Business Context and Reporting Period
Company: Southern Copper Corporation (SCC)
Filing Type: Form 10-Q (Unaudited)
Reporting Period: Quarter and nine months ended September 30, 2006
Business Overview: SCC is primarily engaged in the production and sale of copper, with significant by-product production of molybdenum, zinc, silver, and gold. Operations are segmented into Peruvian open-pit operations, Mexican open-pit operations, and Mexican underground operations (IMMSA unit). The company is a large accelerated filer with a two-for-one stock split effective October 2006.
Key Financial Metrics
| Metric (in millions, except per share) | 3 Months Ended Sep 30, 2006 | 9 Months Ended Sep 30, 2006 |
|---|---|---|
| Net Sales | $1,412.2 | $3,810.3 |
| Operating Income | $804.5 | $2,086.1 |
| Net Earnings | $521.6 | $1,382.4 |
| Earnings Per Share (Basic & Diluted) | $1.77 | $4.69 |
| Dividends Paid Per Share | $1.00 | $3.75 |
| Operating Cash Flow | $522.6 | $1,093.1 |
| Cash and Cash Equivalents (Sep 30, 2006) | $918.1 | |
| Total Debt (Current + Long-term) | $1,537.8 | |
| Debt to Total Capitalization | 31.0% |
Material Changes vs. Prior Period
- Revenue Growth: Net sales increased 37.1% in Q3 2006 and 30.3% for the nine-month period compared to 2005. This was driven principally by higher copper, zinc, and silver prices, partially offset by lower molybdenum prices and reduced sales volumes.
- Profitability: Net earnings rose 41.2% in Q3 and 41.1% for the nine months ended September 30, 2006, compared to the prior year periods.
- Production Volumes: Mine copper production decreased 20.7% in Q3 2006 (311.5 million lbs) due to illegal work stoppages at Mexican open-pit mines (La Caridad and Cananea) and lower ore grades in Peru. Molybdenum production dropped 40.0% in Q3.
- Cost Structure: Operating costs increased significantly due to the purchase of third-party copper concentrates to offset strike-related production losses. However, cash costs excluding by-product revenues were higher by 26.7 cents/lb in Q3 2006 compared to 2005.
- Derivative Impact: Losses on copper derivative instruments reduced net sales by $30.3 million in Q3 2006 and $288.2 million for the nine-month period, compared to minimal impact in 2005.
Guidance, Outlook, Risks, and Unusual Items
Management Commentary and Outlook
- Production Recovery: The La Caridad mine reopened in July 2006 and reached 70% capacity by September 30, 2006. Management expects to restore 100% capacity in Q4 2006.
- Capital Projects: The Ilo smelter modernization project is 94.1% complete with an estimated cost of $500 million (including capitalized interest). Completion is targeted for January 2007 to meet environmental compliance (PAMA).
- Dividends: A quarterly dividend of $1.375 per share was approved for payment in December 2006.
Risks and Contingencies
- Labor Disputes: Significant risk of future strikes. Illegal work stoppages in Mexico in 2006 caused substantial production losses and increased costs due to third-party concentrate purchases.
- Legal Proceedings:
- Peru: Ongoing litigation regarding "labor shares" (acciones laborales) involving former employees. The company asserts claims are meritless and has not accrued a liability.
- Tax: Active audits by the U.S. IRS and Peruvian tax authority (SUNAT) regarding depreciation methods, interest capitalization, and royalty charges. The company believes provisions are adequate.
- Asarco: Potential exposure to claims related to the parent company's acquisition of SCC from Asarco, though the company believes these are without merit.
- Environmental: Compliance with Peruvian mine closure laws requires a finalized plan and financial guarantees. The company has recorded a preliminary liability of $5.6 million but notes the final cost is uncertain pending regulatory approval.
- Political: Recent elections in Peru and Mexico introduce uncertainty regarding economic policies and potential new taxes or contributions.
Investor Verification Checklist
- Strike Resolution: Verify the timeline for full production recovery at La Caridad and Cananea mines and the associated cost of third-party concentrate purchases.
- Derivative Exposure: Review the impact of copper swap settlements on Q4 2006 earnings, as 57.3 million pounds of production are hedged at prices ranging from $3.52 to $3.68/lb.
- Environmental Compliance: Monitor the approval status of the Ilo smelter modernization and the final mine closure plan costs in Peru.
- Tax Contingencies: Track the resolution of IRS and SUNAT audits, specifically regarding the capitalization of drilling/blasting costs and royalty assessments.
- By-Product Pricing: Assess the sensitivity of earnings to molybdenum prices, which have declined significantly from 2005 peaks, reducing the credit against operating costs.