Rio Tinto Committed To Increased Shareholder Returns

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– Capex guidance reduced
– Debt target eased
– Dividend policy ensured
– Buyback possible

 

By Greg Peel

Australia’s big two diversified materials companies, BHP Billiton ((BHP)) and Rio Tinto ((RIO)), have both recently held investor days to disclose latest considerations of strategy. They have been timely in the face of substantial falls in the prices of iron ore and coal since August result releases, and in BHP’s case, in oil as well.

These falls have cast a pall of doubt over the Big Two’s intentions to finally reward long suffering shareholders with meaningful returns through progressive dividend policies (dividend payouts growing incrementally), rather than perennially feeding cash flow back into major growth projects.

The problem for both companies is that they are trying to juggle several balls and not drop any. Both have abandoned over-the-top tier one project developments/acquisitions in favour of “sweating” existing assets harder and targeting only higher return expansion projects, such as Pilbara iron ore. As expansion has brought in increasing cash flow, debt has been reduced to more comfortable levels. But on the other side of the equation, non-core assets have also been sold off and capital expenditure plans have been much reduced.

Earlier in the year it appeared both would be able to pursue growth projects and reduce debt and increase shareholder returns, given significant levels of cash flow, reduced capex and greater capital efficiency from “sweated” assets. But big falls in commodity prices over the year have now substantially reduced forecast cash flow, despite China importing greater volumes and a weaker Aussie dollar providing some offset. This has led analysts to question whether all of growth, debt reduction and returns can be pursued coincidentally. Something will have to give, analysts have warned.

At last month’s BHP investor day, Citi came away expecting BHP management to “move heaven and earth” in reducing costs and capex in order to maintain its intended progressive policy. But running the numbers, Citi and other brokers noted the company would come out cash flow negative after paying progressive FY15-16 dividends even if capex were reduced. Having just reduced debt to a targeted, manageable level, would BHP once again increase its debt to pay shareholders, and in so doing risk its credit rating?

Either way, it appears BHP is unlikely to raise dividends until after the spin-off of “Newco” around mid-2015, which will leave only core iron ore, coal, copper and energy assets. See Is BHP’s Progressive Dividend In Doubt?

It is a different story over at Rio Tinto.

It must first be noted that BHP is a producer of oil & gas and Rio is not. Nor is Rio intending to spin off any “Newco”, remaining committed to its aluminium business (for which the outlook is now much improved) and also to its thermal coal business, despite a lacklustre price outlook. As the price of energy falls, so too does the cost of both companies’ operations. For BHP this represents some offset against falling oil & gas revenues but for Rio it’s a direct gain, assisting in the reduction of capex.

At the first of Rio’s two investor days, management reduced 2014 capex guidance to US$8.5bn from the US$9bn previously set at the first half result in August, which represents a fall of 34% on 2013. The company will continue with its plans to expand Pilbara iron ore production to 360mtpa from 220mtpa, but further efficiencies and asset “sweating” will reduce the capital intensity of that planned expansion to US$110-120/t from a previous US$120-130/t. Analysts point out, nevertheless, that the bulk of this reduction will be achieved by deferring the greenfield Silvergrass project by a further year while concentrating on brownfield expansion.

Through cost reductions, Rio remains unequivocally committed to “sustainably and materially increasing shareholder returns in 2015”. The intended progressive dividend policy is a “contract with shareholders”.

That’s great news for said shareholders, but analysts point out that falling commodity prices and subsequent falling cash flow means cost reductions will not be sufficient to cover both increased shareholder returns and targeted debt levels. Something has to give.

To that end, Rio announced that having achieved its target of reducing debt to a mid-teen level (US$17bn), management is now happy to switch to a 20-30% gearing range. Not only does this imply management is comfortable to let debt now increase a little (US$17bn represents 22%) but when asked about the A credit rating, management responded “the ratings agencies will take their own view”. This suggests to analysts Rio is not fazed about a rating downgrade to BBB+.

If that is the case, analysts all concur a “material” return to shareholders could also include a share buyback of around US$3bn while debt would still remain in the gearing range. Macquarie suggests to do so is a sacrifice from management in order to maintain its promise as the funds would be more valuable to Rio than to Rio shareholders. On the other hand, Morgans highlights falling costs, assisted by falling energy prices, in suggesting Rio may even struggle to spend the lower capex amount now guided, leaving room for greater cash flow.

Despite reiterating its commitment to capital returns, management was not prepared to confirm exactly what form they would take. Fair enough, suggests Morgan Stanley, while commodity prices remain volatile. It is nevertheless universally assumed a progressive dividend policy will be an element and analysts are in agreement a buyback would be more sensible than a special dividend. Assumptions for the first dividend increase, in 2015, are a consistent 10%.

All eight brokers on the FNArena database retain Buy or equivalent ratings on Rio. A consensus target price of $75.44 suggests 30% share price upside, although given all the moving parts, individual broker targets range from $67.00 (Citi) to $87.10 (Deutsche Bank).
 

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