Rio Reports Lower Underlying Earnings On Lower Prices, Expansion On Track

Rio Tinto (NYSE:RIO) released its half-yearly results on Thursday, August 8. It reports earnings figures on a semi-annual rather than a quarterly basis. The company reported a net profit of $1.72 billion for the first six months of 2013, down from $5.88 billion for the same period in 2012. The net earnings figure incorporates the effect of a number of factors other than the core business of the company such as write-offs and non-cash exchange losses. Therefore, a better metric for comparison would be the underlying earnings figure.

Underlying earnings in H1 2013 were $4.3 billion compared with $5.15 billion in H1 2012. This was mainly due to lower realized prices for its products this year, especially iron ore. There was also negative impact from energy costs, inflation, tax charges and other one-time items. The results could have been worse if the negative impact hadn’t been offset by post-tax cost reductions of $978 million that the company achieved in H1. ^[1]

The key priorities going ahead will be to continue focusing on achieving cumulative cost savings of $5 billion by end of 2014, allocate capital in a disciplined manner and divest non-core assets.

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Lower Underlying Earnings

Lower product prices in the first half of 2013, due to a slowdown in China and subdued growth in the rest of the world accounted for a $1.3 billion drop in underlying earnings. The iron ore spot prices varied between $110-160 per tonne and Rio recorded an average price realization of $137/ton in H1 2013, which is $5/tonne lower than that in H1 2012. Coking coal prices were weak due to strong growth in supply and a simultaneously weak import demand. The copper market, as expected, was in a supply surplus situation in the first half of the year. This contributed to a 7% decline in prices.

The impact of lower prices was offset to some extent by higher volumes. The iron ore production capacity expanded, leading to higher production. The volumes in the aluminium business also grew, primarily due to the resumption of production in Alma following the resolution of the lockout that occurred in 2012. However, volumes declined in the gold and industrial minerals business. The net effect of volume related changes was to increase underlying earnings by $228 million.

The company also achieved post-tax cost reductions of $978 million. This includes cost reductions on account of improvement in operational efficiency as well as exploration and evaluation related spending. ^[2]

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. In 2013, it is expected to be around $14 billion. Of this, around $6.9 billion was incurred in the first half of the year, mainly on large projects in the Pilbara iron ore region. Rio expects to be able to expand production capacity at Pilbara to 290 million tons this year.

Interestingly, while Rio has so far been talking about reaching 360 million tonnes of production at Pilbara by end of 2015, the comments in the recent earnings call indicated more flexibility. According to Sam Walsh, the CEO, Rio is evaluating multiple options to achieve this capacity growth and is open to flexibility with respect to timescale and capital intensity. The final decision will be taken by the end of this year. ^[3]

Rio Tinto acknowledged that the Chinese economy will evolve structurally over time as it moves to a consumption led growth model from an investment and export driven one. During this transformation, the company expects a lot of volatility due to sentiment changes which will make it difficult to predict overall growth. However, it remains bullish on China in the long term and expects robust growth in the absolute demand for commodities. While we think that the long term growth prospects of China are still up for debate and are likely to be influenced by the country’s policy choices, we agree with Rio’s assessment about volatile times ahead. We expect wild price fluctuations in commodity markets in this period of volatility, as sentiment keeps shifting between extremes.

We have a Trefis price estimate for Rio of $56 which will be revised shortly now that the half-yearly earnings results are out.

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1. Rio Tinto H1 2013 Earnings Report, Rio Tinto Media Release [↩]
2. Rio Tinto H1 2013 Earnings Presentation, Rio Tinto [↩]
3. Rio Tinto Q2 2013 Earnings Conference Call, Seeking Alpha [↩]