Rio Tinto plc (RIO): Two Bad Acquisitions With a Huge Writedown

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A Deeper Look at South Africa’s Commodity IndustryRio Tinto plc (ADR) (NYSE:RIO) just announced that it expected to have a huge impairment charge of as much as $14 billion in its full year 2012 results. Following the non-cash impairment charge, the company’s CEO, Tom Albanese, resigned and was replaced by Iron Ore’s chief executive Sam Walsh. The news seemed to be quite negative for this UK mining giant. Should investors be bearish about Rio Tinto?

Business Snapshot

Rio Tinto is considered one of the largest mineral corporation in the world, with different product groups including aluminum, copper, diamonds, iron ore, etc. The majority of Rio Tinto’s earnings were generated from the iron ore segment, more than $12.85 billion, accounting for 82.6% of the total group underlying earnings in 2011. The second biggest earnings source was copper, with $1.93 billion in earnings, representing 12.4% of the total 2011 earnings. In the last 10 years, Rio Tinto has managed to generate consistently positive operating cash flow and free cash flow. The operating cash flow has increased from $2.72 billion in 2002 to more than $20 billion in 2011. The free cash flow has fluctuated in the range of $535 million to $13.69 billion for the last 10 years. Rio Tinto had quite a strong balance sheet.  As of June 2012, it had nearly $55.68 billion in total stockholders’ equity, nearly $7.3 billion in cash, $1.77 billion in short-term debt and $19.4 billion in long-term debt. The debt/equity ratio was only 0.3x and the interest coverage was quite high at 27.6x.

Two Huge Bad Acquisitions

Rio Tinto would recognize $14 billion in non-cash impairment charge in fiscal 2012, including $3 billion relating to Mozambique Coal and $10 billion - $11 billion decrease in its aluminum assets’ carrying value. The company also expected several write-downs of $500 million. The total $14 billion impairment charges related to two bad acquisitions. The $3 billion write-down has nearly wiped out the total acquisition cost of $3.7 billion, which Rio Tinto has paid to acquire the coal assets in Mozambique. The $10-$11 billion charges has increased the total write-down on Alcan’s acquisition to nearly $30 billion, representing 80% of the total purchase price of $38.1 billion in 2007.  Jan du Plessis, Rio Tinto’s chairman said:

The Rio Tinto Board fully acknowledges that a write-down of this scale in relation to the relatively recent Mozambique acquisition is unacceptable. 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.”

In 2010, Rio Tinto’s net income was the highest in the last 10 years, at $14.3 billion. In 2011, it earned only $5.8 billion. The huge non-impairment charges might drag Rio Tinto’s full year 2012 earnings into negative figures.

Potential Near Term Price Drop?

At the current trading price of $55.85 per share, Rio Tinto is worth $103.15 billion in the market. The market is valuing Rio Tinto at 25.55x trailing P/E and 1.82x P/B. The $14 billion non-cash charges would be equal to 13.6% of the company’s total market capitalization. If we assumed that Rio Tinto is fairly valued in the market, I would expect the equivalent drop in its market price. Otherwise, Rio Tinto would look more expensive with the higher price/book valuation.

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