MANAGEMENT DISCUSSION AND ANALYSIS

This management discussion and analysis of the results of Industrias Peñoles, S.A.B. de C.V. and Subsidiaries (“Peñoles” or “the Company”) in fiscal year 2020 is based on the financial statements prepared according to the International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). In accordance with IAS 21, the functional currency must be identified for each one of the consolidated entities based on the currency in the principal economic environment in which the entity operates. For all subsidiaries, with exception of certain non-operating companies and certain companies that provide services, the functional currency is the U.S. dollar.

The Company changed its reporting currency to US dollars (functional currency) starting from January 1st, 2019. The present analysis of the consolidated financial results is made accordingly, and financial results obtained in 2020 are compared with those of 2019 in millions of US dollars, unless otherwise indicated. The term "US$" refers to dollars of the United States of America.

It is recommended that this section be read in conjunction with the consolidated financial statements and their accompanying notes.

Peñoles is a publicly trading company whose shares have been listed on the Mexican Stock Exchange (BMV) since 1968 under the ticker symbol: PE&OLES.

Peñoles operates principally in the following sectors:

  • Exploration
  • Mining
  • Metals (smelting and refining)
  • Inorganic chemicals

Prices and macroeconomic variables

The main variables that had a bearing on Peñoles’ results were:

  1. Metal prices: in dollar terms, average prices showed a mixed behavior compared to the previous year: precious metals had favorable variations: gold (+27.1%) and silver (+27.7%). As to industrial metals zinc and lead declined (-11.2%) and (-8.7%), respectively, while copper’s avegare was higher (+2.7%).
  2. Treatment charges: base treatment charges increased, on average, 48.8% for lead concentrates and 5.3% for zinc concentrates.
  3. Exchange rate (peso-dollar):
    2020 2019 % chg.
    Close 19.9487 18.8452 5.9
    Average 21.4886 19.2616 11.6
  4. Consumer Inflation rate (%):
    2020 2019
    Annual 3.15 2.83

Consolidated results

In 2020 the COVID-19 outbreak spread rapidly around the world. Countries took various measures to protect the population from contagion, and the confinement put a brake on consumption and industrial activity, especially during the first half of the year. The uncertainty generated around the evolution of the pandemic caused great volatility in financial markets and a sharp drop in metal prices in the first half of the year. In the case of base metals, only copper recovered due to better fundamentals, while gold and silver, as safe haven, increased significantly. The final impacts of the pandemic are still uncertain.

The Mexican government restricted on certain economic activities considered non-essential as of March 30. At the end of May, mining was included as an essential activity, requesting certain sanitary requirements and protocols that the Company fully complied with for the safe and staggered return to work. In this context, Peñoles took a series of measures to safeguard the health of its employees, contractors and nearby communities, in addition to taking care of liquidity by reducing costs, expenses and investments to those strictly essential for the maintenance of operations and the execution of approved projects.

This affected the Company's operating rhythm, and as a result, production and sales volumes were lower than expected. Gold was the most affected, due to the extension of the operating restrictions for open-pit mines. The Company's revenues fell in the first half of the year and recovered during the rest of the period, favored by the rebound in gold and silver prices. In this way, the lower volumes sold and the effect of the contraction in zinc and lead prices were offset, so that annual revenues exceeded those of the previous year. Hedging transactions on metals prices and exchange rate—which are intended to reduce volatility in EBITDA—reported an opportunity cost higher than that recorded in 2019.

The Company decided to suspend the operations of Madero (zinc) and Milpillas (cathode copper producer) mining units because the sharp drop in base metal prices made them unprofitable for the moment. Milpillas stopped mining extraction and continued producing cathodes from previously deposited copper ore that was being leached in patios. Also, as planned, operations were stopped at Bismark, a zinc mine, and the unit shutdown process began due to the depletion of its mineral reserves.

The cost of sales was lower than the previous year, due to the measures applied to reduce costs, the higher average exchange rate that decreases the value in US dollars of the portion of costs incurred in pesos (approximately 50% of the production costs), the suspension of operations in the aforementioned mines and lower consumption, in addition to a credit derived from the recognition of gold inventories in the Herradura leaching patios. Operating expenses were also lower, due to the slower pace of exploration activities, lower sales and the savings measures implemented.

Peñoles and its subsidiary Fresnillo plc took advantage of the favorable market conditions and solid credit profile to issue bonds and restructure its long-term debt, therefore financial expenses increased due to the costs incurred in these transactions. Likewise, there was a higher charge for impairment of assets, at the Madero and Milpillas mining units mainly derived from the suspension of operations, as well as in the Fuerza Eólica del Istmo plant.

On the other hand, the Company made a voluntary correction to the tax treatment of the mining work carried out from 2013 to 2019, which implied a higher provision for income taxes in the period, in addition to an increase in deferred taxes due to the devaluation of the peso against the dollar.

Due to the aforementioned factors, the financial results for the year 2020 and their variations with respect to 2019 were as follows: net sales US$ 4,673.3 (+ 4.5%), gross profit US$ 1,249.0 (+ 43.4%), EBITDA US$ 1,456.7 (+ 50.4%), operating income –not including other expenses and income nor impairment loss – US$ 742.6 (+ 170.0%) and net loss of the controlling interest -US$ 34.4, unfavorable compared to the net income of US$ 35.5 obtained in 2019.

Income statement

The following rainbow chart shows the variation by item of results and its influence on the change in net income from 2019 to 2020 (in millions of dollars):



(1) Other expenses include impairment losses.
(2) Cost of Metal is net of Revenue from Treatment Charges, Income on inventories and other items.
(3) Financial expenses include Exchange result.

The variations are discussed below:

Net sales amounted to US$ 4,673.3, of which 86.5% were exports. The variation of +US$ 201.4 (4.5%) compared to 2019 sales is explained as follows:

  • Due to higher average prices of gold, silver and in the realization prices in the sale of concentrates +US$ 658.0.
  • Lower volumes sold, especially gold, concentrates and copper, in -US$ 426.6.
  • Income from other products and services +US$ 1.9.
  • The foregoing, accompanied by a variation in metal hedging operations, at -US$ 31.9.

The cost of sales of US$ 3,424.3, had a variation of -US$ 176.8 (-4.9%) for the reasons described below:

  • Lower production costs in -US$ 115.6 (-4.4%), mainly in the following concepts:
    • Energy (-US$ 41.0, -9.9%) due to lower consumption of diesel, natural gas and metallurgical coke that offset the increase in the cost of electricity.
    • Contractors (-US$ 36.0, -8.0%) due to less work by external contractors in the development of mining and civil works.
    • Maintenance and repairs (-US$ 30.7, -9.0%) in maintenance and mechanical and electrical repairs, in major repairs and guaranteed maintenance cost, due to the fact that the previous year higher costs were incurred to stabilize the new plant that increased the refined zinc production capacity.
    • Operating materials (-US$ 28.3, -7.6%) lower in explosives and detonators, iron, steel, anchors, construction materials and reagents.
    • Raw materials (-US$ 2.6, -7.7%) due to lower cost of ammonia and magnesium oxide.
    • Depreciation and amortization (+US$ 19.0, + 2.8%) derived from the investments made in the Fresnillo plc mines and the start-up of the Capela mining unit.
  • A credit of -US$ 114.3 from inventory changes, mainly derived from the recognition of gold inventories at Herradura leaching patios, this is, a favorable variation of -US$ 135.1 compared to a charge to the cost of +US$ 20.7 in 2019.
  • Higher cost of the metal sold (+US$ 73.9) whose variation is derived from the following concepts:
    • Lower volume of concentrates and other materials purchased to third parties for the metallurgical business, which decreased the Cost of Metal (-US$ 12.3).
    • However, the above was offset by the higher consumption of inventory from third-party materials in the metallurgical business, as well as by the higher prices of gold and silver (+US$ 114.6).
    • As a consequence of the lower volumes purchased from third parties in the period, revenues from treatment charges, which are recorded as a credit to the cost of metal, were lower (by US$ 56.4).
    • Other items were favorable (in -US$ 74.8) due to a credit from recovery of high-grade lead-silver waste as the Silver II Recovery process came into operation, lower expense in the import of concentrates and higher recoveries in the metallurgical business.

Higher revenues and lower costs favored the gross profit, which registered an increase of +US$ 378.1, (+ 43.4%) compared to the figure obtained in 2019. The gross profit margin on net sales was 26.7%, favorable compared to the 19.5% of the previous year.

Operating expenses (not including other expenses and income) totaled US$ 506.4, a figure 15.0% lower (-US$ 89.4), as a result of:

  • A reduction in exploration and geological expenses (-US$ 67.1, -32.2%), because we reduced field work due to the pandemic, especially in contractor drilling, rights and tests.
  • Lower administrative and general expenses (-US$ 16.1, -6.1%), in travel, staff benefits, fees and office expenses, partially offset by higher expenses in communication and technology due to the provision of infrastructure for home office and the improvement of communications inside the mines.
  • Lower selling expenses (-US$ 6.2, -5.1%) in freight and transfers.

EBITDA for the year amounted to US$ 1,456.7, favorable at +US$ 488.0 (+ 50.4%); EBITDA margin on net sales of 31.2% was above 21.7% in 2019. Similarly, the operating profit of US$ 742.6 increased by + US$ 467.5 (+ 170.0%) with which the operating margin on net sales improved from 6.1% to 15.9%.

There were impairment losses on long-lived assets totaling -US$ 166.4 mainly at the Milpillas and Madero mining units, derived from the suspension of their operations due to the sharp fall in prices of industrial metals, in addition to the company Fuerza Eólica del Istmo due to the increase in electricity generation costs. These losses were +US$ 99.8 higher than those of the previous year by -US$ 66.6 in the Madero, Milpillas and Bismark units. In the latter, assets are totally impaired.

The item of other income (expense), net (excluding losses from impairment of long-lived assets) of -US$ 14.7 was lower compared to -US$ 19.8 of the previous year, derived from:

  • Higher income in +US$ 17.1 due to reversal of non-capitalized remediation expenses in closed units, profit from the sale of concentrates and higher income from leasing.
  • Higher expenses in +US$ 12.0, especially those corresponding to impairment of operating materials in the mining units whose operations were suspended, in addition to a loss in the sale of materials and waste, which were partially offset by lower maintenance expenses of the closed mining units and remediation expenses, in addition to the fact that in 2019 there was a loss in the sale of concentrates.

Net financial income (expenses) amounted to -US$ 283.8, an increase of US$ 175.5 compared to -US$ 108.2 in 2019, and is made up of:

  • Financial income of US$ 25.2, slightly lower than US$ 27.7, due to lower interest earned on investments, partially offsetting higher interest collection from clients.
  • Financial expenses of -US$ 259.8, higher than -US$ 138.6 registered in 2019, due to a higher interest provision arising from the increase in financial debt, since the Company and its subsidiary Fresnillo plc issued long-term international bonds for a total of US$ 1,450. Industrias Peñoles issued US$ 600, and US$ 300 of the proceeds were used to pay in advance a syndicated loan that expired in 2024. Likewise, the interest rate coverage on said loan was closed, which had a financial cost of US$ 25.1, which will be paid according to the original maturities of the amortized loan. Fresnillo plc, for its part, issued new bonds for US$ 850 and repurchased US$ 482 of the US$ 800 bonds due in 2023, which implied a financial cost of US$ 60.8.
    There was also a financial expense of US$ 29.4 derived from the update and surcharges for the voluntary adjustment to the tax treatment of mining works, which compares unfavorably with US$ 9.0 from the previous year.
  • Exchange loss of -US$ 49.2, unfavorable compared to the profit of US$ 0.7 in 2019, due to the effect of the depreciation of the peso against the dollar on monetary assets and liabilities in pesos.

In the interest in the results of associated companies, a loss of -US$ 3.3 was recorded, higher than the one obtained the previous year of -US$ 1.1.

With the above, income before taxes amounted to US$ 274.4, an increase of + US$ 195.2 compared to US$ 79.2 of the previous year.

The provision for income taxes of US$ 184.8 was higher by US$ 217.9 compared to the provision in favor of -US$ 33.1 in 2019, which is attributed to the following factors:

  • Higher Income Tax caused (US$ 255.0 vs US$ 206.1), derived from the higher taxable base of the period, the effect of the exchange rate on the tax values of assets and liabilities, in addition to non-recoverable tax losses due to the suspension of operations of the Madero and Milpillas mining units. Likewise, the Company made a voluntary adjustment to the tax treatment of mining investments made in fiscal years 2013 to 2019 for all its underground mining operations, which involved the payment of US$ 80.4, of which US$ 49.7 correspond to a reclassification of the deferred tax liability and the recognition of credit balances from the Income Tax and the remaining US$ 30.7 corresponded to updating and surcharges recognized in financial expenses and penalties recorded in other expenses.
  • The foregoing was partially offset by a provision for deferred taxes for the creation and reversal of temporary differences of -US$ 113.0, lower compared to -US$ 206.9 in the previous year.
  • Higher provision for special mining rights, net of its corresponding deferred tax (US$ 44.3 compared to -US$ 20.4 from the previous year).
  • Lower credit for the benefit of the Special Tax on Production and Services (IEPS) on diesel consumed by operations, of -US$ 1.5 compared to -US$ 11.9 in 2019.

Due to the aforementioned factors, the consolidated net profit for fiscal year 2020 was US$ 89.6, lower by -US$ 22.8 (-20.3%), of which -US$ 34.4 correspond to a loss of the controlling interest (unfavorable in comparison to the income of US$ 35.5 in 2019) and US$ 124.0 to income of non-controlling interests (higher compared to the income of US$ 76.9 in fiscal year 2019).

Cash flow statement

As of December 31, 2020, the Company had cash and cash equivalents for US$ 1,592.7, representing an increase in cash of +US$ 1,066.4 compared to the balance at the end of 2019 of US$ 526.3 (including -US$ 0.6 from conversion effects).

The most relevant concepts of the period were as follows:

  1. Net cash flows from operating activities of +US$ 1,113.1. This heading is made up of items directly related to the operations, excluding items with no impact on cash, such as depreciation and amortization, income tax provisions, impairments and unrealized interest. It also includes changes in working capital, among which the investment made in inventories stands out.
  2. Net cash flows from investing activities of -US$ 553.1 in the following concepts:
    • Purchase of property, plant and equipment, for -US$ 561.3, in the maintenance of operating units and in projects under development. The main investments are detailed below.
    • Interest collected +US$ 10.1.
    • Proceeds from the sale of property, plant and equipment +US$ 3.4.
    • Capital contribution in associated companies -US$ 4.7.
    • Collection of loans granted and other items -US$ 0.6.
  3. Net cash flows from financing activities of +US$ 507.1, from:
    • Loans granted and repayed (net of transaction costs) +US$ 663.1.
    • Loans from partners in non-controlling investment +US$ 63.7.
    • Interest paid on financial debt -US$ 104.0.
    • Payment of premium for repurchase of Fresnillo plc bonds -US$ 60.8.
    • Dividends paid to the non-controlling interest -US$ 33.8.
    • Lease payment and other items -US$ 21.2.
Company/
Unit
US$ M Application
Fresnillo plc 401.4
  • Juanicipio Project
  • Tailings flotation plant at Fresnillo (Pyrites Project II)
  • Adjustments in Fresnillo mine
  • Mine works
  • Capitalizable mining equipment
  • Tailings deposits
Met-Mex 50.8
  • Silver Recovery II
  • Comprehensive water management
  • Fixed asset replacements
Capela 45.1
  • Mining works, fixed assets and infrastructure
Química del Rey 16.4
  • Replacement of critical equipment
  • Replacements in Plants A and B of sodium sulfate
  • Gypsum deposit
Tizapa 14.1
  • Mine works
  • Diesel equipment for mine
Velardeña 8.3
  • Mine works
  • Machinery and equipment
Sabinas 7.9
  • Mine works
  • Purchase and rehabilitation of in mine equipment
  • Reinforcement of tailings deposits
CONTENTS

2020 brought us great challenges and lessons. Our Annual Report highlights the strengths that have allowed us to overcome difficulties while generating value to our stakeholders.

The following abbreviations will be used throughout the report:

oz =
lb =
Mm3 =
Ml =
Mlb =
Mlbe =
Moz =
koz =
t =
Mt =
kt =
MI =
US$B =
US$M =
US$/t =
US$/oz =
US¢/lb =
US¢/lbe =
ounces
pounds
million cubic meters
million liters
million pounds
million pounds equivalent
million ounces
thousand ounces
metric tons
million metric tons
thousand metric tons
million liters
billion dollars
million dollars
dollars per metric ton
dollars per ounce
dollar cents per pound
dollar cents per pound equivalent

PROFILE
We are a proud Mexican company, committed to our country, with presence in the international market.

FINANCIAL HIGHLIGHTS
In a complex environment, we focused on preserving liquidity, while continuing our priority investments.

MANAGEMENT REPORTS
We manage our business responsibly and prudently, with a long-term vision.

PERFORMANCE
Our operations faced great challenges during the year. We improved our processes and sought cost reduction.

ENERGY AND TECHNOLOGY
We incorporated new technologies to increase productivity and efficiency.

CORPORATE GOVERNANCE
Our corporate governance ensures transparency, the compliance with organizational values and accountability.

INFORMATION FOR SHAREHOLDERS
Contacts available for our shareholders

FINANCIAL STATEMENTS
We present our audited financial information in thousand US dollars.



DISCLAIMER
This Annual Report contains certain forward-looking information relating to Industrias Peñoles, S.A.B. de C.V. and its subsidiaries (Peñoles or the Company) that is based on assumptions made by its management. Such information, as well as the statements with respect to future events and expectations are subject to certain risks, uncertainties and factors that could cause the actual results, performance or achievements of the Company to be materially different at any time. Such factors include changes in general economic, governmental policy and/or business conditions nationally and globally, as well as changes in interest rates, inflation rates, exchange rates, mining performance in general, metal demand and quotations, and raw material and fuel prices, among others. Due to these risks and factors, actual results may vary materially from the estimates described herein, for which reason Peñoles does not assume any obligation with respect to such variations or to information provided by official sources.