VANCOUVER — At a shareholder meeting in Sydney, Rio Tinto’s (NYSE: RIO; LSE: RIO) executive team laid out a plan to reinvigorate the world’s second-largest miner.
“This is a great company, but to be frank, we had lost focus on what matters: delivering superior value,” said Sam Walsh, Rio Tinto’s CEO. “We are taking decisive action . . . we are improving performance, we are strengthening our balance sheet and we are delivering results. Progress speaks for itself. Don’t get me wrong — we have more to do.”
Rio’s new focus on shareholder returns shines through in the company’s outlook on capital spending, especially when viewed in a historical context. Between 1995 and 2005, Rio spent an average US$1.5 billion each year on capital projects. In the following five years, capital spending averaged US$5.5 billion annually. Spending peaked in 2011 to 2013, when Rio spent an average of US$14.5 billion every year on capital projects.
“This most recent step change upwards is just not sustainable,” said Chris Lynch, Rio’s chief financial officer. “We will be more disciplined in the allocation of capital in future.”
That change is already underway. In 2013, Rio’s total capital expenditure will be less than US$14 billion, which is a 20% reduction compared to 2012. In 2014 spending will decline to US$11 billion, and in 2015 capital spending will total US$8 billion.
Exploration and evaluation spending is also down, totalling US$800 million less in 2013 compared to 2012.
“We will only allocate capital to a project where it can generate a return well above our cost of capital, taking into account a range of potential risks,” Lynch said. “And it’s not just about net present values and internal rates of return. It’s about much more than that. The investment parameters have changed. We want to invest in a sustainable way through the cycle, which means we invest only what we can afford, having consideration of shareholders’ expectations of returns and the robustness of our balance sheet.”
Lynch said the company’s debt grew from US$4 billion in late 2010 to more than US$22 billion today. To bring it down to “a more sustainable level,” Lynch says paying down debt will be a priority in 2014.
Lynch is getting his guidance from Walsh, who, as he nears the end of his first year at Rio’s helm, looks to have embraced his role as the cost-cutting cleaner-upper. In 10 months he completed US$3.3 billion in asset sales and devised plans to cut 3,800 staff jobs. The asset sales removed another 3,000 jobs from Rio’s roster.
Walsh stepped into the CEO role in January, taking over from Tom Albanese. Albanese had overseen a spending spree that included the $38-billion purchase of Canada’s Alcan, one of the world’s largest aluminum makers, in 2007. The aluminum market has since declined significantly, with prices falling from near US$2,800 per tonne in early 2011 to US$1,750 per tonne today.
As a result, Rio wrote down Alcan’s value by US$11 billion, just as Walsh took over from Albanese. Other units within Rio’s global aluminum portfolio have likewise struggled, and the major has recorded aluminum-related writedowns totalling US$28 billion.
With no recovery in sight, aluminum’s ongoing fragility has Rio looking to cut costs in that unit by US$1 billion by the end of next year. The cost-cutting exercise comes after insufficient interest from buyers forced Rio to cancel plans to spin off its Pacific Aluminum business. Instead, the company is shutting its money-losing Gove alumina refinery in Australia’s Northern Territory. That closure adds to more than 600,000 tonnes of annual aluminum smelting capacity that Rio has closed or curtailed since 2009. In that time the company has also sold 13 aluminum businesses, realizing US$4.4 billion in proceeds.
“I believe we own some of the world’s best aluminum assets,” said Walsh. “But the outlook for that sector remains challenging over the medium term.”
The silver lining in Rio’s aluminum unit is bauxite. Bauxite is the primary mineral source of aluminum and bauxite demand is rising, as several nations develop domestic alumina refineries. China is one of those nations, and strong Chinese bauxite demand means Rio sees an “excellent opportunity to grow” its bauxite business over the coming years, according to Jacynthe Côté, chief executive of Rio Tinto Alcan.
A focus on returns does not mean Rio is cutting back across every sector. In fact, the company is expanding its iron-ore operations in Western Australia based on ever-growing Chinese demand. However, the company did reconfigure that expansion to delay major capital spending for some time.
Rio had planned to build the Koodaideri mine and related 180 km railway line within the next few years, a megaproject that would have cost US$3 billion. Now that plan is on the shelf, deferred until Rio has pulled all the output it can from its existing operations.
By taking advantage of opportunities at existing mines, Rio says it could grow production by more than 60 million tonnes per annum between 2014 and 2017. This is possible in part because Rio’s focus on building transportation infrastructure in recent years means its mine capacity is less than its infrastructure capacity, for the first time in a decade.
But reduced capital spending “is not at the expense of value-adding growth,” Walsh said. “This is clearly demonstrated by our breakthrough Pilbara iron-ore expansion. Expanding our world-class, high-margin Pilbara operations represents the most attractive investment opportunity in the sector, and it is in line with my commitment to be totally focused on only allocating capital to opportunities that will generate the best returns.”
Iron ore is Rio’s most valuable product, but the miner also produces a lot of copper. The chief executive of Rio’s copper group, Jean-Sébastien Jacques, said the long-term fundamentals for copper remain strong.
“We estimate that between 2012 and 2025, the industry will need to add an incremental 2 million tonnes of annual capacity just to maintain current production levels,” Jacques said. “This is driven by structural grade decline at existing operations and mine closures. But with demand continuing to increase — mostly driven by China and other emerging markets — we predict that the supply gap could actually reach 9 million tonnes of annual capacity by 2025.”
Bridging the gap between declining output and rising demand would require 10 new mines the size of Escondida operating in the next 12 years, which means one every 14 months. Escondida is the world’s largest copper mine, representing 5% of global annual production.
The market fundamentals mean Rio remains keen on copper, though within a structure that emphasizes maximum returns. Jacques says he is using five strategies to work towards this goal. The first is portfolio management.
“Effectively, we are replacing high-cost operations with low-cost ones,” he said.
Jacques says Rio’s copper portfolio consists of “4 plus 2,” which describes Rio’s four operating copper assets and its two key development projects. Rio owns 100% of the Kennecott Utah Copper Corp., has an effective 34% stake in the huge Oyu Tolgoi copper–gold mine in Mongolia, owns 30% of Escondida and earns 40% of production from the large Grasberg copper–gold mine in Indonesia.
On the development side, Rio’s two key projects are Resolution, an Arizona project that hosts the world’s third-largest undeveloped copper resource, and La Granja, a large, prefeasibility-stage project in Peru.
Continuing down Jacques’ list of strategies, the second is productivity, to which Rio has reduced its copper workforce by 25%. The third is reducing support costs by centralizing functions instead of relying on contractors, which has saved the company $50 million this year. Finally, Jacques is optimizing mine plans and exerting greater discipline around capital spending.
As head of the world’s second-largest mining company, Walsh monitors changes in the global economy. He said he sees continued “market fragility and volatility” and underlying structural weaknesses. However, those risks run alongside signs of modest economic recovery, with positive U.S. gross domestic product growth in the first nine months of the year, greater stability in Europe and suggestions of renewed confidence at the Chinese government’s recent Third Plenary Session.
“And the economic development of other markets, including India, the ASEAN countries, the Middle East, the former Soviet Union, South America, and Africa, will also contribute to ongoing demand for our products, as their growth continues apace,” Walsh said. “Therefore, I remain optimistic about the demand for our products, which are vital for the developing world.”
Along with continued demand, Walsh said he expects supply constraints for many commodities.
“Poor returns on some investments made of the past few years are leading investors to demand higher rates of returns and lower capital expenditure,” he said. “This means that the rate of supply growth across some commodities is likely to be lower than many previously predicted.”
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