and with the additional duty, it may reduce further. With less export from India, Chinese steel producers have started buying more iron ore from Australian miners. Rio's iron ore shipment in the fourth quarter of 2013 increased 8% quarter over quarter due to China's growing demand.

Stable growth in iron ore demand from China and expected decrease in supply from other countries like Iran and India will increase Rio Tinto's sales, which will help the company allocate its additional supplies from the production increase. Also, since surplus volumes are expected to stay in control due to increasing demand, iron ore prices may not fall below $110 per metric ton this year. As the company produces iron ore at the cost of $50 per metric ton, even after the fall in price, it will be in a good position to generate significant profit by selling additional iron ore volumes. Since iron ore accounts for 78% of the company's EBITDA, increase in sales will boost the company's overall revenue.

Why the miner is cutting cost?

Rio Tinto's debt burden increased in the previous few years due to its higher capital expenditures for expansion of mines and infrastructure in countries like Australia, the U.S. and Mongolia. The company is aiming to bring its debt level to about $15 billion by 2015, from the $22 billion reported in June 2013.

As low commodity prices are affecting Rio's profit, the company is increasing production volume from its existing facilities, to lower the cost per unit and improve its cash position. It is increasing iron ore volume in the Pilbara region from its existing mines, and it has deferred investing decisions on new mines. By doing so, the company's capital cost for this project will reduce by about $3 billion from its previous estimation. The company has also reduced its capital expenditure budget to $11 billion in 2014 from $14 billion in 2013, and it will further reduce it to $8 billion in 2015. To reduce spending, the company is suspending some of its coal, aluminum and industrial minerals projects. Along with capex, Rio Tinto is also trying to reduce its operational expenditures. Last year, it reduced its operating cash cost by more than $2 billion, and it is aiming to cut it by another $3 billion by 2015.

Due to the company's cost cutting initiatives and lower capex in the coming years, Rio Tinto will be in a good position to reduce its debt by 2015, and in 2016 it can generate about $3 billion of surplus cash, which it could return to investors as a special dividend or through a share buyback program.

The company has always been known for providing good dividends. The table below shows the dividend growth for the last three years:

Calendar Year

Pay amount

2013

$1.76

2012

$1.65

2011

$1.16

Click to enlarge

With a history of increasing dividends, after meeting its debt target Rio will return more value to investors.

Conclusion

As iron ore is the major source of revenue for Rio Tinto, the company continues to increase its production. Since demand in China is still stable and exports from countries like Iran and India are expected to stay low, the company will be in a good position to sell its incremental production. In addition, due to its low production cost, the company will keep generating profit even after iron ore prices fall.

By reducing its capital investments and operating expenditures, the company will be able to cut its debt and will return more value to investors. With growing iron ore demand and an improving financial position, I recommend a buy for the stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.