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In an environment where commodity prices like copper are falling companies like Southern Copper Corporation (NYSE:SCCO) are in trouble since it generates most of its revenue from copper. Therefore, investors should be cautious when making investment in the copper industry. As far as Southern Copper is concerned the company's net profit is very sensitive to the slight change in the copper price. A $0.01/lb change in the copper price can have an impact of $8 million on the bottom line. Therefore, at the moment, I believe that it could be quite a risky decision for the investors to take exposure in copper. Let's further analyze the company's recent performance and future prospects to determine whether or not it is an investment opportunity.

Cash Margin Declining To An Alarming Level

As shown in the following table, the copper price was $3.16/lb in 2008 when the recessionary period started. However it declined to $2.33 during fiscal year 2009and at the same time the operating cash cost declined from $1.57 to $1.36.Despite the decrease in operating cash cost cash margin declined from $1.59 to $0.97 in fiscal year 2009 due to low copper prices. After that, the copper price picked up the pace and reached $3.04/lb in fiscal year 2010. It can be clearly seen that the cash margin of the company since 2008 was at its highest in fiscal year 2011 when the copper price was at its peak of $4/lb. Although the operating cash cost increased in fiscal year 2011increase in copper price not only offset that increase but also boosted the cash margin. Soon after 2011 the copper prices started declining and reached $3.35/lb during the first nine months of fiscal year 2013. For the first 9 months of fiscal year 2009the operating cash cost was $1.92/lb. As a result of continuous decline in copper price and an increase in the operating cash cost, the cash margin was $1.43in the first 9 months of fiscal year 2013;its lowest since 2010.

For the growth in topline, it is essential that the copper price improves in the future. In order to post decent margin and growth in the bottom line some key metrics must improve. Either the copper price needs to increase or the company needs to curb its costs. As far as copper price is concerned I believe it is beyond the control of the company.

In the case of cash cost, the following graph shows that the company was not be able to lower it during the last five years except in fiscal year 2009. Operating cash cost increased $1.57/lb to $1.92/lb until the first nine months of fiscal year 2013. Operating cash cost increased at a CAGR of 4.11 percent from fiscal year 2008 to the first nine months of fiscal year 2013. Operating cash cost mainly increased because of cost inflation, high fuel and power costs and high labor costs during the period.

SOURCE: Company Presentation

Four things Regarding Future Performance

Some key points that can influence the company's performance in the future are production, operating cash cost, metal prices, and the company's business segments. Let's analyze each of these points in detail. As shown in the following pie chart, the company generated 78 percent of revenues from copper. The remaining 22 percent was generated through the sales of other metals including silver, molybdenum, and zinc. Therefore, I can conclude that copper can materially affect the company's margins in the future.

SOURCE: Company Presentation

Key Metrics

With regards to the production schedule, the company is expected to increase its production over the next five years. The following graph shows the production schedule of copper over the next five years. Copper production is expected to reach 1,145,000 metric tones by 2017 from 630,000 metric tones in fiscal year 2013.

SOURCE: Company Presentation

The increase of copper production is not a good decision. I believe that the company should diversify rather than invest further in metals. Moreover, in an environment where copper prices are very low and are expected to be lower, to me it is quite unwise that the company is increasing its production. Either the company should control its costs or diversify the portfolio in such an environment when commodity prices are suppressed.

Growth in bottom line is a function of growth in the topline and control over the operating cash costs. Growth in the topline is dependent upon copper prices. Copper price depends upon the balance of demand and supply. According to Barclays Plc and the International Copper Study Group in Lisbon the surplus will reach a 13 year high of 272,000 metric tones. Therefore, I believe that the copper price will remain suppressed over the next few years owing to supply surplus of metal.

According to World Bank estimates, the copper price is expected to decline to $3.15/lb by 2018. Furthermore, The company's operating cash cost increased at a CAGR of 4.11 percent over the last five years. Assuming that the company's operating cash cost increased with a CAGR of 4.11 percent over the next five years owing to cost inflation, higher fuel and power costs and labor costs, the company's cash margin is expected to decline drastically to $0.80/lb by 2018 from $1.43 during the first nine months of the current fiscal year.

Assuming the best case scenario where the operating cash cost increased by just 2%the company's cash margin will decline to $1.03/lb by 2018 which is quite low in my opinion. Therefore, I do not see any growth in the bottom line of the company.

Final Note

Owing to low commodity prices and increasing operating cash costs the company's cash margins are expected to be lower over the next five years. I believe that if the company continues to increase production while it is unable to control cash costs then there will not be any growth in the bottom line. Adding to the risk, if the other competitors in the industry follow the pattern and also increase production in the future in the copper prices might further decrease and will result in a lower cash margin.

Furthermore, the company's PEG ratio is 1.28 times which is well above the industry average of 0.81 times. Therefore, considering the multiple factors, I would recommend investors take short position in the stock.

Source: Southern Copper Corp: A Story Of Declining Margins