Pilbara Power: Rio Ramps Up

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– Rio's 290mtpa expansion ahead of schedule
– Infrastructure for 360 underway
– Mining capacity decision pending
– Iron ore prices may prove a headwind for earnings

By Greg Peel

“Whether by the front door or by the trap door, two of the world’s biggest diversified resource companies, BHP and Rio Tinto, have both lost their CEOs this year. A common theme in their departure was over-extended mega-project investment or acquisition, leading to significant value write-downs worth billions. As is often the case, the two newbie CEOs have immediately shifted their companies into consolidation mode. Consolidation means improving productivity, reducing costs and offloading non-core assets.

“One is reminded that asset sales and cost-cutting, such as staff cuts and store closures, became the popular response across the spectrum of Australian and global stock market sectors to the GFC. The overwhelming intention was to reduce debt, the cost of which had become unmanageable. At the time, stock analysts warned that such exercises could go either way, depending on the circumstances. Either the newly streamlined company would emerge a lean, mean fighting machine, or it would emerge a mere shadow of its former self, with much reduced earnings potential.”

• Lean, Mean, Mining Machines, FNArena March 13, 2013

Productivity. It’s been a buzz word in Australia ever since the excesses of the noughties gave way to stark reality in the 2008 GFC. Debt in particular may have defined the GFC but as in the case of any boom-bust cycle, operational fat was also exposed in the fallout along with indulgent acquisition and investment plans. In Australia’s case, productivity has always been beholden to relative high wage and benefit rates for workers as well as management excesses, making productivity increases incrementally more difficult to achieve. But when laundry assistants in remote WA mining camps started earning six digits, the writing was on the wall.

As noted in the excerpt above, the CEOs of Australia’s two major, globally diversified miners, BHP Billiton ((BHP)) and Rio Tinto ((RIO)), were gone by early this year. With them went the “expand or die” wish-lists of tier one mega-projects which throughout history have either defined or dishonoured a CEO’s legacy. In the sudden realisation China’s economic growth could not, even in theory, accelerate forever, out went the non-core peripheral assets, out went the excess mining workers and laundry assistants and, presumably, down came the board room lunch allowance.

The new CEOs have also killed off the mining services boom in one fell swoop of refusing to pay up any more for contracted services. But unlike others in the resources sector they have not completely shelved all expansion plans. This is where the productivity part really comes in. In the case of their iron ore operations, both BHP and Rio could have sat on the Pilbara production they already have and simply churned out the cashflow like a supermarket. Indeed, shareholders were hoping this is exactly what would happen, with cashflow then returned as dividends. But no, both have elected to go ahead with their Pilbara expansion plans, having shelved most everything else.

It’s a risky call, and not one that sits well with shareholders. Is it sensible to expand global seaborne iron ore supply now that China’s growth rate is slowing to a steadier pace? That cashflow will have to be reinvested back in. If iron ore prices fall on increased supply meeting falling demand, it’s all over bar the shouting. But China’s growth rate is slowing, not reversing to the negative. China will still need more and more iron ore, just not at the pace that was evident in the pre-GFC boom. That’s what the miners are banking on.

In the meantime, the plan is to “sweat” the assets. Squeeze every last drop of margin out of every lump of iron ore. Money spent sensibly on infrastructure improvements can generate ultimate cost of sale reductions. Moving services in-house instead of paying contractors will help. Trimming the workforce and soldiering on without laundry assistants will reduce operational costs. And expanding not through expensive greenfield asset development but through partly developed brownfield assets and the “stretching” of existing asset production will improve returns on capital expenditure, and increase internal rates of return.

Six months after FNArena introduced the new lean, mean mining machines with the article above, Rio Tinto management thought it was time, or maybe it was now safe, to take mining analysts on a tour of the Pilbara. Indeed, judging by analyst reactions, Rio is pretty damned impressed with itself. And sceptical analysts could not help but be impressed as well.

Rio shipped Pilbara iron ore at an annualised rate of almost 275mtpa in August, which is a new record. The company’s planned expansion to 290mtpa is ahead of schedule and ahead of budget, with the ramp-up expected to be achieved by the second quarter of 2014 rather than end-2014 as previously assumed. The first ship to leave the new Cape Lambert port has been loaded four months ahead of schedule.

Critical infrastructure at Cape Lambert, including two new car dumpers, is expected to be completed by early 2015 and this will take Rio’s rail and port infrastructure capacity up to 360mtpa. This is the next target level, albeit final board approval is still pending on an actual mine capacity expansion to 360mtpa – a decision that should be forthcoming in the next few months. Rio has multiple options at hand for increasing the mine capacity, but the focus remains one of reducing capital intensity and increasing returns.

Management is targeting sustainable iron ore cost reductions of US$240m as part of its US$3bn cost reduction plan across the wider portfolio, which Macquarie notes will deliver a US$1/t or 2.8% cut to the overall iron ore operational expenditure bill. At least 40% of this target appears already to be delivered, the broker suggests, and management expects all-in costs to fall from last year’s US$47/t to US$35.5/t (in real terms) by 2020. That’s an implied annual rate of reduction of around 4%. Iron ore now accounts for around 85% of the value of the company’s diversified operations.

Another US$5.9bn has been approved for the infrastructure expansion to 360mtpa and, in terms of mine expansion, the first step is to stretch the existing brownfield expansions before finally moving to more capital intensive greenfield expansion. Productivity improvements at all stages of the supply chain provide CIMB with the confidence Rio can extract another 5-10% from its investments, which could ultimately push levels to 380mtpa or beyond. But the question remains: Is this all a good idea when China’s growth rate is slowing?

Rio shareholders appear to be split into two camps: Those who fear global iron ore overcapacity and a rapid mean reversion in the iron ore price, and those who support Rio’s expansion to 360mtpa but have been worried the company would elect to go slow on that target. In the case of the latter, that fear appears now to be unfounded. CIMB, for one, is modelling a 360mtpa run rate by 2017 but now believes this could be achieved by 2016. In the case of the former, things are never crystal clear.

China is expected to remain the demand growth engine, notes Citi, but there is also growth ex-China. South Korea is expected to add 18mt of new steel production capacity by 2018. All up, ASEAN is expected to add 30mt of steel production capacity and South America 25mt. Japan is also now benefiting from the weaker yen and by 2018, European demand is expected to recover by some 25mt, Citi points out. On the supply-side, Indian exports are not expected to recover in 2013 given the monsoon but could eventually recover to 20-30mt, but as a steel producer Indian will ultimately become a net iron ore importer, Rio believes.

Some 62% of global iron ore supply is currently shipped to China, 22% to Japan, 12% to Korea and Taiwan and 4% to Europe. China has its own domestic production as well, but it is lower grade and Citi expects it to remain highly price sensitive. Grades will fall further as Chinese mining starts moving underground, while the costs of wages and power are rising and the appreciating renminbi is providing a headwind. Around 70% of China’s iron ore mines are owned by private companies and hence are unlikely to be supported by the state as are other commodities, such as aluminium.

Citi is more bullish on iron ore prices beyond 2015 than market consensus. The broker still sees Chinese GDP growth easing to 7% in the short-term but believes steel production will grow by 4% per annum through to 2020 before the economy matures and production peaks at around one billion tonnes by 2030. This is also Rio’s view, and it is unchanged from when the company began working on the expansion. This suggests to Morgan Stanley that Rio believes the market “needs the 360 project”, and management has not altered its long term iron ore price assumption or prices in between.

Rio intends to put the additional tonnes provided by the ramp-up to 290mtpa on the spot market. Currently, supply is priced on a mix of monthly (45%), quarterly lagged (31%), quarterly actual (12%) and spot (12%), notes Citi, with new tonnes taking spot to 17% in 2014. Some 25% of sales to China are expected to be at spot. Notably, iron ore market activity and tender interest has been much higher lately on Rio’s own E-tender gateway than in material put on global intermediary platforms.

The iron ore price remains the critical factor for Goldman Sachs. From a qualitative perspective, the broker came away from the Pilbara field trip impressed by the sheer scale and quality of the assets and the high morale across the business. But quantitatively, not much changes regarding the broker’s investment case. It’s hard to see any upside from better than expected execution by Rio, and that puts all the focus on the iron ore price to move earnings, the broker warns.

Globally, Goldman is forecasting 400mt of new global iron ore supply by 2015, at which point the average price will have declined to US$80/t (current spot US$138/t).  At that level the broker calculates Rio’s PE would be around 13.4x compared to the recent average of 8-10x.

Rio itself expects medium-term iron ore prices to drift lower, but demand is still growing and Macquarie suggests as the lowest cost producer with perhaps the lowest cost expansion option, Rio is well placed to capitalise. Using its own long-term price assumptions, JP Morgan calculates the internal rate of return of Rio’s Pilbara expansion project has improved to 23% from 19% on the back of new capex and timing guidance. JP Morgan also expects a headwind from a medium-term decline in iron ore prices, but believes Rio shares will continue to re-rate as projects are delivered ahead of plan and free cashflow improves, providing greater options for capital.

So the state of play is: Rio has shelved other ambitious tier one projects in response to a slower global economy and divested of non-core assets but rather than sit back as an ex-growth iron ore producer paying out cashflow as a high dividend yield, as Woodside Petroleum is currently doing, Rio has elected to push on with its iron ore capacity expansion plans. These plans are ahead of schedule and a productivity drive is bringing down all-in costs.

The company is confident the world “needs” Rio’s expanded supply capacity on balance with expected ongoing global steel production growth, with China the primary driver. Brokers waver between those who agree with Rio’s outlook and those who believe the iron ore price will still come under pressure from new global supply. In between are the likes of Macquarie who is happy to back Rio Tinto, except not at its current share price.

Despite such doubts, every one of the eight FNArena database brokers has a Buy or equivalent rating on Rio, with a consensus target price of $76.44 suggesting nearly 20% upside. Mind you, the Rio share price has not reached the consensus target price for quite some time. Goldman Sachs and Morgan Stanley, on the other hand, maintain Hold or equivalent ratings.

FNArena’s Stock Analysis show consensus forecast 2014 earnings growth for Rio of 16.2% and dividend growth of 6.2% for a 3.2% yield. By contrast (and noting that Rio trades on a December year-end and BHP on a June year-end), BHP is showing FY14 forecast earnings growth of 4.4% and dividend growth of 6.6% for a 3.9% yield. The consensus target on BHP of $39.31 is suggesting 8.6% upside. BHP draws a split of four Buy and four Hold or equivalent ratings.
 

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