Rio Tinto Looks To Make A Fresh Start

By Stephen D. Simpson, CFA | January 24, 2013 AAA

Apparently there's only so much even a generally passive board of directors can take before it feels the need to do something. Rio Tinto (NYSE:RIO) has announced a large impairment charge for 2012 and the replacement of its CEO - both largely tied to unsuccessful and wasteful expansion /capital allocation strategies. Now it is up to new management to chart a new path and improve returns in a more uncertain commodity climate.

SEE: A Beginner's Guide To Mining Stocks

Change at the Top
While the phrasing of the press release from Rio Tinto was sanitized and generic, I don't believe it is a stretch to suggest that Rio Tinto chose to fire Tom Albanese, its CEO of nearly six years. Certainly, Albanese's performance during his tenure gave cause to make a move.

Only about three months into the job, Albanese spearheaded the company's $38-billion-plus deal for Alcan - a move that has been very nearly an unmitigated disaster for Rio Tinto. Around the same time, the company refused to seriously consider a bid from rival BHP Billiton (NYSE:BHP). Years later, back in 2011, the company launched an aggressive (and so far largely unsuccessful) acquisition of coal company Riversdale.

In short, Rio Tinto under Tom Albanese was quite liberal in tossing money at acquisitions. What ultimately undid his tenure, however, was the timing and return of these deals - in many cases Rio Tinto paid top dollar, and the operations acquired haven't contributed all that much to the company's long-term returns.

Perhaps the most telling statement on his tenure is a long-term chart - although Rio Tino has outperformed a few major miners during Albanese's tenure (Anglo-American and Xstrata), the company has very definitely lagged behind BHP Billiton and has also trailed Vale (NYSE:VALE).

SEE: Strike Gold With Junior Mining

Another $14 Billion in Impairments
Rio Tinto's decision to take another $14 billion in impairment charges tied to acquisitions draws a thick red line under the end of Albanese's term as CEO. Roughly $10 billion to $11 billion of the writedown is tied to the company's aluminum assets, marking about $29 billion in total impairments, or three-quarters of the initial deal value.

The rest of the impairment charge, about $3 billion, is tied to the Riversdale coal assets in Mozambique. This has proven to be a very challenging resource opportunity to bring online, with higher capital expenditures and delays in processes such as securing approval to barge out the coal.

Where to Now?
The good news for Rio Tinto shareholders is that the company quickly turned to Sam Walsh, previously the head of Rio Tinto's iron ore division. This has been far and away the most successful of Rio's major operations, and Walsh has built an "on time, on budget" reputation for himself. I would expect Walsh, as head of the entire company, to lead a drive to be much more efficient with costs and much more discerning in capital allocation - both of which the company clearly needs.

At the same time, I'm not sure that there are easy solutions for Rio Tinto. A goal to cut cash costs in the iron ore business by one-quarter by 2020 is all well and good, but it will be challenging. Likewise, the aluminum operations are likely to see ongoing pressure - while Alcoa (NYSE:AA) needs aluminum prices at $1 or $1.10 per pound to thrive, Rio Tinto arguably needs prices of $1.10 or higher just to earn a real return on capital (and that's with generous assumptions on the expense structure and cost of capital).

SEE: Oil And Gas Industry Primer

The Bottom Line
For all of the talk of cost cutting and capital allocation, it's still true that if commodity prices run again, Rio Tinto will go along for the ride. That's particularly true if recent iron ore prices prove to be sticky. That said, I find Rio Tinto to be a mediocre pick right now. I do believe there's a sizable long-term opportunity for Walsh to cut costs and improve returns, but Rio Tinto shares aren't trading at a large discount to fair value today.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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