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Rio Tinto’s crucial lesson for investors

No company is too big to be stung by the pricing power of a dominant customer, not even when the owner is the New Zealand government. This is the crucial lesson for investors being dealt out by commodity giant Rio Tinto (ASX: RIO) at the moment as the company plays hard-ball in negotiations for lower power prices for its South Island-based aluminium smelter.

The smelter, located on Tiwai Point Peninsula, is 80% owned by Rio in partnership with Japan’s Sumitomo Chemical Company Ltd (TYO: 4005). It is New Zealand’s only aluminium smelter and it consumes one seventh of the country’s electricity output. After nine months of negotiations Rio is threatening to close down the smelter if an agreement on lower prices cannot be reached.

The repercussions of a close down would be massive. It would result in a drop of wholesale power prices, which would hit revenues not only of currently listed electricity companies like Contact Energy (NZX: CEN), which is 53% owned by Origin Energy (ASX: ORG), but also two NZ government-owned electricity companies Meridian Energy and Mighty River Power, which are slated to be sold to partial public ownership this year.

The move would be a double blow for the country’s government, which would not only lose up to NZ$506 million annually injected into the economy by the smelter, but the impact on electricity prices would likely result a lower initial public offer price for shares in the two electricity companies. In response to the threat the government had offered Rio “a modest amount of money to try and help bridge that gap in the short to medium term” according to State Owned Enterprises Minster Tony Ryall, though that offer has been rejected by Rio.

The negotiations are part of cost cutting measures being undertaken by Rio Tino, which made a net loss of $3bn in 2012 due to lower commodity prices, particularly in iron ore, as well as lower copper and gold volumes.   The company subsequently announced plans to cut $5 billion of costs across 2013 and 2014.

Foolish takeaway

The situation is a very real lesson for investors on pricing power risk. When one or two dominant customers make up a large percentage of revenues the loss of a customer can have a huge impact. This often affects smaller companies, such as supplies to big supermarket chains like Wesfarmersowned Coles, or Woolworths, but as costs are slashed by major resource companies the issue may become increasingly common for suppliers of support services and equipment to the industry’s dominant players. It pays to know your company’s customers.

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The Motley Fool’s purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead.  This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Motley Fool contributor Regan Pearson doesn’t own shares in any companies mentioned in this article.

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