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Dear shareholders:
On behalf of the Board of Directors of Industrias Peñoles, I am pleased to report our results for the year ended December 31, 2005. Exceptional operating performance combined with high metal prices pushed sales, gross profit, EBITDA, and operating and net profits to their highest levels in the company’s history.
This performance underscores the strength of Peñoles’s business strategy: our vertically integrated operations, ongoing investment in capacity expansions, operating efficiencies and exploration activity—even in low metal price environments. By investing in tomorrow’s growth, irrespective of economic or industry cycles, we establish a solid foundation for the future.
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MARKET CONDITIONS
Global economic expansion in 2005 reflected the continued dynamism of industrial development in China and India, solid U.S. economic gains, and growth in most major emerging and industrialized markets. Although escalating energy and commodity prices somewhat slowed the overall pace of growth from the previous year, strong industrial demand and lower inventories, as well as geopolitical instability and hurricane-related issues in the U.S. Gulf Coast region, drove metal prices to near 20-year highs.
The year 2005 was marked by challenges and opportunities for the mining and metals industry. Several companies could not profitably manage their operations given significantly higher production costs; shortages of mining equipment delayed some expansions and new operations from coming on line; scarcity of concentrates led to greater competition among smelters for materials to be treated; and labor issues plagued a number of companies. On the upside, however, unparallel industrial and institutional investor demand created an exceptionally favorable environment for the mining and metallurgical sectors.
The average price of silver in 2005 was US$7.32 per ounce, a 9.6% increase over 2004, while gold averaged US$444.9 per ounce, an 8.7% increase. A decline in zinc inventories helped push prices up by 31.9% to US$0.6268 per pound, while demand for lead increased prices by 10.1% to US$0.4429 per pound.
Higher metal prices had a favorable impact not only on mining companies, but also on smelters and refiners, whose treatment, refinery and delivery charges are partially based on a price participation scale. Thus, both our mining and metals operations recorded higher revenues from the rise in metal prices.
The average peso exchange rate decreased against the dollar by 3.5% in the year, which impacted sales in peso terms, as approximately 95.0% of Peñoles’s sales are dollar-denominated or linked. Higher unit costs for most inputs drove up cash costs across the industry worldwide, while the appreciation of the peso compounded that effect for Peñoles. Metallurgical coke prices rose 55.5%, fuel oil 49.6% and natural gas 31.7%, all in dollar terms.
In electricity, however, we benefited from the first full year of operations at Termoeléctrica Peñoles (TEP), the 230-megawatt power plant providing a secure supply of electric energy to our operations. The cost of electric energy supplied by TEP was 23.1% lower than the rate we would have obtained from the state-run utility Comisión Federal de Electricidad (CFE), representing US$27.6 million in savings.
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OPERATING HIGHLIGHTS |
Exploration and New Projects
Investments to identify new ore deposits and expand reserves in regions near existing mines increased 53.0% over 2004, to US$48.5 million. These funds were directed at an extensive portfolio of exploration projects and prospects in Mexico and Latin America. Activities in the year included:
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At El Saucito, near the Fresnillo district in Zacatecas, the first phase of exploration identified geological resources of more than 1.0 million equivalent gold ounces.
Direct exploration activities in the year included initial construction of a 300-meter shaft and a 2,240-meter-long ramp.
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At La Virgen, in the La Ciénega mining district in Durango, extensive exploration continued along known veins. Indicated ore grade is 9.0 grams of gold per ton, with 990,000 tons of indicated reserves.
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At Pecobre, our CODELCO joint venture project in the Sonora copper belt, diamond drilling has inferred 1,000 million tons of 0.3% copper equivalent, and 400 million tons of 0.4% zinc. Additional exploration work will continue to determine the viability of this project.
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At the Francisco I. Madero zinc mine in Zacatecas, diamond drilling indicated additional mineral resources of 9.8 million tons, while proven and probable reserves increased 26.0% to 27.5 million tons, with an average ore grade of 3.3% of zinc.
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In order to efficiently access and process potential mineral resources controlled by Peñoles at land adjacent to Grupo Mexico’s idle Velardeña mine in Durango, we purchased the assets of this facility from them. The infrastructure will facilitate exploration at our nearby mining prospect.
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We established strategic alliances with two junior companies to explore specific prospects of interest, in Zacatecas with MAG Silver, and in Durango with Endeavour Silver.
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Preliminary drilling has indicated important mineral structures at a number of gold/silver projects and prospects in the states of Durango and Chihuahua. Ongoing exploration activities to identify the mineral bodies and quantify resources will continue in 2006.
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In Peru, we continue to explore at our Capac Orco gold project, and may form an association with a local partner in order to advance the development of the site. We also continue to explore several copper prospects in the country.
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In March, we sold the Mezcala gold project in Guerrero to Goldcorp in a US$70- million transaction. Peñoles believed that the potential growth of Mezcala, a joint venture with Newmont Gold, was limited by its location between two ore deposits already owned by the acquirer.
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In February 2006, Agnico Eagle confirmed its US$65-million acquisition of the Pinos Altos gold project in Chihuahua, after a period in which it had been granted exploration rights. The identified volumes at this site did not meet the minimum expected mine size in accordance with our investment criteria.
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Construction was 95.4% complete at the Milpillas copper project in Sonora by year-end 2005, and equipment testing commenced. The cumulative investment at year-end 2005 was US$201.8 million, of an estimated US$217.8-million total investment. Copper cathode production is scheduled to start up by the second quarter of 2006, with a targeted annual average output of 55,000 tons of refined metal.
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Mining Operations
Overall metal contents produced in Peñoles’s mines increased in 2005, reflecting the benefit of the first full year of expanded capacity at Fresnillo and Sabinas, and nine months of additional capacity at La Ciénega, following a combined investment of US$47.7 million.
Silver production rose from 44.4 million ounces in 2004 to 47.4 million (+6.7%) in 2005; gold production rose from 337,850 ounces to a record 376,090 (+11.3%); zinc production rose from 209,200 to 211,690 tons (+1.2%); and lead production rose from 54,200 to 61,960 tons (+14.3%). Peñoles continues to be the top producer of silver, gold, zinc and lead in Mexico. The following developments contributed to these results:
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In order to efficiently extract lowergrade material at Fresnillo, milling capacity at this Zacatecas-based mine increased by 33.5%, reflecting the previous year’s expansion. Silver production rose to a record 33.9 million ounces, a 7.3% increase, while zinc contents production also rose as a result of continued operation of the tailings plant.
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The expansion at the La Ciénega mine was completed in March, increasing milling capacity by 31.3 per cent. A new SAG mill and flotation and filtration areas were installed, and the construction of a second tailings plant was initiated. The mine produced a record 212,233 equivalent ounces of gold.
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In April, construction of the fourth stage of the leaching pad at La Herradura was completed over an 18-hectare area, helping boost gold contents production at this open-pit mine in Sonora to a record 183,690 ounces. The fifth stage of the leaching pad construction is currently underway, scheduled to start up in April 2006, which will enable us to produce an annual average of 200,000 ounces by late 2006. In addition, stripping was begun to prepare for future mine expansion.
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The first full year of expanded capacity at the Sabinas polymetallic mine in Zacatecas was reflected in a 15.4% year over year increase in milled ore. Lead contents production rose by 18.1% to 4,940 tons; silver production increased by 12.5% to 3.8 million ounces; and zinc production totaled 32,245 tons, up 6.2 per cent.
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Higher ore grades at Francisco I. Madero boosted silver and lead production by 24.8% and 103.0% respectively, while zinc production remained unchanged.
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We implemented a more aggressive exploration plan at Naica to increase production and reserves within the next two years. In 2005, lower ore grades and reduced exploitation areas caused a decline in silver, lead and zinc contents production at this mine, which has been in operation for more than 50 years.
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Exploration efforts at all of our mines increased or replaced mineral resources on a comparable basis.
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Smelting and Refining Operations
As an integrated company, a large percentage of the raw material received by our Met-Mex metallurgical complex in Torreón, Coahuila is sourced from Peñoles’s own mines. During the year, 39.5% of lead concentrates and 59.0% of zinc concentrates originated from our mines, with the remainder purchased from third parties.
As a result of past upgrades in equipment and processes, Met-Mex increased its ability in 2005 to eliminate impurities, allowing it to treat complex and lower quality concentrates. With intense global competition and scarcity of materials, this was an additional competitive advantage that enabled us to refine metals from a wide variety of inputs.
Therefore:
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Refined silver production grew from 80.5 to a record 91.3 million ounces (+13.5%) in 2005, of which 47.5% was attributable to Peñoles’s own concentrates.
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Refined gold production in 2005 rose to a record 1,128,720 ounces from 756,080 in the year prior (+49.3%). Production reflected higher volumes sourced from our mines (31.3% of total), as well as higher intakes of third-party concentrates and materials rich in precious metal content at the lead silver smelter and lead-precious metals refinery (68.7% of total).
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Refined zinc production reached a new record of 232,465 tons. Of the year’s production, 59.0% was attributable to Peñoles’s concentrates. By the fourth quarter of 2005, this plant was running at a capacity of 255,000 tons per year.
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Higher inputs of concentrates at the lead-silver smelter boosted refined lead production from 131,620 to 142,525 tons (+8.3%) in 2005. Peñoles’s own concentrates accounted for 45.6% of total refined lead production.
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Process improvements and energy savings initiatives led to an 8.0% reduction in natural gas consumption at the lead-precious metals refinery.
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Chemical Operations
The four main inorganic chemical product families produced by Peñoles are closely linked to both the mining and metals operations, by making beneficial use of their byproducts and processes. In 2005:
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Production of magnesium oxide rose 17.0% to 85,795 tons, reflecting greater anticipated demand and operating continuity in specialties such as refractory, caustic and electrofused. Sales of magnesium sulfate rose 17.9% to 31,050 tons as a result of higher market demand.
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We implemented a number of projects to counter the rising cost of energy, a primary cost component of production. In the sodium sulfate plant, we automated certain processes to reduce electric energy consumption by 4.5 per cent. At the magnesium oxide plant, we substituted expensive fuel oil and natural gas with other materials such as pet coke, saving 46.0% with respect to fuel oil costs and 56.0% compared to natural gas costs in the dolomite calcination area, and 8.0% in terms of overall energy consumption.
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FINANCIAL
HIGHLIGHTS
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Net sales, excluding hedging results, rose 23.9% in 2005 to $21,444.5 million (US$1.9 billion), fueled by record volumes and strong metal prices.
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Total production costs increased 8.7% as a result of higher costs for operating materials such as explosives and steel used in drilling and milling, as well as for preventive maintenance to extend the life of equipment. Furthermore, average metallurgical coke, fuel oil and natural gas costs increased by 55.5%, 49.6% and 31.7% respectively, all key energy sources used in our processes.
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However, cost of sales rose 25.4% as a result of the aforementioned increase in cost of production, as well as higher volumes of metal purchased from third parties at higher prices. This latter variable accounted for the majority of the increase in cost of sales.
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EBITDA rose to $3,807.9 million, from $3,120.7 million in the year-ago period. The 22.0% increase was somewhat higher than the 21.2% gross profit growth, after higher exploration expenses (+41.8%).
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Operating profit increased 37.0% year over year, from $1,916.2 million in 2004 to $2,624.6 million in 2005.
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The company registered extraordinary income of $442.3 million, primarily derived from the sale of the Mezcala asset.
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Net profit in the year totaled $1,693.0 million, a 57.2% increase over 2004.
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Peñoles’s market capitalization at year-end 2005 totaled $23,447.1 million (US$2.2 billion). The market value of the company has increased by 807.5% since the end of 2000.
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HUMAN RESOURCES
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Headcount in 2005 increased from 6,842 to 7,060, primarily to staff the Milpillas project as it approaches the start-up of mining operations.
Negotiations with labor unions have been especially and abnormally difficult.
As a result of a thorough restructuring process of the company, we rotated a number of our executives in an effort to develop their skills and prepare the successors that the company will need in the future.
We take safety seriously, as risk of accidents is inherent to our industry. The responsibility to protect the well-being and physical safety of our employees is a corporate priority. In 2006, we will continue to work with our employees to ensure they have the best training, supervision and equipment at our mines and plants.
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OUTLOOK 2006
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We believe that demand for both base and precious metals will remain strong in 2006, with little change forecast in market fundamentals. Industrial growth in markets such as China and India will continue to drive base metal consumption, while precious metal prices will likely remain high, reflecting imbalances in the global economy, orderly central bank sales of gold and the perception of their being a safe haven investment.
As the world’s largest silver producer and Latin America’s leading producer of refined gold and lead, we will continue to benefit from these macroeconomic factors. In addition, we will continue to leverage our competitive edge by investing in strategic growth.
For 2006, we have budgeted US$53.5 million to explore new ore deposits and expand reserves at existing mines; US$33.3 million to complete mine development at Milpillas; and US$246.8 million in other property, plant and equipment expenditures. Our most important challenge will be to hold down production costs and strengthen our margins in an environment of prolonged high energy and raw material prices. To do so, we will continue to leverage the efficiency gains obtained this year, while implementing new process improvements throughout the company with the intensive use of technology.
Dear Shareholders: Our outstanding results this year were strongly influenced by the favorable behavior of metal prices. The strategy we have pursued during the past years has helped us capitalize on the upside momentum of these prices. Nevertheless, I must recognize the talent, dedication and efforts of our personnel, the active participation of the Board of Directors and Executive Committee, as well as the confidence that you have placed in us. These factors have enabled Peñoles to operate efficiently and achieve record levels of production and profits, for which we thank you. These achievements contributed to the enrichment of our cherished Mexico.
Alberto Baillères
Chairman of the Board of Directors
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