Rio Tinto (NYSE:RIO) released its annual results on Thursday, February 14. The company reported a net loss of $3 billion for 2012, down from $5.8 billion in 2011. This was largely due to the hefty $14 billion impairments it had to take on account of writedowns in the aluminum and Mozambican coal businesses. Since the net income figure in 2011 was also skewed downwards owing to impairments of $9 billion that year, a better metric to compare would be the underlying earnings figure. Underlying earnings in 2012 stood at $9.3 billion compared to the 2011 figure of $15.5 billion. This was due to a combination of lower prices and a net negative effect from variance in volumes.
The key priorities going ahead will be to achieve cost savings of $5 billion over the next two years and generate significant cash from the sale of non-core assets and businesses. The bulk of Rio’s $5 billion cost-cutting plan will be borne by its aluminum and coal businesses, particularly in Australia, which have been hit hard by weak commodity prices and the strong Australian dollar.
Lower Underlying Earnings
Lower product prices in 2012, due to a slowdown in China and subdued growth in the rest of the world accounted for a $5.3 billion drop in underlying earnings. A steep fall in iron ore prices resulted in a negative earnings impact of $3.7 billion. While iron ore prices were relatively stable in the first half of the year, in the second half they fell to as low as $89 per tonne before recovering to over $150 per tonne in early 2013.
Other contributions to a reduction in underlying earnings came from lower aluminum and copper prices. While a 16% decline in London Metal Exchange (LME) aluminum prices reduced earnings by $940 million, 10% lower copper prices due to a slight supply surplus impacted earnings negatively by $300 million.
While the increase in iron ore and copper volumes increased earnings by $634 million, lower gold grades and absence of metal share at the Grasberg mine reduced earnings by $943 million. The net effect of volume variance therefore reduced earnings by just over $300 million.
Rio had to take impairment charges of $9.3 billion in 2011, mainly on account of its aluminum business which faced challenging market conditions due to a downturn in demand and market surplus. Aluminum prices declined further in 2012, while the Australian and Canadian dollars remained strong. These factors, coupled with high energy and raw material costs, reduced the market valuation’s of Rio’s aluminum business substantially.
The value of Mozambican assets had to be written down because of logistical issues and revision of estimates about recoverable coal reserves. Rio had initially planned to transport coal by barge along the Zambezi river, but the government never approved the proposal. Mozambican coal has proved difficult to get from pithead to port because of infrastructural issues which are expected to last for at least a decade more. Also, at the time of acquisition, coking coal was fetching $290 per tonne but today the price is nearly $165 per tonne.
Overall impairment charges would have been still higher were they not offset by the creation of a deferred tax asset of $1.1 billion following the introduction of the Mineral Resource Rent Tax (MRRT) in Australia last year.
Future Strategy And Outlook
Rio aims to achieve operating cost savings of $2 billion in 2013 and a further $3 billion in 2014. These will come mainly from the aluminum and energy businesses and also central service and support costs. Also, the company thinks that its capital expenditure peaked in 2012 at $17 billion and will be lower going forward.
Iron ore production next year is expected to increase to 265 million tonnes from its present level of 237 million tonnes. Also, one-third of its long term contracts have now expired, increasing exposure to current market prices, which are significantly higher than existing contract averages. By the end of 2013, around three quarters of these contracts will expire, resulting in higher margins. 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, and the company is betting on a 8% growth rate in China next year. Rio expects countries in South-East Asia and India to offset flat and then falling consumption in China after the mid-2020′s. ((Investor Seminar Presentation, Rio Tinto))
All things equal, we agree with Rio’s assessment about future demand and think that average commodity prices will be higher than those in the past. Periodic bouts of volatility may persist but nonetheless, growth is expected to be higher on the whole. There is significant room for growth for economic development and construction demand in emerging markets given the low starting base in many of these places. This will be the main driver to the iron ore industry going forward.
The aluminum business, however, is likely to face challenging market conditions for a few years to come. A structural shift has occurred driven by the decoupling of the supply chain for bauxite, alumina and aluminum, and continuing growth in the Chinese smelting industry. Some governments have opted to provide incentives for loss-making smelters to continue operating which is preventing the rationalization of high-cost capacity, thus depressing prices.
We have a Trefis price estimate for Rio of $45 which will be revised now that the fourth quarter earnings results are out.