Rio Tinto (NYSE:RIO) reported a strong Q3 performance despite challenging market conditions, particularly in the wake of a slowdown in China. The company reported record quarterly iron ore production, primarily due to increased production from its Pilbara mines in Australia. Copper, coal, bauxite, alumina, and titanium dioxide production were all higher this quarter on a year-over-year basis.^[1]

These results are surprising given the weak global macroeconomic conditions. It remains to be seen to what extent profit margins have been eroded as a result of lower prices, particularly for iron ore. We’ll have to wait for the annual report to get a better idea on this front since the company reports financial performance only on a half-yearly and annual basis, not quarterly. It has only released an operations review report for Q3 2012. Rio does not hold a briefing after its production report is released so it is difficult to get an idea of its quarterly financial performance or its view on market conditions. However, using other sources like its recently concluded investor seminar presentation and transcript, it is clear that the company is upbeat about its long-term prospects. These sources also give us some insight into the management’s current thinking and strategy.

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Operational Performance

Iron ore production from its Pilbara mines was reported to be 63 million tonnes while total production stood at 67 million tonnes, both 5% higher on a year-over-year basis. The company maintained its yearly iron ore production guidance of 250 million tonnes. You can check the effect of iron ore shipments on Rio’s Trefis valuation using our interactive graph below:

At 132,000 tonnes, mined copper production was 21% higher year-over-year.^[2] While production of thermal coal showed 21% year-over-year growth, production of coking coal declined by 13% due to the impact of dragline mechanical issues at Hail Creek and a major plant shutdown at Kestrel as part of the mine extension project. Bauxite and alumina production were 13% and 20% higher respectively than Q2 2011, driven by increased third party demand for bauxite, expanded refining capacity at Yarwun, and record production at Gove. Aluminum production, however, was 10% lower than the corresponding quarter in 2011, as ramp up to normal capacity continued following resolution of the Alma labour dispute. ((Third quarter 2012 operations review, Rio Tinto Media Release))

Strategy And Perspectives

From the investor seminar material, we conclude that the company is giving importance to reducing costs across its operations, and isn’t likely to approve any new, large-scale capital-intensive projects in the near term. This is in view of weak commodity prices and a faster-than-expected cooling of China’s economy. It, however, intends to remain on track with expansion plans in the Pilbara iron ore region. The aim is to expand extraction capacity to 283 million tonnes a year by the end of 2013 and to 353 million tonnes per year by 2015. The overall capital expenditure in future is expected to come down from this year’s expected figure of $13.7 billion.^[3]

The company is also focusing heavily on leveraging technology to increase efficiency and keep costs under control. It already has a program in place called “Mine of the Future” with dedicated resources. In view of burgeoning capital costs in the mining sector, this sounds like a good long-term strategy.^[4]

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. In the near-term, iron ore prices might rise since some producers in China have halted operations due to high costs and low prices. The economic stimulus provided by the Chinese government is yet to show its effect as well.

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 high on the whole. The population in emerging markets remains aspirational and there is significant room for growth, given the low starting base in many of these places.

We have a Trefis price estimate for Rio of $45 which is nearly 7% below its market price.

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