Xstrata Plc - annual report 2006

Chief Executive’s Report

M L Davis

On the fifth anniversary of the listing in March 2002 of Xstrata plc on the London Stock Exchange, the Group is unrecognisable from its beginnings as a small, growth-constrained and narrowly-diversified company operating in only three commodities and three countries. Today, as one of the largest diversified mining companies, Xstrata comprises operations and projects across 19 countries, with top four industry positions in each of its major commodity markets and an extensive pipeline of value-creating growth projects.

We have reached this position by relentlessly pursuing shareholder value on three fronts:

first, executing a strategy of growth and diversification whenever we identify value enhancing opportunities consistent with our metrics of value and risk;
second, a continuous programme of productivity and efficiency improvement at all operations; and
third, a consistent search for ways to enhance the net present value (NPV) of the existing asset base through resource to reserve conversion and process innovation.

In summary, growth has been achieved and value created through:

the successful completion and integration of three company-transforming acquisitions;
a series of valuable bolt-on additions to our core businesses;
the on-going extension of mine lives at a number of our key assets;
the delivery of significant internal growth projects in our alloys, coal and zinc businesses; and
an industry-leading performance in containing operating costs across the Group.

In 2006 alone, three major acquisitions with a combined cost of $19.6 billion – Falconbridge Limited, one-third of Cerrejón Coal and Tintaya Copper – were successfully completed, contributing to the Group’s progress and transforming the breadth, range and scale of its businesses.

Three major acquisitions

The acquisition in March of a one-third interest in the Cerrejón coal operation in Colombia, one of the world’s premier coal mining assets, provided Xstrata with additional exposure to high quality, premium thermal coal with access to the growing North American, South American and European markets. Cerrejón has already outperformed the assumptions made at the time of the acquisition and the mine’s exceptional resource base, the expansion currently under way and the potential for future growth – together with the recent resurgence in thermal coal prices – all give me great confidence that this transaction will secure significant additional value for our shareholders over the long-term.

The acquisition of the Tintaya copper operation from BHP Billiton in June provided Xstrata Copper with an additional 120,000 tonnes of annual copper production and a significant strategic position in southern Peru. We also recognised the potential for further growth at Tintaya from the associated satellite deposits and I am delighted that in the eight months since acquiring the assets, the Xstrata Copper team has already confirmed resources of some 470 million tonnes at 0.7% copper at the Antapaccay deposit, just 9 kilometres from Tintaya. A drilling programme will now commence with the intention of upgrading this resource base further as part of a pre-feasibility study into the development of the project. Subsequent to the acquisition, synergies have been identified with a value of $110 million and these are being progressively realised. In addition, a further $50 million of value has already been realised through ongoing operational management initiatives, with a range of other significant initiatives being actively pursued in 2007.

Finally, the most significant step of all came with the successful acquisition of Falconbridge Limited. The acquisition was launched in May and completed in October, but in truth commenced over one year earlier, with the opportunistic purchase of a 20% stake in that company. Securing this stake gave Xstrata an essential advantage in the contested acquisition, enabling us to offer the remaining Falconbridge shareholders the certainty of cash at a substantial premium, while containing the average price paid per share to gain 100% of the company.

As a result of these acquisitions, Xstrata is now a one million tonne per annum copper producer with an unrivalled suite of growth options, exposure to all major copper metallurgical technologies and an excellent position in South America. The Group also maintains a significant position in the nickel market with excellent potential to grow, has gained exposure to North America and is the world’s largest zinc producer, with a profitable, integrated aluminium business.

Growth in earnings

The acquisitions completed in 2006 contributed $4.6 billion to Xstrata’s pro forma 2006 EBIT of $8.3 billion, demonstrating the very significant earnings accretion achieved through adding cash generative operations to the portfolio at a time of sustained high commodity prices.

On a pro forma basis, stronger commodity prices contributed to an increase of over 119% in attributable profit to $4.9 billion. EBITDA (pre-exceptionals) rose to $10.4 billion, with Xstrata’s operations generating $9.4 billion of cash.

In 2006, for the third consecutive year, prices for every commodity produced by the Group (with the single exception of vanadium) were higher at the end of the year than at the beginning. While average prices for coking and thermal coal were marginally lower, average prices for base metals were substantially higher than in the previous year. Base metals prices remain highly volatile, as evidenced in the first few months of 2007, but they remain significantly above long-run averages and comfortably ahead of any of the assumptions that underpinned our acquisitions in 2006.

Xstrata Nickel’s Koniambo project in New Caledonia contains one of the largest undeveloped nickel orebodies in the world

The high cost inflation associated with inputs into the mining industry, to which I referred in my interim report, continued to impact our operations in the second half of the year. In particular, demand for contract labour, fuel, explosives and construction materials continued to outstrip supply, resulting in increased lead times for equipment delivery and rapidly escalating prices. Mining sector inflation, together with the impact of CPI inflation, impacted EBIT at the former Xstrata operations by a total of $274 million, which is very significant. However, there is some evidence that the rate of price increases may have slowed somewhat in the second half of the year, although it is too early to see if this will continue in 2007.

Value creation from the portfolio

Efficiency gains

The full impact of the rising prices of inputs was mitigated by a highly creditable performance in containing real costs by our commodity businesses. The operating cost base of the legacy Xstrata operations was reduced by $56 million in 2006 – a fifth consecutive year of real operating cost savings, with a particularly strong performance in the second half.

These cost savings clearly demonstrate the benefit of new, lower cost production coming on stream from the range of brownfield growth projects that Xstrata has commissioned in the past two years. In particular, increased lower-cost production of thermal coal from Rolleston and longwalls in New South Wales and of coking coal from the Wollombi deposit, the commissioning of the highly efficient Lion ferrochrome smelter and increased production from the lower-cost Black Star zinc-lead open pit mine and McArthur River open test pit all contributed to this exceptional result. In addition, the outstanding cost performance of our zinc business benefited from further efficiency gains in our European smelters, with a $23 million gain from San Juan associated with improved recoveries, particularly of silver.

Extensions of mine lives and resources

Further extensions to mine reserves and resources have been confirmed at a number of Xstrata’s operations and exploration projects, prolonging the life of our operations and providing significant increases to the net present value of these assets. In particular, it is very pleasing that the Xstrata Copper team has been able to adapt the mine plan at Alumbrera to access additional mineralization in the bottom of the open pit, extending the life of this operation by a further year, for the third year running. Similarly, at Mount Isa, additional underground reserves of some 7 million tonnes have been established to extend the mine life by a further year. We are also progressing into pre-feasibility stage exciting possibilities to exploit lower grade underground resources at Mount Isa through bulk mining methods.

Additional resource extensions have been confirmed at the Wandoan thermal coal project, the Raglan nickel mine, the Kabanga and Araguaia nickel projects, and the Las Bambas copper project. At Las Bambas, indicated and inferred resources have increased by 69% from 300 million tonnes at 1.1% copper to 508 million tonnes at a grade of 1.14% copper using a 0.5% cut-off grade. The presence of substantial volumes of high grade skarn-style copper mineralization, with notable grades of molybdenum and gold, supplemented with large, lower grade copper porphyry mineralization confirm the potential scale and quality of this mineral district.

Nickel core samples from Kabanga exploration project, Tanzania

Bulldozer on the stockpile at Bulga thermal coal mine, Australia

The proximity of the substantial Mineral Resource at the Antapaccay deposit to the existing Tintaya infrastructure, indicates its significant potential both to increase production and to extend the life of Tintaya – substantially increasing the NPV of this acquisition, as well as to leverage the development of the Las Bambas mineral district, some 100 kilometres away.

The acquisition of Falconbridge has dramatically extended average mine life within our copper business. Based on current production rates and proven and probable reserves, the average mine life of Xstrata’s copper assets has been extended from approximately 13 years to over 20 years, whilst further conversion of the currently known resource base would extend this beyond 30 years.

Internal growth projects

Xstrata now has an extensive pipeline of major growth projects across our commodity businesses that can be brought on in line to feed market demand. In 2007 our nickel business will continue to progress the Araguaia, Koniambo and Kabanga greenfield projects, while the Nickel Rim South project remains on track for first production in 2009.

The Falconbridge acquisition has completely transformed the scale and range of internal growth options available to our copper business, which now holds a portfolio of five major, greenfield projects that have the potential to more than double the Group’s current one million tonnes of annual copper production. In addition to increasing the resource base at four of these projects, Xstrata Copper has taken up its 62.5% option and will assume management control of the Tampakan project from our partners Indophil Resources at the end of March 2007.

Our coal business continues to benefit from a wealth of brownfield expansion projects at Cerrejón Coal, Rolleston and across our New South Wales operations, as well as greenfield opportunities such as the 7 million tonnes per annum Goedgevonden Project in South Africa, the massive Wandoan coal project in Queensland and the Glendell project in New South Wales. In Xstrata Alloys, our chrome business is already benefiting from the new low-cost production from the Lion ferrochrome operation, which has significant brownfield expansion potential.

In our zinc business, expansions of the McArthur River open-cast mine (to 320,000 tonnes per annum) and the concentrator at Mount Isa are already under way, increasing annual production and lowering the cost base of these businesses. The low capital cost 60% expansion to 8 million tonnes per annum of the zinc-lead concentrator will have the additional benefit of doubling the supply of our own concentrate to our European smelters.

Xstrata’s executive and business unit management have recognised the challenge of delivering this scale of growth on time and on budget in the current industry environment of high inflation and equipment and skills shortages. I am confident that our past successes, the robust risk management process and devolved accountability that underpin our business approach and the impressive project management expertise that we have gained in the Falconbridge acquisition, will all contribute to the successful realisation of our industry-leading growth options.

Integration of Falconbridge and Synergy Benefits

The formal integration of Falconbridge into Xstrata was completed at the end of December 2006, just four months after we gained management control in August 2006. The smooth and efficient integration of an acquisition of this magnitude and complexity bears testimony to Xstrata’s integration methodology and to the expertise of a network of integration team members drawn from across our business units, both of which have now been refined and tested on a number of large transactions.

Nickel

A new commodity business, Xstrata Nickel, led by Ian Pearce former COO of Falconbridge, has been established with its head office in Toronto. The inclusion of this team expands the breadth and depth of Xstrata’s technical capabilities, and provides real impetus to our strategic aim to grow the nickel business rapidly. One of the new team’s pressing objectives is to work closely with CVRD Inco to optimise efficiencies across the operations of both companies in the Sudbury basin. Tremendous potential exists to unlock value, extend the lives of the Sudbury operations and to bring on additional growth through this process. Teams from Xstrata Nickel and CVRD Inco are now actively engaged in negotiating a commercial structure to deliver these benefits. I expect that we will be able to confirm later this year how we intend to work together and, in the process, the extent of the synergy value that each company will create for its shareholders. I am confident that our revised estimate of Xstrata’s share of Sudbury synergies of $120 million per annum (previously $80 million) remains conservative.

Copper

Falconbridge’s copper assets have been fully integrated into Xstrata Copper. The resulting portfolio of copper operations and growth projects is arguably the most exciting and prospective in the sector. Xstrata Copper has been structured into five operating divisions across Argentina, Canada, North Chile, Southern Peru and North Queensland, designed to maximise the potential of the regions in which they operate. Xstrata Copper has identified approximately $60 million of annual operating synergy benefits arising from the integration of the former Falconbridge copper assets. The progressive implementation of integration plans will see these benefits fully realised during 2007.

In addition, a once-off finance re-structuring benefit of $58 million was achieved as a result of the copper asset integration.

Zinc

Similarly, Xstrata Zinc has absorbed the Falconbridge zinc assets, creating a new operating division, Xstrata Zinc Canada, and further improving Xstrata’s integration across zinc concentrate mining and smelting. The combination of Falconbridge’s zinc business with Xstrata’s existing assets has propelled Xstrata to become the world’s largest zinc producer and annual synergies of $11 million have been identified through the integration process.

Aluminium

The Falconbridge acquisition also provided entry to aluminium, another new commodity. Xstrata Aluminum is an integrated aluminium producer, predominantly based in the US and active across the entire value chain from bauxite through to downstream products.

As signalled at the time of the acquisition, we are conducting a strategic review of this business, to assess its potential as a platform for future growth in this new commodity, compared to the prospects for a profitable sale, and I expect a final decision to be made during the first half of this year.

Technology and research

The world-class former Falconbridge technology and research activities have been consolidated into a single activity as Xstrata Process Services, to provide mineral processing expertise and support to all of Xstrata’s businesses worldwide. Falconbridge’s commercial processing technologies, including the widely-used Kidd Process for copper refining, have been absorbed into Xstrata Technology, which specialises in marketing world-class processing technologies to clients worldwide.

Exploration

Falconbridge’s exploration function has been restructured in line with Xstrata’s approach to exploration. We continue to believe that greenfield exploration is best achieved through partnerships with juniors, who are better equipped to identify new resources successfully, and from within business units where existing assets can be leveraged to maximise the returns from exploration. This restructuring has resulted in the devolution of exploration activities to the relevant business units, a rationalisation of non-essential activities, reduction in headcount and an ongoing programme of exiting non-core exploration properties and tenements, often retaining an option to participate in the most promising. To date, the total consideration value of these divestments is just over $60 million, whilst the divestment of equity investments yielded $7 million.

Corporate and head office costs

In keeping with our entrepreneurial management structure, authority and responsibility has been devolved wherever possible to the copper, zinc, nickel and aluminium business units. This has resulted in headcount reductions and downsizing of corporate facilities. One-off costs associated with the integration totalled $50 million and comprise primarily redundancy and facilities closure costs – more than offset by the one-off $67 million proceeds from exploration disposals discussed above. Resulting from the successful integration process, I am pleased to report that our estimate of head office and exploration synergies has increased by 88% to $75 million per annum.

Annual synergy gains

As a consequence of these successful steps, the original estimate of synergies in our investment case for the acquisition of Falconbridge has been significantly surpassed. At the time of the transaction, we estimated around $120 million of annual cost savings ($40 million associated with the head office costs at Falconbridge and $80 million in potential synergy gains in the Sudbury basin). Our estimate of operational synergy benefits (including the revised $120 million estimate of attributable Sudbury synergies already highlighted) has risen to some $265 million per annum.

In addition to these annual pre-tax cost savings, a further $280 million of annual synergies are expected to result from the inclusion of the former Falconbridge assets within our financial structure from 2007.

As a consequence, the acquisitions of Falconbridge and Tintaya have secured over $4 billion of sustainable value creation for shareholders.

I am proud of our team who, once more, have executed the integration in an exemplary fashion, reinforcing my view that post-acquisition integration is one of Xstrata’s distinctive capabilities. Through the Falconbridge acquisition, we have gained an outstanding pipeline of organic growth projects, an entry into nickel and aluminium, geographic diversification into North America and exceptional people with the talent and skills to help Xstrata continue to grow and unlock value from our portfolio. I also commend the professionalism with which the former Falconbridge employees participated in the integration, a factor which contributed substantially to its success.

The Skills Training Centre at the Lion Ferrochrome smelter is providing training to local community members

Compliance with the South African Mining Charter

During the course of the year, Xstrata plc concluded a ZAR2.4 billion ($387 million) agreement with African Rainbow Minerals Limited (“ARM”), which established a new majority black-owned company, ARM Coal, and introduced meaningful and sustainable black economic participation in Xstrata’s South African coal business. The newly established ARM Coal (51% owned by ARM and 49% by Xstrata) owns a 20% participation share in Xstrata’s existing South African coal business. ARM subsequently took up a further direct 10% stake, at a cost of ZAR400 million, which, together with ARM’s 51% share of the Goedgevonden project, resulted in 36% of Xstrata’s South African coal business being owned by historically disadvantaged South Africans. ARM Coal provides both Xstrata and ARM with an alliance through which existing and future growth opportunities in Africa can be pursued.

In addition, in February 2007, Xstrata Alloys concluded a ZAR575 million agreement with the Bakwena Ba Mogopa community in respect of Xstrata’s fully integrated Rhovan vanadium facility in South Africa. The Community is the surface owner of the property on which the facility is located. Through the transaction, the Community will have an effective 26% participation in the Xstrata Alloys vanadium business through a Pooling and Sharing Venture, similar to the Xstrata-Merafe Chrome Venture.

As a result, all of our South African businesses have now met the ownership provisions of the Mineral and Petroleum Resources Development Act of 2002 (“MPRDA”) and Xstrata is the first major international mining company to have been acknowledged by the Department of Minerals and Energy as being in full compliance with the Act and the Mining Charter.

Balance sheet, dividend, capital management

Xstrata spent a total of $19.6 billion and assumed debt of $3.8 billion to fund acquisitions in 2006. Despite this significant outlay of cash, the Group has maintained its investment grade credit rating, through successful equity issues to raise a total of $8 billion and an over-subscribed $2.25 billion debut US bond offering.

These capital raisings, together with continued very strong cash generation from Xstrata’s operations, have enabled the repayment in full of both equity and debt bridge facilities associated with the acquisition representing a total of $9.5 billion. This, together with the exceptional cash generation of its assets, position Xstrata to fund capital expenditure in 2007, while still rapidly repaying corporate debt. While gearing of 41% at year end is currently above our target range, further bank debt has been paid down in early 2007 and gearing is expected to decline significantly in the current year.

A small-scale chicken farm is one of several community enterprise development initiatives supported by St Ann bauxite mine, Jamaica

The operations control room at the Horne smelter, Canada

With no material debt falling due within the next 18 months and an excellent spread of maturities within the Group’s bond and bank debt facilities, Xstrata is well positioned to fund its capital expenditure in the current year, currently expected to be around $2.4 billion. Additional initiatives to diversify funding and expand the debt portfolio maturity further may be considered opportunistically during the current year.

The acquisition of 20% of Falconbridge for $28 per share in August 2005 gave Xstrata an important strategic advantage in the acquisition of Falconbridge. The fact that we had acquired 20% of the company at this price allowed us the flexibility to compete for the remainder of the equity and, as a result, the average purchase price of C$56.44 per share was comfortably within our valuation range. However, under International Financial Reporting Standards (IFRS), goodwill is calculated separately for each acquisition stage, regardless of the average price paid per share to acquire the entire interest. This creates an obvious gap between the average price per share actually paid by Xstrata for the 100% interest and the price paid for the remaining 80% equity (C$62.50 per share), resulting in the creation of additional goodwill of some $1.5 billion. In view of the above, the usual impairment tests unsurprisingly result in an impairment charge of $1,378 million in the statutory income statement.

The proposed final dividend of 30¢ represents an increase of 34% compared to the previous year, and has been rebased at this higher level to reflect the cash generated by the enlarged Xstrata, together with our continued confidence in the outlook for the current year and beyond.

Pleasingly, the rapid earnings growth and transformation achieved by Xstrata has translated into record value creation for shareholders. In 2006, Xstrata delivered a total annual shareholder return of 112%, far outstripping its industry peers. One pound invested in Xstrata at the time of our initial public offering in 2002, would have increased in value by some 430% to nearly £5.30 at the end of 2006, demonstrating the significant wealth Xstrata has created for its shareholders over the last five years. Value creation remains the core tenet of our activities and the measure by which all of our growth initiatives are judged.

Outlook

Commodity prices have again performed very strongly in 2006. While it is unlikely that average prices for base metals will continue to rise at a similar rate in 2007, the fundamental outlook for the industry remains positive. The rapidly industrialising economies of China and India and the satisfactorily performing economies of the older ‘Asian tigers’ and Europe will continue to drive demand growth for metals and energy, despite an underperforming US economy. On the supply side, the tight availability of major projects, skilled resources and cheap power and the challenges of difficult geographies, inadequate infrastructure, significant cost inflation and the depleting nature of reserves across the industry will continue to moderate growth in production.

As a consequence, there is no sign that commodity prices are rapidly returning to long-run averages, and the price environment remains very favourable, particularly in our traded thermal coal and ferrochrome businesses, where contract prices have been negotiated above last year’s levels. We therefore move into the next stage of Xstrata’s development, delivering the benefits of our recent acquisitions and the immense growth optionality inherent within the portfolio, with a following wind.

This positive outlook often appears to need reiteration in the face of the increased volatility that is now such a feature of the equity and commodity markets. This challenging environment also creates opportunities for those companies that are well positioned and that have the global intelligence, management momentum and shareholder support that enable them to capitalise from the two major trends that continue to characterise our industry: a robust price environment and on-going consolidation. Critical to any such success is also one’s confidence in the price assumptions that underpin valuations – particularly the short-term price assumptions at times of exceptionally high prices. For this reason, Xstrata is engaged in a continual review of its short- and long-run commodity price assumptions.

Xstrata is well positioned to maintain its track record of success based on:

a focused and consistent strategy of delivering growth as well as NPV enhancement;
a clear view on how focusing on the price of assets and how to operate them in the most effective way – not just some elusive search for “quality” – creates real value;
a culture that is not comfortable with standing still; and
a devolved management structure that builds a sense of empowered ownership across our teams.

It is therefore to the men and women in Xstrata to whom I first address my thanks. Xstrata’s success over the past five years has been delivered by your dedication, your commitment to safety and to the values that underpin our Mission Statement, and your hard work.

We will continue to build on our success to date in creating a positive, safe work environment and the mutually beneficial partnerships with our stakeholders that are an essential element of future success.

Xstrata has a small but talented team at the centre. They are due much credit for the role which they have played since our IPO in 2002.

I also thank my fellow directors and my executive colleagues for their courage, support and wisdom. The willingness of the non-executive directors to back this management has allowed Xstrata to emerge as a major force in the mining and metals industry.

2007 has launched itself with volatility and debate. I am, however, steadfast in my belief that Xstrata’s drive for growth and value creation can be realised by a management who are alive to the opportunities and who can manage the challenges.