Rio Tinto Spending less delivering more

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1 AUSTRALIA RIO AU/RIO LN Outperform Price (at 05:10, 29 Nov 2012 GMT) A$57.18/ Volatility index Low/Medium 12-month target A$ 80.00/ month TSR % Valuation A$ 96.51/ DCF (WACC 9.3%, ERP 5.0%, RFR 6.0%) GICS sector Materials 30-day avg turnover A$m Combined market cap US$m 99,213 Number shares on issue m Investment fundamentals Year end 31 Dec 2011A 2012E 2013E 2014E Revenue m 65,678 55,918 65,455 70,725 EBIT m 23,620 12,463 15,957 16,889 Reported profit m 5,826 8,303 9,944 10,376 Adjusted profit m 15,549 8,322 9,944 10,376 Gross cashflow m 20,075 12,838 14,972 15,819 CFPS 1, PGCFPS x PGCFPS rel x EPS adj EPS adj growth % PER adj x PER rel x Total DPS Total div yield % ROE % EV/EBITDA x Net debt/equity % RIO AU vs ASX 100, & rec history Note: Recommendation timeline - if not a continuous line, then there was no Macquarie coverage at the time or there was an embargo period. Source: FactSet, Macquarie Research, November 2012 (all figures in USD unless noted) 30 November 2012 Spending less delivering more Event RIO held its annual investor day in Sydney: The focus was on the iron business (which will be driven by Pilbara volume additions) and titanium dioxide (which at an earlier stage is still looking to ride the price cycle). Impact U$5bn of cumulative cost savings targeted by end-2014: This apparently equates to sustainable annual savings of ~U$3bn from 2015 (of which U$500m has already been banked). If achieved, this would equate to a ~10% cost reduction across the business, with the coal and aluminium divisions being singled out for special attention. However, while well intentioned, progress against these targets is likely to be almost impossible to track given its reliance on current market conditions. Capital allocation investments now competing with buybacks: Despite growing capital constraints, RIO reaffirmed its commitment to both its progressive dividend and its A credit rating which is seeing growth, sustaining and exploration capex all pushed out. Combined, these measures have significantly improved RIO s funding metrics under S&P s criteria for A- rated companies (Fig 3). Meanwhile, new project approvals will now apparently have to demonstrate higher returns than the alternative of returning cash to shareholders (suggesting that at low share prices RIO may increasingly divert cash away from investments and into buybacks). Iron ore spending less to deliver more: In the Pilbara, current capacity has been increased by 7mtpa (or 3%) to 237mtpa via de-bottlenecking. What s more, despite cost pressures and the high AUD, management reaffirmed its targeted capital intensity of the 140mpta expansion - from 220mpta to 360mtpa - in the mid-u$150 s per tonne (although we estimate slightly higher at U$168/t). This has been achieved both by reducing the scope of work (scrapping Brockman 4 will save U$1bn) and also by the slightly increased nameplate capacity. Earnings and target price revision Material medium term earnings up-lift: We have increased earnings forecasts by 3%, 5% and 10% in 2012, 13, and 14 respectively to reflect the incremental Pilbara capacity and the cost saving initiative. NAV rises 4.7% to A$96.51/sh: This jump again reflects incremental Pilbara capacity and lower sustaining capex (this adds ~A$3.2/sh) and the cost saving initiative (which adds ~A$1/sh). Price catalyst 12-month price target: A$80.00/ (was A$76.00) based on a DCF methodology. Catalyst: RIO will report 4Q12 production on 15th January. Action and recommendation Maintain Outperform rating but increasing price target by 5% to A$80/sh: The higher price target is driven by the jump in NAV, which is largely driven by the more tangible incremental production and lower sustaining capex guidance in the Pilbara rather than the more esoteric targeted cost reductions across the portfolio. Please refer to the important disclosures and analyst certification on inside back cover of this document, or on our website

2 Spending less delivering more Fig earnings forecasts rise by a significant 10% reflecting the incremental Pilbara capacity, the faster ramp up of the new capacity and the ongoing cost saving initiatives US$bn Fig 2 Our NAV rises ~A$4/sh (or 4.7%) to A$96.51/sh this is driven by higher production and lower costs in the iron ore division as well as cost savings across the portfolio A$ps FY14 earnings (previous) Pilbara increase by 7mtpa Cost savings Early Pilbara production FY14 earnings (new) NPV (previous) Iron ore Energy Other NPV (new) Source: Macquarie Research, November 2012 Source: Macquarie Research, November 2012 U$5bn of cumulative cost savings targeted by end-2014 Management is targeting cumulative cash cost savings of U$5bn by the end of 2014 (vs levels) although a material portion of this appears to be driven by forex assumptions. While these reductions will be spread across the portfolio, it appears that in the first instance, the low returning coal and aluminium divisions will be singled out for special attention. Management was at pains to stress that these cost reduction targets are predicated on current market conditions, meaning all bets are essentially off once forex rates and commodity prices move (which of course is inevitable). As a result, while well intentioned, progress against these targets is likely to be impossible to track. Annual savings of ~U$3bn (or ~10% of the current cost base) is deemed sustainable going forward. If delivered this could add up to ~U$12/sh or almost 15% of our current valuation (if it has no revenue impact). However given that much of this saving relates to forex and much of the rest will be difficult to track, we have only assumed annual savings of ~U$750m. While management stressed that any shut downs would be driven by profitability rather than cost reduction targets, it nevertheless appears that such significant (~10%) cuts could also have at least some impact on the revenue line. Capital allocation investments now competing with buybacks Despite finding itself in an increasingly capital constrained environment, management reaffirmed its commitment to both the progressive dividend and the A credit rating (indeed it appears both remain sacrosanct suggesting any further macro deterioration would drive an even more aggressive cost cutting or divestment programme). Against this backdrop, management again reiterated that it expects no major project approvals but significant divestment proceeds in What s more, management also expects to cut the exploration budget by U$1bn over the balance of this year and next. Interestingly, any new project approvals will now have to demonstrate higher returns than the alternative of returning this cash to shareholders. This suggests that at low share prices RIO may increasingly divert cash away from investments and into buybacks. Overall, we continue to believe restrictive capital management policies are hurting the efficiency of both BHP and RIO s spending plans. Specifically, we see onerous progressive dividends along with unwavering commitments to top tier credit ratings encouraging the diversified miners to become procyclical investors (that is they acquire, invest and buyback shares at the top of the cycle as prices are high and sell assets or defer capex when prices are low at the cyclical bottom). 30 November

3 Aside from growing accustomed to unsustainable dividend growth, investors are perhaps also overlooking the all-in cost of these progressive dividends namely that the lack of financial flexibility they generate force RIO to buy high and sell low. At best this approach attracts a high opportunity cost from inefficient capital allocation and at worst, it simply destroys value. Supporting this view, management suggested that RIO began running into capital constraints back in 4Q11 and is consequently trimming capital budgets accordingly. In part this appears to be driven by a deferral of the mine spend associated with the 360mtpa expansion in the Pilbara (which presumably will still be needed, but is now more likely to occur in a subsequent higher commodity price, higher cost environment in the future). Similarly, another target for cost reductions is sustaining capital which ultimately is non-discretionary, meaning any current capex savings may end up being significantly more expensive in the future. Fig 3 The reduced capex and increased Pilbara cash flow have significantly improved RIO s funding metrics under S&P criteria for A- ratings Fig 4 While credit ratings and dividends have been maintained through the cycle, RIO s acquisitions and buybacks are seemingly pro-cyclical 250% 200% FFO/TD previous funding positon new funding position required FFO/TD Buybacks Acquisitions/(divestments) Free cash flow (post capex and dividends) S&P GSCI Ind Metals (RHS) % 35 US$bn % % % CY02 CY04 CY06 CY08 CY10 CY Source: Company data, Macquarie Research, November 2012 Source: Company data, Macquarie Research, November 2012 Pilbara iron ore spending less to deliver more In the Pilbara, current capacity has been increased by 7mtpa (3%) to 237mtpa via de-bottlenecking (apparently with the promise of a further 7mtpa to come), meaning the sanctioned expansion milestones now become 290mpta, 340mpta and 360mtpa, all of which is due to be on-stream by 1H16 (indeed it now appears that first ore from the 340mtpa expansion is expected in 4Q14 rather than previous guidance of 1H15). Fig 5 First production for 290mtpa expansion is due in 4Q13 and will kick off expansion towards 360mtpa Fig 6 Sustaining capex is high in the near-term with replacement mines Pilbara iron ore (mtpa) US$/t Sustaining capex Opex (Total) H03 2H04 1H06 2H07 1H09 2H10 1H12 2H13 1H15 2H16 1H18 2H19 1H11 1H12 1H13 1H14 1H15 1H16 1H17 Source: Company data, Macquarie Research, November 2012 Source: Company data, Macquarie Research, November November

4 Despite the inflationary cost environment and the high AUD, management re-affirmed the capital intensity of the 140mpta expansion (from 220mpta to 360mtpa) in the mid-u$150 s per tonne. It appears this has been achieved both by reducing the scope of work (scrapping Brockman 4 will save U$1bn) and also by the slightly increased nameplate capacity. Although still officially unapproved, it was suggested that the new Pilbara mines were among the very highest returning opportunities in the RIO portfolio and management is therefore confident that this spend will be sanctioned in due course (depending on the macro environment). That said, delaying the mines appears to have no discernable impact on the ramp up to 360mtpa. We understand that the majority of the targeted U$1bn annual sustaining capital savings across the RIO portfolio will come from the Pilbara driven by increased scale of operations and further technology improvements. In real terms we estimate this will see sustaining capital fall from U$5.5/t to ~U$4/t by Management continues to expect 3 rd party iron ore expansion capacity to be delivered late creating a tight market and high prices which will support the anticipated on-time delivery of RIO s own expansion tonnes (apparently including Simandou from mid-2015). However given the seemingly low execution risk associated with RIO s Pilbara expansions, this part of the story at least would appear reasonably safe (although we continue to think Simandou may take a little longer than current guidance). Partly due to the scale benefits offered by its Pilbara growth projects, judging by its published cost curve, in real terms RIO appears to expect a ~25% fall in the unit costs of its Pilbara operations between now and 2020 this compares to only a 10% fall for BHP and a 14% reduction for Vale. Fig 7 Based on historic capex announcements (which need to be fx adjusted and hence our estimated U$2.2bn fx adjustment) we estimate the capital intensity of RIO s expansion to 360mtpa at U$168/t (slightly higher than management guidance of mid-u$150 s) Growth capex (100% basis) US$bn aggregate US$/t pa Comments Dampier system efficiencies (to 225mtpa) Approved in 2010; Port improvement works Dampier debottlenecking (to 237mtpa) Approved in late 2010, Increase shiploading capacity and associated rail stock Total incremental to 237mtpa Other (power, water, autonomous trains) 2.7 Power (~US$0.8bn); Trains (~US$0.5bn); Water (~US$0.5bn), Other (~US$0.9bn) Expansion to 290mtpa 7.9 Brockman 4, WTS, Nammuldi LoM + US$4.3bn for infrastructure & CL dredging Expansion to 360mtpa (approved) 6.2 Cape Lambert expansion, replacement car dumper, gas fired power station Expansion to 360mtpa (unapproved) 4.2 Mine approvals pending for Silvergrass, Koodaideri to add 70mtpa capacity FX impact 2.2 Difference between Macq AUD est and RIO's previous AUD assumptions Total 140mtpa increment to 360mtpa Sustaining capex (HD4, Yandi LoM) 4.9 Hope Downs, Yandi LoM expansion & capacity expansion, Marandoo LoM Underlying 140mtpa increment to 360mtpa 28.4 Source: Macquarie Research, November 2012 Elsewhere in the RIO portfolio Simandou: Despite being tucked away at the back of the presentation (even behind Damiper Salt and the soon-to-be divested Diamonds division), Simando apparently remains one of RIO s most important and challenging projects and remains on-track for first shipments in mid Coal: With management suggesting virtually any new Australian coal project is subeconomic the local coal project options are understandably under review (although like BHP, management stressed that all mines are currently cash flow positive). Aluminium: The Aluminium business remains on-track to deliver its U$1.6bn of EBITDA improvement by end 2015 (with U$266m so far since 2011 with Yarwin 2 and Kitimat yet to come), while it also sounds as if the Gove refinery could be at risk of closure in the new year. 30 November

5 Titanium Dioxide: TiO2 is expected to become a significant earnings contributor over the coming decade entering a new phase of commodities demand and consequently with a tightening market envisaged, management expects to achieve payback on the RBM division within 5 years. However, in the near term RIO is bringing forward maintenance at RBM to capitalise on a period of forecast market softness in November

6 Fig 8 Summary Share price: A$ Target price: A$ Profit & Loss 2010A 2011A 2012E 2013E 2014E Divisional EBITDA 2010A 2011A 2012E 2013E 2014E Gross sales revenue US$m 60,323 65,678 55,918 65,455 70,725 Iron Ore US$m 16,605 20,930 14,315 15,021 15,352 Consolidated revenue US$m 56,576 60,537 51,018 59,497 64,375 Energy US$m 2,374 2,232 1,124 1,009 1,130 - Operating Costs US$m 33,274 33,804 35,495 40,653 44,225 Diamonds & Minerals US$m ,286 2,764 2,586 EBITDA US$m 23,302 26,733 15,524 18,844 20,150 Aluminium US$m 2,418 1, ,506 2,132 - Depreciation & amortisation US$m 3,437 3,817 4,268 4,606 4,986 Copper US$m 4,503 3,394 2,091 4,119 4,502 Share of JCE NPAT US$m 1, ,208 1,719 1,725 Other operations US$m EBIT US$m 21,128 23,620 12,463 15,957 16,889 Intersegmental adj. US$m Net interest payable US$m Sub-total US$m 26,620 29,491 19,456 24,117 25,670 - Amortisation of discount US$m Other items US$m Pre-tax profit pre-exceptionals US$m 20,219 22,885 11,897 15,165 15,821 Exploration & other US$m ,215-1,393 Exceptional charges US$m 261-9,681-1, Underlying EBITDA US$m 25,978 28,521 18,055 22,147 23,463 - Tax expense US$m 5,296 6,439 2,218 4,799 4,988 - Minorities US$m Production 2010A 2011A 2012E 2013E 2014E Reported Net Profit US$m 14,324 5,826 8,303 9,944 10,376 Aluminium kt 3,790 3,826 3,450 3,755 3,938 - Exceptional items (post tax) US$m 337-9, Alumina mt Macquarie Adjusted Profit US$m 13,987 15,549 8,322 9,944 10,376 Borates kt Adjusted Net Profit US$m 13,987 15,549 8,322 9,944 10,376 Coking coal mt Profit growth % 157.9% 11.2% -46.5% 19.5% 4.4% Other Coal (Australia) mt Effective tax rate % 30% 31% 36% 38% 38% Copper kt Diamonds mct EPS adjusted US ps Gold koz EPS growth (adjusted) % 111% 13% -44% 19% 4% Iron Ore mt DPS US ps Titanium feedstock kt 1,392 1,442 1,595 1,800 1,800 Underlying EBITDA US$m 25,978 28,521 18,055 22,147 23,463 Key Assumptions 2010A 2011A 2012E 2013E 2014E AUD/USD exchange rate A$/US$ Cash Flow 2010A 2011A 2012E 2013E 2014E Aluminium US /lb Net cashflow from operations US$m 22,126 26,589 14,891 20,659 22,415 Copper US /lb Dividends from JV & Associates US$m 1, ,169 2,283 2,314 Gold US$/oz Net interest US$m Lump iron ore US /mtu Minority dividends paid US$m Fine iron ore US /mtu Tax paid US$m -4,100-6,197-4,496-4,104-4,852 Coking coal US$/t Operating Cashflow US$m 18,277 20,030 10,670 18,006 18,740 Thermal Coal US$/t Asset sales / (purchases) US$m 2,975-5, Capital expenditure US$m -4,553-12,534-17,162-14,965-13,635 Exploration & other US$m ,678-1,815-2,265 Investing Cash Flow US$m -1,711-18,815-19,506-16,781-15,900 Dividends paid US$m -1,754-2,236-3,017-2,833-3,000 Debt drawdown / (repayment) US$m -9,360 4,208 5, Equity financing & other US$m 504-3, Financing Cash Flow US$m -10,610-1,449 2,492-2,833-3,000 Cash Flow Pre-Funding US$m 14,812-1,021-11,853-1, Net Cash Flow US$m 5, ,344-1, Free Cash Flow US$m 16,566 1,215-8,837 1,226 2,840 Balance Sheet 2010A 2011A 2012E 2013E 2014E Cash US$m 9,948 9,670 3,520 1,912 1,752 Current assets US$m 13,217 12,316 12,236 12,236 12,236 Fixed assets US$m 56,024 64,967 77,823 87,517 95,130 Other assets US$m 33,213 32,592 32,786 32,888 33,334 Total assets US$m 112, , , , ,452 Current liabilities US$m 13,602 14,999 12,972 13,354 13,742 Total liabilities US$m 47,128 60,337 59,824 60,994 61,592 Minority interests US$m 6,941 6,669 9,892 9,892 9,892 Shareholder equity US$m 65,274 59,208 66,540 73,558 80,860 Total debt US$m 14,341 21,804 24,178 24,178 24,178 Net debt US$m 4,621 12,134 20,658 22,266 22, Average diluted shares m 1,972 1,936 1,852 1,852 1,852 Ratio Analysis 2010A 2011A 2012E 2013E 2014E Net Debt / Equity % 7% 20% 31% 30% 28% Net Debt / (Net debt + Equity) % 7% 17% 24% 23% 22% EBIT Net Interest Cover x Net interest cover x Payout Ratio % 15% 18% 33% 29% 30% EBITDA Margin % 41% 44% 30% 32% 31% 9.33% Nominal $USm $US/sh $A/sh /sh Underlying EBITDA Margin % 43% 43% 32% 34% 33% Iron Ore 92, EBIT Margin % 39% 40% 26% 29% 28% Energy 14, EV/EBITDA (fixed debt) x Copper 30, EV/EBITDA (prospective) x Industrial Minerals 7, GCFPS US ps 927 1, ,012 Aluminium 16, PGCFPS x Diamonds Other Operations & Investment 2, ROE (NPAT / Equity) % 27% 28% 15% 17% 15% Net Debt -18, ROCE (EBIT / Debt + Equity) % 31% 33% 30% 35% 29% RIO TINTO NPV 146, RIO TINTO NPV (spot fx conversion) PE x Premium/(Discount) to NPV (@ long run AUD:USD): -40.7% -36.0% Adjusted AUD PE x Market Capitalisation ($USm): 99,213 Adjusted GBP PE x Dividend yield % 2.1% 2.8% 2.9% 3.1% 3.2% Franking % 100% 100% 100% 100% 100% 30,000 25,000 20,000 15,000 10,000 5,000 0 Energy 8.7% Underlying EBITDA US$m ROCE (EBIT / Debt + Equity) NPV Breakdown Diamonds Industrial Aluminium 0.5% Minerals 10.0% 4.9% Copper 18.8% Iron Ore 57.1% 35% 34% 33% 32% 31% 30% 29% 28% 27% 26% PGCFPS x PE x A 2011A 2012E 2013E 2014E 35,000 30,000 25,000 20,000 15,000 10,000 5, ,000 Divisional EBITDA contribution (US$m) 2010A 2011A 2012E 2013E 2014E Prices as at 1am AEST, 30 November 2012 Source:, IRESS, Macquarie Research, November November

7 Important disclosures: Recommendation definitions Macquarie - Australia/New Zealand Outperform return >3% in excess of benchmark return Neutral return within 3% of benchmark return Underperform return >3% below benchmark return Benchmark return is determined by long term nominal GDP growth plus 12 month forward market dividend yield Macquarie Asia/Europe Outperform expected return >+10% Neutral expected return from -10% to +10% Underperform expected return <-10% Macquarie First South - South Africa Outperform expected return >+10% Neutral expected return from -10% to +10% Underperform expected return <-10% Macquarie - Canada Outperform return >5% in excess of benchmark return Neutral return within 5% of benchmark return Underperform return >5% below benchmark return Macquarie - USA Outperform (Buy) return >5% in excess of Russell 3000 index return Neutral (Hold) return within 5% of Russell 3000 index return Underperform (Sell) return >5% below Russell 3000 index return Volatility index definition* This is calculated from the volatility of historical price movements. Very high highest risk Stock should be expected to move up or down % in a year investors should be aware this stock is highly speculative. High stock should be expected to move up or down at least 40 60% in a year investors should be aware this stock could be speculative. Medium stock should be expected to move up or down at least 30 40% in a year. Low medium stock should be expected to move up or down at least 25 30% in a year. Low stock should be expected to move up or down at least 15 25% in a year. * Applicable to Australian/NZ/Canada stocks only Recommendations 12 months Note: Quant recommendations may differ from Fundamental Analyst recommendations Financial definitions All "Adjusted" data items have had the following adjustments made: Added back: goodwill amortisation, provision for catastrophe reserves, IFRS derivatives & hedging, IFRS impairments & IFRS interest expense Excluded: non recurring items, asset revals, property revals, appraisal value uplift, preference dividends & minority interests EPS = adjusted net profit / efpowa* ROA = adjusted ebit / average total assets ROA Banks/Insurance = adjusted net profit /average total assets ROE = adjusted net profit / average shareholders funds Gross cashflow = adjusted net profit + depreciation *equivalent fully paid ordinary weighted average number of shares All Reported numbers for Australian/NZ listed stocks are modelled under IFRS (International Financial Reporting Standards). Recommendation proportions For quarter ending 30 Sept 2012 AU/NZ Asia RSA USA CA EUR Outperform 50.00% 56.85% 61.54% 41.38% 63.19% 44.15% (for US coverage by MCUSA, 7.35% of stocks covered are investment banking clients) Neutral 36.62% 25.14% 27.69% 52.13% 30.77% 30.57% (for US coverage by MCUSA, 9.31% of stocks covered are investment banking clients) Underperform 13.38% 18.02% 10.77% 6.49% 6.04% 25.28% (for US coverage by MCUSA, 0.00% of stocks covered are investment banking clients) Company Specific Disclosures: Macquarie and its affiliates collectively and beneficially own or control 1% or more of any class of Limited's equity securities. The analyst and/or associated parties own or have other interests in securities issued by Limited. The Macquarie Group acted as financial advisor to RIO on a recommended off-market takeover bid of Riversdale Mining Ltd as announced on 23 December Within the last 12 months, Macquarie Group has received compensation for investment advisory services from Limited. The Macquarie Group acted as financial advisor to Limited and Mitsubishi Development Pty Ltd in relation to the potential acquisition proposal made to Coal & Allied Industries Limited as announced on 8 August Within the last 12 months, Macquarie Group has received compensation for investment advisory services from Limited. The Macquarie Group will or expect to receive compensation for investment advisory services from Limited and Mitsubishi Development Pty Ltd. The Macquarie Group acted as Sole Financial Adviser to, Mitsubishi Development and Hunter Valley Resources in a Scheme of Arrangment to acquire all of the shares in Coal & Allied Industries Limited which they do not already own as announced on 26 August Within the last 12 months, Macquarie Group has received compensation for investment advisory services from Limited. The Macquarie Group will or expect to receive compensation for investment advisory services from Limited, Mitsubishi Development Pty Ltd and Hunter Valley Resources. Macquarie Bank Limited makes a market in the securities in respect of Limited. Important disclosure information regarding the subject companies covered in this report is available at Analyst Certification: The views expressed in this research reflect the personal views of the analyst(s) about the subject securities or issuers and no part of the compensation of the analyst(s) was, is, or will be directly or indirectly related to the inclusion of specific recommendations or views in this research. The analyst principally responsible for the preparation of this research receives compensation based on overall revenues of Macquarie Group Ltd (ABN , AFSL No ) ( MGL ) and its related entities (the Macquarie Group ) and has taken reasonable care to achieve and maintain independence and objectivity in making any recommendations. General Disclosure: This research has been issued by Macquarie Securities (Australia) Limited (ABN , AFSL No ) a Participant of the Australian Securities Exchange (ASX) and Chi-X Australia Pty Limited. 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8 30 November