Rio Tinto Group, the Anglo-Australian mining giant that just admitted publicly that it’s worth $14 billion less than previously stated, is at a crossroads.
While the size of the write-down surprised many analysts, the two main reasons did not. Chalk it up to a pair of bad deals. In 2007, Rio, the world’s second-largest mining company behind Australia's BHP Billiton Ltd., paid $38 billion for Canada’s Alcan aluminum group. Four years later it ponied up $38 billion for a majority stake in a Mozambique coal explorer called Riversdale Mining Ltd., a company it had been pursuing for nearly four years.
Both of these acquisitions were foolhardy. The Alcan purchase closed at the end of a commodities boom, just as aluminum prices were about plunge by more than 20 percent. Subsequently, China, which uses more aluminum than any other country, took over the top spot in global production of the metal -- meaning its need for aluminum from Western suppliers like Rio plummeted. Now, based on current and expected aluminum prices, Rio says its Alcan unit is worth $3 billion to $4 billion, or about a tenth of its sticker price.
Riversdale had to be revalued because it turned out there was little infrastructure to export coal from its prospects, and there was even less support from the Mozambique government to remedy the problem. Further, the price of the type of coal that Riversdale produces -- so-called metallurgical coal -- has fallen 43 percent since Rio bought it. Rio now says Riversdale is worth a scant $1 billion, though some analysts expect it to carry a book value of about $600 million.
Rio also wrote down other properties by some $500 million. The precise size of the company's accounting changes will be disclosed on Feb. 14, when the mining outfit reports its annual earnings.
Rio is a sprawling company, employing some 77,000 people in more than 40 countries. Through dozens of subsidiary operations that spiral through a complex corporate web, Rio produces everything from iron for skyscrapers; aluminum for cars, aircraft fuselages and beverage cans; and uranium to run nuclear power plants. It's also the world’s top producer of natural color diamonds, such as the Argyle pink and champagne diamonds.
And until recently, the 139-year-old company has had a remarkable run. Between 2005 and 2011, Rio's operating margins were consistently well above 20 percent, except for recession-plagued 2009 when its operating margin slipped to 17 percent, nothing to be ashamed of. Annual revenue tripled during that time to over $60 billion.
And even as metals prices took a big hit in 2012, Rio still generated solid earnings. Net profit came in at about $6 billion in the first half of the year, a 20 percent decline from the prior year's comparable period. Rio's management might have been able to weather this downturn, but when the company had to admit how badly it had blundered in the acquisitions of Alcan and Riversdale, Rio's board had to take action. "A write-down of this scale ... is unacceptable," said Chairman Jan du Plessis. "We are also deeply disappointed to have to take a further substantial write-down in our aluminum businesses, albeit in an industry that continues to experience significant adverse changes globally.”
Clearly, even for a company with a market capitalization of $122 billion, heads had to roll. And roll they did. On Thursday, CEO Tom Albanese, the 55-year-old New Jersey native, was fired, as was Doug Ritchie, a top lieutenant who handled the Riversdale acquisition.
Today, Rio faces a choice. One option is to pursue the strategic drive begun by Albanese to boost reserves and hike production. Success in that approach is linked to the expectation that commodity prices will rally and perhaps catapult Rio into the industry’s top spot. With emerging markets like Indonesia, Turkey, Brazil, the Philippines and many southeast Asian economies expected to lead global GDP growth for the next decade, the demand for cars, appliances and housing by those regions’ expanding middle class will likely put upward pressure on commodity prices.
Another option is to begin exercising a much higher level of capital discipline and maximizing the efficiency of existing assets. The rationale behind that choice is that the demand and supply of minerals is too fickle -- and thus commodity prices are too uncertain -- to base a company’s strategy on. Mining companies can take more than 10 years to evaluate a prospect, bid on the property, agree with the domestic government on how sales or earnings will be divided, prepare the site for exploitation and build all the structures needed to produce the metal. By the time a project is on stream, the demand for the mineral, the level of supply coming from rival miners, the government and its policies can and often do change -- all or any of which can render initial calculations and estimates irrelevant.
Which option Rio takes will depend in large measure on the company’s board and who it picks to run the company. Until recently, the board clearly preferred the first option, as witnessed by the fact that it retained Albanese as CEO for six years, far longer than many expected after the Alcan acquisition turned into a bust.
Albanese’s immediate replacement is Sam Walsh, a 63-year-old Australian and 21-year veteran of Rio who most recently ran the company’s iron ore operations. Because of his age, he is seen as a transitional figure, but he is also widely respected as someone far too valuable to be a mere placeholder. During his tenure, earnings from iron ore climbed to 80 percent of Rio’s profit. Many of the company’s iron mines routinely produce above their rated, or “nameplate,” capacity. The company’s huge Pilbara mine in Western Australia, for example, has an annual nameplate production capacity of 237 metric tons, but in 2011 it produced 249 metric tons of iron. Production is set to climb to 360 million metric tons by 2015.
Walsh is known as an excellent manager of costs and assets. As a result, many analysts expect him to take Rio in the direction of fiscal discipline rather than expand production.
Paul McTaggart, an analyst with Credit Suisse, said he anticipates that the company will “progress on turning back cost inflation in Australia, [with] the overall cost cutting targets [of] $3.4 billion.”
Besides cutting costs to boost profits, Walsh is likely to sharpen the company’s assessment of merger and acquisition opportunities.
Alessandra Lancellotti, an analyst with Frost & Sullivan, believes that under Walsh, Rio will “invest in profitable products, not choosing the metal or mineral type. I do not see [questions about strategy] as a product portfolio issue, but keeping profitability.”
In many ways, this strategy had already begun under Albanese, despite his initial bias for expanding the company's holdings and reserves. Late last year, Albanese described Rio's direction this way: “We are taking further tough action to roll back the unsustainable cost increases of the past few years and are maintaining a relentless focus on improving productivity."
And just days before his departure, Albanese again said that the company was “taking action to roll back unsustainable cost increases.”
To cut costs and rightsize its portfolio, it's extremely possible that Rio will divest of some of assets. Coal is a possible target.
“I do not believe the aluminum business would be divested, since it is the second highest business for the company in terms of revenues, and prices are likely to grow,” Lancellotti said. “For coal, the situation is quite different since this raw material is not aligned with the company's sustainability strategy.”
One asset Rio has been dangling for a possible sale is its diamond business, one of the largest in the world with operations in Canada, Australia and Zimbabwe and a book value of $1.3 billion.
McTaggart suggested a potential buyer.
“Harry Winston recently sold its retail diamonds business to Swatch," he said. “This could pave the way for him to make an offer for Rio’s diamonds business."
Whatever strategy Rio chooses, one thing is certain: A once seemingly invincible giant will be cut down to size, at least for the immediate future.