Lower Iron Ore Prices Will Reduce Rio’s Year-Over-Year Revenues And Profits

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Rio Tinto (NYSE:RIO) will release its yearly results on Thursday, February 13. The company has already released its operations review report for 2013 which says that it has beaten its own estimates with respect to the production of iron ore, which constitutes the bulk of the portfolio. Rio reported record quarterly iron ore production, primarily on increased production from its Pilbara mines in Australia.

The production of each of iron ore, copper, bauxite, aluminum, thermal coal, and titanium dioxide was higher in 2013 as compared to 2012. This is especially laudable for iron ore and copper because a cyclone at the end of December hampered operations in the Pilbara iron ore region and an accident at the Bingham Canyon mine affected copper mining operations. [1]

While the operating results for the year are impressive, it remains to be seen to what extent profit margins have slipped as a result of lower prices, particularly for iron ore. Among notable developments, there were some asset sales in the fourth quarter and an announcement about cutting spending drastically over the next two years. [2]

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Operational Performance

The global iron ore production figure at Rio’s facilities stood at 266 million tonnes, of which 209 million tonnes was its own share. This was 5% higher than the previous year’s figure. Most of Rio’s iron ore production comes from the mines in the Pilbara region of Australia. Production from this mine stood at 250.6 million tonnes, of which 199.9 million tonnes belonged to Rio. The shipments of iron ore stood at 259 million tonnes. Iron ore prices in 2013 stayed largely between $130-$140 per tonne in the second half of the year, defying all expectations. This was mainly because the expected slowdown in China failed to dampen demand for iron ore to feed the steel industry. [3]

You can check the effect of iron ore shipments on Rio’s Trefis valuation using our interactive graph below:

Copper production rose by 15% as compared to 2012, mainly due to recovery in ore grades at Kennecott Utah Copper and ramp up to full capacity at Oyu Tolgoi. The production figure stood at 631.5 million tonnes which exceeded Rio’s revised guidance of 590,000 tonnes following the accident at Bingham Canyon.

While the production of bauxite and alumina rose by 11% and 12% respectively, driven by increased third party demand for bauxite and expanded refining capacity at Yarwun, the production of aluminum declined by 10%. Aluminum production suffered as it took time to ramp up production to normal capacity following resolution of the Alma labor dispute.

There were some other key notables as well. Rio managed to generate operating cost savings worth $2 billion relative to 2012. It announced the sale of non-core assets worth $3.5 billion, of which $2.5 billion was completed in 2013. The company also reduced its capital expenditure by more than $1 billion, against a target of $750 million.

Notable Developments And Outlook

According to us, the biggest development this quarter was Rio’s announcement about drastic spending cuts over the next two years which 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. [4]

This move is aimed at reducing the company’s debt as well as ensuring higher returns to shareholders who are not happy about Rio’s debt-fueled acquisitions of the past which turned out to be ill-advised. We analysed this move by Rio in a previous article. [5]

Rio also decided to shut down its Gove alumina refinery in Australia which will reduce its alumina production by 2.7 million tonnes per annum. [6]

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. Rio expects countries in South-East Asia and India to offset flat and then falling consumption in China after mid-2020’s.

While Rio is upbeat on iron ore prices, we are skeptical that its optimism is well-founded. There is a lot of production capacity coming online over the next 2-3 years and China is consciously trying to reorient its economy to a consumption-driven model from an investment-led model. The combination of these factors is likely to cause iron ore prices to bottom out around 2018, thus adversely affecting Rio’s cash flows and profits.

We have a Trefis price estimate for Rio of $55 which will be revised once the fourth quarter earnings results are out.

See More at TrefisView Interactive S&P Capital IQ Analyses (Powered by Trefis)

Notes:
  1. Rio Tinto announces record production for iron ore, bauxite and thermal coal in 2013, Rio Tinto Media Release []
  2. Iron Ore Spot Price Chart, YCharts []
  3. Rio Tinto’s Iron-Ore Shipments Reach Record High in 2013, WSJ []
  4. Rio Tinto is delivering on its commitment to create greater value for shareholders, Rio Tinto Press Release []
  5. Rio Tinto Announces Spending Cuts Over The Next 2 Years To Reduce Debt, Trefis []
  6. Rio Tinto reveals it will close Gove alumina refinery in Northern Territory by July, ABC News []