Rio Tinto (RIO)

Keeping the heat on

The jostle for supremacy amongst the mining heavy weights took a further twist last week. A first quarter update from Rio Tinto (LSE, RIO) has in our view turned the heat back on BHP Billiton. A stellar iron ore result and successful integration of the Alcan acquisition vindicate Rio's decision to spurn a revised 3.4-for-1 share offer in February. And with long term output growing rapidly and commodity prices continuing to rise apace, Rio is becoming more valuable by the day.

Whilst overall the result was extremely solid in our view, the real story and standout performer was the iron ore division. First quarter production was a record, rising 16 percent on last year to 43 million tonnes. With output set to increase, it is handy then that iron ore prices remain robust.

Another major driver behind Rio's performance was the aluminium business. We take great encouragement from the manner in which the miner has bedded down the US$38 billion acquisition of Alcan. The deal helped drive bauxite production 106 percent higher, alumina up 236 percent and aluminium 386 percent.

In terms of Rio's other businesses a surprise package was uranium where production leapt 20 percent to 3.35 million pounds. However on the flip side, hard coking coal output fell 27 percent to 1.04 million tonnes. In addition, mined and refined copper output declined 6 and 23 percent respectively whilst diamond production fell 35 percent.

Nevertheless, all in all we remain of the view that the latest result further underlines the quality of Rio's operations and why BHP remains in vigorous pursuit.

Meanwhile standing pat is not on Rio's agenda. Continual investment in operations will, in our view, ensure that output levels across the group continue to rise. Following the weighty acquisition of Alcan, additional headroom to invest in future growth should increase. Besides robust operating cashflows, Rio will also gain around US$10 billion from divesting non-core assets this year.

From a non-operational perspective, speculation continues to flow about BHP's next move, and 'will they or won't they' increase their offer. As we have suggested previously, a 4-for-1 deal is likely to be the minimum required to get things over the line.

Whether BHP acts now (before antitrust approvals are submitted to European regulators) is moot. We believe a deal at some point is highly likely, and that Rio remains in a position of strength. That said, in our opinion, any sensible agreement will be perceived as a 'bargain' in the years ahead. China's double digit growth and the world's emerging economies will continue to fuel robust demand for a host of commodities, many of which Rio and BHP supply. As such, earnings going forward should be very well supported.