Following the recent publication of an update on Rio Tinto's (RIO) Pilbara expansion, one of our readers wrote in to suggest that we shouldn't get too carried away with the Anglo-Australian miner's operational progress since the appointment of new chief executive Sam Walsh, cautioning "there are many who still expect significant [iron ore] oversupply next year". Our reader may well have a point, but Rio is better-placed than many of its rivals to ride out a faltering price environment due to its low production costs, allied to a renewed focus on reducing forward capital commitments, hiving off non-core assets and freeing up cash flows. With this in mind, we've decided to assess whether Rio, along with its chief domestic rival BHP Billiton (BLT), will be able to generate a sufficient level of free cash flow from their expanded iron ore operations to fund a significant step up in investor returns.
Institutions turn the screw
Of course, it's not just Rio that has changed tack with regard to its capital allocation, but the bulk of heavyweight miners including Vale SA, Anglo American (AAL) and Freeport-McMoRan. The shift in strategy came after a succession of multi-billion dollar write-downs across the industry, which culminated in Glencore Xstrata (GLEN) booking a $7.7bn (£4.7bn) charge in August of this year. In all, the miners wrote down just under $50bn from their books last year, with Rio alone chiming in with a $14bn charge linked to its Mozambique coal operations and its disastrous Alcan acquisition - the latter of which probably precipitated the departure of former chief executive Tom Albanese.
Even prior to these write-downs, the mining industry was coming under intense pressure from institutional investors to start prioritising shareholder returns at the expense of the big-ticket capital projects that had dominated strategic thinking since the early part of the new millennium. Aside from their ability to respond to volatile commodity prices, we believe that the big miners will only be able to regain the confidence of the market once they demonstrate their ability to fund a steady increase in returns to shareholders. The capital drain of recent years disguises the fact that the big mining companies had historically been a reliable source of income for fund managers and investors. Nevertheless, since the capital crisis of 2007-08, the mining industry’s share of the total UK dividend payout has grown steadily. At 13 per cent through 2013, it is now the third-biggest contributor behind the banks and the oil companies (see table - mining is included in the Basic materials sector).
One distinct advantage that BHP has over its chief competitor in the FTSE 100 is its diversified business mix. BHP recently confirmed that its petroleum business would account for almost a third of the production growth forecast across the group through the 2013-15 financial years, just behind iron ore with 37 per cent. Coal would account for 19 per cent of growth, while the group’s copper segment weighs in with 10 per cent. Conversely, Rio’s exposure to global iron ore markets - and by extension, to China's economy - is borne out by the fact that it derived 44 per cent of revenues and 75 per cent of cash profits at the half-year stage from iron ore.
Despite a seasonal dip in June, iron ore prices have proved to be remarkably resilient through much of this year, although some analysts believe that China's drive to cut excess capacity in its steelmaking industry could dampen prices through the early part of next year. At $132 a tonne, the iron ore spot price is slightly in advance of its 2013 average, but that figure is likely to contract during the first quarter of 2014. The IC expects the pace of restocking in China to slow during the first quarter, although it’s worth bearing in mind that the country’s inventories are still below the 2011-12 peaks, which ultimately undermined global prices. Realistically, we can expect prices to average around $110-$115 through 2014, although the scale benefits of both Rio's and BHP's expansion plans in Australia will be augmented by the ongoing falls in cash costs down under, combined with a negative outlook for the Australian dollar.
Percentage of total dividends by sector, 2007 to date
