Rio Tinto launched a stirring defense of its iron ore strategy last week, with the basic message that it will still make huge profits even as the price slumps to five-year lows.
Leaving aside, for the moment, that some of Rio Tinto's price and demand assumptions for the steel-making ingredient still look heroic, the real question to be answered is can the company convince the market that it's on the right path?
To do so, Rio Tinto will have to break the shackles of the strong correlation of its share price to that of Asian spot iron ore.
Since the 2008 recession the Australian-listed shares of the world's second-biggest iron ore miner have moved pretty much in lockstep with the price of the steel-making ingredient, although this year the correlation has shown signs of breaking down.
Iron ore has fallen a dramatic 48 percent this year, with the close on Nov. 28 of $69.80 a tonne only marginally above the $68 reached on Nov. 26, which was the weakest since June 11, 2009.
Rio Tinto's shares ended at A$59.10 ($49.64) on Nov. 28, down just 13.3 percent for the year.
The question is whether the nexus between the share price and iron ore has broken or whether the relationship is likely to be restored, most probably by the shares losing value since the prospect of iron ore rebounding is slim given the huge supply overhang in the market.
Rio Tinto Chief Executive Sam Walsh and his team would probably prefer you to believe that the relationship has changed on a fundamental basis, mainly on the back of the miner's success in delivering additional tonnes at what are very low prices.
Rio Tinto's investor seminar in Sydney on Nov. 28 showed that the company expects its iron ore business to remain hugely profitable.
It forecasts that the margin on earnings before interest, tax, depreciation and amortisation (EBITDA) will average 56 percent between 2015 and 2019.
This is based on the consensus iron ore forecast, but even an outcome of $15 per tonne below the consensus only cuts the margin to 47 percent.
Given that the consensus iron ore forecast for 2015, on a cost and freight to North China basis, is $85 a tonne, it looks virtually certain that the margins based on a price $15 below the consensus will be the most likely outcome.
However, even at the lower end of the expected price scale, Rio Tinto's presentation is remarkably bullish.
IS COST-CUTTING A STRUCTURAL CHANGE?
The story is one of managing and cutting costs, with the unit cost per tonne of iron ore, including shipping, sustaining capital and royalties projected to decline from $47 a tonne in 2012 to $35 in 2020.
Rio Tinto said at last week's seminar that these savings will allow it to generate significant free cash, which it will use to generate increased returns to shareholders, most likely in the form of a raised dividend at the full-year results in February 2015.
A positive view of Rio Tinto's relative outperformance of the spot iron ore price this year would be that investors have bought into, to some extent, the theory that the company can cost-cut its way to enduring success.
Much will still depend on the iron ore price not falling much further, and China actually going on to increase annual steel demand to somewhere in the region of 1.1 billion tonnes a year, which is still about a third higher than the likely output this year of about 826 million tonnes.
Both of these are still risky assumptions, with iron ore prices still under pressure as Rio Tinto, and major competitors BHP Billiton and Brazil's Vale, all plan to continue increasing output.
Peak steel demand in China may also come sooner than expected, and at a level below the 1 billion tonne mark, as the growth rate in the world's second-largest economy slows to a more sustainable rate.
Rio Tinto will have to keep delivering increased dividends to keep investors interested, and the company may become more of a dividend play rather than a capital gain investment.
The shares are presently little changed from the A$60.77 they fetched on June 11, 2009, when iron ore was last around current levels, meaning a buy-and-hold strategy hasn't delivered capital gains for investors in recent years.
Rio Tinto's management, in common with the executives of its competitors, seem unwilling to acknowledge that what has happened in iron ore isn't quite what they expected.
They did not expect the price collapse, even though they did anticipate the market moving to surplus from deficit, and they were too bullish on China's demand growth.
Now they are playing a different game, trying to convince investors that being the lowest cost producers will still ensure strong profits.
This may well be the case, but investors will now want to see those profits being distributed to them.
Disclosure: At the time of publication Clyde Russell owned shares in BHP Billiton and Rio Tinto as an investor in a fund.
Source: Reuters
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