Miners must bury a dividend distraction

The little tussle over dividend policy between Jan du Plessis and the Australian Shareholders’ Association at Rio Tinto’s annual meeting today is both a sign of the times and of a continuing conflict of timelines between the big miners and their shareholders.

The ASA wants Rio to abandon the "progressive" dividend policy it shares with BHP Billiton under which they try to maintain their dividends at sustainable levels. It wants Rio to move to a more conventional, and far higher, fixed payout ratio of dividends to earnings similar to the policies of the major banks.

At a simplistic level that’s understandable. Investors are clamouring for yield in a world where fixed interest returns have been demolished by the tsunami of cheap credit flowing from central bank printing presses. The big banks and miners that dominate the Australian sharemarket are the most obvious sources of that extra yield.

Except that, for the big miners at least, the opportunity to divert a deluge of cash has probably passed, with Rio and BHP’s cash flows essentially halved by the dive in commodity prices last year even as their capital expenditure programs were nearing a peak.

For Rio in particular, the need to protect its credit rating and maintain a stable balance sheet while its committed capex program remains large and in the context of volatility and uncertainty in commodity markets makes it vital that it retains a significant proportion of the capital it generates from its earnings.

Du Plessis and his new chief executive, Sam Walsh, made it clear that their focus was on delivering improved shareholder returns, which Walsh said had been "diluted" in recent times.

Miners, however, have no option but to think and invest longer term given that they are dealing with depleting resources and therefore require a different balance between delivering income returns to shareholders today and investing for capital preservation and growth in the longer term than, say, banks.

The mistake made by the miners, and particularly by Rio, wasn’t that they got that balance wrong but that in some instances they invested poorly. As a general statement the big miners allowed the capital and operating costs of some of their projects to escape their control – they lost some discipline.

In Rio’s case the big mistake was the disastrous bid for Alcan, compounded by the misjudgement of the Riversdale coal acquisition in Mozambique. All the key executives and the chairman who drove the Alcan deal are, of course, now gone.

All the miners are now addressing the cost issue – Rio is targeting $US5 billion of costs over the next two years – and rationalising their asset portfolios to get rid of sub-economic or non-core operations. That process might throw off some surplus capital that could be returned to shareholders.

With the frenzy of the resources price and investment boom now subsiding rapidly, inevitably the investment decisions will be more disciplined and cautious. There will, however, be investment.

There has been some controversy over the next potential major expansion of Rio’s Pilbara iron ore business, arguably the best iron ore business in the world. Should Rio pour more billions of dollars into the Pilbara or give that cash to its shareholders?

The iron ore price, having peaked at stratospheric levels, fell precipitously last September before a more recent recovery to levels about a third lower than the peak. There is an industry view the price will soften again in the second half of the year and a growing view among analysts that the flood of new supply within the pipeline will create excess production as early as next year, with obvious implications for the price.

It is worth considering that the late dive in prices last year wiped $US4 billion from Rio’s earnings even though its iron ore output rose by about nine million tonnes. If prices do fall in the second half of this year and are then clobbered by a surplus in 2014 it will hit Rio’s earnings hard.

As the low-cost producer Rio (and for that matter BHP and Vale) can withstand a period of low prices as the surplus works its way out of the market and still generate solid margins and profits.

If that scenario of a structural change in the market does play out, as is likely, the only obvious option for growing iron ore earnings would be to add more low-cost volume and displace the higher-cost production – driving the higher cost projects out of the market.

With proper discipline on capital and costs further investment in the business makes longer term sense – and will drive, not necessarily big increases in dividends, but long-term shareholder value relative to what might otherwise be the case without the investment.

Provided the big miners can generate better long-term returns from the capital they generate than would be generated from cash in their shareholders’ hands, it makes sense to retain earnings and invest that internally-generated capital in high-quality projects.

It makes even more sense to ensure that their balance sheets are shock-proof, given the amplitude of the volatility they have and are experiencing and the uncertainty over the economic path ahead for China.

Sam Walsh and his counterpart at BHP, Andrew Mackenzie (who formally takes up his position tomorrow), have both made it clear they will intensify their focus on delivering better shareholder returns and that one of the yardsticks against which prospective investments will be tested would be cash returns to shareholders.

In an environment of lower profitability, lesser cashflows, more disciplined evaluations and, consequently, a narrower and higher quality range of investment options, of course, testing those potential investments that get through the finer decision-making screens against cash returns to shareholders doesn’t necessarily lead to the cash being returned.

Pursuit of capital growth, largely successfully in an industry where both the risks and returns are high, has generally been the story of the big end of the Australian mining industry and is likely to remain so.

What matters in the longer term is not how returns on invested capital are generated for shareholders – whether via cash distributions or through capital gains – but how well that capital has been invested.

Walsh and du Plessis, and Mackenzie and his chairman, Jac Nasser, are adamant that they’ll improve the disciplines around the deployment of capital and improve shareholder returns in the process.