Rio Tinto Full Year 2015 Earnings Review: Favorable Exchange Rate Movements And Cost Reduction Initiatives Mitigate Impact Of Weak Commodity Prices

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Rio Tinto (NYSE:RIO) released its full year 2015 results and conducted a conference call with analysts on February 11. [1] As expected, the sharp decline in iron ore prices negatively impacted the company’s results, with favorable exchange rate movements and the company’s cost reduction initiatives partially offsetting the impact of lower commodity prices on margins. Rio Tinto’s EBITDA margin declined to 34% in 2015 from 39% in 2014, despite a steep 43% year-over-year decline in the reference price for Rio Tinto’s iron ore sales. [2] Rio Tinto’s revenues stood at $34.8 billion in 2015, around 27% lower on a year-over-year basis, with lower commodity prices (partially offset by higher volumes) negatively impacting the company’s top line. [2] The company’s underlying earnings (which exclude the impact of one-time items on profits) declined to $4.5 billion in 2015, from $9.3 billion in 2014. [2] The main takeaway from the conference call was the management’s acknowledgment of the adverse commodity pricing environment and the reaffirmation of the need to control costs and preserve cash flows.

Lower Commodity Prices

Decline in Iron Ore Prices, Source: Y Charts

The chart shown above illustrates the decline in iron ore prices over the course of the last twelve months. Rising production from iron ore majors in the face of weak demand from China, the world’s largest iron ore consumer, has translated into an oversupply situation, which has negatively impacted prices. Since iron ore is an important raw material for the steel industry, the demand for iron ore by the steel industry is the primary determinant of the demand for the commodity. As per World Steel Association estimates, the demand for steel in China is set to decline for the third straight year in 2016. [3] Since the Chinese steel industry accounts for the purchase of nearly two-thirds of the world’s seaborne iron ore supply, weakness in demand for iron ore in China has negatively impacted prices of the commodity. [4] Despite the weakness on the demand side, major iron ore mining companies such as Vale, Rio Tinto, and BHP Billiton have ramped up production, creating an oversupply situation. The surplus of seaborne iron ore supply is expected to rise to 97 million tons by 2018 from an expected surplus of 65 million tons in 2016. [5] With an oversupply situation expected to prevail over the next couple of years, iron ore prices are unlikely to recover significantly in the near term.

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Besides impacting iron ore prices, weakening Chinese growth has negatively impacted the prices of commodities such as copper and aluminum, which, in turn, adversely impacted Rio Tinto’s results. Benchmark prices for Rio Tinto’s copper and aluminum sales declined 20% and 11% year-over-year, respectively, in 2015. [2] Lower commodity prices lowered Rio Tinto’s underlying earnings by $7.7 billion, with favorable exchange rate variations and lower cash costs mitigating the impact of lower prices on results. [2]

Favorable Exchange Rate Movements and Lower Cash Costs

With the majority of Rio Tinto’s mining operations concentrated in Australia and Canada, the strengthening of the U.S. Dollar against global currencies helped reduce the company’s costs in Dollar terms. Favorable exchange rate movements boosted Rio Tinto’s underlying earnings by $2 billion. [2] In addition to favorable exchange rate movements, Rio Tinto’s cost reduction initiatives helped lower the company’s cash costs and boosted underlying earnings by $833 million post tax. [2] Thus, a reduction in cash costs and favorable exchange rate movements cushioned the impact of the sharp decline in commodity prices on Rio Tinto’s results.

The Road Ahead

Given the subdued commodity pricing environment, the management stressed  cost reduction and disciplined capital allocation as the way forward for the company. The management revised downwards its capital expenditure guidance for 2017  to $5 billion, from its previous guidance of $7 billion. [6] Moreover, the company is targeting an additional $2 billion in cash cost reductions over the course of 2016 and 2017. [6] With the ongoing downturn in commodity prices adversely affecting Rio Tinto’s business prospects, these measures will stand the company in good stead in the near term.

 

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Notes:
  1. Rio Tinto Annual Results 2015 Presentation Script, Rio Tinto Website []
  2. Rio Tinto’s Full Year 2015 Results, SEC [] [] [] [] [] [] []
  3. Short Range Outlook 2015-2016, World Steel Association []
  4. China Plans Iron Ore Subsidy for Miners Amid Rout, News Says, Bloomberg []
  5. Iron Ore Outlook Cut by Morgan Stanley as Supply Floods Market, Bloomberg []
  6. Rio Tinto’s Full Year 2015 Earnings Presentation, Rio Tinto Website [] []