SOUTHERN COPPER CORP quarterly report, Q2 FY2015

Business context and reporting period

Southern Copper Corporation (SCC), an integrated copper and other-minerals producer operating primarily in Peru and Mexico, filed this unaudited Form 10-Q for the quarter and six months ended June 30, 2015. Grupo Mexico indirectly owned 86.1% of SCC at quarter-end. Comparisons below are with the corresponding 2014 periods; dollar amounts are in U.S. dollars.

Financial and operating performance

Metric	Q2 2015	Q2 2014	Six months 2015	Six months 2014
Net sales	$1.383 billion	$1.487 billion	$2.658 billion	$2.842 billion
Operating income	$503.1 million	$597.3 million	$940.1 million	$1.160 billion
Net income attributable to SCC	$294.7 million	$337.3 million	$577.1 million	$660.6 million
Diluted earnings per share	$0.37	$0.40	$0.72	$0.79
Operating cash flow	$334.8 million	$333.5 million	$533.2 million	$681.8 million
Capital investments	$284.9 million	$360.1 million	$507.7 million	$697.0 million

• Q2 sales fell 7.0% and six-month sales fell 6.5%, principally due to lower metal prices. Six-month average copper prices declined about 14% year over year on both LME and COMEX measures; molybdenum and silver averages fell 32.2% and 17.5%, respectively. Higher copper sales volumes partly offset price declines.
• Operating income margin was approximately 36.4% in Q2 versus 40.2% a year earlier, and 35.4% for the first half versus 40.8%. Operating costs and expenses rose 2.1% for the first half despite lower sales, including $16.5 million of Buenavista environmental remediation expense and higher depreciation.
• The six-month effective income tax rate declined to 33.3% from 39.8%; the filing cites lower Mexican royalty-tax impact and reduced dividends from Mexican operations among the reasons.
• Mine copper production increased 8.6% in the first half to 786.4 million pounds. Zinc production declined 21.8%, silver 3.3%; molybdenum production increased 2.0%.
• Cash and cash equivalents were $1.572 billion at June 30, versus $364.0 million at year-end 2014; short-term investments were $573.4 million versus $338.6 million. Current assets totaled $3.863 billion and current liabilities $1.016 billion.
• Debt carrying value was approximately $6.152 billion, including $200 million current debt, versus $4.181 billion at year-end. SCC issued $2.0 billion of senior unsecured notes in April: $500 million due 2025 at 3.875% and $1.5 billion due 2045 at 5.875%. The proceeds are for general corporate purposes, including capital investment.
• First-half operating cash flow decreased $148.6 million year over year, reflecting lower earnings and a larger use of cash from operating assets and liabilities. Investing cash use was $739.5 million, including $507.7 million of capital investments and $234.8 million of net short-term investment purchases. Financing provided $1.395 billion, primarily from the bond issue, offset by dividends and share repurchases.
• Cash dividends were $0.10 per share in Q2; first-half dividends were $0.20 per share versus $0.22 in 2014. SCC repurchased $414.6 million of shares during the first half.

Material changes versus the prior comparable period

• Lower metal prices outweighed higher copper sales volumes, reducing first-half revenue by $184.1 million and SCC-attributable earnings by $83.5 million.
• Copper sales volume rose 14.0% in the first half, led by Mexican open-pit operations; Buenavista copper production benefited from the SX-EW III plant. Zinc output was impaired by flooding at Santa Eulalia and lower grades at IMMSA mines.
• Cash cost per pound of copper excluding by-product revenues improved to $1.67 for the first half from $1.91. Including by-product revenues, it increased to $1.05 from $1.00, as lower by-product prices reduced credits.
• Debt increased following the $2.0 billion note issuance. First-half capital investment declined 27.1% from 2014, while cash and short-term investments increased materially, largely in conjunction with financing and investment activity.
• SCC early adopted ASU 2015-03, retrospectively presenting debt issuance costs as a deduction from debt carrying value; the change affects presentation, not reported earnings or cash flows.

Outlook, management commentary, risks and unusual items

• Management forecast 2015 copper production of 771,500 tons, approximately 90,000 tons above 2014; molybdenum production of 23,200 tons, silver production of 12.8 million ounces, and zinc production of 74,400 tons. Zinc recovery at Santa Eulalia was expected by Q4 2015. These are forward-looking estimates, not guarantees.
• Management described long-term copper fundamentals favorably but noted near-term macroeconomic uncertainty and lower prices. Its sensitivity estimates for the remaining six months of 2015 indicate annual net-income effects of approximately $54.0 million per $0.10/lb copper-price change, $14.5 million per $1/lb molybdenum change, $6.2 million per $0.10/lb zinc change, and $4.0 million per $1/oz silver change, assuming production, sales and tax assumptions hold.
• Tia Maria’s environmental impact assessment was approved, but its construction permit was delayed amid community opposition. The $1.4 billion project had $359.4 million spent through June 30; management said it expects much of the equipment could be redeployed if the project does not restart and believes any impairment would not be material.
• Other major projects include the $1.2 billion Toquepala expansion, expected to add 100,000 tons of annual copper capacity by 2017, and the Buenavista expansion program. SCC completed the $100 million cash acquisition of the El Pilar project on July 6; preliminary plans contemplate $300 million additional development investment, 35,000 tons of annual copper cathodes, and commercial operations by 2018.
• The August 2014 Buenavista leaching-solution spill led to remediation obligations, regulatory proceedings and lawsuits. SCC estimated a $97.3 million contingent liability at June 30; it reported $16.4 million paid before the trust and approximately $74.9 million deposited in the trust. PROFEPA imposed fines of approximately $1.7 million, and further sanctions or claims may follow. SCC stated it did not expect the spill-related proceedings to materially affect its financial position or results, but outcomes and damages remain uncertain.
• Other contingencies include Peruvian former-employee labor-share litigation for which management has made no provision because it asserts defenses and cannot reasonably estimate the amount; ongoing disputes over the Tia Maria-related Virgen Maria concessions and a Peruvian tailings dam; and prolonged strikes at the San Martin and Taxco mines, which remain suspended.
• Peruvian union agreements were due to expire in the second half of 2015, with negotiations expected to begin in Q3. Metal-price volatility, project delays, operating disruptions, water and geological issues, foreign exchange, labor relations, litigation and environmental regulation are among the stated risks.
• Management concluded disclosure controls and procedures were ineffective at June 30 because of a previously reported material weakness involving access controls and segregation of duties in the Mexican operations’ prior ERP system. SAP was implemented there beginning February 2015 and remediation and testing remained in progress. Management nevertheless stated the interim financial statements fairly present the company’s financial position, results and cash flows. The independent accountant performed a review, not an audit, and reported no material modifications were known to be necessary.

Important facts for investors to verify

1. Whether lower metal prices persist and how they affect revenue, by-product credits, margins and the provisional pricing of open sales. SCC disclosed estimated post-quarter sales reductions of $11.7 million for July settlements and a further $10.9 million for later settlements based on July 24 forward prices.
2. Progress against production guidance and resolution of the Santa Eulalia flooding and Buenavista water issues.
3. Debt service and funding needs alongside capital spending, dividends, repurchases and the announced project pipeline.
4. Permitting and community developments at Tia Maria, and execution, cost and timing of the Toquepala, Buenavista and El Pilar projects.
5. Final remediation costs, trust disbursements, regulatory outcomes and litigation exposure from the Sonora River spill; the eventual exposure in the unquantified labor-share cases.
6. Completion and effectiveness testing of the ERP access-control remediation, given management’s disclosed ineffective controls.