Rio Tinto’s Full Year 2014 Earnings Review: Cost Reduction And Higher Volumes Offset Impact Of Low Commodity Prices On Results

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Rio Tinto (NYSE:RIO) released its full year 2014 results on February 12. Higher production volumes and the company’s cost saving efforts offset the impact of lower commodity prices on the company’s results in 2014. Rio’s EBITDA margins held steady at the same level in 2014 as compared to the previous year at 39%. [1] The company’s revenues stood at $47.7 billion in 2014, around 7% lower as compared to $51.1 billion in 2013. [1] A fall in commodity prices reduced year-over-year revenues by $5.4 billion, whereas higher volumes boosted revenues by $2 billion, resulting in a $3.4 billion decline in revenues. [1] The company’s underlying earnings, which exclude the impact of one-time items on the company’s profits, stood at $9.3 billion in 2014, as compared to $10.2 billion in 2013. [1]

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Lower Commodity Prices

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Rio’s average realized price for iron ore fines declined around 30% in 2014. [1] Iron ore is an important raw material for the steel industry. Thus, demand for iron ore by the steel industry plays a major role in determining its prices. Benchmark international iron ore prices are largely determined by Chinese demand, since China is the largest consumer of iron ore in the world. It accounts for more than 60% of the seaborne iron ore trade. [2] Chinese steel demand growth is expected to slow to 2.7% in 2015, from 6.1% and 3% in 2013 and 2014, respectively. [3] Weak demand for steel has indirectly resulted in weak demand for iron ore.

On the supply side, an expansion in production by major iron ore mining companies such as Vale, Rio Tinto, and BHP Billiton has created an oversupply situation. The worldwide surplus of seaborne iron ore supply is expected to rise to 300 million tons in 2017, from an expected surplus of 175 million tons in 2015, and a surplus of 72 million tons and 14 million tons in 2014 and 2013, respectively. [4] [5] A combination of weak demand and oversupply has resulted in weak realized iron ore prices for Rio in 2014. [6]

Rio’s average realized copper price fell 7% to $3.10 per pound in 2014. [1] Copper was characterized by weak demand and pricing environments in 2014. The weakness in demand for copper was mainly due to subdued demand from China, which accounts for nearly 40% of the global demand for the metal. [7]. Chinese GDP growth is expected to slow to 6.8% in 2015, from 7.4% and 7.8% in 2014 and 2013 respectively, with the deteriorating economic situation reflected in the prospects of the manufacturing sector, indicated by China’s Manufacturing Purchasing Managers Index (PMI) figures. [8] The Manufacturing PMI measures business conditions in the manufacturing sector of the concerned economy. When the PMI is above 50, it indicates growth in business activity, whereas a value below 50 indicates a contraction. Chinese Manufacturing PMI, reported by China’s National Bureau of Statistics, stood at 49.80 in January, and has ranged between 50.1 and 51.7 for the full year 2014. [9] Weakness in the manufacturing sector has contributed to weak demand for industrial metals, and consequently, the prices of these metals.

A fall in commodity prices lowered the company’s underlying earnings by $4.15 billion in 2014, as compared to 2013. [1]

Higher Volumes

Higher volumes boosted Rio’s underlying earnings by $1.43 billion in 2014, as compared to previous year. [1] This was primarily because of higher iron ore shipment volumes. Consolidated iron ore production at Rio’s facilities stood at 295.4 million tons, which was 11% higher year-over-year. [10] The sharp increase in volumes was primarily due to the ramp-up of production to a rate of 290 million tons per year (Mt/a) at Rio’s Pilbara operations in May 2014. [11] Located in Western Australia, the Pilbara iron ore mines represent nearly 95% of Rio’s global iron ore production. [12] A sharp increase in production volumes lowered the company’s average costs of production and boosted margins as costs were diluted over higher volumes.

Lower Cash Costs

Rio Tinto’s cost reduction initiatives boosted the company’s underlying earnings. In 2014, the company realized $958 million in post-tax operating cash cost savings. [1] In addition, the company lowered its exploration and evaluation costs by $217 million. [1] The company has prioritized evaluation spending on projects which have the greatest potential to deliver value in the medium term, with spending on some longer dated options reduced.

Outlook

The company intends to continue with its strategy of cost reduction and disciplined capital allocation. The company has revised its capital expenditure guidance for 2015 downwards to $7 billion, from its previous guidance of $8 billion. [13] The company intends to maintain capital expenditure at $7 billion for the medium term starting in 2015. [13] This approach to disciplined capital allocation will help Rio Tinto operate competitively in the prevailing subdued commodity pricing environment.

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Notes:
  1. Rio Tinto’s Full Year 2014 Results Media Release, Rio Tinto Website [] [] [] [] [] [] [] [] [] []
  2. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg []
  3. Short Range Outlook for Apparent Steel Use 2013-2015, World Steel Association []
  4. Iron Ore Price Forecast Cut by Morgan Stanley on Supply, Bloomberg []
  5. Iron Ore Caps 2014 Loss as Morgan Stanley Says Worst Over, Bloomberg []
  6. BHP, Rio Gamble with Stacked Iron Ore Deck, Mineweb []
  7. Copper Ends at 5-Month Low on China Worries, Wall Street Journal []
  8. World Economic Outlook January 2015, IMF []
  9. China Manufacturing PMI, Trading Economics []
  10. Fourth Quarter 2014 Operations Review, Rio Tinto Media Release []
  11. Rio Tinto announces landmark Pilbara iron ore operational performance ahead of schedule, Rio Tinto Media Release []
  12. Rio Tinto’s 2013 20-F, SEC []
  13. Rio Tinto’s Full Year 2014 Earnings Presentation, Rio Tinto Website [] []