SOUTHERN COPPER CORP/ - Quarter Report: 2005 September (Form 10-Q)

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

2005

Third Quarter

FORM 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

 

For Quarter Ended September 30, 2005

Commission file number 1-14066

 

SOUTHERN COPPER CORPORATION

(Exact name of registrant as specified in its charter)

 

Delaware (State or other jurisdiction of Incorporation or organization)		13-3849074 (I.R.S. Employer Identification No.)
2575 East Camelback Rd. Phoenix, AZ (Address of principal executive offices)		85016 (Zip Code)
Registrant’s telephone number, including area code		(602) 977-6595

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  ý     No  o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Act of 1934)

Yes  ý     No  o

 

As of October 31, 2005 there were outstanding 147,228,025 shares of Southern Copper Corporation common stock, par value $0.01 per share.

 

Southern Copper Corporation

 

INDEX TO FORM 10-Q

 

Part I.  Financial Information:
Item 1.		Condensed Consolidated Combined Financial Statements (unaudited)
		Condensed Consolidated Combined Statement of Earnings three months and nine months ended September 30, 2005 and 2004
		Condensed Consolidated Combined Balance Sheet September 30, 2005 and December 31, 2004
		Condensed Consolidated Combined Statement of Cash Flows three months and nine months ended September 30, 2005 and 2004
		Notes to Condensed Consolidated Combined Financial Statements
Items 2. and 3.		Management’s Discussion and Analysis of Financial Condition and Results of Operations and Quantitative and Qualitative Disclosure about Market Risk
Item 4.		Controls and Procedures
Independent Accountants’ Report
Part II.  Other Information:
Item 1.		Legal Procedures
Item 4.		Submission of Matter to a Vote of Security Holders
Item 6.		Exhibits
Signatures
Exhibit 3.1		Amended and Restated Articles of Incorporation dated September 20, 2005
Exhibit 15		- Independent Accountants Awareness Letter
Exhibit 31.1		- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 31.2		- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 32.1		- Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 32.2		- Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

 

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Part I — FINANCIAL INFORMATION

 

Item 1. Condensed Consolidated Combined Financial Statements

 

Southern Copper Corporation

 

 

CONDENSED CONSOLIDATED COMBINED STATEMENT OF EARNINGS

(Unaudited)

 

		3 Months Ended September 30,								9 Months Ended September 30,
		2005				2004				2005				2004
		(dollars in thousands, except for per share amounts)
Net sales:
Non affiliates		$	1,027,701			$	713,397			$		2,916,652		$	1,996,589
Affiliates		2,492				26,136				17,628				67,692
Total net sales		1,030,193				739,533				2,934,280				2,064,281
Operating costs and expenses:
Cost of sales (exclusive of depreciation, amortization and depletion shown separately below)		382,994				348,403				1,185,669				922,427
Selling, general and administrative		20,199				17,259				59,202				51,257
Depreciation, amortization and depletion		74,818				48,065				206,329				143,365
Exploration		6,361				3,311				17,205				10,547
Total operating costs and expenses		484,372				417,038				1,468,405				1,127,596
Operating income		545,821				322,495				1,465,875				936,685
Interest expense		(26,454			)	(30,243			)	(71,266			)	(93,882			)
Capitalized interest		6,056				3,069				12,316				7,614
Gain (loss) on derivative instruments		3,717				—				(8,404			)	—
Loss on debt prepayments		(12,530			)	—				(22,629			)	—
Gain on disposal of property		—				20,682				2,084				42,998
Other income (expense)		1,898				(3,751			)	(1,774			)	(6,620			)
Interest income		5,051				1,655				13,541				5,280
Earnings before taxes on income and minority interest		523,559				313,907				1,389,743				892,075
Taxes on income		152,573				93,260				405,443				265,183
Minority interest		1,576				3,868				4,598				11,597
Net earnings		$	369,410			$	216,779			$	979,702			$		615,295
Per common share amounts:
Net earnings—basic and diluted		$		2.51		$		1.47		$	6.65			$		4.18
Dividends paid		$		1.04		$		0.76		$	4.67			$		1.57
Weighted average common shares outstanding (Basic)		147,228				147,225				147,227				147,224
Weighted average common shares outstanding (Diluted)		147,228				147,225				147,227				147,224

 

The accompanying notes are an integral part of these condensed consolidated combined financial statements.

 

 

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Southern Copper Corporation

 

CONDENSED CONSOLIDATED COMBINED BALANCE SHEET

(Unaudited)

 

		September 30, 2005					December 31, 2004
		(dollars in thousands)
ASSETS
Current assets:
Cash and cash equivalents		$			766,870		$		710,707
Marketable securities		—					45,267
Accounts receivable trade:
Non affiliates		325,259					425,790
Affiliates		4,532					15,353
Accounts receivable—other		63,982					33,081
Inventories		384,155					352,377
Prepaid and other current assets		27,999					52,966
Total current assets		1,572,797					1,635,541
Net property		3,186,763					3,068,486
Capitalized mine stripping, net		300,819					318,116
Leachable material, net		180,001					134,621
Intangible assets, net		121,351					123,496
Other assets, net		35,175					38,933
Total Assets		$	5,396,906				$	5,319,193
LIABILITIES
Current liabilities:
Current portion of long-term debt		$		10,000			$	152,314
Accounts payable		154,920					142,362
Accrued income taxes		206,027					293,295
Due to affiliated companies		48,705					66,524
Deferred income taxes		7,192					42,500
Accrued workers’ participation		131,960					84,245
Other accrued liabilities		29,527					180,678
Total current liabilities		588,331					961,918
Long-term debt		1,215,249					1,177,974
Deferred income taxes		267,237					243,600
Other liabilities		120,611					105,179
Asset retirement obligation		5,924					5,643
Total non-current liabilities		1,609,021					1,532,396
Commitments and Contingencies (Note I)
MINORITY INTEREST		11,634					11,284
STOCKHOLDERS’ EQUITY
Common stock		1,474					1,474
Additional paid-in capital		726,382					728,265
Accumulated comprehensive income		2,464,530					2,088,445
Treasury stock		(4,466				)	(4,589			)
Total Stockholders’ Equity		3,187,920					2,813,595
Total Liabilities, Minority Interest and Stockholders’ Equity		$		5,396,906			$	5,319,193

 

The accompanying notes are an integral part of these condensed consolidated combined financial statements.

 

 

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Southern Copper Corporation

 

 

CONDENSED CONSOLIDATED COMBINED STATEMENT OF CASH FLOWS

(Unaudited)

 

		3 Months Ended September 30,						9 Months Ended September 30,
		2005			2004			2005			2004
		(dollars in thousands)
OPERATING ACTIVITIES
Net earnings		$	369,410		$	216,779		$	979,702		$	615,295
Adjustments to reconcile net earnings to net cash provided from operating activities:
Depreciation, amortization and depletion		74,818			48,065			206,329			143,365
Capitalized mine stripping and leachable material		(25,353		)	(21,831		)	(77,898		)	(65,675		)
Remeasurement loss (income)		(1,089		)	8,424			10,946			3,721
Provision for deferred income taxes		(51,653		)	26,766			(18,217		)	46,685
Gain on sale of property		—			(20,682		)	(2,084		)	(42,998		)
Loss (gain) on derivative instruments		(3,717		)	—			8,404			—
Loss on debt prepayments		12,530			—			22,629			—
Minority interest		1,576			3,868			4,598			11,597
Cash provided from (used for) operating assets and liabilities:
Accounts receivable		(85,814		)	(34,675		)	46,061			(103,482		)
Inventories		(15,620		)	(22,930		)	(31,778		)	(77,028		)
Accounts payable and accrued liabilities		261,259			89,920			(42,108		)	171,850
Other operating assets and liabilities		(77,994		)	(18,839		)	(113,969		)	8,809
Net cash provided from operating activities		458,353			274,865			992,615			712,139
INVESTING ACTIVITIES
Capital expenditures		(120,694		)	(59,906		)	(263,311		)	(149,138		)
Purchase of marketable securities		—			—			(74,339		)	—
Sales of marketable securities		—			—			119,606			—
Other		4,699			923			(11,678		)	(6,326		)
Sales of property		546			20,682			1,177			42,998
Net cash used for investing activities		(115,449		)	(38,301		)	(228,545		)	(112,466		)
FINANCING ACTIVITIES
Debt repaid		(680,080		)	(150,461		)	(1,098,685		)	(344,251		)
Debt incurred		793,646			—			993,646			—
Escrow on long-term loans		—			—			(311		)	(5,241		)
Dividends paid to common stockholders		(153,556		)	(60,413		)	(603,599		)	(125,386		)
Distributions to minority interest		(650		)	(471		)	(4,159		)	(978		)
Other		—			(6		)	123			(33		)
Net cash used for financing activities		(40,640		)	(211,351		)	(712,985		)	(475,889		)
Effect of exchange rate changes on cash and cash equivalents		(6,560		)	(15,811		)	5,078			(10,972		)
Increase in cash and cash equivalents		295,704			9,402			56,163			112,812
Cash and cash equivalents, at beginning of period		471,166			455,020			710,707			351,610
Cash and cash equivalents, at end of period		$	766,870		$	464,422		$	766,870		$	464,422

 

 

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		3 Months Ended September 30,							9 Months Ended September 30,
		2005				2004			2005			2004
		(dollars in thousands)
Supplemental disclosure of cash flow information: Cash paid during the period for:
Interest		$		20,469		$	33,403		$	66,274		$	88,363
Income taxes		$	122,624			$	28,381		$	569,309		$	115,491

 

The accompanying notes are an integral part of these condensed consolidated combined financial statements.

 

 

6

 

Southern Copper Corporation

 

NOTES TO CONDENSED CONSOLIDATED COMBINED FINANCIAL STATEMENTS

(Unaudited)

 

A.           In the opinion of Southern Copper Corporation, formerly named Southern Peru Copper Corporation, (the “Company”, “Southern Copper” or “SCC”), the accompanying unaudited condensed consolidated combined financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the Company’s financial position as of September 30, 2005 and the results of operations and cash flows for the three months and nine months ended September 30, 2005 and 2004.  The condensed consolidated combined financial statements for the three months and nine months period ended September 30, 2005 and 2004 have been subjected to a review by PricewaterhouseCoopers, the Company’s independent public auditors whose report dated October 14, 2005, is presented on page 37.  The results of operations for the three months and nine months ended September 30, 2005 and 2004 are not necessarily indicative of the results to be expected for the full year.  The accompanying condensed consolidated combined financial statements should be read in conjunction with the combined financial statements at December 31, 2004 included in the Company’s Registration Statement on Form S-3 dated June 6, 2005, as amended and the combined financial statements included in the Company’s Registration Statement on Form S-4, dated October 28, 2005.

 

On April 1, 2005, the Company acquired Minera México S.A. de C.V. (“MM”) from Americas Mining Corporation (“AMC”), a subsidiary of Grupo México S.A. de C.V., the controlling stockholder of the Company.  The Company exchanged 67,207,640 newly-issued shares of its common stock for the outstanding shares of MM’s direct majority stockholder, and MM became a 99%-owned subsidiary of the Company.  As a part of this transaction, the Company paid a special transaction dividend of $100 million to all of its stockholders.  Upon completion of the merger, Grupo México increased its indirect beneficial ownership of the Company’s capital stock from approximately 54.2% to approximately 75.1%. The Company now owns 99.95% of Minera Mexico.  The Company is now in the process of integrating the two companies that had previously been affiliated but operated independently.

 

The April 2005, transaction is accounted for in a manner similar to a pooling of interests, since it involves the combination of entities under common control.  Accordingly, all of MM’s historical assets and liabilities are combined with SCC on a historical cost basis for all periods prior to April 1, 2005, since they were under common control during all of these periods.  The difference in the value of the new shares is recognized in equity. The results of operations, cash flows and balance sheet for periods prior to April 1, 2005, have also been prepared on a combined basis and intercompany balances and transactions have been eliminated.

 

B.             Common Stock:

 

In connection with the acquisition of MM, the Company’s class A common stock was converted into common stock and preferential voting rights were eliminated.  On June 9, 2005, Cerro Trading Company, Inc., SPC Investors L.L.C., Phelps Dodge Overseas Capital Corporation and Climax Molybdenum B.V., subsidiaries of two of SCC’s founding shareholders’ and affiliates, sold their equity holdings in SCC.

 

C.             Inventories were as follows:

(in millions)

 

		September 30, 2005			December 31, 2004
Metals at lower of average cost or market:
Finished goods		$	33.6		$	22.1
Work-in-process		208.7			187.2
Supplies at average cost		141.9			143.1
Total inventories		$	384.2		$	352.4

 

 

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D.    Income Taxes:

 

The Company’s income tax provision for the nine months ended September 30, 2005 and 2004 was $405.4 million and $265.2 million, respectively.  These provisions include income taxes for Peru, Mexico and the United States.  The effective tax rates for the 2005 and 2004 periods are 29.2% and 29.7%, respectively.  While these tax rates are comparable, included in the 2005 tax provision is a refund of $43.4 million received by our Mexican subsidiary for asset-based taxes (minimum income tax) paid in prior years.  Without the benefit of this credit the Company’s effective tax rate for the 2005 period would increase to 32.3%.  The disparity in the tax rates is the result of an increase in expenses that are not deductible in computing income tax for our Mexican operations, substantially all of which is related to a one time non-deductible expense of $31.1 million for workers’ participation resulting from a change in law regarding the basis of calculation.

 

E.              Provisionally Priced Sales:

 

At September 30, 2005, the Company has recorded provisionally priced sales of 95.9 million pounds of copper, at an average forward price of $1.76 per pound. Also the Company has recorded provisionally priced sales of 8.7 million pounds of molybdenum at the quarter-end market price of $34.00 per pound. These sales are subject to final pricing based on the average monthly LME or COMEX copper prices and Dealer Oxide molybdenum prices in the future month of settlement, which will largely occur in the fourth quarter of 2005.

 

Following are the provisionally priced copper and molybdenum sales outstanding at September 30, 2005:

 

 

 

Provisional sales adjustment, including invoices pending of final analysis, booked in accounts receivable and net sales, were as follows at September 30, 2005:

 

 

At October 31, 2005, the market price of copper and molybdenum increased(decreased) by $0.14 and $(3.20) per pound, respectively.  Therefore the Company’s accounts receivable as of September 30, 2005, would have decreased by $14.7 million, if the Company would have used these market prices in its forward sales price adjustment.

 

 

8

 

F.              Derivative Instruments:

 

The Company occasionally uses derivative instruments to manage its exposure to market risk from changes in commodity prices and interest rate risk exposure.  The Company does not enter into derivative contracts unless it anticipates a future activity that is likely to occur that will result in exposing the Company to market risk.

 

Copper swaps:

In the first half of 2005, the Company entered into copper swap contracts to protect a portion of its 2005 copper production for future sales at a fixed copper price.  The Company recorded losses of $9.4 million related to these copper swap contracts in the nine month period of 2005.  These losses are recorded as non-operating items on the condensed consolidated combined statement of earnings.

 

At September 30, 2005, the Company did not hold any open copper swaps.

 

In the first two weeks of October 2005, the Company entered into copper swap contracts to protect 63.1 million pounds of copper in October 2005 at prices of $1.90 per pound and $1.879 per pound.  These contracts are as follows:

 

 

(1)          SCC will receive (pay) if the actual average COMEX copper price for period is under (over) swap price on quantity hedged.  As a result of these transactions, SCC lost $1.7 million which will be recorded in the fourth quarter of 2005.

 

Interest rate swaps:

In October 2004, MM and Citibank-Banamex entered into an interest rate swap agreement for a notional principal amount of $600 million.  Under this agreement, MM agreed to pay Banamex a fixed rate equivalent to 3.49% and, in exchange, Banamex agreed to pay a variable rate equivalent to 3-month LIBOR.  Payments under the interest rate swap are scheduled to match the interest payment dates of the $600 million Citibank credit facility.  Additionally, in April 2005, the Company entered into a contract to hedge interest rate exposure on $120 million of its $200 million Citibank credit facility.  Under this contract the Company pays fixed rate interest payments at 4.46% and receives a variable rate equivalent to three month LIBOR.  Payments under the interest rate swap are scheduled to match the interest payment dates of the $200 million credit facility.  Both of these loan facilities were repaid and the related swaps were terminated in July 2005.  As a result of this transaction the Company recorded gains of $7.7 million and $5.0 million in the third quarter and first nine months of 2005, respectively.

 

On July 19, 2005 the Company entered into a one day interest rate swap contract on $700 million of its $800 million notes issued.  Under this contract, the Company makes fixed rate interest payments at 4.46% and receives a variable rate equivalent to 5.375% of treasury bonds maturing on February 15, 2031.  As a result of this transaction, the Company recorded a loss of $4.0 million in the condensed consolidated combined statement of earnings for the cost of terminating this transaction.

 

The Company recorded net gains of $3.7 million and $1.0 million related to the interest swap transactions in the third quarter of 2005 and the first nine months of 2005, respectively.  These gains are recorded as non-operating income on the condensed consolidated combined statement of earnings.  At September 30, 2005, the Company did not hold any open interest rate swap contracts.

 

9

---

 

G.             Debt and Credit Facilities:

 

On July 27, 2005 the Company issued $200 million 6.375% Notes due 2015 and $600 million 7.5% Notes due 2035.  The notes are senior unsecured obligations of the Company.  The Company paid $8.8 million of costs related to the issuance of these notes.  The net proceeds from the issuance and sale of the notes were used to repay outstanding indebtedness of the Company’s Peruvian and Mexican Operations, under its $200 million and $600 million ($480 million outstanding) credit facilities, respectively, and the balance will be used for general corporate purposes, including repayment of additional debt.  The Company filed a Registration Statement on Form S-4 with respect to these Notes on October 28, 2005.  The indentures relating to the notes contain certain covenants, including limitations on liens, limitations on sale and leaseback transactions, rights of the holders of the notes upon the occurrence of a change of control triggering event, limitations on subsidiary indebtness and limitations on consolidations, mergers, sales or conveyances.  All of these limitations and restrictions are subject to a number of significant exceptions, and some of these covenants will cease to be applicable before the notes mature if the notes attain an investment grade rating.

 

In January 2005, the Company signed a $200 million credit facility with a group of banks led by Citibank, N.A.  In the first quarter of 2005, proceeds of this credit facility were used to prepay $170 million of the bonds issued under the Company’s Peruvian bond program.  In April 2005 an additional drawdown of $30 million was used to prepay the remaining outstanding bonds.  The Company capitalized $2.8 million of costs associated with this facility.  The Company paid a prepayment penalty of 1%, or $2.0 million, to the Peruvian bondholders.  Additionally, the Company wrote off $2.3 million of previously capitalized bond issuance cost.  Both amounts are included in the condensed consolidated statement of earnings on the line item “Loss on debt prepayments”. On July 28, 2005 this credit facility was repaid and the Company wrote off $2.5 million of deferred financing cost.

 

On March 30, 2005, the Company prepaid $120 million of the principal amount outstanding under MM’s $600 million Citibank credit facility. On July 28, 2005 the remaining balance, $480 million, of this credit facility was repaid.  Additionally, the Company wrote off $10.2 million of deferred financial cost, $10.0 million of which was charged in the third quarter of 2005.

 

On May 5, 2005, the Company repurchased $94.6 million of MM’s outstanding senior unsecured bonds (referred to as Yankee bonds).  In connection with this purchase the Company paid a premium of $5.7 million, which is included in the condensed consolidated combined statement of earnings on the line “Loss on debt prepayments”.

 

H.    Related Party Transaction:

 

On January 15, 2004, the Company entered into a tolling agreement with ASARCO, LLC (“Asarco”), a former shareholder of the Company and a subsidiary of Grupo Mexico.  Under terms of the agreement, in the first quarter of 2004 the Company, through its wholly owned US subsidiary, Southern Peru Limited (“SPL”), commenced delivering to Asarco, at its Amarillo, Texas refinery, copper cathodes for conversion into copper rods, which the Company sells to customers in the United States.  The Company has agreed to deliver 60,000 tons of copper to the Asarco refinery in 2005 under the agreement. Deliveries to the Asarco refinery, which are made on a monthly basis, amounted to approximately 29,500 tons through July 7, 2005.  On July 8, 2005 Asarco declared Force Majeure, notifying SPL that because of a strike at their facilities, they would be unable to accept shipments from the Company.  Accordingly, deliveries to the refinery were suspended and the Company has redirected the copper otherwise intended for delivery to the refinery to other customers.  At September 30, 2005 the Company did not have copper at the Asarco refinery.  The Company pays Asarco a tolling charge upon its receipt of copper rods.  These charges are based on competitive market terms.  Through June 9, 2005 the Company sold a portion of the copper treated by Asarco, approximately $13.7 million, to The Marmon Group — Cerro Wire, a stockholder of the Company until June 9, 2005.

 

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As of September 30, 2005 our Mexican operation has $2.2 million net of accounts receivable from sales and services provided to Asarco.

 

The Company’s Mexican operations have a contract with Ferrocarril Mexicano, S.A. de C.V. (“FerroMex”), a subsidiary of Grupo Mexico, which provides for transportation services.  The Company uses FerroMex’s railroad both to ship a portion of its mine production and to carry supplies to its operations.  The Company pays market-based rates for these services.  In the nine months ended September 30, 2005 and 2004, the Company recorded charges of $18.9 million and $13.1 million, respectively, for this service.

 

On October 20, 2005, the Company’s board of directors approved the acquisition of 6,386,521 shares of Minera Mexico from Grupo Mexico.  The acquired shares represent 0.81833% of the outstanding shares of Minera Mexico and were purchased at the average closing price of the last 30 days ended October 19, 2005.  The Company now owns 99.95% of Minera Mexico.

 

I.      Commitments and Contingencies:

 

Commitments:

 

Peruvian Operations

 

Royalty Charge:

 

In June 2004, the Peruvian Congress enacted legislation imposing a royalty charge to be paid by mining companies in favor of the regional governments and communities where mining resources are located. In November 2004, more than 5,000 Peruvian citizens filed a request to the Peruvian Constitutional Tribunal to have the law declared unconstitutional. However, in April 2005, the Constitutional Tribunal ruled the royalty law to be constitutional and therefore applicable to mining activities in Peru.  On June 28, 2005 the court dismissed the lawsuit and the Company has decided not to appeal.  Under the new law, the Company is subject to a 1% to 3% royalty charge, based on sales, applicable to the value of the concentrates produced in the Toquepala and Cuajone mines. The Company made provisions of $17.6 million and $26.2 million in 2004 and the first nine months of 2005, respectively, for this new royalty charge, which went into effect as of June 25, 2004. These provisions were included in cost of sales (exclusive of depreciation, amortization and depletion) on the Company’s condensed consolidated combined statement of earnings.

 

In addition, the Constitutional Tribunal stated that this charge applied to all concessions held in the mining industry, implying that those entities with stability contracts are subject to this charge. The Company believes that this interpretation is incorrect and intends to protest the imposition of the royalty charge on its SX/EW production, which is operating under a tax stability agreement (“Guaranty and Promotional Measures for Investment Contract”).  Provisions made by the Company for the royalty charge do not include approximately $4.8 million of additional potential liability relating to its SX/EW production from June 30, 2004 through September 30 2005.

 

Power Purchase Agreement:

 

In 1997, the Company sold its Ilo power plant to an independent power company, Enersur S.A., for $33.6 million.  In connection with the sale, a power purchase agreement was also completed, under which the Company agreed to purchase all of its power needs for its Peruvian operations from Enersur S.A. for twenty years commencing in 1997.

 

The Company agreed to amend its power purchase agreement in June 2003, resolving certain issues that arose between the parties and reducing power costs for the remaining life of the agreement.  The Company made a one-time contractual payment of $4.0 million to Enersur S.A. under terms of the new agreement. The new agreement releases Enersur S.A. from the obligation to construct additional capacity upon notice to meet the Company’s increased electricity requirements from the planned

 

11

 

expansion and modernization. The Company believes it can satisfy the need for increased electricity requirements from other sources, including local power providers.

 

Environmental Matters:

 

Peruvian Operations

 

Some of the Company’s operations are subject to applicable Peruvian environmental laws and regulations.  The Peruvian government, through its Ministerio de Energía y Minas (the Ministry of Energy and Mines, or MEM) conducts certain annual audits of the Company’s Peruvian mining and metallurgical operations.  Through these environmental audits, matters related to environmental commitments, compliance with legal requirements, atmospheric emissions and effluent monitoring are reviewed.  The Company believes that it is in material compliance with applicable Peruvian environmental laws and regulations.

 

In accordance with Peruvian regulations, in 1996 the Company submitted its Programa de Adecuación y Manejo Ambiental (the Environmental Compliance and Management Program, known by its Spanish acronym, PAMA) to the MEM.  A third-party environmental audit was conducted in order to elaborate the PAMA.  The PAMA applied to all current operations that did not have an approved environmental impact study at the time.  SCC’s PAMA was approved in January 1997 and contains 34 mitigation measures and projects necessary to (1) bring the existing operations into compliance with the environmental standards established by the MEM and (2) identify areas impacted by operations that are no longer active and need to be reclaimed or remediated.  By the end of 2004, 31 of these projects were completed, including all PAMA commitments related to the Company’s operations in Cuajone and Toquepala.  The three pending PAMA projects all relate to the Ilo smelter operations.  The primary areas of environmental concern are the smelter reverberatory slag eroded from slag deposits up until 1994, and atmospheric emissions from the Ilo smelter.

 

The slag remediation program is progressing as scheduled and is expected to be completed by 2007.  With respect to the smelter emissions, the third phase of the Ilo smelter modernization has started and is scheduled to be completed by 2007.  In July 2003, the Company awarded the contract to provide the technology and basic engineering for the modernization of the Ilo smelter to Fluor Chile S.A. and Xstrata plc (formerly M.I.M. Holdings Limited).  The Company believes that the selected technology complies with the current environmental regulations.  This project is the Company’s largest short-term capital investment project and is estimated at $500 million, including $294.3 million expended through September 30, 2005.  Beginning in 1995 and continuing while this project is under construction, the Company has established an emissions curtailment program that has allowed the Company to comply with the annual sulfur dioxide air quality standard (established by the MEM in 1996) in the city of Ilo.

 

On October 14, 2003, the Peruvian Congress published a new law announcing future closure and remediation obligations for the mining industry.  The law was amended on May 28, 2004 and again on May 8, 2005.  The current modification establishes that mining companies submit their mine closure plans within one year of publication of final regulations.  On August 16, 2005 final regulations were published and the Company has initiated the preparation of the required mine closure plan.  As part of the law and the qualifying regulations the Company is also required to engage an independent consulting entity to prepare the mine closure plan.  The final plan, which is required by August 2006, is subject to approval by MEM and open to public discussion and comment in the area of Company operations.  Additionally, the law requires companies to provide financial guarantees to insure that remediation programs are completed.  The Company anticipates that this law will increase its asset retirement obligations and require future expenditures and amortizations over the life of the mine to satisfy its requirements.  The Company believes the liability for these asset retirement obligations cannot currently be measured, or reasonably estimated, until the Company has substantially completed its mine closure plan and is reasonably confident that it will be approved by MEM in its most material respects.

 

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The Company foresees significant environmental capital expenditures in 2005 and continuing into 2006.  During the first nine months of 2005, $140.3 million of environmental capital expenditures were made on the smelter project, from a 2005 budget of $171 million.

 

Mexican Operations

 

Some of the Company’s operations are subject to Mexican federal, state and municipal environmental laws, to Mexican official standards, and to regulations for the protection of the environment, including regulations relating to water supply, water pollution, air pollution, noise pollution and hazardous and solid wastes.  Some of these laws and regulations are relevant to legal proceedings pertaining to the Company’s San Luis Potosí facilities.

 

The principal legislation applicable to the Company’s Mexican operations is the federal Ley General del Equilibrio Ecológico y la Protección al Ambiente (the General Law of Ecological Balance and Environmental Protection, or the Environmental Law), which is enforced by the Procuraduría Federal de Protección al Ambiente (Federal Bureau of Environmental Protection, or the PROFEPA).  The PROFEPA monitors compliance with environmental legislation and enforces Mexican environmental laws, regulations and official standards and, if warranted, the PROFEPA may initiate administrative proceedings against companies that violate environmental laws, which in the most egregious cases may result in the temporary or permanent closing of noncomplying facilities, the revocation of operating licenses and/or other sanctions or fines.  Also, according to the Código Penal Federal (Federal Criminal Code), the PROFEPA has to inform corresponding authorities regarding environmental crimes.

 

The Company’s operations near the U.S.-Mexican border are also subject to the Agreement on Cooperation for the Protection and Improvement of the Environment in the Border Area, or the La Paz Agreement, which was concluded in 1983 between the United States and Mexico for the purpose of improving air quality along the border.  The La Paz Agreement establishes sulfur dioxide emissions standards and requires the installation and maintenance of emission monitoring and record-keeping systems at our smelters in northwestern Mexico.  In order to maintain compliance with sulfur dioxide emissions standards promulgated under the Environmental Law and the La Paz Agreement, MM shut down the Cananea smelter and operations at Monterrey in December 1999.  Mexican environmental regulations have become increasingly stringent over the last decade, and this trend is likely to continue and may be influenced by the environmental agreement entered into by Mexico, the United States and Canada in connection with NAFTA in February 1999.  However, the Company’s management does not believe that continued compliance with the Environmental Law or Mexican state environmental laws will have a material adverse effect on the Company’s business, properties, results of operations, financial condition or prospects or will result in material capital expenditures.  Although the Company believes that all of its facilities are in material compliance with applicable environmental, mining and other laws and regulations, the Company cannot assure you that stricter enforcement of existing laws and regulations or the adoption of additional laws and regulations would not have a material adverse effect on the Company’s business, properties, results of operations, financial condition or prospects.

 

Due to the proximity of certain facilities of our Mexican operations near urban centers, the authorities may implement certain measures that may impact or restrain the operation of such facilities.  Any enforcement action to shut down any such facilities may have an adverse effect on the operating results of the relevant subsidiary.

 

The Company has instituted extensive environmental conservation programs at its mining facilities in Peru and Mexico.  The Company’s environmental programs include water recovery systems to conserve water and minimize contamination of nearby streams, revegetation programs to stabilize the surfaces of the tailings dams and the implementation of scrubbing technology in the mines to reduce dust emissions.

 

 

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Litigation Matters:

 

Peruvian Operations

 

1.               Garcia-Ataucuri and Others vs. SCC:  In April 1996, the Company was served with a complaint filed in Peru by approximately 800 former employees seeking the delivery of 38,763,806.80 “labor shares” to be issued in a proportional way to each in accordance with their time of work with SCC, plus dividends.  The Company conducts its operations in Peru through a registered Branch. Although the Branch has neither capital nor liability separate from that of the Company, under Peruvian law it is deemed to have an equity capital for purposes of determining the economic interest of the holders of investment shares. The labor shares litigation is based on claims of former employees for ownership of labor shares issued during the 1970s until 1989 under a former Peruvian mandated profit sharing system. We assert that the claims are meritless and that the labor shares were distributed to the former employees in accordance with the then in effect Peruvian profit sharing system. We do not believe that an unfavorable outcome is reasonably possible. In 1971, the Peruvian Government enacted legislation providing that workers in the mining industry would participate in the pre-tax profits of the enterprises for which they worked at a rate of 10%. This participation was distributed to the workers with 40% in cash and 60% as an equity interest in the enterprise. What remains of the equity participation is now included in the balance sheet caption “Minority interest.”  Under the law, the equity participation was originally delivered to the “Mining Community”, an organization representing all workers. The cash portion was distributed to the workers after the close of the year. The accrual for this participation was (and continues to be) a current liability of the Company, until paid. In 1978, the law was amended and the equity distribution was calculated at 5.5% of pre-tax profits and was made to individual workers of the enterprise in the form of labor shares. These labor shares represented an equity interest in the enterprise. In addition, equity participations previously distributed to the “Mining Community” were returned to the Company and redistributed in the form of labor shares to individual employees or former employees. The cash participation was adjusted to 4.5% of pre-tax earnings and continued to be distributed to employees following the close of the year. Effective in 1992, the law was amended to its present status. The workers participation in pre-tax profits was set at 8%, with 100% payable in cash. The equity participation component was eliminated from the law. In 1995, the Company offered to exchange new common shares of the Company for the labor shares issued under the prior Peruvian law. Approximately 80.8% of the labor shares issued were exchanged for the Company’s common shares, greatly reducing the Minority interest on the Company’s balance sheet. Since 1995, the Company has periodically purchased labor shares on the open market. In 1998, labor shares were renamed “investment shares.”  At September 30, 2005, the investment share interest in the Company’s Peruvian Branch amounted to 0.71%.

 

As stated above, in April 1996, the Company was served with a complaint filed in Peru by approximately 800 former employees seeking the delivery of a substantial number of “labor shares” (now referred to as “investment shares”) of its Peruvian Branch plus dividends on such shares. This amount corresponds to the total number of labor shares for the full Company workers, and the complaint is seeking to have such shares issued to the plaintiffs in proportional way to each in accordance with their time of work with the Company, plus dividends on such shares.  In December 1999, a civil court of first instance of Lima decided against the Company, ordering the delivery of the investment shares and dividends to the plaintiffs. The Company appealed this decision in January 2000. On October 10, 2000, the Superior Court of Lima affirmed the lower court’s decision, which had been adverse to the Company. On appeal by the Company, the Peruvian Supreme Court annulled the proceeding noting that the civil courts lacked jurisdiction and that the matter had to be decided by a labor court. The lower court dismissed the lawsuit in January 2005.  The plaintiffs have appealed to the superior court.

 

The Company has not made a provision for this lawsuit because it believes that it has meritorious defenses to the claims asserted in the complaint.

 

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2.               In June 2004, the Peruvian Congress enacted Law N° 28258, creating a “royalty charge” to be paid by mining companies in favor of the regional governments and communities where mining resources are located.

 

The Company and other mining companies have individually challenged before lower courts the constitutionality of this law through an “injunction procedure” (Acción de Amparo). In January 2005, a civil court in Lima accepted a lawsuit initiated by the Company, challenging the constitutionality of the mining royalty law of June 2004.

 

In April 2005, the Constitutional Tribunal ruled the royalty law to be constitutional and therefore applicable to mining activities in Peru.  The decision issued by the Peruvian Constitutional Tribunal cannot be appealed and must be observed by lower courts.  On June 28, 2005 the court dismissed the lawsuit and the Company has decided not to appeal.

 

Class Action

Three purported class action derivative lawsuits have been filed in the Delaware Court of Chancery (New Castle County) late in December 2004 and early January 2005 relating to the merger transaction between the Company and MM, (the “Transaction”). On January 31, 2005, the three actions—Lemon Bay, LLP v. Americas Mining Corporation, et al., Civil Action No. 961-N, Therault Trust v. Luis Palomino Bonilla, et al., and Southern Copper Corporation, et al., Civil Action No. 969-N, and James Sousa v. Southern Copper Corporation, et al., Civil Action No. 978-N—were consolidated into one action titled, In re Southern Copper Corporation Shareholder Derivative Litigation, Consol. C.A. No. 961-N and the complaint filed in Lemon Bay was designated as the operative complaint in the consolidated lawsuit.  The consolidated action purports to be brought on behalf of the Company’s common stockholders.

 

The consolidated complaint alleges, among other things, that the Transaction is the result of breaches of fiduciary duties by the Company’s directors and is not entirely fair to the Company and its minority stockholders. The consolidated complaint seeks, among other things, a preliminarily and permanent injunction to enjoin the Transaction, the award of damages to the class, the award of damages to the Company and such other relief that the court deems equitable, including interest, attorneys’ and experts’ fees and costs. The Company believes that this lawsuit is without merit and is vigorously defending against this action.

 

The Company does not believe that the aforementioned legal proceedings and tax contingencies mentioned below will have a material adverse effect on the financial position or results of operations of the Company and its consolidated subsidiaries.

 

Mexican Operations

 

Ejido Land Matter:

In July 1991, the Mexican agricultural community of Pilares de Nacozari Ejido, or Ejido, commenced an action in the first federal district court in Sonora, Mexico against the Mexican Ministry of Agrarian Reform, or the Ministry.  The action alleged improper expropriation of approximately 1,500 hectares of land adjacent to the La Caridad mine on which certain of Mexcobre’s (a subsidiary of Minera Mexico) facilities are currently located.  Mexcobre was not named as a defendant in the action although it was included as an interested third party due to its ownership of the land.  Mexcobre bought the land in question in 1976 from the Banco Nacional de Obras y Servicios Públicos, which had previously acquired it as a beneficiary of the expropriation by the Ministry in 1973 and has alleged legal and physical impossibility of returning the land.

 

After two previous rulings stating that it is impossible to return the land as a means of restitution, a third and final ruling from the Mexican Appellate District Court instructed the district court judge to resolve the legal and material impossibility of returning the land as a means of restitution.   The district court

 

 

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judge ruled that it is only partially impossible to physically return the land and ruled that legal impossibility has not been proved.  Mexcobre has filed a complaint (queja) against this ruling. We believe that if the Ejido requests indemnity instead of a return of the land, Mexcobre’s financial liability with respect to such compensation would not be material.

 

Coremi Royalties:

When Mexcobre originally received mining concessions related to its La Caridad unit in 1970, it was required to pay royalties to the Council of Mineral Resources, which is referred to as Coremi.  When the Mining Law came into effect in 1992, this obligation was terminated.  However, Coremi, the Mexican Superintendent of Mining and the Mexican Secretary of Economy, did not concede that the royalty obligation to Coremi was terminated and, in 1995, Coremi initiated a series of legal actions that are still pending.  In August 2002, Coremi filed with the Third Federal District Judge in Civil Matters, an action demanding from Mexcobre the payment of royalties due since 1997.  Mexcobre answered and denied Coremi’s claims in October 2002 and currently is in the discovery stage (etapa de ofrecimiento de pruebas).  The parties are currently seeking a negotiated settlement.  The Company and Mexcobre believe that any such payment related to this matter would not be material to it or to Mexcobre.

 

San Luis Potosí Facilities:

The municipality of San Luis Potosí has granted Desarrolladora Intersaba, S.A. de C.V., licenses of use of land and construction for housing and/or commercial zones in the former Ejido Capulines, where the residential project “Villa Magna” is expected to be developed in the near future.

 

The “Villa Magna” residential project will be developed within what IMMSA believes are the boundaries of an environmental and safeguard buffer zone required to be created and maintained pursuant to the Environmental Law and its regulations, based on a risk study approved by the Environmental and Natural Resources Ministry.  This risk study revealed that the operation of the zinc refinery, by its nature, represents potential risks to third parties.

 

Based on the foregoing, IMMSA has initiated two different actions regarding this matter:

 

(i)                     first, against the Municipality of San Luis Potosí, requesting the annulment of the authorization and licenses granted to Desarrolladora Intersaba, S.A. de C.A. to develop “Villa Magna” within the zinc plant’s safeguard and buffer zone; and

 

(ii)                  second, against the PROFEPA’s administrative resolution “advising” (rather than enforcing) the Municipality to acknowledge the safeguard buffer zone around IMMSA’s zinc refinery as approved by the Environmental and Natural Resources Ministry.

 

These actions are awaiting final resolutions.  IMMSA believes that, should the outcome of the above mentioned legal proceedings be adverse to IMMSA’s interests, the construction of the “Villa Magna” housing and commercial development would not, in itself, affect the operations of IMMSA’s zinc plant.

 

In addition to the foregoing, IMMSA has initiated a series of legal and administrative procedures against the Municipality of San Luis Potosí due to its refusal to issue IMMSA’s use of land permit in respect of its zinc plant.  The Municipality has refused to grant such license based on the argument that IMMSA has failed to submit, as part of the application process, a manifestación de impacto ambiental (environmental impact assessment).  IMMSA believes that the environmental impact assessment is not required because IMMSA will not undertake construction activities. The trial judge has ordered the Municipality to continue the analysis of IMMSA’s request to issue the licencia de uso de suelo (use of land permit).  The municipality has refused to issue the land use permit.  IMMSA is considering whether to file and “amparo” or injunctive relief against such resolution to compel the court to issue the land use permit.

 

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Tax Contingency Matters:

 

US Internal Revenue Services - IRS

Federal, state and foreign tax authorities regularly audit the Company in the United States and internationally. These audits can result in proposed assessments. In 2002, the US Internal Revenue Service (IRS) has issued a preliminary Notice of Proposed Adjustment for the years 1994 through 1996. In 2003, the Company settled these differences with the IRS and made a payment of $4.4 million, including interest. Generally, the years 1994 through 1996 are now closed to further adjustment.

 

The IRS is now completing its field audit of the tax years 2000 through 2002 and had previously completed the field audit work for 1997 through 1999. During the audit of the tax years 1997 through 1999, the IRS questioned the Company’s accounting policy for determination of useful lives, the calculation of deductible and creditable Peruvian taxes, the methodology of capitalizing interest and the capitalizing of certain costs (drilling, blasting and hauling) into inventory value as items for possible adjustment. In the fourth quarter of 2003, the Company and the IRS had jointly requested technical advice from the IRS National Office to help resolve the inventory value dispute. In August 2005 the National Office of the IRS responded to the IRS field audit group’s request for technical advice.  The issuance of this technical advice memorandum (TAM) allowed the IRS to close the field audit work of the audit cycles 1997 through 1999 and 2000 through 2002.  The TAM accepts the position of the IRS field office and concludes that the Company is required to capitalize mining costs to its leach dumps based on the weight of material moved, without regard to metal content or recoverability.  On October 5, 2005 the Company filed a formal protest with the IRS to appeal the proposed changes with respect to the TAM conclusion, as well as other items of adjustment proposed by the IRS field audit group.  These other adjustments include the methodology of capitalizing interest, the determination of useful lives for depreciable property, the calculation of deductible and creditable Peruvian taxes and the established service fee between the Company and related parties. The Company believes that the positions that it is reporting to the IRS are correct and appropriate.  The Company believes that it has substantial defenses to the proposed IRS adjustments and that adequate provisions have been made so that resolution of any issues raised by the IRS will not have an adverse effect on its financial condition or results of operations. Significant management judgment is required in determining the provision for tax contingencies. The estimate of the probable cost for resolution of the tax contingencies has been developed in consultation with legal and tax counsel. The Company does not believe that there is a reasonable likelihood that there is an exposure to loss in excess of the amounts accrued therefore.

 

Peruvian Operations:

 

In Peru the “Superintendencia Nacional de Administración Tributaria” (SUNAT), the Peruvian Tax Administration, regularly audits the Company. These audits can result in proposed assessments.

1)              In year 2002 the Company received assessments and penalties from SUNAT for fiscal years 1996 through 1999, in which several deductions taken were disallowed. SUNAT has challenged the Company’s depreciation method and deduction of other expenses related to charges incurred outside of Peru from 1996 through 1999, and the deduction of certain exchange differences and interest expenses from 1997 through 1999. The Company appealed these various assessments and resolution is still pending.

 

In February 2003, the Peruvian tax court confirmed SUNAT’s assessments and penalties with regard to depreciation and deductions of other expenses incurred outside of Peru for fiscal years 1996 and 1997.  Consequently, the Company recognized an additional tax and workers participation liability for fiscal years 1998 and 1999 on the amounts assessed by SUNAT. Therefore, in 2003 the Company recorded a charge to workers’ participation, (included in cost of sales (exclusive of depreciation, amortization and depletion) on the statement of earnings) and income tax expense of $0.5 million and $4.4 million, respectively. The Company, however, has not recognized a liability for penalties and interest

 

 

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assessed by SUNAT in connection with the depreciation and other expenses deduction as it considers they are not applicable. The status of the penalty appeals and other tax contingencies is as follows:

 

a)                          Year 1996:  With regard to the appeal of the penalty related to fiscal year 1996, the Company was required to issue a letter of credit to SUNAT of $3.4 million, which was issued in July 2003. This deposit is recorded in other assets on the condensed consolidated combined balance sheet. The Peruvian tax court denied the Company’s appeal in February 2004.  Consequently, in April 2004, the Company filed a lawsuit against the Peruvian tax court and SUNAT in the superior court of Peru. The Company was not required to issue a deposit for appeal of assessments and rulings with respect to any other years.  This lawsuit is still pending resolution.

b)                         Year 1997:  With regard to the penalty issued by SUNAT related to fiscal year 1997, in November 2002 the Peruvian tax court indicated that the penalty needed to be modified and declared the previously issued penalty null. According to this tax court resolution, SUNAT issued a new penalty in December 2003.  This penalty and penalties related to fiscal years 1998 and 1999 have been protested before SUNAT.  The Company’s appeal before the Peruvian tax court related to the assessments (pertaining to the deduction of certain interest expense) for fiscal year 1997 was denied. In this regard, in May 2003, the Company filed a lawsuit before the superior court against SUNAT and the Peruvian tax court, seeking the reversal of the ruling of the tax court. In July, 2005 the Superior Court remanded the case to SUNAT for a new pronouncement. SUNAT has appealed the courts decision to the supreme court in Lima.

c)                          SUNAT has not ruled on the interest deductions for 1998 or 1999.

d)                         The Company has not recorded any expense associated with the assessment challenging deductions of interest expense for the years 1997, 1998, or 1999, nor has the Company recorded any expense associated with the assessments for the years 2000 and 2001.

e)                          Years 1998 and 1999: The Company’s appeal is still pending resolution by SUNAT.

 

2)              In December 2004 and January 2005, the Company received assessments and penalties from SUNAT for the fiscal years 2000 and 2001, in which certain deductions taken by the Company were disallowed. SUNAT has objected to the Company’s method of deducting vacation pay accruals in 2000, a deduction in 2000 for a fixed asset write-off, as well as certain other deductions in both years.  The Company has appealed these assessments and resolution is still pending.  The Company received penalties and assessments from SUNAT relating to the treatment of foreign exchange differences for 2000 and 2001, which the Company is contesting before SUNAT.

 

Mexican Operations

 

In May 2005, the Mexican Supreme Court rendered a decision that changed the method of computing the amount of statutory workers’ profit sharing required to be paid by some Mexican companies.  The Supreme Court’s ruling in effect prohibited the application of net operating loss carryforwards in computing the income used as the base for determining the workers’ profit sharing amounts.  The Company has elected to recognize in its results of operations for the first nine months of 2005 $31.1 million for workers’ profit sharing related to 2004 in addition to the 2005 year-to-date estimate of our potential liability.

 

Labor Matters

 

In the last several years the Company has experienced a number of strikes or other labor disruptions that have had an adverse impact on its operations and operating results.  For example, in Peru on August 31, 2004, unionized workers at the mining units in Toquepala and Cuajone initiated work stoppages and sought additional wage increases based on high metal prices.  The strike was resolved on September 13,

 

 

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2004.  In Mexico, on July 12, 2004, the workers of Mexicana de Cobre site went on strike asking for the review of certain contractual clauses.  Such a review was performed and the workers returned to work 18 days later.  On October 15, 2004, the workers of Mexicana de Cananea, a subsidiary of Minera Mexico, went on strike, followed by the Mexicana de Cobre workers.  The strike lasted for six days at Mexicana de Cobre and nine days at Mexicana de Cananea.  In both cases, the operations at the Mexican mines ceased until the strike was resolved.  The Company cannot make assurances that they will not experience strikes or other labor-related work stoppages in the future that could have a material adverse effect on its financial condition and results of operations.

 

In July 2005, the unionized workers of Asarco commenced a work stoppage, which could have a material adverse effect on Asarco and its business prospects.  A further deterioration of the financial condition of Asarco could result in additional claims being filed against Grupo México and its subsidiaries, including Southern Copper Corporation, Minera México or its subsidiaries.  Any increase in the financial obligations of our parent corporations, as a result of matters related to Asarco or otherwise, could, among other matters, result in our parent corporations attempting to obtain increased dividends or other funding from us.  As a result of various factors, including the work stoppage which commenced in July 2005, on August 9, 2005, Asarco filed a voluntary petition for relief under Chapter 11 of the U.S. Bankruptcy Code before the U.S. Bankruptcy Court of Corpus Cristi, Texas.  Asarco’s bankruptcy case is being joined with the bankruptcy cases of its subsidiaries.  Asarco is in continuing possession of its properties and is operating and managing its businesses as a debtor in possession.  However, it is impossible to predict how the bankruptcy court will ultimately rule with respect to such petitions and the impact such rulings will have on Asarco and its subsidiaries.

 

Other Legal Matters

 

Our direct and indirect parent corporations, including AMC and Grupo México, have from time to time been named parties in various litigations involving Asarco.  In March 2003, AMC purchased its interest in SCC from Asarco.  In August 2002 the U.S. Department of Justice brought a claim alleging fraudulent conveyance in connection with Asarco’s environmental liabilities and AMC’s then-proposed purchase of SCC from Asarco.  That action was settled pursuant to a Consent Decree dated February 2, 2003.  The consent decree is binding solely on the U.S. government.  In October 2004, AMC, Grupo México, Mexicana de Cobre and other parties, not including SCC, were named in a lawsuit filed in New York State court in connection with alleged asbestos liabilities, which lawsuit claims, among other matters, that AMC’s purchase of SCC from Asarco should be voided as a fraudulent conveyance.  While Grupo México and its affiliates believe that these claims are without merit, we cannot assure you that these or future claims, if successful, will not have an adverse effect on our parent corporations or us.  Any increase in the financial obligations of our parent corporations, as a result of matters related to Asarco or otherwise, could, among other matters, result in our parent corporations attempting to obtain increased dividends or other funding from us.  In 2005, certain subsidiaries of Asarco filed bankruptcy petitions in connection with alleged asbestos liabilities.  In July 2005, the unionized workers of Asarco commenced a work stoppage, which could have a material adverse effect on Asarco and its business prospects. A further deterioration of the financial condition of Asarco could result in additional claims being filed against Grupo México and its subsidiaries, including SCC, Minera México or its subsidiaries. As a result of various factors, including the work stoppage, which commenced in July 2005, on August 9, 2005, Asarco, filed a voluntary petition for relief under Chapter 11 of the U.S. Bankruptcy Code before the U.S. Bankruptcy Court of Corpus Christi, Texas. Asarco’s bankruptcy case is being joined with the bankruptcy cases of its subsidiaries. Asarco is in continuing possession of its properties and is operating and managing its businesses as a debtor in possession.

 

Asarco believes that by utilizing the Chapter 11 process it can achieve an orderly restructuring of its business and finally resolve, among other contingencies, its environmental and asbestos claims. However, it is impossible to predict how the

 

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bankruptcy court will ultimately rule with respect to such petitions and the impact such rulings will have on Asarco and its subsidiaries.

 

J.                Capitalized Mine Stripping:

 

The Company uses the accounting policy of capitalizing mine stripping after production has commenced, during periods when waste material exceeds the life-of-mine stripping ratio.  This policy is one of a number of policies that are used in the mining industry to address waste removal during operations.  The policy results in the smoothing of stripping costs over the life of the mine and facilitates the matching of mine production costs over the life of the mine with mine revenues.

 

On March 17, 2005 Emerging Issues Task Force or “EITF” reached a consensus on issue No.04-06, “Accounting for Stripping costs Incurred during Production in the Mining Industry”, which was ratified by the Financial Accounting Standard Board or “FASB”, on March 30, 2005 and the subsequent modification to the transition provision approved by the “EITF” in its June, 2005 meeting.  The consensus stated that stripping costs incurred during the production phase of a mine are variable production costs that should be included in the cost of the inventory produced (extracted) during the period that the stripping costs are incurred. The Company expects to adopt the guidance on January 1, 2006, with the most significant impact of adoption being on the capitalized stripping asset net of taxes and on retained earnings.

 

At September 30, 2005, the Company had on its balance sheet $300.8 million of costs associated with capitalized mine stripping, net, which will be impacted by this consensus.  We anticipate that a significant portion of this asset will be written off and equity and net income would be reduced accordingly.  In addition, future-operating income could be negatively impacted to the extent that costs previously capitalized are expensed at a faster rate than we had previously amortized stripping costs.

 

K.    Segment and Related Information:

 

The Company operates in a single industry, namely mining copper.  Prior to the April 1, 2005 acquisition of Minera Mexico, the Company determined that its operations in Peru fell within one segment.  With the acquisition of Minera Mexico the Company continues to operate principally in one industry, the mining of copper.  However, because of the demands of managing operations in two countries, effective April 1, 2005, Company management views the new Southern Copper as having three operating segments and manages on the basis of these segments.  Additionally, in mining copper the Company produces a number of metal by-products, most important of which are molybdenum, silver and zinc.  The significant increase in the price of molybdenum over the past two years has had an important impact on the Company’s earnings.  Nevertheless, the Company continues to manage its operations on the basis of the three copper segments.  Added to the segment information is information regarding the Company’s molybdenum sales.  The segments identified by the Company are:

 

1.               Peruvian operations, which includes the Toquepala and Cuajone mine complexes and the smelting and refining plants, industrial railroad and port facilities which service both mines.

 

2.               Mexican open pit copper mines, which includes La Caridad and Cananea mine complexes and the smelting and refining plants and support facilities which service both mines.

 

3.               Mexican underground mining operations, which includes five underground mines that produce zinc, copper, silver and gold, a coal and coke mine, and several industrial processing facilities for zinc and copper.  This group is identified as the IMMSA Unit.

 

The Chief Operating Officer of the Company focuses on operating income as measure of performance to evaluate different segments, and to make decisions to allocate

 

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resources to the reported segments.

 

Financial information relating to Southern Cooper’s segments is as follows:

 

		Three Months Ended September 30, 2005 (dollars in millions)
		Mexican Open Pit				Mexican IMMSA Unit				Peruvian Operations				Corporate and other Eliminations			Consolidated
Net sales outside of segments		$		395.0		$	63.4			$		571.8		$	—		$		1,030.2
Intersegment sales		13.9				21.6				7.9				(43.4		)	—
Cost of sales (exclusive of depreciation, amortization and depletion)		160.1				66.6				191.3				(35.0		)	383.0
Exploration		0.9				1.9				3.6				—			6.4
Depreciation, amortization and depletion		49.4				6.1				19.3				—			74.8
Selling, general and administrative expense		7.4				4.0				8.4				0.4			20.2
Operating Income		$		191.1		$	6.4			$	357.1			$	(8.8	)	545.8
Less:
Interest expense, net																	(15.3			)
Gain on derivative instruments																	3.7
Loss on debt prepayment																	(12.5			)
Other income (expense)																	1.9
Taxes on income																	(152.6			)
Minority interest																	(1.6			)
Net Earnings																	$	369.4
Capital expenditures		15.4				8.9				96.4				—			120.7
Total Assets		$	2,366.1			$		469.9		$		3,194.5		$	(633.6	)	$	5,396.9

 

		Three Months Ended September 30, 2004 (dollars in millions)
		Mexican Open Pit				Mexican IMMSA Unit				Peruvian Operations				Corporate and other Eliminations				Consolidated
Net sales outside of segments		$		264.1		$	47.3			$	428.1			$		—		$	739.5
Intersegment sales		—				31.1				—				(31.1			)	—
Cost of sales (exclusive of depreciation, amortization and depletion)		137.6				62.8				188.2				(40.2			)	348.4
Exploration		0.6				1.2				1.5				—				3.3
Depreciation, amortization and depletion		22.2				5.6				19.9				0.4				48.1
Selling, general and administrative expense		6.8				4.8				6.7				(1.1			)	17.2
Operating Income		$		96.9		$	4.0			$	211.8			$		9.8		322.5
Less:
Interest expense, net																		(25.5			)
Gain on disposal of property																		20.7
Other income (expense)																		(3.7			)
Taxes on income																		(93.3			)
Minority interest																		(3.9			)
Net Earnings																		$		216.8
Capital expenditures		8.5				3.1				48.3				—				59.9
Total Assets		$	3,105.7			$		579.6		$		2,256.8		$	(998.6		)	$		4,943.5

 

 

21

 

		Nine Months Ended September 30, 2005 (dollars in millions)
		Mexican Open Pit			Mexican IMMSA Unit			Peruvian Operations			Corporate and other Eliminations			Consolidated
Net sales outside of segments		$	1,220.7		$	176.5		$	1,537.1		$	—		$	2,934.3
Intersegment sales		88.4			151.4			7.9			(247.7		)	—
Cost of sales (exclusive of depreciation, amortization and depletion)		639.6			255.2			538.1			(247.2		)	1,185.7
Exploration		3.3			4.6			9.3			—			17.2
Depreciation, amortization and depletion		132.5			17.4			56.4			—			206.3
Selling, general and administrative expense		20.3			11.6			25.2			2.1			59.2
Operating Income		$	513.4		$	39.1		$	916.0		$	(2.6	)	1,465.9
Less:
Interest expense, net														(45.6		)
Loss on derivative Instruments														(8.4		)
Loss on debt prepayment														(22.6		)
Gain on disposal of property														2.1
Other income (expense)														(1.8		)
Taxes on income														(405.4		)
Minority interest														(4.6		)
Net Earnings														$	979.7
Capital expenditures		41.5			23.8			198.0			—			263.3
Total Assets		$	2,366.1		$	469.9		$	3,194.5		$	(633.6	)	$	5,396.9

 

		Nine Months Ended September 30, 2004 (dollars in millions)
		Mexican Open Pit			Mexican IMMSA Unit			Peruvian Operations			Corporate and other Eliminations			Consolidated
Net sales outside of segments		$	830.0		$	143.1		$	1,091.2		$	—		$	2,064.3
Intersegment sales		0.2			93.2			—			(93.4		)	—
Cost of sales (exclusive of depreciation, amortization and depletion)		389.9			169.8			465.8			(103.1		)	922.4
Exploration		1.1			3.3			6.1			—			10.5
Depreciation, amortization and depletion		68.0			16.7			57.6			1.1			143.4
Selling, general and administrative expenses		18.2			11.6			21.0			0.5			51.3
Operating Income		$	353.0		$	34.9		$	540.7		$	8.1		936.7
Less:
Interest expense, net														(81.0		)
Gain on disposal of property														43.0		)
Other income (expense)														(6.6		)
Taxes on income														(265.2		)
Minority interest														(11.6		)
Net Earnings														$	615.3
Capital expenditures		29.2			9.9			110.0			—			149.1
Total Assets		$	3,105.7		$	579.6		$	2,256.8		$	(998.6	)	$	4,943.5

 

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