Rio Tinto Announces Spending Cuts Over The Next 2 Years To Reduce Debt

Rio Tinto (NYSE:RIO) has announced plans to cut spending dramatically over the next two years. This decision is driven by the company’s desire to bring down its existing debt level and maintain its credit rating.

Most of the spending cuts will be borne by Rio’s aluminum and coal businesses. The company has unambiguously outlined, that the focus areas for the next few years will be its iron ore and copper businesses. The spending cuts will result in capital expenditures being reduced to $11 billion in 2014 and $8 billion in 2015. This represents a massive reduction from the peak spending levels of $17.6 billion in 2012. ^[1]

The new plan is an effort to get rid of the excesses that were incurred in the debt-fueled acquisition era before the 2008 economic crisis. In 2007, Rio had spent a mind-boggling sum of $38 billion to acquire Canadian aluminum major Alcan, which had to be written down substantially over the next few years as aluminum prices crashed. Rio’s new strategy also means that its heavy dependence on iron ore is poised to continue for the next few years, and the company’s fortunes will rise and fall in tandem with iron ore prices. ^[2]

We have a Trefis price estimate of $55 for Rio Tinto, which represents 5% upside to the current market price.

See Full Analysis for Rio Tinto Here

What Is The Thought Process Behind The New Strategy?

Rio currently has around $22 billion worth of debt on its balance sheet, which it is keen to reduce in order to have more flexibility in doing business. Less debt on the balance sheet would allow it to consider acquisitions without having to constantly worry about increasing leverage to unsustainable levels.

Global prices for most commodities, barring iron ore, have been falling and this has prompted calls by investors to slash costs and generate returns after years of heavy spending on acquiring and building assets. Therefore, Rio has decided to place its bets on iron ore, whose prices have been resilient even in the face of a slowdown in China, the dominant consumer of iron ore. Indeed, Rio expects the annual consumption of steel in China to increase from the present level of 700 million tonnes to about a billion tonnes in 2030. Rio expects China to continue urbanizing, especially in light of the recent Third Plenum reforms announced by the Chinese government. While there is a real fear that iron ore prices will plunge over the next three or four years as new supplies come online, Rio is betting that much of the new expected supply will fail to materialize. According to the company, investors are not happy with poor returns on some investments made over the past years, and are demanding higher rates of return and lower capital expenditure from companies engaged in the iron ore business. This means that much of the new expected supply may be put on hold or scrapped and never see the light of day, thus allowing iron ore prices to hold up. ^[3]

The Specifics Of The Plan

Rio aims to invest around $2 billion to increase its annual iron ore output in Australia by about 25% from 265 million tonnes to 360 million tonnes in the next few years. This amount is, however, less than half the originally estimated amount of $5 billion. Rio expects to achieve its expansion target despite such a massive reduction in spending  as it now plans to focus on brownfield projects instead of greenfield ones. This means that it will tap mineral reserves near its existing operations instead of establishing new mine sites, which will reduce capital costs. As a result, its previous plan to build a new mine at Koodaideri in the Pilbara region of Australia has been shelved for at least three years, while a decision on building another mine called Silvergrass has been deferred for about a year. It is quite possible that Rio may slow down spending rates which would result in the production capacity expansion being completed only in 2017 instead of the original target of 2015. ^[4]

Rio also plans to reduce the aluminum division’s cost by about $1 billion by the end of next year. It has already decided to shut down its Gove alumina refinery in Australia. Using a combination of cost reduction and increases in liquidity, Rio hopes to make its aluminum business strong enough for a potential sell-off once the market improves. It has been unsuccessful in selling the aluminum business in the past owing to weak aluminum prices. ^[5]

Implications For Rio’s Business

Rio already derives more than 90% of its net profit from the iron ore business and the latest plan will only tie its fortunes to the commodity further. If iron ore prices do undergo a correction contrary to what Rio expects, the company will have a huge problem on its hands. In any case, Rio cannot legitimately claim to be a diversified mining major now for many years to come. A bet on Rio is essentially a bet on the iron ore market.

We think that it is too early to definitively claim that the Chinese demand for iron ore will continue to be in line with supply growth. According to us, Rio is taking a rather bold bet by asserting that much of the new expected supply won’t actually materialize as a result of insufficient return generating potential.

Understand How a Company’s Products Impact its Stock at Trefis

1. Rio Tinto is delivering on its commitment to create greater value for shareholders, Rio Tinto Press Release [↩]
2. Rio Tinto to cut capital spending on aluminum, coal, The Globe And Mail [↩]
3. Rio Tinto banking on stable iron ore prices, Australian Mining [↩]
4. Rio Tinto unveils new growth plan halving expansion costs, The Sydney Morning Herald [↩]
5. Rio Tinto to suspend production at Gove alumina refinery, Rio Tinto News Release [↩]