What Might Aluminum Mean to RIO?

In mid-2007 Rio Tinto RIO bought Canada's Alcan for $38.1 billion in cash, now widely regarded as one of the most ill-timed acquisitions in corporate history. A key plank was that aluminum prices had not run like the other metals and value remained on the table. But the reason aluminum had not run was that the market was flush with high-cost Chinese output, seemingly immune to the realities pressuring mortal "for-profit" companies. The Chinese production persisted and Rio Tinto sailed headlong into the Global Financial Crisis before it could off-load noncore assets. Gearing spiked to near 200% levels, and if not for the grace of shareholders the company might have been reporting profits in Renminbi and updates in Cantonese.

As history shows, Rio Tinto survived and sold around $7.5 billion net in assets in the three years to 2010. Along with 2009's $15.2 billion rights issue, strong cash flows, and a freeze on capital expenditure, the company is now net debt neutral at the mid-2011 mark. This is in no part thanks to the aluminum division, which continues to underperform in contrast to copper and iron ore.

Prior to Alcan in 2006, Rio Tinto's aluminum division generated around 10% of earnings before interest and tax (EBIT) on a 30% margin. Aluminum margins have not been above 5% since 2008 and were decidedly negative in mid-2009. In 2010, aluminum contributed just 4% of EBIT, making that Alcan acquisition look very expensive indeed. Remember this ignores the interest associated with the Alcan debt!

But can things turn around? Alcan increased Rio Tinto's aluminum capacity nearly fourfold to over 4 million tonnes per annum (Mtpa) and alumina output twofold to 9 Mtpa. There was sense in combining Rio Tinto's excess alumina capacity with a company long on smelting technology and hydro power but short the white powder. Significantly Rio Tinto is still self-sufficient in alumina, a crucial advantage in what is becoming a new pricing paradigm. We pointed to this repeatedly in our reporting on Alumina AWC . The long-held linkage of the alumina price to the LME aluminum price is broken. Alumina prices, now reflective of industry fundamentals, are rising. And aluminum prices are following.

An additional nail in the Chinese stranglehold on pricing is energy. The country has a power problem that, it has been argued, can only be rectified by a tripling in electricity prices to drive new capacity. That would have more than serious ramifications for the Chinese aluminum industry, which is highly energy intensive and an industry that if operated under capitalist principles probably wouldn't exist. China is short cheap coal, the source of 70% of its electricity--a structural issue.

Rio Tinto's Alcan folly may yet turn to triumph, though it probably didn't need to mortgage itself nor shareholders' nerves by moving quite as early as it did. Easy for armchair experts to say in hindsight, of course, harder to time in the real world! Few saw the GFC coming. Iron ore unit operating costs rose at an average cumulative rate of almost 20% over the last decade. Despite this, Rio Tinto's EBIT margins increased by over 50% to 65% thanks to strong pricing. Similarly copper operating costs rose by a cumulative annual 13% with margins regardless doubling due to price to over 50%.

If aluminum prices had been allowed to operate under normal market forces, it is not inconceivable that margins might now be at least 30%, despite the nonetheless admirable 11% cumulative average growth in unit operating cost over the last decade. At that rate, necessitating a $1.40 per lb aluminum price, the aluminum division could be contributing $5.2 billion or 16% to notional expanded fiscal 2011 group EBIT with prospective group earnings of $10.90 per share, placing Rio Tinto on a paltry 7 times price earnings multiple, down from 8.

We don't presume to be so optimistic--Chinese smelters will doubtless fight for survival. Our long-term aluminum price forecast is still at a considerable premium to spot--we are optimistic with cautionary overtones. And the aluminum leverage is worthy of consideration in any Rio Tinto evaluation.