Peñoles - Annual Report 2020

The peso-dollar exchange rate was highly volatile throughout the year. Pressured by jitters over the effects of the pandemic, it reached highs of Ps.25.12 per dollar. Finally, the peso closed the year at Ps.19.95 per dollar, an annual depreciation of 5.9%. Official inflation in Mexico meanwhile was 3.15% in the year, slightly higher than Mexican Central Bank target of 3%, causing the country’s economy to shrink by 8.2%.

At the direction of the Chairman of the Board of Directors, we devised an emergency plan to mitigate the impact of the public health emergency, with a priority on protecting people’s health and safety as well as their jobs. The plan focused on the following points:

Creation of a Crisis Committee made up of the entire senior management team and the Corporate Medical Department, to continually monitor the situation, apply and follow up on the actions taken. This Committee was formed in February before the pandemic was declared.
Protecting people related to the company through the following actions:
- Offering facilities for work from home to as many employees as possible.
- Awareness-raising and information about preventive measures for all personnel.
- Setting up strict sanitary checkpoints and protocols to minimize contagion to employees, contractors and other visitors by early detection and prompt assistance.
- Maintaining compensation levels and preserving employment.
- Providing medical and psychological support to employees at all times.
- Reinforcing support for communities neighboring our operations with food supplies, protection equipment and information about preventive measures, benefiting more than 350,000 people.
Maximizing the company’s liquidity by:
- Scaling back costs, expenses and investments to cover what was strictly necessary, to sustain operations and protect people’s health, and through voluntary pay cuts to senior management.
- Taking advantage of available lines of credit without compromising the company’s credit ratings.
- Closely watching working capital investment and the client portfolio.
- Monetizing part of the market value of metal hedge positions (influx of US$ 87.6 million).
- Restructuring debt, increasing financing and lowering financial cost.

We also supported clinics and hospitals with donations of medical equipment and supplies and cooperated with the authorities to provide medical expertise. Additionally, with the unwavering support of our Chairman of the Board, the Mexican Mining Chamber and other companies in our industry, as well as the mining union FRENTE and other business chambers and organizations, we engaged in constant dialogue with federal, state and municipal authorities to have the mining industry classified as an essential economic activity, in order to maintain limited operations, while placing a priority on the health of our employees and surrounding communities at all times. Thanks to these efforts, the mining-metallurgy industry was declared an essential activity in late May, aligning Mexico with countries like the United States and Canada.

We established sanitary checkpoints and strict protocols in our facilities.We supported our communities, benefiting more than 350,000 people.

In the months of June, July and August we began a process of safe return to work with staggered hours for our personnel, guaranteeing all preventive measures established by the Ministry of Health, the Ministry of Labor and Social Planning, and internal protocols. Peñoles’ operating units received the Sanitary Safety Distinction from the Mexican Social Security Institute, making us the first company in Mexico’s mining and metals industry to be recognized for its safe workplaces.

Clearly, the restrictions of the public health emergency affected our annual production. The following are the highlights of our operating and financial results for 2020. Financial figures are denominated in millions of dollars unless otherwise indicated, and changes were calculated with respect to 2019.

Capital expenditures totaled US$ 561 million (US$ 352 million or 38.5% lower than the year before). Investment in exploration came to US$ 141 million, 32.2% less than in 2019.

With on-site exploration work suspended for seven months, we focused efforts on study and analysis of information already compiled, as well as on the investigation of new prospective areas. A close-loop drilling plan and mining work plan was developed to improve the reliability of resources detected at the Reina del Cobre polymetallic project in Durango (adjacent to Velardeña), which will begin in 2021. In the last quarter of the year, we began a drilling campaign at the new Capela mine to strengthen its reserves. In our other operating units, we assembled databases and interpretation to decide on the 2021 drilling program. Fresnillo plc carried out drilling in ten areas, with interesting results in Fresnillo, Guanajuato and Peru; in the San Julián district, drilling was aimed at converting resources to reserves in the vein system to the south of this district. In Chile some drilling was performed while complying with safety protocols at all times.

In the Mining Division, the startup of the new Capela polymetallic unit in Guerrero was delayed due to sanitary restrictions that limited the number of onsite personnel and a lack of support from suppliers in the final delivery and commissioning of the main equipment. We had to rely on remote support and backup from experienced people at other of our units. Although production was not as high as expected, at the end of the year the plant had reached 99% of its milling capacity and succeeded in producing concentrates with zinc content of 53% on average, and recoveries within the expected range. One of the biggest challenges was achieving efficient separation in the lead-copper circuit; various reagents were tested to improve the grade of lead concentrate. Adjustments continue to improve copper recoveries.

In April, we announced the difficult decision to suspend operations indefinitely at the Madero zinc mine in Zacatecas and the Milpillas unit in Sonora, which produces copper cathodes, because of the steep drop in the price of these metals. High operating costs and low grades meant that for the moment these operations were no longer profitable. For now, Milpillas will continue turning out cathodic copper from the ore deposited at the leaching pads. As a result of this suspension, 267 employees were relocated to other company operations and the remaining 630 were laid off with severance according to the law and the respective union contracts. Also, and as planned, the Bismark zinc mining unit concluded its life cycle after 28 years of operations, having depleted its reserves.

Operations started at the new Capela polymetallic unit in Guerrero. Although the startup was slow, at the end of the year it reached 99% of its milling capacity.

For this reason, in addition to the lower amount of ore produced at Herradura and Noche Buena—after restrictions in the state of Sonora were extended to open-pit mines—the total volume of ore milled and deposited dropped 20.7% to 44.0 million metric tons. This reduced production of gold content to an annual volume that was 9.5% lower, at 824,087 ounces.

Silver mining production totaled 62.6 million ounces, a slight 0.4% lower, due to volume from Capela and development ore from the Juanicipio project (under construction) which was processed at the Fresnillo beneficiation plant. San Julián and Tizapa were able to increase their production thanks to better head grades, making up for the shortfall at Saucito resulting from lower volume processed and lower head grade at Herradura and Velardeña, because of lower grades and, at Sabinas, due to a lower volume processed.

In industrial metals, production of lead content grew by 2.5% to 86,420 metric tons, driven by production at Capela and higher head grades at Saucito. Zinc volume was off slightly (by 1.4%) to 288,072 metric tons, as the lack of production from Madero and Bismark was offset by Capela, Saucito, Fresnillo and Sabinas (all of them with higher grades), in addition to Velardeña, which milled more ore in the year.

The volume of copper produced in concentrates was similar to last year while, at Milpillas, production of copper cathodes totaled 12,444 metric tons, 44.7% less than in 2019 due to the mandatory shutdown of extraction work at the mine.

We continue to advance in adopting international standards for the design, construction, operation and closure of tailings deposits, ensuring they are properly managed in terms of capacity, safety and environmental protection, supported and supervised by a panel of experts.

We also strengthened the key-out system for locating personnel and vehicles within mines, which involves monitoring from a safe operational center.

Fresnillo plc made further progress on construction of a tailings flotation plant at the Fresnillo mine. This is the second phase of the Pyrites project, aimed at increasing silver and gold recovery from tailings at Saucito and Fresnillo. Development was also begun on the Juanicipio silver-gold mine in Zacatecas (56% owned by Fresnillo plc and 44% by MAG Silver Corp), with startup planned for the fourth quarter of 2021.

In metal operations, refined gold output fell to 957,209 ounces (-14.0%), due primarily to lower treatment of from the Herradura and Noche Buena mines. Some shippers temporarily suspended the supply of concentrates, and although the situation returned to normal around mid-year, we had some trouble supplying the necessary amount and quality needed for mixtures to be processed at the lead smelter. With this, lead and silver production declined by 2.4% and 6.2%, to 70.6 million ounces and 111,538 metric tons, respectively, from their levels in the previous year.

Because of the steep drop in metals prices, high operating costs and low grades, we announced the difficult decision to suspend operations at Milpillas and Madero indefinitely.

In the zinc refinery, where annual production capacity was expanded to 350,000 metric tons a couple of years ago, most of the technical problems have been solved relating to balancing the processes and ensuring the correct interaction of the old (roasting) plant and the new (direct leaching) plant. This, combined with a lower volume of concentrates treated due to the contingency, caused an 8.0% reduction in refined zinc output, to 260,943 metric tons. We are confident that with the adjustments made, the zinc refinery will be working at capacity by 2021. We also successfully interconnected a project that will increase the recovery of silver content in high-grade zinc concentrates, which should add between 3 and 3.5 million ounces of silver to annual production.

Another challenge we faced was a temporary contraction in domestic refined zinc demand, although we were able to place our products on export markets.

Demand also fell sharply for chemical magnesium products, mainly refractory and caustic grades. Sodium sulfate volume totaled 745,892 metric tons, 3.7% less than the year before, but magnesium sulfate broke a production record with 62,583 metric tons due to strong performance in the domestic agriculture industry.

With regards to energy, our priority is to ensure a supply for our operations at competitive costs, as well as the efficient, sustainable use of fuel and electricity. Our demand for electricity in 2020 declined by 2.7% because the increase in consumption resulting from the zinc plant expansion was offset by the suspension of work at three mines. Our portfolio of power generating plants produced enough to supply 104.7% of our own needs, including the power from the Mesa La Paz wind farm, which began producing energy in April. But we had to buy more energy from the Federal Electricity Commission, at a 14.0% higher cost, due to delays in the entry into force of new transmission agreements and migration of qualified users to the wholesale electricity market, as a result of the energy policy decreed by the Mexican authorities. For this reason, the unit cost of energy was 6.7% higher than last year (US¢ 6.86/kWh), also affected by higher transmission rates in legacy contracts, whose constitutionality is being discussed.

We remain committed to increasing the proportion of clean energy in our supply matrix, aiming at 100% renewable energy by 2028, if the change in the country’s energy policy will allow us to do so. To this end, we have been analyzing alternatives for wind and solar farms near our operations. In 2020, clean energy accounted for 40.6% of our consolidated consumption.

Taking advantage of favorable conditions in financial markets, and backed by Peñoles’ solid financial profile and continuing investors confidence, we were able to successfully place new bond issues on international markets under Rule 144A Reg/s totaling US$ 600 million at attractive rates, in two tranches: US$ 100 million through the reopening of a US$ 550 million bond placed in 2019 at 10 year-maturity and another for US$ 500 million at 30 years. This new issue received credit ratings of “BBB” (investment grade) from Fitch and S&P Global, with a stable outlook. The bonds issued last year maintain the same ratings. Part of the proceeds were used to prepay a US$ 300 syndicated loan originally maturing in 2024. Fresnillo plc meanwhile placed a successful US$ 850 million Rule 144A Reg/S bond issue at 30 years and bought back US$ 482 million of a US$ 800 million issue expiring in 2023. The credit ratings assigned to this issue were “BBB” from S&P Global, and “Baa2” from Moody’s Investor Service, both with a stable outlook.

In financial results, our gross sales—excluding hedging results—grew 5.2% to US$ 4.72 billion, due to higher prices of gold and silver, which offset the effects of lower zinc and lead production and a drop in sales volume. Our hedging of metal prices and exchange rates, in order to reduce the risk of significant fluctuations and temper the volatility of our EBITDA, generated an opportunity cost of US$ 35 million, higher than the cost of US$ 3 million reported the year before. Including hedging results, net sales came to US$ 4.67 billion, a 4.5% increase.

The cost of goods sold was 4.9% lower, at US$ 3.42 billion, which can be attributed to: (i) the reduction in production costs caused by a slower pace of operations, cost-cutting measures, and the peso’s depreciation, which benefited costs denominated in domestic currency; (ii) a credit for recognition of gold inventory at Herradura’s leaching pads; and (iii) the lower cost of metal purchased from outside shippers.

General expenses totaled US$ 506 million, 15.0% less than in 2019. With this, EBITDA amounted to US$ 1.46 billion and operating income was US$ 743 million, increases of 50.4% and 170.0%, respectively, over fiscal year 2019. Net financial expense rose by 162.1% to US$ 284 million, due primarily to the contracting and restructuring of long-term debt described above. We are also reporting other net expenses of US$ 15 million, and impairment losses totaling US$ 166 million on long-lived assets at the Bismark, Milpillas and Madero units, where activities were suspended last year, as well as at Fuerza Eólica del Istmo.

Provision for income taxes totaled US$ 185 million, an increase of US$ 218 million (compared to -US$ 33 million) for various reasons, among them the voluntary adjustment to the tax treatment on outlays for mining work between 2013 and 2019, an increase in the provision for deferred taxes, and a higher tax base for the year. Thus, there was a net loss for the controlling interest in US$ 34 million for fiscal year 2020.

Although net results for the last year were negative, Peñoles remains a solid company, with prudent management and an extensive track record of overcoming difficult times, and 2020 was no exception. Peñoles maintains the best sustainable development and corporate governance practices, encourages social engagement and promotes its ethics and values at work and in everyday life. This ensures that our company can survive, adapt and prosper over time, to continue generating value for our stakeholders. All of these qualities, along with our employees, which are our most valuable asset, represent our greatest strengths as we look toward the future.

Negotiations with the various unions with which we have collective bargaining contracts have been conducted in a cordial and respectful manner, in a framework of cooperation and mutual benefit. We also continue to modernize workplaces to enhance productivity and improve the quality of life and income of our employees.

I thank the Chairman and members of the Board of Directors and Executive Committee for their confidence, unvaluable support and the privilege of leading Peñoles. I also express my gratitude to our employees for their enormous commitment, professionalism and dedication.

Rafael Rebollar González
Chief Executive Officer

On the energy front, our priority is to ensure the electricity for our operations at competitive costs, as well as an efficient, sustainable use of energy.