Buried Treasure

Rio Tinto's Guy Elliott is not your typical CFO. Starting life as an investment banker, he joined Rio Tinto 26 years ago without a formal accountancy background, and worked his way up through marketing and business development to running the company's Brazilian operations. In 2002 he moved into the top finance chair and 18 months ago also took on responsibility for the development of strategy.

"Every company organises itself differently," says Elliott. "Some CFOs are at the traditional finance director / accounting end of the spectrum. In my case, besides being a financial steward, I also carry responsibility for strategy, business development and economic forecasting. I don't carry responsibility for IT, procurement, shared services and insurance, all of which might traditionally be handled by the CFO."

Elliott is perfectly frank about the limitations of his non-accounting background, but doesn't see it as an issue. "I have not found it any kind of problem," he says. "May I also say that I would not be able to do this without the support of very effective people in areas such as tax, control and accounting. It is important to have people who, for instance, are very familiar with the details of accounting standards."

BOOMING COMMODITIES

Elliott's tenure in the finance and strategy roles comes at a time when Rio Tinto is riding a tidal wave of cash at a high point in the commodity price cycle. Chinese demand continues to rise and orders from Japan, still the bigger customer, have risen as the economy there stabilises.

Increased production contributed over $1.1bn to last year's figures and net earnings rose 58% to $5.2bn. The company is using its cash flow both to invest - $2.5bn in 2005; at least $3bn this year and again next year - and it is also in the process of giving back some $4bn to shareholders. This repayment of surplus capital, its capital management programme, is key to Rio Tinto's strategy.

RETURNING VALUE TO SHAREHOLDERS

"It is a priority to maintain the integrity of our progressive dividend policy, which we have had for many, many years at the company," says Elliott, who fully supports the US approach of returning excess cash to shareholders. "In 2004/5 we increased our yearly dividend by just short of 25%. Because that is progressive, we intend never to pay less than that and when we can, we will increase it."

"A progressive dividend policy doesn't cut the dividend during recession. When we announced the 2004 results we said we needed to return capital to shareholders. This was initially done off-market in Australia. Towards the end of the year we did an on-market buy-back in London."

"By February 2006 we had given back $1bn. We then started a new programme to return $4bn by the end of 2007, market conditions permitting. $1.5bn was paid in April 2006 as a special dividend. We have been buying back on-market in London and from the beginning of February to June 2006, we had bought back $1bn."

Elliott maintains that despite the cyclical nature of the commodities business, the company can develop a relatively stable and rising cash flow. "This is because we have focused on the quality of our investments," he says. "Large-scale mines that are amenable to low-cost expansion can generate strong cash flows even in a recession."

BALANCED APPROACH TO FUNDING

Elliott is adamant that Rio Tinto has a pretty simple process as far as funding is concerned. "Our cash flow is very strong despite the fact that we are spending at record levels," he states. "Thinking about the debt side of the balance sheet is less important than it would be in a different part of the cycle."

At year-end 2005, net debt stood at $1.3bn, giving a modest gearing of just 8%, despite the level of capital buy-back. "We seek a balance between bond issuance and commercial paper," Elliott explains. "As a consequence, our debt, which is quite low, is composed of a few remaining bond issues that we made early in this decade and they are running out." Elliott is content to let these issues mature, seeing no sense in a prepayment programme. Nor does Rio Tinto seek to structure its debt into long-term, fixed rate, but prefers to ride the markets.

"Our policy in general is to expose ourselves fully to short-term rates," he says. "So when we entered into long-term bonds, it was our practice to swap them into short-term. The consequence is that at most points we are exposed to short-term rates. There is little fixed rate and we have a little commercial paper outstanding."

INVESTORS WANT EXPOSURE

The focus on short-term rates also extends, with limited exceptions, to foreign exchange and commodity prices. Rio Tinto does not hedge. "The reason we don't is that we think the shareholders who buy Rio Tinto stock are seeking exposure to exactly these markets," explains Elliott.

"If they themselves thought that the time had come to hedge, then they could do so. The only real hedging we do is when we buy and sell properties. But in general we are allowing the market to determine the prices of our products. We are not seeking to second guess them. We think that this is well understood by our shareholders."

This makes Rio Tinto a tough challenge for any investment bankers pedalling the mantra that not to hedge is akin to speculation. "I am not enamoured of sophisticated financial products that make all kinds of claims and are very often quite expensive," avers Elliott. "Simplicity has many virtues."

FACING RISK

Even after giving shareholders part of its war chest, Elliott is certain that the business still has considerable financial capacity for the right new investments, over and above the $6bn two-year programme currently underway.

"My view is that in our business we don't want to be risk-averse," he states. "We need to take some risks in order to make money. We need to be risk-aware. We need to understand the full range of risks to which we are likely to be exposed, especially at the capital end. It is important in this respect that the CFO and the CEO complement each other."

Besides price and exchange rate volatility, Elliott lists environmental commitments and political risks as well as the vagaries of weather and logistics as things that concern him as finance director.

Analysts point out that Rio Tinto, 58% of whose operations are in Asia-Pacific, has famously shied away from significant involvement in Africa because of political risk. "Rio Tinto is no Lonrho," comments one industry observer. However, Elliott believes that Rio Tinto operates high-quality risk-assessment procedures. Where a project is rejected he insists that good reasons must be given.

So, had the strong cash flow tempted the company to move its risk markers? "There are always people who are enthusiastic to do projects or make acquisitions," says Elliott. "We maintain the integrity of our investment-appraisal system, which is rigourous and risk-aware. We want to be exposed to the maximum number of investment opportunities. We want to appraise them, not conservatively, but to estimate the outcome that we think is most likely."

RISING PRODUCTION COSTS

Nevertheless, not all the company's figures have been heading in the right direction. Despite its highly profitable year, Rio Tinto's unit costs rose 5% in real terms. "Though a 5% increase is significant, it stands in good comparison with the rest of the industry," asserts Elliott.

"Some of that rise is because we had increased the level of expansion. We had invested in business improvement programmes. We had boosted the production of molybdenum - an area with a very high margin, even though it increased costs. You need to differentiate between costs which are in the nature of investment and costs which are unwelcome."

Among the latter are higher costs driven by a shortage of equipment supplies, which Elliott ascribes to the cyclical movement in the industry. The dearth of the huge tyres for ore-moving trucks, which can cost between $20,000 and $50,000 each, presented all mining companies with problems.

Such tyres are practically impossible to obtain unless users have long-established relations with suppliers. Rio Tinto, says Elliott, enjoys such relationships and has also reduced day-to-day tyre wear by ensuring that tracks are smooth and loads optimised. All mines throughout the group pool information on tyre wear and so help develop best practice.

EQUIPMENT SHORTAGES

There has, however, been a shortage of the monster trucks themselves as well as shovels and grinding equipment. "Like the mining industry itself, the tyre industry has been taken by surprise," explains Elliott. "The necessary new capacity will not come on-stream until 2008. We have been working very systematically to handle the issue. We have not lost any production from this shortage. Not all mining companies can say that."

Rio Tinto, with a worldwide workforce of 27,800 is also suffering a shortage of skilled employees, which has been pushing up wage levels. Elliott's view is that many of the gains from automation have already been made. However, in a capital-intensive industry that is always seeking greater capital efficiencies, he does not rule out further automation savings.

With current mining operations and prospecting underway in everything from aluminium to zinc, Rio Tinto is well placed to profit from the record global demand for minerals and Guy Elliott is likely to be a very busy man.

Wondering what to do with a cash flow surplus, by how much to increase investor dividends, and how many billions should be reinvested in production are things that most finance directors would give their right arms to be kept busy with.