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Southern Copper (SCCO) reported an 11% decline in annual revenue in 2013, compared to the previous year. The company generates most (78%) of its revenue from copper sales, making it highly susceptible to low copper prices. The average copper price on the London Metal Exchange (LME) declined from $3.61 per pound in 2012 to $3.32 per pound in 2013. In response to this 8% decline, the company's stock reacted strongly, dropping by almost 27% last year.

However, copper prices could move up this year driven by Chinese demand. China accounts for almost 44% of the world's copper consumption, and the utilities sector makes up more than 40% of the country's copper consumption. A good conductor of electricity, copper is used in generating, transmitting, and distributing power. The State Grid Corporation of China (SGCC), which meets 80% of the country's power demand, will be increasing its capital expenditures by 13% this year, raising its annual investment to $60 billion. This will increase demand for copper from the Chinese power sector. Considering China's share in global copper consumption and the share of the utilities sector in the nation's copper consumption, the increase in capex by SGCC will help in keeping a check on copper prices, if not driving the price up.

Another factor that could move copper's price up is the ongoing mineral-ore export ban in Indonesia. Earlier this year, the Indonesian president approved a ban on the export of mineral ores to improve the country's domestic processing industry. Even though the government has relaxed the ban on export of copper concentrates until 2017, copper producers in Indonesia will have to pay a progressive export tax of 25% in 2014, which will rise to 60% by mid-2016. Owing to this change in regulation, companies like Freeport McMoRan (FCX) and Newmont Mining (NEM) will be negatively affected. Together, these companies produce 97% of Indonesia's copper output and will now be required to either pay higher export tax on copper concentrates or domestically process their output.

However, the lack of copper smelters in Indonesia will create bigger problems for the country's copper miners. Presently, there is only a single copper smelter, PT Smelting Gresik, present in Indonesia, to which Freeport allocates 40% of its Indonesian mine output. Newmont also sends the maximum copper concentrate that can be accepted by PT Smelting. As a result, both Freeport and Newmont may have to either defer production or pay higher taxes until more smelters are built in Indonesia. Currently, Freeport has deferred its Indonesian copper production, resulting in a monthly production loss of 40 million pounds of copper. If the ban stays in its current form, the copper output from Indonesia will certainly take a hit. In such a scenario, there could be an upside to copper's price.

Is the company moving in the right direction?

The upside move in copper prices will depend on a number of factors, and if the prices remain subdued in 2014, copper producers will be under more pressure to increase sales volume and reduce operating costs. For Southern Copper, the cost of producing copper has been lower compared with that of Freeport. Net cash cost, a common metric used by copper companies, refers to the cost of producing copper, net of by-product credits. For 2013, Southern Copper reported a net cash cost of $0.996 per pound of copper. On the other hand, the net cash cost of producing copper for Freeport was $1.49 per pound. Freeport derived almost 65% of its annual revenue from copper production in 2013, and as a result of higher production costs; Freeport's net profit margin came in much lower than that of Southern Copper.

Net profit margin

2013

2012

2011

Southern Copper

27.2%

29.0%

34.2%

Freeport McMoRan

12.7%

16.9%

21.8%

Southern Copper reported impressive profit margins over the past three years. Moreover, the company is planning to increase its production capacity, which will further help in maintaining a low cost structure. Over the next three years, the company will expand production capacity from 630,000 tons to 1.175 million tons. This 87% increase in overall capacity will be led by the Buenavista project, for which individual capacity is expected to rise by 171% from 180,000 tons to 488,000 tons by 2015. Further, the company expects to receive Environmental Impact Assessment (EIA) approval for its Tia Maria project in the second quarter of this year. Upon receiving the approval, Southern Copper could begin the developmental work and expects production to begin by the end of 2016. The Tia Maria project will have an annual capacity of 120,000 tons and will improve the company's overall capacity. These expansions will allow Southern Copper to improve its sales even if copper prices remain low.

However, Southern Copper will be increasing capex substantially in the coming years to fund these projects. For 2014, the company plans to incur $2.3 billion of capex on the expansion program. Historically, the company has generated considerable cash flows that have helped in funding its capex. A cash-flow-to-capex ratio of greater than 1.0 indicates the company's ability to fund its capex through internally generated funds.

Parameter

2011

2012

2013

Operating cash flow

(in $ million)

2,070

2,004

1,867

Capital expenditures

(in $ million)

613

1,052

1,703

Cash flow to capex

3.38

1.90

1.09

Conclusion

Southern Copper's expansion will help the company generate higher revenue in the coming years. Moreover, the company has maintained a low cost structure, allowing it to post good profit margins. Furthermore, above discussed factors could drive the price of copper higher in the coming years. I recommend a buy on this stock.

Source: Southern Copper: Minor Bump, But Long-Term Fundamentals Look Intact