“Economies of Scale” is one of the major parameters avoiding entry of new players into Steel Pipes & Tubes business. Economies of Scale is important in commodity business because of products with lower margins and no pricing power. But, in case of Pipes & Tubes segment, the scenario is slightly different. I’ll explain you the Economies of Scale advantage in Steel Pipes & Tubes segment directly as we analyse the companies and their costing, let’s us get started.

Have a look at the sheet below of Ratnamani Metals & Tubes Limited:

Other details i.e. Common Size Profit & Loss and detailed breakup of each expense heads i.e. Manufacturing, Admin, Selling and Finance costs are available in the excel sheet itself.

I have done this for all the companies, and now our job is to analyse each of the expense head carefully to understand how the costing differs companies to companies and products to product as well as across years (2011 to 2020). As explained, when companies go huge, their relative costs reduces. This reduction in cost is what we need to analyse to understand what advantages companies enjoy with higher economies of scale.

You will get all the data of profit & loss, expense breakup, common sizing, etc. all companies in this: Excel Sheet. Let us get into analysis part of the data & data crunching:

Firstly, the main problem in our segment is that there are only 7 companies (those company whose data can be reliably taken). And these companies cater to different product categories. Usually the analysis should have been done across companies in Large Caps, Mid-Caps & Small Caps to understand how costing differs with respect to size of companies. But in our case, due to limited number of companies and also companies catering to different product categories, it is difficult for us to derive a meaningful conclusion by comparing on basis of size.

Look at the companies above, and how they cater to different product categories (Production). Going by general nature of comparing company’s w.r.t. size, I have categorised companies on that basis also. Look at the snapshot of costing of different companies on basis of size:

1. Large v/s Mid v/s Small

Average of figures were taken from 2011 to 2020 for each companies so that comparison remains fair. Here, we have grouped these 7 companies into large, mid and small. After this, detailed cost analysis was performed to understand any meaningful data and conclusions.

However, unfortunately, there was no connect observed across categories. The figures did not derive any meaningful conclusions. The main reason of this could be majorly companies operating into different product categories. Let us look closely at the comparison across Large, Mid and Small companies within this segment of Steel Pipes & Tubes.

As you can observe, Material Cost across categories do not depict anything. Ideally, larger companies order huge quantities of Input Materials and are in position to ask for discounts leading to cost advantage. Similar interpretation goes for manufacturing cost. But, the trend gives no such indication.

We see here, employee cost as % of sale slowly increases as companies move from small to large categories. This is possible due to hiring a lot of staffs for sales & marketing across regions and geographies which is lesser for smaller companies.

Expenses like Legal Charges, Rent, Insurance, Auditors, Travelling, other expenses, etc. depends on companies to companies and they are not comparable across categories.

One important thing to observe in size comparison is that, as companies move from smaller to larger categories, the profit margin have fallen down. This is quite a negative point, but as I said companies are not comparable due to their operations across product categories. Hence, we leave the comparison of companies based on their size and move to comparison based on product categories.

• Product category comparisons: ERW v/s SAW v/s Seamless.

Here we can see from table below, companies are divided based on products categories viz. SAW, ERW & Seamless Pipes. Do keep in back of mind size of each companies. For easy understanding, companies first in the table are of larger size i.e. Apollo, Maharashtra Seamless and Welspun are largest companies in their respective segments. Size of companies are based on revenue they generate.

Now, the comparison is of apples to apples (i.e. Product Category wise). From a general overview, material cost as % of sales is highest for ERW segment when compared to SAW and Seamless Pipes. This also coincides with our logic that ERW segment is basic commodity type business and hence margins are less and number of players are also more. For SAW, there are only 4 players in the market focused to maintain minimum profitability. For seamless, limited number of players and complexity in producing it. Hence, margins for Seamless and SAW are on higher side when compared with ERW Pipes.

Few Quick other observations regarding costs (look at excel file for detailed breakup):

• Manufacturing cost is on higher side for seamless pipes segment, this also is logical as I have explained why making seamless pipes is not an easy task and require good high end machinery and expertise. Also, power as % of sale is on very higher side for seamless companies.

• SAW pipes are heavier and huge to transport. Hence, they are usually located near port or application market. For that reason, freight cost is highest for SAW Pipes as % of sales. For seamless & ERW pipes, they usually come in small sizes and hence can be transported easily when compared to SAW, leading to less cost of transportation for these companies.

• Expenses like Rent, Insurance, other expense, etc. are very company specific and hence depends on company to company. Also, they are very small cost as % of sales, to be ignored.

• More skilled employees are required in SAW companies. The reason might be handling of pipes and manual work requirement like welding, cleaning, support staff to assist pipe direction, etc. in these companies which cannot be automated with heavy pipes. Hence, Employee cost in SAW is highest followed by Seamless pipes and then ERW companies.

• Advertisement cost is higher in ERW segment. The main reason is, ERW is also sold to consumer segment, fabricators, etc. Hence, where there is consumer or retail involved, there is requirement of advertisement to influence consumers buying preference. SAW & Seamless are requirement of corporate companies and hence quality matters more and there is no brand consciousness for these corporate buyers.

• Depreciation as % of sale is lowest for ERW segment. Also justifies that many unorganized sectors are into ERW making where capital requirement on Fixed Asset is comparatively low then SAW and Seamless Pipes. Capital requirement is huge in SAW & Seamless Pipe production.

• Overall, margins for seamless pipes is highest followed by SAW Pipes. Seamless pipes requires special expertise to produce and command a higher price. Also, number of players in seamless pipes are very limited and these pipes are emerging as import substitute, due to recent positive developments. ERW has least margin maybe due to very competitive nature of business and also because companies are currently focused on expanding their revenues first, then concentrate on profitability.

Hence, above are just very basic difference across product categories. Seamless Pipes have emerged as the best product category followed by SAW Pipes and then ERW Pipes. I have few more observations for company specific cases indicating how the costing have moved over the years.

• APL Apollo Tubes

As you know, APL Apollo have the highest number of plants i.e. currently 10 plants which are spread across different regions. So, freight cost as % of sale should keep on getting lower over the years and the same is visible:

Freight cost have reduced from 3.64% to 2.65%. But, one thing I would like you to notice is that. APL Apollo has come up with famous DFT technology which claims to reduce input wastage, higher production efficiency and higher capacities (Source: AR). But, the same is not visible in numbers. Although the capacity utilizations have increased over the years, but material/ manufacture costing as % of sale have not given much difference over the years. However, due to various acquisition over the years along with rapid development, it might take time for the figures to reflect in costing. Therefore, this particular point should be checked in future to understand actual benefit out of this new DFT technology.

• Ratnamani Metal

Management of Ratnamani has indicated in their annual reports that they work on 100% green energy and captive energy generated from roof top solar panels and windmill capacities. Hence, because of this reason, the power & fuel cost as % of sales is firstly lowest when compared to any seamless company and it is lowest by huge gap i.e. approx. 7%. This is major reason why Ratnamani have been consistently generating higher profit margins when compared to peers. As companies get bigger, they employ their own green captive power plants leading to high cost savings and that gives a huge boost on margins. Obviously, to set up these green energy, Capital Investment is definitely needed but they are usually a one-time expense. Not only that, these windmills have been generating revenue for company over the years as seen from their annual reports.

• Gandhi Special Tubes

Gandhi Special tubes sell its product to majorly OEM companies. Hence, for OEM, the cost of pipe as % of their sales is firstly very less. Second, they do not understand the pricing of Pipes industry. Hence, this is very major benefit for Gandhi Special Tubes where it is constantly able to lock in higher sales and leading to very high profit margins. Look at the snapshot here:

Hence, as mentioned earlier that generally economies of scale means that companies are able to reduce their cost as % of sales over time when they get huge. Here in case of Steel Pipes & Tubes the source of higher profit and lower cost is completely different.

We have understood costing advantage for few companies. To state ‘cost factor has been unique with different companies’. For some, freight cost saving is major factor, materials cost being lower for some, power cost & manufacturing cost being lower for some other, etc. Hence, there is no such rule here that bigger companies are enjoying economies of scale. Actually, the sector of Steel Pipes & Tubes is so small overall that companies have still not able to gain advantage of higher economies of scale. Total 7 companies combined revenue for the year 2020 totals to only Rs. 30,219/- Cr. Hence, the industry itself is very small and so economies of scale have still not been fully realised by even major companies within the segment.

For this reason, I think that cost advantages are specific to companies themselves. But as the opportunity size widens and companies grow, we might see the following changes happening overall for costing advantage:

1. Efforts to consistently reduce Freight Cost as they form major cost as % of the sales. (2%-8%)
2. Efforts to reduce power & fuel cost or manufacturing cost by implementing power reducing procedures like installation of LED lights, use of natural gas, use of captive green power, etc.
3. Efforts to reduce costing in relation to materials by better techniques to acquire materials and usage of high technology machinery which reduces wastage and gives higher output.
4. Efforts directed towards serving niche market and VAP category. This leads to higher realization per ton and better EBITDA margins per ton, and will be reflected in way of lower costs.

The main purpose to conduct cost analysis was to understand how larger companies are reaping advantages of economies of scale. But we did not see larger companies having significant costing advantage. What we saw was instead, more important. Firstly, the industry itself is very small and companies are expanding itself to serve more niche products, VAP category and producing high end products with possible import substitute and opening up new doors of exports. Hence, as of now companies are focused on expansion to newer markets by producing VAP for niche markets which bring higher revenue and margin and leads to lower costs as % of sales. However, there are few companies like APL Apollo, Ratnamani which enjoys costing advantage due to control on basic costs like freight & power. Also, serving to User Industry where margins are higher like OEM & Exports, making VAP Products, serving critical equipment have been focus of companies to improve profitability.

Hence: “Economies of Scale in Steel Pipes & Tubes Industry is enjoyed not by costing advantage, but capability of companies to make Value Added Product and serve to Niche Markets.”

What happens when companies sell to niche market, produce Value Added Produce, serve to user industry where there are huge margins, etc.? Companies are able to get better sale price per ton with almost similar costing of basic product, this leads to higher profit in form of EBITDA per ton. All of these have been explained above.

But, let us think on plain basis i.e. all companies cater to only one standard product with one standard price and costing. In such scenarios, how can one company become more profitable over other? Here, we touch on concept of Marginal cost of each product sold, which is the main aspect of operating leverage (and part of economies of scale).

Costs are bifurcated into Variable Costs, Semi-Variable Costs and Fixed Costs. Variable costs are cost which depends on number of products produced. As production volume rises, variable costs also rises proportionately. Fixed Costs are just opposite and does not rely on number of units products. Either thousand unit production or a lakh unit production, the fixed cost is fixed at certain amount irrespective of volume production. Semi-Variable are costs somewhat having mix of fixed and variable. So, as production rises, these costs rise but at slower pace.

Hence, when production goes higher, fixed costs per unit reduces due to higher units, and this reduces costing overall leading to higher profits. This is major aspect of costing due to which companies want to sell more. For few industries, fixed cost forms major cost, and as the volume production & sales rises, fixed cost per unit keeps reducing. Hence, for industries for which major part of costing is fixed, achieving higher sales will make their costing significantly lower. This is actually the trend which we wanted to observe at the start of this blog. Now, let us try to analyse the same in steel pipes & tubes segment.

Look at the common size costing back again. What are the major costs? Major costs above net profit are Material Cost, Manufacturing Cost, Employee Cost, interest cost, depreciation and Freight Cost. Simply, Material Cost are variable cost. The more you produce, the more is requirement of raw materials.

Let me give you a simple tabular format explaining nature of costing along with reasoning:

No.	Costing Head	Nature	Reasoning	EOS advantage achieved?
1	Material Cost	Variable	More R.M. requirement for higher production. Also R.M. cost depends on market determined prices.	No. Costing moves along with production.
2	Manufacturing Cost	Semi-Variable	Power & Fuel cost as % of sales reduces over time as scale increases.	Yes, few expenses reduces even if production rises.
3	Employee Cost	Variable	Bigger companies have higher % of employee expense with sales.	No. More employee costs incurred for managing huge business.
4	Freight Cost	Semi-Variable	As scale increases, factories set up near advantage location reducing overall freight cot as % of sale.	Yes, freight costs reduces over time.
5	Depreciation	Fixed	Fixed, and reduces as % of sale as companies scale up.	Yes.
6	Finance Cost	Fixed	Actually reduces with higher economies of scale. This is because companies generate cash and repaying loan reduces interest.	Yes.

So, we see EOS (Economies of Scale) advantage being achieved for smaller costs. You might again refer excel sheet and be able to understand completely how the cost have moved over time.

Hence folks, I have tried to explain you how higher economies of scale Gives Company with better costing advantage, which in turn leads to low cost seller, and in turn improves the profitability of company. This is the reason why commodity business emphasis on more sale volume to turn profitable.

Thank You!

 

Disclaimer: Views are personal and presented through independent research. By no means there is any stock advice. Also, presented content is for learning purpose only. I might be wrong in presenting data and inaccurate data, let me know if you find any discrepancies.