The current article aims to highlight the key aspects of the business of nonferrous metal companies primarily dealing in Aluminium, Zinc, Copper, Lead etc. After reading this article, an investor would understand the factors that impact the business of nonferrous metal companies and the characteristics that differentiate a fundamentally strong nonferrous metal company from a weak one.
Key factors influencing the business of nonferrous metal companies
1) No pricing power of nonferrous metal producers:
All nonferrous metals like aluminium, zinc, copper, lead and others are globally traded commodities. The prices of these metals are decided by the trading at the London Mercantile Exchange (LME), which factor in global demand and supply as well as inventory position in different parts of the world.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 3:
non-ferrous metal prices in India are largely benchmarked to the London Metal Exchange prices, which in turn are influenced by the international demand-supply position.
As the metal produced by one player is almost indistinguishable from the metal produced by another player; therefore, the customers can easily switch their suppliers. As a result, even the largest and the most well-known nonferrous metal producers are price-takers in this industry and have to accept the price determined by LME.
As the sales price is similar for almost all the players across the world; therefore, any nonferrous metal producer has to be cost-competitive at an international level because, otherwise, cheaper exports from foreign players would give it strong competition.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 4:
a primary metal producer, notwithstanding duty protections, needs to be globally cost competitive for it to remain profitable across the business cycles.
Advised reading: How to do Business Analysis of a Company
2) Being the lowest-cost producer is essential for nonferrous metal companies:
Because nonferrous metal producers cannot dictate prices to their customers; therefore, the only way for them to increase profitability is to reduce costs.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 3:
Since all producers are necessarily price-takers, profitability of individual players depends upon their respective positions on the industry cost curve
Nonferrous metal companies use the following strategies to reduce their costs:
2.1) Large-sized plants with economies of scale benefits:
Nonferrous metal producers usually create very large manufacturing plants to benefit from the economies of scale and have a lower cost of production.
A large-sized plant reduces per unit cost of production as it spreads fixed costs over a large size of final production. In addition, large size also helps the company reduce costs by negotiating better terms with their suppliers and customers.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 4:
large scale of operations…confers upon it the ability to control costs through greater bargaining power against raw material suppliers and customers, enter into long-term supply contracts with large customers, access funds from the market at better rates, besides the economies of scale, which accrues from its size.
Reduction in the cost of production by establishing large plants is so much that nonferrous metal players usually create plants, which are even larger than the domestic requirements.
In India, the production of most nonferrous metals exceeds their consumption. As a result, India is a net exporter of nonferrous metals.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 1:
during FY2021 over 60% of primary aluminium manufactured and over 35% of primary zinc manufactured were exported.
Currently, India imports copper because its largest copper-producing plant of Sterlite is currently closed due to environmental concerns. Otherwise, when this plant was operational, then India was a net exporter of copper as well.
Rating methodology for primary nonferrous metals manufacturers by ICRA, Feb. 2020, page 3:
Additionally, with the current domestic aluminium and copper capacities being in excess of domestic demand, producers are forced to focus on the export
Creating large plants exceeding domestic consumption is not limited only to India. It is also observed in developed countries like Japan, which also has an excess capacity for nonferrous metals. As a result, its players have to compulsorily export to other countries by being more cost-competitive.
Rating methodology for nonferrous metals by Japan Credit Rating Agency, July 2011, pages 1-2:
In Japan, domestic production exceeds domestic consumption, and it exports metals to China and other East Asian regions
Improving cost-competitiveness to compete against the new smelters being built one after another in emerging countries
Therefore, compulsory reliance on economies of scale to lower the cost of production forces nonferrous metal producers to create large plants even exceeding domestic requirements. They have to export even though exports are less profitable than sales in the domestic market.
Rating methodology for primary nonferrous metals manufacturers by ICRA, December 2017, page 2:
Metals sold in the domestic market typically have a premium over export markets…Since imports would have additional logistics and other import related costs, domestic prices are higher than international prices, thus providing higher margins.
Advised Reading: Credit Rating Reports: A Complete Guide for Stock Investors
2.2) Vertical integration:
Nonferrous metal players like aluminium, zinc, copper, lead etc. attempt to integrate their operations forward as well as backwards to capture as much value in the supply chain as possible so that they may reduce their production costs.
For example, nonferrous metal companies enter into mining operations to ensure a cheaper and steady supply of ore. It also helps them avoid the impact of highly-volatile ore prices.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 3:
Entities with captive mines of ores, typically, not only have a lower raw material cost but are also secured against raw material availability risks.
Entering into mining operations helps metal producers immensely because usually miners get the highest share of the overall value chain in metal extraction and processing.
As per Japan Credit Rating Agency, while determining the price for the ore, out of the price determined on London Mercantile Exchange (LME), the metal producers (smelters) retain only the processing/refining margin and have to pass on the remaining to the ore-mining companies.
Rating Methodology for Nonferrous Metals by Japan Credit Rating Agency, July 2011, page 2:
The ore price paid by smelters to mining companies is the amount after subtracting the cost of processing (TC/RC = cost of smelting / cost of refining) from the LME price.
Metal producers (smelters) and ore miners used to agree on a base price and if the LME price was higher than the base price, then the difference was shared between the miner (90%) and the smelter (10%). However, with the increasing bargaining power of miners, now, the entire difference in the LME price and base price is taken by the miners.
Rating Methodology for Nonferrous Metals by Japanese Credit Rating Agency, July 2011, pages 2-3:
the portion of the LME price exceeding the base price, which was shared…90% for the mining company and 10% for the refining company…however, made the market more oligopolistic…and any benefits from an increase in the LME price are now enjoyed by mining companies.
As the price charged by the miners takes away the maximum part of the value-addition; therefore, nonferrous metal producers that have capital mines are able to enjoy a significant cost advantage over their competitors.
Just like backward integration into mining helps nonferrous metal producers, similarly, forward integration into more value-added products helps them as they can gain a higher share of profit margin in the entire value chain and can price their products cheaper than their competitors who are not vertically integrated.
Further advised reading: How to analyse New Companies in Unknown Industries?
2.3) Captive power production:
Production of nonferrous metals like aluminium, copper, zinc and lead etc. is a very energy-intensive process where the ore needs to be melted to separate the metal. Therefore, power & fuel cost is one of the most significant parts of operating expenses; especially, for aluminium, the power cost is even higher than the raw material (ore) cost.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, pages 3 and 11:
The manufacture of non-ferrous metals is an energy-intensive process
Typically, power and fuel costs of an integrated aluminium player account for around 30% of its operating income as against nearly 15% and 8% for an integrated copper and zinc player, respectively.
As a result, controlling power costs is one of the essential steps for any nonferrous metal producers, especially aluminium smelters. Therefore, almost all of them tend to have captive power plants mostly run on coal, which offer a cheaper source of power.
Having a captive source of power is so important for being cost-competitive that during coal block auctions, nonferrous metal producers were the most aggressive bidders for coal blocks.
Rating methodology for primary nonferrous metals manufacturers by ICRA, Sept. 2015, page 3:
Given the importance of assured supply of coal, aluminium players were among the most aggressive bidders in the first two rounds of coal block auctions
Every new aluminium smelter has to mandatorily plan for a captive power plant otherwise, it would not be cost-competitive.
Rating criteria for the aluminium industry by CRISIL, February 2021, page 6:
Aluminium manufacturing is a highly energy-intensive process…any capacity expansion programme envisaged will need to be accompanied by appropriate additions to captive power generation capacity.
2.4) Technological upgradation:
Nonferrous metal producers need to keep upgrading their technology to reduce their production costs. This is because the new machines consume less power. Older plants are cost-inefficient and may involve a significant investment to make them cost-competitive.
Rating methodology – nonferrous metals by CARE, August 2022, page 4:
This has resulted into cost reduction and hence improvement in profitability of the entities who have adopted/upgraded to these technological changes…older plants/outdated technology may incur substantial replacement/modernisation cost.
Additionally, plants with the latest technology also capture valuable by-products during the refining & smelting process. These by-products provide an additional source of income for the companies and reduce the overall cost of production of nonferrous metals.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 3:
a modern plant typically uses allied facilities for by-product recovery (silver and nickel during production of zinc), which provides an extra avenue of income to the manufacturers, thus bringing down production costs on a net basis.
2.5) Logistics cost:
Production of nonferrous metals involves moving a large amount of bulky raw materials from mines to the plant and then moving finished goods from the plant to the customers. For example, to produce one tonne of aluminium, about 7 to 8 tonnes of raw material is needed.
As a result, nonferrous metal producers need to carefully plan the location of their plants because saving on logistics costs would provide them with a huge cost advantage over their competitors.
Rating methodology – nonferrous metals by CARE, August 2022, page 4:
To manufacture a tonne of aluminium around 7-8 tonnes of raw material is required…Companies whose plants are close to the sources of raw material are likely to have an advantage in terms of transportation cost, lower wastage, inventory holding period and therefore the working capital cycle.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 3:
Mines, in close proximity to the refinery, help keep carrying costs low, which in turn has a cascading effect on the overall cost of production.
Advised reading: How to do Financial Analysis of a Company
3) Highly capital-intensive, concentrated industry:
Nonferrous metal production is a very capital-intensive industry. This is because to be a competitive producer, a company needs to invest a large amount of money in an integrated plant, and develop captive mines as well as a captive power plant. In addition, it needs to keep spending money to upgrade the technology of the plant.
The requirement of a large amount of capital acts as a strong entry barrier to new players. As a result, primary nonferrous metal industries that produce the metal from its ore are dominated by only a few very large players. For example, in India, the aluminium and copper industries have three players each whereas there is only one player each in zinc and lead production.
Rating methodology – nonferrous metals by CARE, August 2022, page 1:
Indian, primary non-ferrous metals industry is highly concentrated with not more than three players each in aluminium and copper smelting and only one player manufacturing zinc and lead through the primary route.
Even though the production of nonferrous metals is a fixed capital-intensive business, it is not so much working capital-intensive.
As per ICRA, nonferrous metal producers do not need a large amount of working capital because they have to keep a low inventory of finished goods and get quick payments from their customers.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 7:
The primary non-ferrous metal industry is not working capital intensive, driven by a quick cash conversion cycle on account of low finished goods inventory and limited credit period provided to customers.
Advised reading: Inventory Turnover Ratio: A Complete Guide
4) Cyclical nature of nonferrous metals business:
Nonferrous metals are consumed primarily in industries like automobiles, construction, consumer goods etc., where demand is highly correlated with general economic growth. As a result, the demand for nonferrous metals goes through alternate phases of boom and bust.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 6:
non-ferrous metal being a cyclical industry, profitability varies significantly along the cycle.
The cyclicity in the nonferrous metals industry is exacerbated by the long gestation period of their production plants. During an upcycle, when the demand for nonferrous metals is higher than production, many companies announce capacity expansion projects. These projects get completed simultaneously after a long period of 3-6 years. As a result, at the time of project completion, the industry changes from a deficit to surplus production leading to a down-cycle.
Key credit factors for the metals and mining upstream industry by Standard and Poor’s, December 2013, page 3:
Cyclicality is exacerbated by excess supply from large-scale capacity additions. High prices and margins during good times stimulate existing companies and new entrants to start large, long-lead-time projects, leading to periods of industry overcapacity that can last for years.
A typical example of the exuberance of metal producers leading to overcapacity and thereby a down-phase was seen in Nickel.
Key credit factors for the metals and mining upstream industry by Standard and Poor’s, December 2013, page 3:
This happened in the nickel market, for example, when record nickel prices in 2007 and 2008 triggered an increase in nickel pig iron capacity in China and high-pressure, acid-leach capacity elsewhere. This led to production consistently exceeding consumption for a number of years, pushing inventory higher and constraining prices below marginal producers’ costs.
During cyclical down-phases, many small players in the industry shut down their businesses, which leads to a decrease in production and a resultant increase in prices and profits for the remaining producers.
Nonferrous metal companies try to protect their business from the cyclicity risk by going for diversification.
Advised reading: Detailed Analysis Of A Company: A Framework
5) Diversification helps in the nonferrous metals industry:
Nonferrous metal producers attempt to diversify their business along different aspects to reduce the impact of cyclicity on their business.
5.1) Large, vertically integrated operations:
Nonferrous manufacturers that are integrated, both backwards and forward, are relatively better placed to face industry down-cycles than standalone smelters.
Players who are backwards integrated into mining see lower fluctuations in their earnings because fluctuations in the mining and refining earnings are usually opposite to each other.
Rating methodology for nonferrous metals by Japan Credit Rating Agency, July 2011, page 5:
Changes in the earnings of mining businesses are the opposite of those of refining businesses, which, thus, contributes to the overall stability of earnings
Nonferrous metal players who are forward integrated into more value-added products show a lower impact of cyclicity. This is especially true for those integrated players who supply products to different industries as they are less impacted by adverse developments related to any one industry.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 4:
Additionally, forward integration by primary players into downstream businesses protects them against the volatility risks associated with commodity metal prices to an extent…since different downstream products find applications in different industries, forward integration into more value-added products enables a company to lower its dependence on any particular user industry or customer.
Integrated nonferrous metal players are usually large in size, which provides them operational flexibility of shutting down parts of their business to reduce operating costs and the impact of a down-cycle.
Metals and mining rating methodology by Scope, Germany, October 2022, page 9:
Larger and more diverse companies typically have a greater flexibility in operations and have the option of temporarily closing some plants and furnaces when demand is lower and restarting the facilities when demand recovers
Advised reading: Asset Turnover Ratio: A Complete Guide for Investors
5.2) Geographical diversification:
Diversification in the location of plants as well as customers of the company protects it from many regional adverse developments.
If the manufacturing plants of a company are spread across many geographies, then the company is relatively well protected from risks like natural disasters, social & political unrest etc.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 4:
ICRA evaluates the locational diversity of the operating assets, which helps reduce geographical risks.
Companies, which focus on both domestic as well as overseas markets are much better protected against demand-supply, regulatory and political risks of any one country.
Rating methodology – nonferrous metals by CARE, August 2022, page 3:
Entities having a balance of domestic & exports markets are in a better position to meet the challenges arising from decline in demand in a particular country, adverse changes in duty structure, imposition of trade restrictions or political instability in a particular region.
Therefore, large, diversified, integrated nonferrous metal players are better placed than single-location, non-diversified players.
6) Regulatory, environmental and social risks:
Nonferrous metal players face a significant regulatory risk because of many reasons.
First, the prices of nonferrous metals are linked to the import parity price, which is inclusive of all the import/customs duties imposed by the govt. In addition, the govt. decides the royalty on the ore and coal mining by the players from their captive mines.
The role of the govt. in imposing customs duty and royalties has a significant impact on the profitability of nonferrous metal players.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 3:
profitability of domestic manufacturers is dependent on the applicable royalties on mining of minerals as well as import and export duty structures
In the past, govt. had increased levies on mining, which impacted the profit margins of metal players.
Rating methodology for primary nonferrous metals manufacturers by ICRA, Sept. 2015, page 2:
as per the Mines and Mineral (Development & Regulation) Amendment Act 2015 (MMDR), cost of minerals in the country would go up due to the imposition of new levies towards District Mineral Foundation and National Mineral Exploration Trust.
The second aspect of regulatory risk arises from the fact that nonferrous metal players require large land parcels for putting up their plants and for mining operations. Policies of the govt. for land acquisition and other approvals pose a significant regulatory risk for the companies.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 3:
Regulatory risks related to Government policies on land acquisition, environmental and forest clearance etc are some of risks related to the mining operations
Nonferrous metal producers face a significant environmental risk because their production process leads to a lot of pollution and waste generation. Due to polluting processes, the manufacturing of nonferrous metals has shifted from developed countries to developing countries.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 11:
The manufacture of non-ferrous metals is an energy-intensive process and requires a substantial use of fossil-fuels which results in greenhouse gas emissions, industrial waste generation, and environmental pollution.
To meet the forever tightening environmental regulations, nonferrous metal companies need to spend a significant amount of money to upgrade their technology and production processes.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 11:
Increasing regulatory requirements to reduce greenhouse gas emissions and stricter air pollution standards may lead to higher costs for manufacturers in the medium term
Nonferrous metal producers also face local social issues due to labour-intensive, polluting production processes as well as due to land acquisition and rehabilitation of displaced persons. Any failure to keep the local community on their side may lead to local unrest, which may stop the construction/production of the plants.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 11:
The sector is exposed to labour-related risks and risks…Also, the adverse impact of environmental pollution in nearby localities could trigger local criticism. Also, the manufacturing plants require vast tracts of land. Therefore, rehabilitation and resettlement (R&R) challenges associated with acquisition of large land parcels…remains an important risk
Therefore, nonferrous metal producers must coordinate their production and expansion plans by keeping the local community’s response in its mind.
7) Foreign exchange risk:
The prices of all nonferrous metals like aluminium, zinc, copper, lead etc. are determined by the trading on London Mercantile Exchange (LME). As a result, these prices are quoted in foreign currency.
Therefore, any change in the movement of the Indian Rupee (INR) to foreign currencies like the US Dollar (USD) impacts the selling price of nonferrous metal players even if they are selling it within the domestic market.
As the selling price of the companies depends on foreign currencies whereas their operating costs are incurred in domestic currency (INR); therefore, these companies are exposed to foreign exchange (forex) risk even if they do not do any exports.
Rating methodology – primary non-ferrous metal manufacturers by ICRA, March 2022, page 9:
The manufacturing costs of a domestic primary non-ferrous metal producer are incurred primarily in the domestic currency. On the other hand, selling prices are linked to the exchange rate and benchmarked against the landed cost of imports, even if the company sells its produce within the country.
Therefore, every nonferrous metal company should hedge its forex risk well; otherwise, sharp movements of foreign exchange may pose a significant risk for the company.
Advised reading: How to do Business Analysis of a Company
8) Key ratios for analysis of nonferrous metal companies:
Apart from the standard ratios of financial and operating efficiency analysis, an investor may use the following ratios to ascertain production efficiency and compare it with peers to assess whether the company has any competitive strength in its operations.
Profit margin per tonne: which assesses the overall costs including the consumption of ore as well as power per tonne used in the production process. It may also be analysed by contribution margin per tonne. A company with more efficient operations would have a higher profit margin per tonne of metal sales.
The marginal cost of production: this helps in determining the price at which the company would start losing money during a down-cycle as discussed earlier in the example of Nickel.
Sales price premium over LME price: the LME price reflects the price of base metal. The premium earned by any company represents the value addition achieved by it in its production process.
Total debt/tonne of manufacturing capacity: provides a benchmark for comparing the leverage of different players within the industry.
Summary
Nonferrous metal production is a highly capital-intensive business without any pricing power. Numerous domestic and foreign players compete for the nonferrous metals business where the prices are determined by trading at London Mercantile Exchange (LME).
In this industry, all the players, however large or small, are price takers. A customer can easily switch from one supplier to another without any significant impact on her business. As a result, nonferrous metal producers cannot charge any premium prices than their peers.
The only way to earn a higher profit margin than peers is to reduce one’s production costs. As a result, large players with economies of scale and relatively better negotiating power with customers and suppliers are in an advantageous position. In addition, nonferrous metal producers go for vertical integration into mining and value-added products to capture a higher share of the value of the supply chain.
Players installed power plants for captive use because nonferrous metal production is energy-intensive and a lower cost of power provides a competitive advantage. Companies need to regularly upgrade their plants to use cost-efficient technologies, which requires additional investments.
As a result, nonferrous metal production becomes a highly capital-intensive business where only a few deep-pocketed companies can survive. Still, these big players are also price takers because nonferrous metals are globally traded commodities. If domestic prices rise beyond a limit, then cheaper imports will flood the market to reduce the prices.
The industry is cyclical because it depends on consumer industries like automobiles, construction, consumer goods etc., where demand depends on the general economic situation. Therefore, nonferrous metals undergo alternate periods of boom and bust.
Companies go for large, integrated business operations to reduce the impact of cyclicity on their business. In addition, companies with geographical diversity in plant and customer location are at an advantage because they are relatively well protected from geographical, political, regulatory and social risks of any one geography.
Profits of nonferrous metal producers depend a lot on the customs duties as well as mining royalties imposed by the govt. In addition, policies related to land acquisition, environmental laws, rehabilitation of displaced persons etc. significantly impact the business of nonferrous metal producers. Companies need to handle such regulatory, environmental and social risks diligently to succeed in their business.
Even if a nonferrous metal producer sells its products only in the domestic market, still, it is fully exposed to foreign exchange (forex) fluctuation risk because the sale price of nonferrous metals even in the domestic market is linked to LME price, which is quoted in foreign exchange. Therefore, hedging forex risk is essential for every nonferrous metal producer.
Therefore, an investor should always keep in mind these multiple aspects of nonferrous metal companies to understand the true picture of their business position.
- No pricing power in the hands of producers.
- Lowest-cost producers have a competitive advantage: technologically advanced, large-sized, integrated plants with captive sources of power, which are located near the sources of raw material
- A highly capital-intensive business where only a limited number of players survive
- Cyclicity in the business
- Diversification helps to stabilize performance: diversification in the business with vertical integration and diversification in the geographical location of plants and customers
- Many external factors pose as risk like regulatory, environmental, social and foreign exchange risks
We believe that if an investor analyses any nonferrous metals company by considering the above parameters, then she would be able to assess its business properly.
Regards,
Dr Vijay Malik
P.S.
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Disclaimer
I, Vijay Malik, am a SEBI-registered Research Analyst (Regn. No. INH100008364). This article is for educational purposes only and does not constitute investment advice or a recommendation to buy or sell any securities. Investors should do their own research before making any investment decisions.
I, or my immediate relatives, do not have any financial interest in the companies discussed as on the date of publication of this article, nor do we hold one per cent or more of the securities of such companies at the end of the month immediately preceding it. I do not have any material conflict of interest and have not received any compensation or other benefits from the companies or any third party in relation to this article during the 12 months preceding its publication. I have not served as an officer, director, or employee of the subject companies, nor have I been engaged in market making activity for them.
