Our take on Rio's Jacobs sale and price cuts
The price reached for Jacobs and the greater-than-expetced price cuts reduce our valuation
Rio Tinto Energy America (RTEA) operates US coal mines mainly in the Powder River Basin of Wyoming and Montana. Jacobs Ranch produced 38.2 million metric tonnes in 2008, equivalent to 30% of RTEA's total 130.8 million tonne equity output. RTEA forms part of the Energy division including Australian coal and uranium and is earmarked for divestment. Energy generated US$3.5 billion or 20% of Rio's 2008 earnings before interest and tax, although RTEA is a lower-margin contributor compared with the Australian export coal mines. While prior asset sales have largely exceeded expectations, the Jacobs Ranch price is less than we would have expected and lowers our valuation. The impact on near-term earnings is marginally accretive.
Price cuts will impact the Australian export coal business. Rio Tinto has agreed to a 44% decline in thermal prices for the 2009 Japanese fiscal year--from US$125 to US$70 per tonne. A large cut was expected but this is below our US$80 per tonne forecast. In addition to being a drag on 2009 earnings, it further reduces our valuation. Rio Tinto produced 22.1 million tonnes of energy coal from Australia in 2008, equivalent to around US$2.4 billion or 30% of total Energy division revenue. Prices for other bulks--coking coal and iron ore--are yet to settle but large cuts are similarly anticipated.
Elsewhere prolonged rain across the west Pilbara in mid-February impacted iron ore movements. East Pilbara mines were not affected but most rail movements were halted due to flooding. Dampier and Cape Lambert ports were also impacted. Partial resumption of rail occurred in late February but full remediation has taken longer. We have lowered our March quarter iron ore production forecast by around one sixth, which, in conjunction with the thermal coal settlement, results in a 7% decline in our 2009 earnings forecast and is again mildly deleterious to value.
Regardless, we remain positive on Rio Tinto, given the steep discount to our fair value estimate. Including the Chinalco transaction, net debt would be around US$25 billion, down from US$41 billion in December. Barring further asset sales, gearing falls from 181% to 105%, though interest cover (around three times) remains stubbornly low--Rio Tinto does of course intend further asset sales.