Commodities

David Fickling is a Bloomberg Gadfly columnist covering commodities, as well as industrial and consumer companies. He has been a reporter for Bloomberg News, Dow Jones, the Wall Street Journal, the Financial Times and the Guardian.

What's the point of assembling mining's best balance sheet if you're not allowed to trash it once in a while?

Rio Tinto Group has worked hard to set its house in order as the last decade's commodities boom turned to bust. In the past three years the London-based company has paid off $8.4 billion in debt, helping it weather a 19 percent decline in industrial metals prices.

Polished Metal
Rio Tinto's balance sheet is looking as good as it's been since the peak of the commodities boom
Source: Bloomberg
Note: Figures to June 2016 based on Bloomberg data. December 2016 based on Rio Tinto report. June 2017 based on analyst estimates. Methodology for calculating Ebitda and net debt may vary.

Among the select group of miners and metals refiners with more than $10 billion in annual sales, Rio Tinto is one of just a handful that could pay off all its debt with less than a year's worth of Ebitda. That position is set to improve further when the company finalizes the $2.5 billion sale of its last remaining thermal coal assets.

Shareholders will no doubt welcome Rio Tinto's decision in annual results Wednesday to reward their loyalty with $3.6 billion in dividends and buybacks -- but their company should take a few more risks. A decade on from Rio Tinto's last attempt at a mega-deal, it's time for another: Alcoa Corp.

An expansion in aluminum might seem an odd choice. Rio Tinto's last giant deal, the $38 billion acquisition of Canadian smelting company Alcan Inc. in 2007, was seen almost immediately as a company-killer.

The Sheen Comes Off
After they crashed in 2008, aluminum prices never recovered the levels they were at before Rio Tinto bought Alcan
Source: Bloomberg
Note: Pricing is for LME three-month rolling forwards.

After aluminum prices gave up their brief post-deal spike amid the 2008 financial crisis, they never recovered the $2,824 a metric ton level where they stood the day the takeover was announced. Saddled with debt, Rio was forced to accept a bailout from the Chinese government by offering the equivalent of an 18 percent equity stake to Aluminum Corp. of China Ltd., or Chinalco.  Tom Albanese, the chief executive officer who hatched the acquisition just months into the job, held on for five-and-a-half years before being replaced by iron ore chief Sam Walsh.

Aluminum's horrible supply-demand dynamics haven't changed recently -- but Alcoa has. Indeed, thanks to a split last year with specialty parts-maker Arconic Inc. and the gradual shutdown of its smelting capacity, these days it's looking more like a miner than Rio Tinto's own aluminum unit, which is now the bigger producer of the metal.

Upstream, With a Paddle
Rio Tinto produces more aluminum than Alcoa these days
Source: Company reports

Just as the oil industry is split between explorers and drillers, pipeline and tanker operators, and refiners, so the aluminum business has its upstream and downstream areas. First, bauxite is dug out of the ground and shipped to refineries, where it's transformed into alumina -- the same stuff rubies and sapphires are made from -- through a chemical process. Alumina is then sent to smelters, where it's subjected to high temperatures and electric current to produce molten aluminum.

It's only aluminum that's chronically oversupplied. In contrast to the lightweight metal's surplus of up to 800,000 tons this year, the world will be as much as 600,000 tons short of alumina and roughly balanced in terms of bauxite in 2017, according to an Alcoa presentation last month.

Furthermore, Rio Tinto likes bauxite. It's one of the four assets -- alongside iron ore, primary aluminum and copper -- that it highlighted as core in an investor presentation in December. The company is spending $1.9 billion on a project to build a 22.8 million ton-a-year bauxite mine in northeastern Australia, and expects Chinese imports of the ore to increase by 100 million tons by 2030.

Alcoa has another advantage. Big mining companies, especially Rio Tinto, have for many years been touting the advantages of so-called tier one assets: Mines that can produce large volumes, at low prices, for many years to come. The problem with such deposits is that they're globally scarce, and -- as Rio Tinto learned in its expensive and scandal-plagued entanglement with a tier one iron ore deposit at Simandou, in Guinea -- often in difficult jurisdictions.

Alcoa is the world's biggest miner of bauxite and refiner of alumina, and can produce each commodity more cheaply than at least 75 percent of its competitors, making its main assets clearly tier one. What's better, all but a handful are in stable democracies such as Australia, the U.S., Brazil, Iceland and Suriname. That's a rare distinction in the global mining industry these days.

Big Brother
A combined Rio Tinto-Alcoa would be a giant of bauxite and alumina, but less so aluminum
Source: Bloomberg

Could a deal be worthwhile? Let's assume Rio Tinto were to offer a 30 percent takeover premium to Alcoa's $6.9 billion market value and finance the deal entirely with debt. That would turn its current $9.6 billion of net debt into about $21 billion, which sounds a lot until you consider it's only 1.65 times the $12.8 billion of Ebitda it posted during 2016.

Assuming synergies are capable of saving 10 percent of Alcoa's $14.5 billion annual operating costs, a combination would add some 15 percent to earnings per share this year and 19 percent in 2018, according to Bloomberg's merger calculator.

Rio Tinto has grown fat over the years owning the upstream assets of the steel business, in the form of the Australian iron ore mines that delivered more than three-quarters of its $6.1 billion in operating income last fiscal year. An Alcoa takeover would result in a company that produced about a third of the world's bauxite and a fifth of its alumina, but just 10 percent of its aluminum.

Rio Tinto has the chance to repeat its best trick. It should take it.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. Based on changes in the Bloomberg Industrial Metals Subindex between Dec. 31, 2013 and Dec. 31, 2016.

  2. Talks on the transaction eventually broke down, leaving Chinalco with a 9.32 percent stake instead.

  3. There is a stake in a bauxite mine at Sangaredi in Guinea -- but Rio Tinto is already an investor in that project.

  4. Indeed, one of the best arguments against a deal is probably that it would give Rio Tinto too much market power in bauxite and alumina, and attract the opposition of antitrust regulators.

To contact the author of this story:
David Fickling in Sydney at dfickling@bloomberg.net

To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net