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Stock in focus – Rio Tinto

by Greg Evans

For centuries, alchemists of all guises have sought to transform mundane materials into valuable ones, such as lead into gold. Rio Tinto might artfully be thought of as the alchemists of the Pilbara, turning the red bounty of Western Australia’s iron ore into cash.

Changes afoot

The world’s largest producer of iron ore has undergone an epiphany under its newish chief executive Sam Walsh, although he has a background in the industry as long as the pythonesque trains that haul the ore across the state.

That shift in thinking has begun to temper the company’s plans to expand its annual production to a gargantuan 360mtpa (million tonnes per annum) and stick with the more sedate existing expansion to 290mtpa so that annual production will more closely align with demand from its key customers in China, Japan, Korea and Taiwan.

By not hurtling towards the proposed 360mtpa target as rapidly as initially outlined, Rio can seek to optimise its existing capacity to extract far more value for each tonne of ore that is harvested.

Rio is already one of the lowest cost producers, at a cash cost just above $US23 per tonne, and, as a consequence, it has incredible EBITDA margins up around 70%. When you put that in the context of the huge tonnage produced and sold each year, it is easy to understand how Rio generated $US53.6 billion of EBITDA in its last three financial years, while iron ore prices were peaking.

Iron ore prices have certainly eased since those heady days, but remain juicy enough, at around $US140 per tonne, for Rio to be confident of its reformulated strategy.

From its mines through to its rail and port infrastructure, Rio’s capacity expansion to 290mtpa is now complete, but production does not necessarily have to match the capacity to produce unless it is sensible to do so. Granted, it does not make sense to have idle capacity but it equally doesn’t make sense to produce more than the market requires.

The challenge ahead

That is the on-going balancing act for Rio as it seeks to optimise its mammoth operations through every step of the chain. If anything marks Sam Walsh’s tenure as CEO, it will be the attention to the fine detail of running the operations at ever improving rates of efficiency.

Rio is running the ruler across every aspect of its business, not just the mine, rail and port operations. Fundamental aspects such as accommodation, power supply, fuel, water management, maintenance, safety, contractors, technology, marketing and sales are all part of the plan to lift productivity.

While there is a great deal that Rio can keep within its control, there will always be factors beyond the reach of the boardroom such as the weather, foreign exchange rates and customer demand, to name just a few.

But the big picture for iron ore producers has changed in their favour.

Demand for the steel-making raw material remains firmly underpinned by the large production requirements in developing Asian nations. Notwithstanding occasional fluctuations in demand, the fundamental long-term pathway for crude steel production looks undiminished for at least the next decade.

The favourable part of that equation is that the price factor has been surpassed by the volume factor.

As long as Rio can sustain its cost advantage, and there is no reason it can’t, then larger volumes will be the main driver of future profits (a factor within Rio’s control) rather than the variability of iron ore prices (beyond direct control).

New targets

Rio continues to plan and evaluate an eventual move towards 360mtpa capacity; a strong indication that the company believes it will be worthwhile. But the pathway and timing of that goal is now already quite different to when the target was first unveiled.

In financial terms, it is difficult to be sure how this will play out, but a more measured and modest approach to the expansion will certainly benefit the cash flow profile.
In short, less haste and more speed, looks to be the defining characteristic of the new way under Sam Walsh.

Far from being over, the mining boom looks to be gaining its second wind, as the industry works towards completing the substantial expansions undertaken over recent years.
When the dust settles on the new direction, investors should get better visibility on the value that Rio Tinto represents at the current share price. The sector has been jilted for most of the year, as unwarranted concerns about Chinese growth cast a shadow over near term earnings.

Even with a seven in front of the growth number, China’s economy will be adding significant value to Rio’s earnings and, on that basis, now is as good a time as any to be accumulating the stock in a portfolio.

It just requires a little bit of belief that Rio can indeed be an apothecary of shareholder wealth.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

Published on: Friday, September 13, 2013

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