Chalco’s staggering 8 billion RMB annual loss surprised most analysts’ forecasts. At AZ China however, we think the focus on last year’s financial results is only scratching the surface. There are more structural challenges facing Chalco. These challenges include higher production costs in primary metal smelting; higher cost in alumina production resulting from the Indonesian bauxite ban, and over-exposure to cyclical downturns.

Comparing to the model

What surprised most forecasts are the additional finance costs from Chalco’s ‘strategic transformation’ which ‘expanded the size of interest-bearing debts’. Here we note the extra finance cost is beneficial to the group’s medium to long run performance, therefore, the rationale for the spending is sound. The real problem remains in its poor gross profit position, as a result of structurally high operating costs combined with cyclical price depression in 2012.

From a segment point of view, the biggest loss contributor is the alumina segment. This raises alarms about the Indonesian bauxite situation, which according to Chalco increased cost of alumina by 4%, and reduced its 2012 production capacity in alumina by 1.7 million tonnes. The alumina division loss highlights a structural problem, which is the on-going reliance on Indonesian bauxite and its impact on Chalco’s alumina business in the future.

Besides alumina, the other problem is in the profitability of primary metal production. The aluminium segment profit was the biggest contributor to Chalco’s 2011 group profit, and it generates more than twice the profit than its alumina division. However, aluminium profitability sank in 2012 and delivered a significant loss to the group. In essence, Chalco needs a profitable aluminium division in order to secure profitability for the whole group.

What could have been a nice profit

We introduce three simple scenarios to demonstrate the structural problem in Chalco’s operation. The first scenario is where we model the income statement with 2011 common-size ratios and apply the real finance cost in 2012; comparing this to the same scenario with a model carrying a lower finance cost figure. The result is Chalco would have made a loss even with higher sales at its 2011 common-size ratio level, due to higher finance cost in 2012. The comparative case of using a lower finance cost figure shows a profit. These results tell an important story, which is Chalco’s 2011 operational level had too high a cost of sales figure; in another word, its costs were already structurally too high in 2011.

The second scenario uses a common-size ratio from a few years ago, which is 2% lower than the 2011 level. Now, we apply the real finance cost to the model and find a nice 2 billion RMB profit for the group. This is evident of the high structural cost that is the main obstacle to the group’s profitability. By lowering costs, the group can improve its position significantly.

The third scenario is when we eliminate the 6,600 Million RMB loss from the primary metal division and apply the real finance cost from 2012; we also eliminate the loss from the alumina division in the calculation. The result is a 961Mn profit for the group. Here we see the combined effect of increased alumina cost and metal production cost to be the primary contributor to the group’s loss.

The above analysis is consistent with the group’s own reports. The current Chalco primary aluminium price is around 15,000RMB/t, a 7% drop. According to Chalco, the metal price was a main force behind the group’s total loss position. Reversing the 7% decline gives a metal price of 16,130RMB/t, which is 5.84Mn RMB of loss per RMB/t decline in metal price. Here we need to re-emphases that an elimination of the 6,600MN RMB loss is not enough for the group to return to profit, because the group would still suffer from high structural costs. Thus, a lowering of cost and a lift in alumina performance are needed, and mere increase in metal price is not enough.

On a cash cost basis

It is possible to find out the extent of pressure that Chalco felt in 2012. Here, we employ AZ China’s cash cost curve model and taking into account the various smelters operated by Chalco in China. The result is consistent with the financial analysis from the group’s financial statements. 60% of Chalco’s capacities are underwater on a cash cost basis; these capacities suffer from structurally high energy costs and they are located in high cost regions. The capacities that are located deep in the North-West do not suffer from a cash loss position.

A simple strategy to remedy Chalco’s position would be to have lower costs. This can be achieved by a migration of the high cost smelters to low cost regions. However, this would require time and significant capital allocation. Meanwhile, Chalco’s plan for diversification to expand upstream businesses is a necessity to maintain the group’s competitiveness in alumina and bauxite. From a cyclical point of view, we also sense a threat from potential price sluggishness in the Chinese aluminium market due to overcapacity and weak demand, which would go on to impair the group’s profitability given its stubborn high costs.

The rating agencies have put Chalco on a negative watch, BBB-. This suggests a worsening of macro conditions would undermine the group’s ability to repay debt. However, there is still a reasonable argument that China can maintain reasonable macro economic growth, which would help Chalco to maintain sales volumes, so we do not expect the rating agencies to move further against Chalco too soon.

Nevertheless, Chalco’s risk is not just low metal price or sluggishness in the economy; it is rather the high structural costs in smelting, and a weaker position in alumina production.