Xstrata Plc - annual report 2007

Chief Executive’s Report

M L Davis

Growth and value creation continued to characterise Xstrata’s performance in 2007. A strong operational performance, boosted by record production across much of the portfolio, enabled the Group to capture the benefits of continued robust demand for metals and energy in its key markets. This strong operating performance, particularly in the second half, was achieved in the face of a number of unpredictable one-off operational disruptions during the year. These included earthquakes in north Chile, a fire at the Mount Isa zinc-lead concentrator, Collahuasi and Antamina SAG mill repairs, Tropical Storm Noel in the Dominican Republic, torrential rain in eastern Australia and load-shedding by Eskom resulting in electricity shortfalls in South Africa.

Despite these incidents and the impact of the weaker US dollar against the majority of Xstrata’s operating currencies, earnings before interest, tax, depreciation and amortisation (EBITDA) rose to some $11.3 billion, 58% and 7% higher than the previous year on a statutory and pro forma basis respectively. Earnings per share rose to $5.78, 9% higher than the previous year on a pro forma basis.

Xstrata’s growth in earnings in 2007 brings the compound annual growth rate in EBITDA since 2002 to almost 100%, with EBITDA margins increasing by 19% over this time period, compared to growth in EBITDA and EBITDA margins of 36% and 14% respectively for the average of Xstrata’s FTSE100 diversified mining peers. It is worth reflecting that Xstrata’s net earnings of $5.5 billion at the end of 2007 represent more than ten times the market value of Xstrata some six years earlier, demonstrating the successful execution of Xstrata’s strategy to deliver superior shareholder value through growth.

Delivery against strategic objectives

The ongoing transformation of Xstrata’s portfolio continued in 2007, with further progress against our strategic objectives to:

Enhance the net present value of our operations through a focus on operational excellence, including improved operational efficiency and productivity, reduced costs, mine-life extensions and mine plan optimisation;
Facilitate a meaningful entry into new commodities;
Complete value-adding bolt-on acquisitions to Xstrata’s existing commodity businesses;
Develop the Group’s industry-leading portfolio of brown- and greenfield growth projects across its commodity businesses; and
Act as a catalyst for industry evolution by pursuing transforming transactions.

NPV enhancement and operational excellence

Xstrata’s portfolio of assets continued to benefit from the acquisition or development of new, low-cost, high quality operations and a range of initiatives to enhance the net present value of our existing assets in 2007.

Once again our businesses achieved an industry-leading performance in reducing real operating costs, trimming $253 million from the cost base. This very pleasing performance marked the sixth consecutive year of real cost savings and demonstrates the significant transformation currently under way across Xstrata’s asset base, as new, lower cost production is introduced and further productivity and efficiency gains are achieved at existing operations. Since 2002, Xstrata has reduced net real operating costs by an average of 1% per annum of the cost base, compared to an average cost increase of 2% annually over this time period by our diversified mining peers, taking into account mining sector inflation in each case. I am delighted that this result, achieved in the face of ongoing and significant cost challenges across the mining industry in particular for energy, fuel and contracted labour, has delivered additional value to shareholders again in 2007. Importantly, our vigilance on real costs has avoided higher fixed costs becoming embedded in our operations during the current extended period of commodity price strength, positioning our business to capture greater value on an ongoing basis.

Sustaining capital expenditure increased to $1.5 billion as we continue to pursue environmental improvements, improved recoveries and operational efficiencies, in particular at the former Falconbridge operations. As a result of increased investment, Xstrata’s businesses achieved further improvements in recoveries of by-products, with consequent real unit cost savings, including silver at San Juan de Nieva and investment to capture value from molybdenum processing at Minera Alumbrera and Altonorte, with a molybdenum feasibility study also under way at Tintaya.

Safety resources and training were also enhanced, emphasising leadership and responsibility at the site level in line with Xstrata’s devolved management model. This investment, together with a range of initiatives, resulted in a very significant reduction in the frequency of injuries sustained at Xstrata’s operations. The most marked improvements came from the former Falconbridge operations, where the frequency of all recordable injuries reduced by 33% compared to the previous year. Overall, Xstrata’s total recordable injury frequency rate improved by 26% to 12.3 per million hours worked.

As I have noted in the past, good safety performance and injury management is, of course, vitally important in protecting our people and assets but it is equally an important indicator of effective leadership and operational excellence. It is rewarding for me that Xstrata’s uncompromising focus on safety and our associated devolution of responsibility to each employee to protect their colleagues and themselves has so rapidly become embedded in the former Falconbridge and other acquired operations.

Despite this excellent performance in reducing injuries, there is no room for complacency in safety performance, particularly with respect to the very significant challenge Xstrata and the mining industry as a whole face in preventing fatalities. It is unacceptable any employee or contractor is fatally injured and we have again dedicated significant resources to addressing the major hazards and behavioural issues that contribute to these incidents.

The value of existing operations was further enhanced during the year through extensions to mine resources and conversions to reserves, leading to the consequent extension of mine lives and optimisation of life of mine plans. Increased mineral resources have been confirmed at a number of copper operations and projects, including Minera Alumbrera, Mount Isa, Lomas Bayas, Tampakan and a substantial 28% increase in the resource base at Collahuasi, supporting our plans to more than double production at this world-class asset. Xstrata Copper has published its first resource statement for the El Pachón project in Argentina, although further project development remains uncertain, in part due to the climate of uncertainty for foreign investment created by the recent moves by the Argentine government to apply export retention taxes to previously exempt mining operations covered by fiscal stability laws.

Our strategy to establish southern Peru as a major new copper-producing district for the Group has been robustly underpinned by the publication of updated resource estimates which indicate an increase of almost 400 million tonnes or 31% in resources for the southern Peru district. This comprises upgraded resource estimates for the Antapaccay and Las Bambas projects and the first resource estimate for the Coroccohuayco deposit. Both Antapaccay and Coroccohuayco are situated approximately 10 kilometres from the existing Tintaya mine infrastructure.

Xstrata Nickel published updated resource estimates for the world-class Raglan operation, adding over 4 million tonnes of resources in 2007 to Zone 5-8, the largest mineral zone in Raglan’s history. Raglan’s expansion to 1.3 million tonnes is already under way with further exploration work planned this year to support this Tier 1 asset’s expansion to over 2 million tonnes. Resources were also increased at the highly prospective Araguaia project in Brazil.

These further improvements to the reserve and resource life position of our operations have resulted in a portfolio which compares favourably to the average resource life of our diversified mining peers, particularly in coking and thermal coal, copper and zinc.

Aníbal Contreras clears slag at the Altonorte metallurgical facility, North Chile

Water quality sampling at Barney Creek, McArthur River zinc-lead mine, Australia

A meaningful entry into new commodities

In August, Xstrata Alloys launched the next stage of its ambitious platinum group metals strategy with an agreed offer for Eland Platinum in South Africa. In addition to the Elandsfontein operation, which commissioned on schedule in October 2007 and delivered 12,000 ounces of PGMs by the year end, the transaction also provided Xstrata with access to the contiguous Madibeng and Beestkraal properties. These have been complemented by the recent acquisition of the New Order Prospecting Rights at the De Wildt property, adjacent to and up-dip from the open cast Elandsfontein operation, permitting a significant optimisation of the mine plans for Xstrata’s existing platinum properties and access to the Madibeng property.

These acquisitions have facilitated Xstrata’s meaningful entry into platinum during historically strong platinum markets and the fundamentals for this commodity remain very promising over the medium term.

Value-adding growth through acquisition

Acquisitions continue to form an important element of our growth strategy and core capability and, as a result of the growth achieved to date, each of Xstrata’s five major commodity businesses now has the critical scale to compete for significant transactions in its own right, multiplying significantly the nodes from which growth can be delivered across the Group.

This capability was emphatically demonstrated through the completion of over $6 billion of acquisitions in six separate transactions in 2007 and in early 2008, following the recent successful conclusion of the acquisition of Jubilee Mines, a Western Australian nickel group, and Resource Pacific, an Australian thermal coal producer. Together, these several bolt-on acquisitions in thermal and coking coal, platinum and nickel constitute the equivalent of the acquisition of a mid-tier diversified mining group and will provide further momentum in the ongoing reduction of the operating cost profile of our business, the potential for further growth, access to new attractive commodities and the powerful transformation of Xstrata’s portfolio.

Last year’s acquisitions have introduced immediate incremental volume growth in key commodities at a time of heightened demand. Equally importantly, each transaction also injects further near-term growth options into Xstrata’s pipeline, which now represents over $30 billion of organic growth projects across each of our commodity businesses.

New South Wales Coal Acquisitions

Xstrata Coal’s position in the Hunter Valley thermal coalfields has been significantly strengthened through the acquisition of the Anvil Hill project and the remaining interests not already owned by Xstrata in Narama and Cumnock Coal. In December, Xstrata Coal made an offer for Resource Pacific which successfully completed on 10 March. These acquisitions together represent an additional 4 million tonnes of predominantly semi soft coal production annually from 2008, increasing Xstrata’s earnings exposure to coal at a time of record spot prices.

The acquisition of Austral Coal represents a significant addition to our Australian coking coal business from the underground Tahmoor coking coal operation, which provides an additional 2.3 million tonnes of premium quality metallurgical product annually and entry into the southern coalfields in New South Wales. Xstrata assumed management control of Tahmoor on 30 October and the operation contributed 257,000 tonnes of coking coal by the year’s end. Critically, Tahmoor’s coal is exported via Port Kembla, one of the few unconstrained ports in Australia.

Xstrata Coal’s timely acquisitions, combined with industry-leading productivity levels, position Xstrata optimally to secure additional value from forthcoming contract negotiations during record thermal coal markets in 2008.

Jubilee Nickel

On 4 February 2008, Xstrata Nickel assumed management control of Jubilee Mines, comprising the operational Cosmos mine and a range of growth projects in Western Australia. These operations form a new operating division, Xstrata Nickel Australasia, with targeted production of 90,000 tonnes per annum by 2013, including Koniambo. Further significant growth potential exists from Jubilee’s prospective land position and the former Jubilee team’s historic exploration success in the region.

Martin Leguizamon surveys the tailings dam at Minera Alumbrera, Argentina

Growth from the portfolio

Xstrata’s extensive growth pipeline, unveiled at our interim results presentation in August and outlined in further detail for the copper, coal and nickel businesses in early December, has increased to over $30 billion of green- and brownfield growth projects due to the addition of new growth projects from the acquisitions completed during the year. Over $12 billion of expansionary capital expenditure is currently approved, with $1.4 billion of expansionary capital expenditure in 2007. Xstrata’s portfolio now comprises more than ten Tier 1 operations and projects that are being prioritised to take advantage of market conditions and support a projected compound annual growth rate of 12% per annum to 2013.

Alloys

In ferrochrome, installed infrastructure at the efficient Lion ferrochrome smelter supports two further phased expansions to bring annual production capacity to over one million tonnes. Xstrata Alloys’ Lion and Lydenburg operations benefit from Xstrata’s proprietary Premus technology, which has demonstrated increased energy efficiency for ferrochrome smelting of over 20% compared to our industry peers.

The key acquisition of Eland Platinum marked the next step in Xstrata Alloys’ exciting growth strategy for its growing platinum business. The Elandsfontein opencast mine began production in late 2007 and is ramping up to reach 250,000 tonnes per month by the third quarter. The infrastructure at the operation has been designed to enable current annual capacity of 183,000 ounces to be doubled. To achieve this, the Xstrata Alloys team is planning the development of a 500,000 tonnes per month underground mine, with the first decline expected to be sunk in the third quarter of 2008, and work to double the capacity of the Eland concentrator will commence in the first half of 2009.

The Eland acquisition also provided us with title over the Beestkraal prospecting area. This highly prospective property of some 11,000 hectares contains a potential 100 million ounce resource and a two-year drilling programme will be initiated to define this resource in the second quarter, at a total capital cost of approximately $26 million.

In total, this strategy is targeting the production of in excess of 1 million ounces of platinum production in the next decade.

Coal

Xstrata Coal continues to benefit from a broad range of brownfield, low cost expansion options across its portfolio. The new Goedgevonden and 5-Seam operations in South Africa commenced production in 2007 and will ramp up in 2008, further improving the overall cost profile of our South African coal business.

Additional near-term growth will come from further expansions at Cerrejón which will reach the 32 million tonnes per annum rate in 2008, with further growth to in excess of 40 million tonnes currently being assessed. The addition of a second dragline at the efficient Rolleston operation in 2007 has further boosted production from this asset, although first half production in 2008 has been impacted to date by heavy rains and flooding in Queensland.

Further out, pre-feasibility studies are under way into the massive one billion tonnes Wandoan resource in the Surat Basin in Queensland, which is expected to deliver over 15 million tonnes annually and could begin production in around 2011.

Copper

Further progress was made in 2007 in assessing and prioritising Xstrata Copper’s world-class portfolio of greenfield growth projects with scoping studies completed for the Frieda River and Las Bambas projects. Tampakan is one of the largest undeveloped copper resources in the Asia-Pacific region. Since assuming management control in March, Xstrata Copper has dedicated considerable effort to community consultation and to improving environmental and social engagement practices. The extended pre-feasibility study is expected to be completed this year, with a comprehensive environmental and social impact assessment in 2009 alongside an expected full feasibility study.

I am particularly pleased that over 1.6 billion tonnes of copper resources have now been confirmed within the newly-established southern Peru division, comprising the Tintaya operation and the Antapaccay, Coroccohuayco and Las Bambas projects. This is a very positive development that should progressively deliver a fourfold increase in annual copper production to half a million tonnes over the next five years from this new division. The rapid development of the southern Peru district is being facilitated by the ability to leverage existing infrastructure, processing and port facilities to maximise the value of these significant mineral resources. It underlines the significant value being created by the Xstrata Copper management team in Peru from our acquisition of Tintaya less than two years ago and from our original acquisition of the Las Bambas option in Peru less than four years ago.

Near-term growth will also be achieved from a further increase in production at the Tier 1 Collahuasi asset in 2008, as part of the ultimate strategy to double current production levels from that mine to 1 million tonnes annually. A drilling programme has also been initiated at the Antamina operation, aimed at clearly defining an expansion plan for this world-class asset and expansions are ongoing at the Altonorte smelter, Lomas Bayas and Mount Isa.

In total, these projects will see Xstrata Copper projected to progressively double annual copper production to some 2 million tonnes over the next five years.

Nickel

Xstrata Nickel’s pipeline comprises three world-class, low cash cost greenfield projects; Araguaia, Koniambo and Kabanga, together with significant brownfield expansions at Raglan, Nickel Rim South, Fraser Morgan and Falcondo. Fraser Morgan and Nickel Rim South will commence production in 2009, and the Sudbury operations are on track to increase production to 35,000 tonnes of nickel. Raglan’s expansion to 1.3 million tonnes is well advanced.

The $3.8 billion Koniambo project in New Caledonia gained Xstrata Board approval in October and will deliver a world-class nickel asset with an extensive resource base, low cash costs and the potential to increase the life of the operation to over 50 years. The acquisition of Jubilee and the establishment of Xstrata Nickel Australasia enhances the potential for synergies and improved regional co-operation between Koniambo and the Western Australian nickel assets.

Zinc

The accelerated development of the new Perseverance zinc mine in Canada will see first production this year. In Australia, 2008 will see the completion of the Mount Isa zinc-lead concentrator expansion to a capacity of 8 million tonnes per annum. The successful completion of this project will see production increase to 340,000 tonnes of zinc, effectively doubling output since our acquisition of MIM in 2003 for a moderate capital cost of $150 million.

The ramping up of Lennard Shelf operations and the development of the Handlebar Hill deposit, together with the ongoing development of the open pit at McArthur River Mine, will further reduce our exposure to third-party zinc concentrate, enabling approximately 90% of the zinc concentrate processed by our smelters to be supplied from our own mines in 2009.

Drilling at the Kabanga nickel project, Tanzania

Nursery worker at the Falcondo rehabilitation initiative, Dominican Republic

Management changes

On 1 January 2008, Peter Coates retired as Xstrata Coal Chief Executive and has been succeeded by Peter Freyberg, previously Director of Operations, Xstrata Coal, who has also joined Xstrata’s Executive Committee. Peter Coates has played a very significant role in shaping Xstrata since its inception, in 2002 and has built the premier thermal coal business in the industry today. I thank him for his outstanding contribution to the Group’s success. I am delighted that Xstrata will continue to benefit from Peter’s extensive industry expertise in his new consultative role as Chairman, Xstrata Australia from 1 April 2008.

Disposal of non-core assets

The disposal of the former Noranda Aluminum business in April realised $1.15 billion of cash and reflected our view that, while profitable, these assets did not provide us with the scale or upstream exposure to represent a suitable entry point from which to build a world-class aluminium business. Similarly, a suite of non-core exploration properties acquired through the Falconbridge transaction were divested during the year, retaining ‘back-in’ rights for the most prospective and realising proceeds of $90 million.

Coal chain capacity constraints

Ongoing constraints in the rail and port facilities that comprise the Australian coal chain, particularly at Dalrymple Bay Coal Terminal and Newcastle port, continued to impact Australian producers’ capacity to increase exports and led to extensive shipping queues at coal terminals. Consequently significant demurrage expenses were incurred by all producers and the cost to Xstrata rose to over $110 million, more than double the previous year’s charges.

In January 2008 an independent facilitator was appointed to resolve the issues that are currently restricting growth in the Hunter Valley coal chain. While any sustainable solution is likely to require two to three years to be fully implemented, this is a positive step towards agreeing on appropriate access protocols and investment plans to match track and rail expansions with planned mine and port capacity increases. Our coal business continues to work closely with the relevant authorities to address this urgent issue and to ensure our operations continue to opportunistically fill any capacity freed up by production problems elsewhere.

South African power

In early 2008, the shortage of South African electricity became acute, necessitating emergency power cuts and outages across the country. In response, Eskom has implemented a mandatory 10% cut in the supply of electricity to the mining and beneficiation industry, stabilising the situation in the near term.

For Xstrata, the most significant impact is on our ferrochrome business which accounts for approximately 90% of our total South African electricity consumption. We currently estimate that restricted power supply will constrain ferrochrome production to approximately 85% of capacity for the second quarter. The outlook for the higher demand winter period remains uncertain, although Eskom coal stocks have been rebuilt to some extent, mitigating the likelihood of further unplanned outages in the near term. Xstrata’s proprietary Premus technology provides a unique competitive advantage in an environment of higher energy costs, since it reduces electricity consumption per tonne of ferrochrome by over 20% compared to other industry processes.

Given the strategic importance of the domestic coal industry in solving the energy crisis, Xstrata’s South African coal operations – the majority of which produce coal for sale to Eskom in addition to export coal – are expected to remain relatively unaffected by reduced electricity supply. Our team at Xstrata Coal South Africa is working closely with Eskom and the national government to assist in securing the supply of coal to domestic coal-fired power stations.

Discussions in respect of industry consolidation

Industry consolidation is a trend we foreshadowed some years ago as we set out to play a central role in the industry’s transformation into a global industry comprising a smaller number of large diversified players with the scale to compete preferentially for new opportunities, generate more stable cash flows and deliver superior returns over the cycle. Indeed, the momentum for consolidation in the global mining industry has undoubtedly accelerated following the announcement of an approach by BHP Billiton for Rio Tinto last year and the subsequent formalised offer in February of this year.

In this respect, on 12 December Xstrata confirmed that it was in discussions with industry participants on a range of topics including consolidation. On 21 January 2008, Vale, a Brazilian mining group, confirmed that it was in discussions with Xstrata management. Discussions with Vale are ongoing and may or may not lead to an offer for Xstrata.

Throughout Xstrata’s rapid evolution into a diversified global mining major, Xstrata’s management team and Board have consistently focused on the value proposition for shareholders. A dispassionate and rigorous assessment of value remains the key consideration for any transaction and we continue to assess a range of opportunities to continue Xstrata’s success to date in delivering superior value to shareholders.

Balance sheet and dividend

Robust cash flows from Xstrata’s operations enabled net debt to be paid down to $12 billion, bringing gearing to 32%, comfortably within the Group’s target range. In addition over $500 million was returned to shareholders through the opportunistic reactivation of the equity capital management programme during a period of market weakness in the second half. A total of 9.3 million shares or 1% of the total issued share capital were repurchased by Batiss Investments and remain available for use as acquisition currency. The maturity of the Group’s borrowings was extended during the year through three major bond issues which, together with the refinancing of Group bank facilities, provide additional flexibility in funding and access to two major debt capital markets.

Consequently, Xstrata is well positioned to fund its extensive range of growth options while retaining the financial firepower to identify and opportunistically complete value-enhancing acquisitions at the commodity business or Group level.

The proposed final dividend of 34¢ per share brings the total for the year to 50¢ per share, 20% higher than the rights-issue adjusted full-year dividend in 2006. This further year-on-year increase in dividends clearly signals the Board’s continued confidence in the very strong prospects for Xstrata and the outlook for ongoing strength in its key commodity markets.

Outlook

While a slowdown in the United States now seems highly probable, with likely negative consequences for short-term growth in the OECD countries, I expect any impact on Chinese GDP growth and emerging market demand for commodities, including metals, to be muted. Chinese GDP growth is driven by the combination of rapidly accelerating domestic demand, investment and export-led growth. With China’s urbanisation ratio approaching 45%, rapid income growth, high savings rates and the urbanisation of around 15 million people annually, the bulk of Chinese demand is driven by internal factors. We expect this demand, coupled with that from India, Russia and a number of south-east Asian economies, to fuel robust growth in global demand for commodities into the medium term.

The short-term outlook depends significantly on US and European monetary policy in the face of a slowdown and, naturally, on its impact on demand for commodities. Rapid reductions in US rates have already signalled willingness to avert a severe slowdown and augur well for a muted reduction in demand for commodities in the OECD markets.

We have previously made the case for a ‘decoupling’ of emerging markets, and in particular the driving force of the Chinese economy, from the US in terms of physical demand for commodities. It is true that financial markets, including investment, currency, credit and equity markets, are increasingly converging, as greater flows of cross-border capital and increasingly open and wealthy emerging markets lead to ever closer global financial integration and more stable financial markets.

On the other hand, demand for commodities is diverging away from a historic dependence on the US and OECD countries. This decoupling is driven by the increased relative importance and intensity of domestic demand for metals, energy and other commodities in China and other emerging markets, compared to developed countries. Already, China alone accounts for over 70% of growth in global mined commodity demand. This decoupling is reinforced by the increased volume of trade between emerging Asian countries themselves, which now exceeds exports to the US from the region. Furthermore, only 50% of US imports are sourced from emerging markets. So, while a significant slowdown in the US and other OECD countries will undoubtedly have an impact on global demand for commodities, we expect this to be muted and temporary, if significant at all.

Forward curves have flattened significantly in the last 12 months in recognition of this stable outlook for commodities. In the short term, however, low exchange stocks and the meaningful presence of financial investors in listed metals are likely to result in ongoing price volatility until uncertainty over the US economy is played out.

I believe that the medium-term outlook for commodities is further strengthened by the return to growth of the Western economies over the next two to three years. Increased investment in ageing infrastructure will renew demand for metals and, together with ongoing investment in the Middle East and emerging markets, will fuel a period of synchronous demand growth across the globe for commodities.

I expect this concurrent growth in demand to outpace even that in evidence between 2002 and 2004.

As a result, I remain very confident in the outlook for all of Xstrata’s commodities through the medium and long term.

The industry as a whole and to some degree Xstrata, face a number of challenges in seeking to meet this unprecedented demand, including continued cost pressures, skill and energy shortages and strong producer currencies. Our operating performance, especially over the last year, has given me further comfort that Xstrata’s operational management is best positioned to continue to mitigate these challenges.

Xstrata’s achievements in operational progress, volume growth, improving safety performance, continued reduction in real costs, determined delivery against our project pipeline and ability to capture opportunistic value-creating transactions are a testament to the skill and dedication of our employees and management teams. Xstrata is perfectly positioned to benefit from the positive demand outlook as we progress the transformation of our portfolio through industry-leading operating performance and the myriad internal and external growth options at our disposal, while continuing to play a central role in the industry’s ongoing evolution.