(The following statement was released by the rating agency) Fitch Ratings-London-July 13: Fitch Ratings has upgraded global mining company Rio Tinto (LON:RIO) Plc/Ltd's (Rio Tinto) Long-Term Issuer Default Rating (IDR) and senior unsecured debt instrument rating to 'A' from 'A-'. The Outlook is Stable. A full list of rating actions is included at the bottom of this commentary.
The upgrade of Rio Tinto's Long-Term IDR reflects material financial flexibility gained through increased cash flow generation and asset disposals in a supportive economic environment. Management is pursuing a value-over-volume strategy and we expect earnings growth to mainly come from productivity improvements, technological innovation, cost control and development projects from Rio Tinto's own pipeline. Management emphasises disciplined capital allocation, which means the group's asset portfolio should evolve over time without a material shift in the underlying business risk. Fitch expects the group to maintain a conservative balance sheet with funds from operations (FFO) adjusted gross leverage below 1.5x and positive free cash flow (FCF) after dividends on a sustained basis.
Rio Tinto is one of the world's top-three mining companies with diversification of assets mostly across OECD countries and products across a number of bulk and base commodities. It also benefits from meaningful economies of scale and proximity of operations to important end-markets, particularly China and North America. KEY RATING DRIVERS Strong Cashflow Creates Financial Flexibility: The strong rebound of commodity prices has led to cash flow from operations jumping to USD13.9 billion in 2017 from USD8.5 billion-USD9.5 billion in the previous two years. Net debt as calculated by Fitch has been reduced to USD5.3 billion by end-2017, which includes the carrying value of the project financing for Oyu Tolgoi of USD4.2 billion, a project that is developing a new underground copper mine in Mongolia. The mine will only start contributing material earnings from 2021 and is 33.5%-owned by Rio Tinto (but fully consolidated due to Rio Tinto having control). Conservative Balance Sheet: We expect FFO adjusted net leverage to remain comfortably below 1.0x over the next four years. FFO adjusted gross leverage could be slightly above our guidance of 1.5x in 2019, due to limited debt maturities in 2018 and 2019 and largecash balances remaining on the balance sheet. Based on commodity prices reported in the year to date we expect the current financial year to be another good year for the mining sector, whereas our rating forecast is based on Fitch's more conservative mid-cycle commodity price assumptions. Market-Leading Iron Ore Franchise: Analysis from CRU Group shows that Rio Tinto has slightly lower cash cost and sustaining capital expenditure in iron ore than BHP. Around 30% of production relates to lump, mostly from Pilbara, a substitute for sinter. Given that the Chinese government implemented cuts of sinter production for environmental reasons last winter and will do so again this winter the premium paid for lump has been healthy. A lower cost position and higher proportion of lump in the mix give Rio Tinto a lead in iron ore. Vale S.A. in comparison markets valued, higher-grade ores but freight costs to China are currently at least USD10/t higher than for Rio Tinto and BHP.
Portfolio Optimisation in Aluminium: The group has been reviewing its aluminium assets. Disposals are underway with binding offers received for the Dunkerque smelter in France and ISAL smelter in Iceland. We believe that Pacific Aluminium, an Australian subsidiary, may also be earmarked for disposal. If those transactions are completed, Rio Tinto will only retain the most competitive alumina and aluminium smelters (leading positions in the first quartile) as well as bauxite mines ranking in the second quartile of the global cost curve (according to data from CRU Group). At the same time, the group is developing Amrun, a bauxite project that will add sizeable reserves and is due for commissioning in 1H19. Rio Tinto targets a first quartile operating cost position with this resource. Copper in Demand: The group's copper mines are on average in the second quartile of the cost curve, the two important operating assets being Escondida in Chile (operated by BHP) and Kennecott in the US. While a small surplus is expected for the copper market in 2018, over the medium-term even reasonable growth assumptions for electric vehicles are forecast to create a step-up in demand and firm up prices. Fitch's conservative mid-cycle assumptions expect copper to rise to USD7,000/t in 2021 from USD6,166/t in 2017. Productivity Gains and Cost Control: The group has set a target to strengthen FCF by USD1.5 billion (annual run rate once the efficiency programme is complete) over 2017-2021. The strategy focuses on value-over-volume and as such productivity creep, rolling out best practices as well as technological innovation have been identified as key drivers for earnings growth. This is particularly important given that asset prices in the prevailing market environment are high, making disposals easier to justify than acquisitions. For 2017 management reported achieved efficiencies of USD400 million, visible progress towards the target. However, progress in 2018 is likely to be more muted due to a return to cost inflation for the mining sector generally. Iron Ore Reserves Replacement: Based on proven and probable reserves existing mines can support production for another 10 years. Rio Tinto has a track record of replenishing reserves in Western Australia. Proven and probable reserves currently stand at 2,783mt, towards the upper end of the range observed over the last 10 years. The group has an ongoing programme of drilling with a focus on evaluating mineralised inventory and conversion to resource. In 2017 Rio Tinto opened the Silvergrass mine, which added 10mt in annual capacity. New projects in development include Yandi Billiard South. Around USD2 billion has been allocated for replacement mine capital over the next three years, the majority of which still needs to be approved and includes some spend on Koodaideri.
Shareholder Returns Credit-Neutral: Dividends and shareholder returns paid in 2017 were high, at a total of USD6.3 billion. For 2018 more funds will be distributed due to dividends and share buybacks already declared as well as the expected disbursement of a large proportion of disposal proceeds from coal, aluminium assets and Grasberg. The group has a dividend policy of distributing 40%-60% of underlying earnings. Therefore, Fitch expects dividends to moderate once earnings weaken. Our rating forecast expects net debt to remain broadly at or below the USD5 billion mark as adjusted by Fitch and that dividends as well as share buyback will be funded by cash flow, not debt. Tariffs Could Distort Markets: The Fitch rating case does not capture i) downside risks that could result from increasing protectionism of important trading partners or ii) a material impact on world GDP growth related to protectionist and retaliatory measures. DERIVATION SUMMARY Rio Tinto is one of the top-three global mining companies. Close peers include BHP Billiton (LON:BLT) Plc (BHP; A+/Negative) and Vale S.A. (BBB+/Stable). Rio Tinto is estimated to derive around 60% of EBITDA from iron ore (including the Canadian pellets business), 20% from the aluminium business, 15% from copper and 5% from other minerals over the medium-term (after adjusting for expected disposals). BHP exhibits slightly better and balanced diversification with around 35% of EBITDA from iron ore, 20% from coal, 30% from copper and 15% from petroleum (over the medium-term and adjusting for expected disposals). BHP's petroleum assets have slightly lower cash flow volatility as earnings exhibit lower correlation to the other commodities. Most of the iron ore for BHP and Rio Tinto comes from Australia, whereas the latter has a competitive advantage due to high demand for and price premium achieved with its Pilbara Blend Lump product. A large proportion of copper for both players comes from the Escondida mine in Chile (BHP: 57.5% ownership; Rio Tinto: 30%). In terms of financial profile Rio Tinto and BHP have similar characteristics with FFO adjusted gross leverage at or below 1.5x and FFO adjusted net leverage comfortably below 1.0x over the medium term. We expect both groups to maintain discipline with regard to capital allocation for growth, while returning significant amounts of funds to shareholders through dividends and share buybacks as long as commodity prices remain supportive and disposal proceeds bolster already large cash balances. Equally we expect both companies to scale back shareholder returns and safeguard positive FCF when commodity prices weaken in a downturn. BHP's 'A+' rating is one notch higher due to the diversification effect from oil & gas assets. Given that the earnings contribution from hydrocarbons has declined over the years and BHP is expected to sell its onshore shale gas assets in the US this year (reducing the contribution to EBITDA to around 15%), the rating is on Negative Outlook, reflecting that the beneficial diversification effect may diminish. In comparison, Vale S.A. is estimated to derive around 80% of EBITDA from iron ore (including pellets) over the medium-term with the remainder coming from nickel, copper and other minerals. Its rating is lower at 'BBB+' due to i) concentrated exposure to one commodity - iron ore, ii) the majority of operations being located in Brazil with a less developed economic environment and systemic governance, iii) higher transportation costs to important markets like China, which is only partly offset by the premium achieved for its higher-grade ore and iv) weaker leverage metrics. KEY ASSUMPTIONS Fitch's Key Assumptions within our Rating Case for the Issuer -Price assumptions for selected commodities: iron ore at USD60/t CFR in 2018 and USD55/t thereafter; aluminium at USD2,350/t in 2018 and USD2,250/t thereafter; copper at USD6,700/t in 2018 and 2019, USD6,800/t in 2020 and USD7,000/t thereafter. -Dividend payout ratio of 60% of underlying earnings in the near-term and 50% from 2020. -A large proportion of asset disposal proceeds to be returned to shareholders via share buy backs. -Capex in line with company guidance: USD5.5 billion in 2018 and USD6 billion for 2019 to 2020. -Net debt to remain broadly stable over the medium-term (2017: USD5,321 million as calculated by Fitch). -No large-scale debt-funded acquisitions. RATING SENSITIVITIES Developments That May, Individually or Collectively, Lead to Positive Rating Action An upgrade is unlikely unless Rio Tinto diversifies into other sectors with lower business risk and correlation to its mining operations. Developments That May, Individually or Collectively, Lead to Negative Rating Action - FFO adjusted gross leverage remaining above 1.5x for a sustained period (2017: 1.3x) - FFO adjusted net leverage remaining above 1.0x for a sustained period (2017: 0.6x) - Net debt / (cash flow from operations minus capex) above 2.0x for more than two consecutive years (2017: 0.57x) - Debt-funded dividends or share buybacks - Iron ore proven and probable reserves falling below 2,000mt on a sustained basis LIQUIDITY Solid Liquidity: At 31 December 2017 Rio Tinto held around USD10 billion in unrestricted cash (as calculated by Fitch), had available USD 7.5 billion under its revolving credit facilities (USD1.9 billion maturing in November 2020 and USD5.6 billion maturing in November 2022) and continues to generate strong cash flow. We do not expect the group to issue new debt in the near future. Existing debt is likely to be repaid with internally generated cash flow or asset disposals. FULL LIST OF RATING ACTIONS Rio Tinto Plc/Ltd - Long-Term IDR: upgraded to 'A' from 'A-'; Outlook Stable - Senior unsecured debt instrument rating: upgraded to 'A' from 'A-' - Short-Term IDR: upgraded to 'F1' from 'F2' Rio Tinto Finance (USA) Ltd - Senior unsecured debt guaranteed by Rio Tinto: upgraded to 'A' from 'A-' Rio Tinto Finance (USA) Plc - Senior unsecured debt guaranteed by Rio Tinto: upgraded to 'A' from 'A-' Rio Tinto Finance Plc - Senior unsecured debt guaranteed by Rio Tinto: upgraded to 'A' from 'A-' Rio Tinto Alcan Inc. - Senior unsecured debt: upgraded to 'A' from 'A-' Contact: Principal Analyst Dmitri Kazakov Director +7 495 956 7075 Supervisory Analyst Oliver Schuh Director +44 20 3530 1263 Fitch Ratings Limited 30 North Colonnade London E14 5GN Committee Chairperson Peter Archbold, CFA Senior Director +44 20 3530 1172 Media Relations: Adrian Simpson, London, Tel: +44 203 530 1010, Email: adrian.simpson@fitchratings.com. Summary of Financial Statement Adjustments - Fitch has adjusted the balance sheet debt by capitalising the annual operating lease expense of USD555 million using the standard 8x multiple. - Fitch has adjusted available cash to reflect USD518 million restricted cash as these funds are not available to apply against debt repayment or are held in jurisdictions which do not allow foreign currency remittances. - USD177 million of debt-related derivatives were added to the debt in line with disclosure in note 24 of the financial accounts. Additional information is available on www.fitchratings.com. For regulatory purposes in various jurisdictions, the supervisory analyst named above is deemed to be the primary analyst for this issuer; the principal analyst is deemed to be the secondary. 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