Item 3. Legal Proceedings
There are no material pending legal proceedings to which Inco or any of its subsidiaries is a party or of which their property is the subject. Inco and its subsidiaries are subject to routine litigation incidental to the business conducted by them, to various environmental proceedings, and to other litigation related to such business that Inco does not believe to be material. Among the environmental proceedings are claims for personal injuries, enforcement actions and certain claims dating back a number of years in which one of our subsidiaries was designated, under the United States federal environmental law known as “Superfund”, or “CERCLA”, as a potentially responsible party. The Superfund claims assert that, as a potentially responsible party, Inco’s subsidiary sent waste to a contaminated landfill or similar site and is jointly and severally liable for the cost of remediating such site. These claims have not proceeded to a point where a reliable assessment can be made of the costs to Inco, assuming responsibility is found to exist or liability is determined, but we believe, based upon our present information concerning these matters and its past experience, that its potential liability, if found to exist, would not be significant.
Inco has from time to time been named as a party or charged in connection with the alleged violation of, including exceeding regulatory limits relating to discharges under, certain environmental or similar laws and regulations applicable to its operations in Canada and elsewhere. Such proceedings have involved, and with respect to currently pending charges may ultimately involve, fines or similar sanctions in excess of $100,000. However, none of these currently pending or threatened proceedings are material, either singly or in the aggregate, to our results of operations, financial condition or liquidity.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders in the fourth quarter of 2005.
PART II
Item 5.
Item 5. Markets for Inco Limited’s Common Shares, Related Shareholder Matters and Inco Limited’s Issuances or Purchases of Equity Securities
Common Shares
Market Information
There are two principal markets on which Inco’s Common Shares are traded, the New York Stock Exchange (the “NYSE”) and the Toronto Stock Exchange (the “TSX”).
The high and low closing sale prices for Inco’s Common Shares as reported on the NYSE and the TSX for each quarter during the past two years are as follows:
On March 13, 2006, the closing sale prices for the Company’s Common Shares were $46.14 on the NYSE and Cdn.$53.54 on the TSX.
Issuance of Unregistered Securities
In the fourth quarter of 2005, a total of 2,557,361 Common Shares were issued on the conversion of our LYON Notes. These Common Shares were not registered under the Securities Act of 1933 in reliance on the exemption from registration provided by Section 3(a)(9) of such Act. The Company received no separate consideration upon such conversion. The Company did not issue any other equity securities that were not registered under the Securities Act of 1933 in 2005.
Holders of Common Shares
The total number of holders of record of the Company’s Common Shares as of February 17, 2006 was 13,612.
Dividends
Subject to the preferential rights of any prior ranking shares (of which none were issued and outstanding as of the date of this report), the holders of Common Shares are entitled to such dividends as may be declared by Inco’s Board of Directors out of funds legally available therefor. No dividend or other distribution on the Common Shares shall be paid, and no Common Share shall be acquired for value, unless dividends on all outstanding Preferred Shares have been paid for all past quarterly periods.
On April 19, 2005, Inco announced that its Board of Directors had reinstated a quarterly cash dividend of $0.10 per share on our Common Shares, beginning June 1, 2005, and on February 7, 2006 we announced that the Board of Directors had increased the quarterly dividend to $0.125 per share, effective for the dividend payable March 1, 2006. The payment of dividends on the Common Shares had been eliminated by the Board of Directors in 1999. The Board continues to review on a periodic basis the declaration and payment of dividends on the Common Shares and its dividend policy. This policy is expected to be evaluated by our Board of Directors upon the completion of the pending acquisition of Falconbridge. The quarter-to-quarter decision as to the amount of the quarterly dividend per Common Share is reviewed by our Board of Directors and determined with reference to a number of factors, including current business results and cash needs.
Common Share Purchase Warrants
As part of the redemption price Inco paid in connection with the redemption of the Company’s Class VBN Shares discussed under “Class VBN Shares” below, Inco issued approximately 11 million Common Share Purchase Warrants (the “Warrants”). The Warrants were issued under, and are governed by, a Warrant Agreement dated as of December 1, 2000 by and among Inco, CIBC Mellon Trust Company, as the Canadian Warrant Agent, and ChaseMellon Shareholder Services, L.L.C., as the U.S. Warrant Agent (the “Warrant Agreement”).
Each whole Warrant entitles the holder to purchase one Common Share at an exercise price of Cdn.$30.00 (or the equivalent in U.S. dollars based upon then prevailing exchange rates at the time of exercise), subject to certain adjustments (the “Exercise Price”), until 5:00 pm (Toronto time) on August 21, 2006. Any Warrants not exercised prior to such date will expire. A Warrant holder does not have any voting or pre-emptive rights or any other rights as a shareholder of the Company until the Warrants held by such holder have been duly exercised and Common Shares of the Company have been issued to the holder pursuant thereto.
The Warrant Agreement provides that the Exercise Price and/or the number and kind of securities or property issuable on the exercise of the Warrants are subject to adjustment in certain events, including (1) the subdivision or consolidation of the Common Shares, (2) the issuance to all or substantially all the holders of Common Shares of a stock dividend or other distributions excluding any issuance of securities to holders of outstanding Common Shares which constitutes a “Dividend Paid in the Ordinary Course” (defined generally in the Warrant Agreement to include dividends or other distributions exceeding certain threshold aggregate or annual amounts based upon the value of the dividends or other distributions paid or consolidated net earnings for specified periods), and (3) the distribution to all or substantially all the holders of Common Shares of (i) shares of any other class, (ii) rights, options or warrants to acquire Common Shares, or (iii) cash, property or other assets of the Company (excluding, in each case, “Dividends Paid in the Ordinary Course”).
The Exercise Price and/or the number and kind of securities or property issuable on exercise will also be subject to certain adjustments in connection with certain other events, including any change, reclassification or alteration of the Common Shares, the consolidation, amalgamation, merger or other similar arrangement of the Company with another Company, or the transfer of all or substantially all of the Company’s assets.
No adjustment in the Exercise Price or the number or kind of securities or property issuable upon exercise will be required to be made (1) unless the cumulative effect of such adjustment or adjustments would change the Exercise Price by at least one per cent or, in the event of a change in the number of Common Shares purchasable upon exercise, the number of Common Shares issuable would change by at least one one-hundredth of a Common Share or (2) in respect of the issue of Common Shares pursuant to (i) the exercise of the Warrants or (ii) the Company’s Optional Stock Dividend Program and Share Purchase Plan and options granted current or former employees of the Company or any other option or share purchase plan.
The Warrant Agreement provides that modifications and alterations to it and to the Warrants may be made if authorized by extraordinary resolution and if all other necessary approvals are received. The term “extraordinary resolution” is defined in the Warrant Agreement to mean, in effect, a resolution passed by the affirmative votes of the holders of not less than 66 2/3 per cent of the Warrants represented and voting at a meeting of Warrant holders or an instrument or instruments in writing signed by the holders of not less than 66 2/3 per cent of the outstanding Warrants. The Warrant Agreement and the Warrants may be modified and altered without authorization by extraordinary resolution and if all necessary approvals are received in order to cure defects or ambiguities, to make ministerial amendments otherwise provided that the rights of Warrant holders are not materially adversely affected thereby.
The Warrants are listed on the TSX and on the NYSE. Subject to applicable law, Inco may purchase Warrants in the market or by tender or private contract, and any Warrants so purchased will be cancelled.
Other Information
Under its articles of incorporation, Inco is authorized to issue an unlimited number of Common Shares.
For a description of Inco’s outstanding debentures and notes which are convertible into Common Shares, see Notes 9 and 13 to the financial statements under Item 8 of this Report.
The Common Shares have general voting rights. At shareholders’ meetings, each holder of these securities is entitled to one vote for each share held and there are no cumulative voting provisions. See Note 16 to the financial statements under Item 8 of this Report.
Class VBN Shares
At a special meeting of shareholders held on November 28, 2000, Inco received the requisite shareholder approval to amend the terms of the Class VBN Shares that had been created in August 1996 in connection with the Company’s acquisition of Diamond Fields to provide for their redemption. The amendments allowed the Company to redeem each of its Class VBN Shares for Cdn.$7.50 (or the equivalent in U.S. dollars) in cash and a fraction, 0.45, of a Warrant. For a description of the Warrants, see “Common Share Purchase Warrants” above. All of the Class VBN Shares were redeemed by the Company, effective December 14, 2000, for a total redemption price of $133 million plus approximately 11.6 million Warrants which were reserved for issuance. As of December 31, 2005, 2004 and 2003, approximately 11 million Warrants had been issued in connection with this redemption. Approximately 550,000 Warrants still have not been issued given the limited number of holders of Class VBN Shares who did not accept the redemption consideration and elected under applicable legislation prior to the effective date of the redemption to have a court in the Province of Ontario determine the fair value of their Class VBN Shares. As of the date of this Report, this court proceeding was still in discovery and related preliminary stages and a related action had been filed in November 2005 in the U.S. in the federal district court for the State of New Jersey.
Preferred Shares
Certain Provisions of the Preferred Shares as a Class
Issuable in Series
Inco’s authorized share capital includes 45 million Preferred Shares issuable in series, each series consisting of such number of shares and having such provisions attached thereto as may be determined by the Board of Directors of the Company, subject to a maximum aggregate issue price of Cdn.$1,500 million (or the equivalent in other currencies). As of the date of this Report, no Preferred Shares were issued or outstanding.
Priority
The Preferred Shares of each series rank on a parity with the Preferred Shares of every other series, and prior to the Common Shares with respect to the payment of cumulative dividends and the distribution of assets on a liquidation, dissolution or winding up of the Company or for the purpose of winding up its affairs (“Liquidation”).
Creation and Issue of Additional Preferred Shares
Subject to applicable law, Inco may, without the consent of the holders of the Preferred Shares as a class, (i) create additional Preferred Shares, (ii) create preferred shares of another class or classes ranking on a parity with the Preferred Shares with respect to the payment of dividends and/or the distribution of assets on Liquidation and (iii) increase any maximum number of authorized shares of any one or more of such other classes of shares. If (but only so long as) any dividends are in arrears on any outstanding series of the Preferred Shares, the Company may not, without the consent, by a simple majority of the votes cast, of the holders of the Preferred Shares as a class, (i) issue any additional series of the Preferred Shares, or (ii) issue preferred shares of another class ranking on a parity with the Preferred Shares with respect to the payment of dividends and/or the distribution of assets on Liquidation.
Class Voting Rights
The holders of the Preferred Shares are not entitled to any voting rights as a class except (i) as provided above, (ii) as provided by law, or (iii) with respect to the right to vote on certain matters as described under “Modification” below. When the holders of Preferred Shares vote as a class, or when two or more series of Preferred Shares vote together at a joint meeting, each holder has one one-hundredth of a vote in respect of each Canadian dollar (or its equivalent in a foreign currency at the date of issuance) of the issue price of the Preferred Shares he or she holds.
The Board of Directors of Inco may, at the time of creation of any series of Preferred Shares, confer voting rights on such series in addition to the voting rights of the holders of the Preferred Shares as a class. It is the Board of Director’s intention that, with respect to the creation of any future series of Preferred Shares, to the extent that such Preferred Shares would have general voting rights then such shares would not have more than one vote in respect of each Preferred Share.
Modification
The class provisions attaching to the Preferred Shares may be amended at any time with such approval of the holders of such shares as may then be required by law or by the rules of any stock exchange on which the shares or any series of Preferred Shares are then listed. Currently, this approval requirement is by at least two-thirds of the votes cast at a meeting of such holders duly called for the purpose and at which a quorum is present, or as are required by the rules of any stock exchange upon which the shares of any series of Preferred Shares are then listed. In addition, the approval by at least two-thirds of the votes cast at a meeting of the holders of all shares of the Company carrying general voting rights is currently required by law for the amendment of such class provisions.
Securities Authorized for Issuance Under Equity Compensation Plans
The number of shares of Inco that may be issued upon the exercise of outstanding options, warrants and rights under our equity compensation plans at December 31, 2005, the weighted average exercise price of such options, warrants and rights, and the number of shares remaining available for future issuance under such plans are shown in the following table:
Other Information
There is no limitation or restriction imposed by Canadian law or by our restated articles of incorporation on the right of a non-resident of Canada to hold or vote Inco’s common shares, except in the case where a non-resident of Canada were to seek to acquire control of Inco. The Investment Canada Act requires notification to and, in certain cases, advance review and approval by, the Government of Canada of the acquisition by a “non-Canadian” of “control” of a “Canadian business”, all as defined in this legislation. Generally speaking, in order for an acquisition to be subject to advance review and approval under this legislation the value of the acquired entity’s gross assets currently must exceed Cdn.$265 million. This threshold is lower if the acquiror is not a resident of a country which is a member of the World Trade Organization. See also the discussion of the Shareholder Rights Plan under “Shareholder Rights Plan” above and in Note 16 to the financial statements under Item 8 of this Report.
Canadian federal tax legislation, in conjunction with applicable tax treaties, generally requires that we withhold 15 per cent from dividends paid by the Company to its shareholders resident in the United States, the United Kingdom and most western European countries. Similarly, depending upon applicable tax treaties, dividends paid to other non-residents of Canada are subject to a withholding tax at a maximum rate of 25 per cent. The amount of a stock dividend (for tax purposes) would generally be equal to the amount by which the stated capital of the Company has increased by reason of the payment of such dividend. Under regulations presently in effect in the United States, the Company is generally subject to the U.S. backup withholding rules which would require withholding at a rate of 28 per cent on dividends and interest paid to certain U.S. persons who have not provided the Company with a taxpayer identification number. Recent legislation enacted in the U.S. has reduced the tax rate to 15 per cent on certain dividends paid to U.S. individual shareholders of non-U.S. corporations such as the Company that meet certain requirements.
Through subsidiaries and affiliates, Inco’s operations are conducted in numerous countries and some $3,600 million of our consolidated total assets are located outside Canada and the United States. Accordingly, operations are subject to various governmental policies or regulations and changes therein and the risks associated with doing business in many overseas locations.
At December 31, 2005, approximately 61 per cent of the holders of our Common Shares had addresses in Canada, approximately 31 per cent had addresses in the United States and eight per cent elsewhere. Canadian residents of record held approximately 50.4 per cent of our issued and outstanding Common Shares, United States residents of record held approximately 49.3 per cent and residents of record of other countries held less than one per cent as at December 31, 2005.
Item 6.
Item 6. Selected Financial Data
The following table provides selected financial data as reported in Inco’s 2005 consolidated financial statements on the basis of GAAP in Canada:
(1)
Net earnings (loss) per common share is calculated by dividing net earnings (loss) applicable to Common Shares by the weighted-average number of Common Shares issued and outstanding for the relevant period.
(2)
Amounts reported in 2001 have not been restated for the change in depreciation and depletion as discussed in Note 2(d) to the financial statements under Item 8 of this Report.
(3)
Prior year amounts have been restated for a change in accounting principles and a restatement. Reference is made to Notes 2(a), 2(b) and 2 - Restatements to the financial statements under Item 8 of this Report.
There are a number of differences between Canadian and United States GAAP. The differences, insofar as they affect Inco’s consolidated financial statements, relate to accounting for post-retirement benefits, currency translation gains (losses), research and development, exploration, asset impairment, our convertible debt, derivative instruments, investments, income and mining taxes and reporting of comprehensive income. A full discussion of these differences is presented in the Notes to the financial statements under Item 8 of this Report and, in particular, Note 24 to such financial statements.
The following table reconciles results as reported under Canadian GAAP with those that would have been reported under United States GAAP:
The selected financial data item “Preferred shares” would be reported in the same amounts under Canadian and United States GAAP. Under United States GAAP, “Total assets” would be reported as $10,249 million at December 31, 2005 (2004 - $9,352 million; 2003 - $7,959 million; 2002 - $7,727 million; 2001 - $9,755 million).
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with our 2005 consolidated financial statements and notes, which are expressed in U.S. dollars and prepared in accordance with generally accepted accounting principles (“GAAP”) in Canada, which generally conform with those principles established in the United States except as explained in note 24 to our 2005 consolidated financial statements. This MD&A contains certain forward-looking statements based on our current expectations or developments, anticipated benefits and other possible occurrences. These forward-looking statements entail various risks and uncertainties, as discussed below, which could cause actual results to differ materially from those reflected in these forward-looking statements. Reference is also made to “Cautionary Statement Regarding Forward-Looking Statements and Forward-Looking Information” and “Material Assumptions” above. Since we have not completed our pending acquisition of all of the common shares of Falconbridge, this MD&A only includes information on the Company alone and without taking into account the benefits of such acquisition unless otherwise expressly indicated in this MD&A with respect to certain forward-looking statements relating to what we have referred to as the “new Inco” to be created by the combination of Inco and Falconbridge. The information in this MD&A is as of December 31, 2005 unless otherwise indicated.
Nature of our Business
As discussed above, we are a leading producer of nickel, a hard, malleable metal which, given its properties and wide range of applications, can be found in thousands of products. The largest end use for nickel is in the production of austenitic or nickel-bearing stainless steels. This end use currently accounts for about two-thirds of demand for primary nickel. We define primary nickel to be nickel produced from nickel-containing ores. The other principal source of nickel, as discussed below, for nickel-bearing stainless steels and certain other industrial applications is secondary nickel or nickel-containing recycled or scrap material. We are also an important producer of copper, precious metals and cobalt and a major producer of value-added specialty nickel products. Our principal mines and processing operations are located in the Sudbury area of Ontario, the Thompson area of Manitoba, Voisey’s Bay in Newfoundland and Labrador, and, through a subsidiary in which we have an equity interest of approximately 61 per cent, PT Inco, on the island of Sulawesi, Indonesia. We also operate wholly-owned metals refineries at Port Colborne, Ontario and in the United Kingdom at Clydach, Wales and Acton, England. We also have interests in nickel refining capacity in Japan, through ITL, in which we have an equity interest of 67 per cent; in Taiwan, through Taiwan Nickel, in which we have an equity interest of 49.9 per cent; and in South Korea, through Korea Nickel, in which we have an equity interest of 25 per cent. Additionally, we have a 65 per cent equity interest in Jinco, a company that produces nickel salts in Kunshan City, China. We also have joint venture operations in China, through Dalian, in which we have a total direct and indirect equity interest of 81.6 per cent, and Shenyang, in which we have a total direct and indirect equity interest of 82 per cent. In March 2005, Shenyang acquired substantially all of the assets which represented the nickel foam business of Shenyang Golden Champower New Materials Corp., a leading Chinese producer of nickel foam. These two ventures in China produce nickel foam products for the Asian battery market. We also have a shearing and packaging operation in China for certain nickel products to meet the specific needs of this geographic market.
Our business operations consist of two segments, our (i) finished products segment, representing our mining and processing operations in Ontario, Manitoba and Newfoundland and Labrador, our refining operations in the United Kingdom and interests in the refining operations in Japan and other Asian countries referred to above, and (ii) intermediates segment, which represents PT Inco’s mining and processing operations in Indonesia, where nickel-in-matte, an intermediate product, is produced and sold primarily into the Japanese market. In the fourth quarter of 2005, production of nickel and copper concentrates at the initial phase, representing an open-pit mine and concentrator and related facilities, of our Voisey’s Bay project, operated by our wholly-owned subsidiary, Voisey’s Bay Nickel Company Limited, started and, accordingly, the assets relating to the initial phase of the Voisey’s Bay project were reclassified from the development projects segment to the finished products segment. Voisey’s Bay produces nickel concentrates for processing by our Ontario and Manitoba operations, as well as copper concentrates for sale to third parties. As part of our strategy to be the world’s lowest cost and most profitable nickel producer, we are currently developing our Goro project in New Caledonia in which we currently hold an approximate 71 per cent equity interest.
In recent years, sales of our primary metal products were concentrated in the United States, Europe, Japan, elsewhere in Asia, and Canada, with about 60 per cent of our 2005 revenues from the sale of a range of nickel products in Asia.
On October 11, 2005, we announced our friendly offer to purchase all of the outstanding common shares of Falconbridge. Our offer is Cdn. $34.00 in cash or 0.6713 of an Inco common share plus Cdn. $0.05 in cash for each Falconbridge common share.
Falconbridge’s common shareholders will have the right to elect to receive all cash or all Inco common shares (plus Cdn. $0.05 per Falconbridge common share), subject to pro ration based upon the maximum amount of cash and Inco common shares offered. Under the terms of our offer, the maximum amount of cash to be paid by us will be approximately Cdn. $2.87 billion, and the maximum number of Inco common shares to be issued by us will be approximately 201 million, taking into account the conversion of Falconbridge’s outstanding convertible debt securities and outstanding share options. Assuming full pro ration of these maximum amounts, this would mean Cdn. $7.50 in cash and 0.524 of an Inco common share for each Falconbridge common share subject to the offer. Our offer is conditional on at least 66 2/3 per cent of Falconbridge common shares being tendered to our offer, receipt of all necessary regulatory clearances and certain other conditions. Pursuant to our notice of extension dated February 27, 2006, the offer is open for acceptance by Falconbridge common shareholders until June 30, 2006, subject to further extension, acceleration or withdrawal. We currently expect to take up and pay for the Falconbridge common shares tendered pursuant to the offer late in the second quarter or sometime in the third quarter of 2006. Assuming that the pending transaction is completed as currently contemplated, we believe that it would create the world leader in primary nickel production and sales and a leading copper producer, with growth prospects in both metals, given the combined company’s expected strong operations and portfolio of growth projects. The combined company that would be created by this pending transaction, which we have referred to as the new Inco, would be expected to generate substantial positive cash flow from operations, assuming that the prices to be realized for the metals and related products produced by the combined company remain at or near the levels realized in 2005, and have the ability to pursue its growth strategy on a scale that neither company could have contemplated individually. The new Inco would be a geographically diverse company, having a presence in North and South America, Asia, the South Pacific and Europe. Combining the two companies’ operations is expected to create significant operating and other synergies that are uniquely available given the proximity of our respective operations in Ontario and elsewhere. These synergies would come from efficiencies in overlapping operations in Ontario, better use of mining and processing facilities in Canada, improving procurement practices and other opportunities for increased efficiencies and cost savings.
Key Factors Affecting our Business
The price of nickel has represented, and is currently expected to continue to represent, the principal determinant of our profitability and cash flow from operations. Accordingly, our financial performance has been, and is expected to continue to be, closely linked to the price of nickel and, to a lesser extent, the price of copper and other primary metals produced by us. Historically, the demand for nickel has been closely correlated to industrial production in the major industrialized geographic regions as well as in those regions which are emerging as significant and industrialized areas, in particular North America, Europe and Asia, and we expect this positive correlation to continue. During 2005 we experienced, and currently expect to continue to experience at least in 2006, favourable demand and realized prices for the nickel products we produce based upon the relationship that has recently existed, and is currently expected to continue to exist at least for 2006, between global nickel supply and demand. While global nickel demand remained relatively strong in 2005 and is expected to remain relatively strong at least in 2006, global nickel supply has not increased significantly, creating an overall global nickel market that was essentially in balance for 2005 but one that we expect will reflect that overall supply may not keep pace with overall demand at least in 2006. While we currently believe that this favourable relationship between global nickel supply and demand will continue beyond 2006, we are not in a position to predict that those conditions will continue given the wide range of factors that could affect such conditions. In 2005, our average realized price for the nickel products we sold was $14,842 per tonne ($6.73 per pound), compared with $13,906 per tonne ($6.31 per pound) for 2004. The LME cash price for nickel, the price that is generally viewed as the benchmark price for nickel, averaged $14,733 per tonne ($6.68 per pound) in 2005, compared with $13,852 per tonne ($6.28 per pound) in 2004. Given the historically high nickel prices that prevailed for at least the first half of 2005, the nickel industry, as also happened in 2004, saw in 2005 some substitution of non-nickel products in place of primary nickel as well as a significant amount of substitution of non-nickel containing stainless steels in place of stainless steels having some or higher grades of nickel.
Since we sell our nickel products in all major geographic markets, the realized prices for our primary nickel and other metal products are influenced by both global and regional supply-demand factors and by the availability and prices of secondary or metal-containing scrap material, including nickel-containing scrap generated by the stainless steel industry and other substitute or competing commodity products for the primary nickel and other metal products we produce. We believe that the industrial-based strength of the Chinese, United States and Japanese economies, coupled with continued slow economic recovery in some European countries, as well as the influence of Metals Trading Funds, were important factors in the increase in nickel price levels on average for 2005 and the volatility experienced in nickel prices during 2005. We currently expect these factors will continue to affect nickel demand and nickel prices at least for 2006.
While the price and global demand for nickel are the most important determinants of our profitability and cash flow from operations, our financial results are also affected by increases in the costs we incur to produce nickel and our other metals. In 2003,
2004 and 2005, we experienced increases in our costs due to a number of factors, including rising energy and pension and other post-retirement benefits expenses, the continued strengthening of the Canadian dollar relative to the U.S. dollar and the effect this has had on our operating costs incurred in Canadian dollars and higher costs for purchased nickel intermediates for our Canadian operations in advance of the availability of nickel concentrates on a significant ongoing basis from our Voisey’s Bay operations. While we have continued to implement programs designed to manage our costs, our ability to continue to do so successfully will influence our profitability and cash flow from operations.
The initial phase or phase one of our Voisey’s Bay project, which includes an open pit mine, concentrator and related facilities and certain research and development and other programs, began, as noted above, commercial production in the fourth quarter of 2005. The first shipment of nickel concentrate from Voisey’s Bay took place on November 16, 2005, well ahead of the original schedule for this project. Our Ontario operations received feed from our Voisey’s Bay operations in December 2005 and began processing this material. During 2005 we completed the rationalization of our cobalt production facilities at our Manitoba operations as well as the installation of the facilities required to receive Voisey’s Bay nickel concentrates. Our Manitoba operations received an initial shipment of nickel concentrates from Voisey’s Bay in late December 2005. In 2005, we spent $353 million, including capitalized interest, on our Voisey’s Bay project and we currently expect to spend approximately $55 million on this project in 2006.
In 2005, we moved forward with the construction of our Goro development project as well as other capital investment initiatives. We spent $344 million, including capitalized interest, on our Goro project in 2005 and we currently plan to spend $1,140 million on this project in 2006 and estimate that we will have to fund approximately $670 million of this total after taking into account funding received or to be received from government assistance programs and partner contributions. In 2004, we announced plans to construct a third dam at a cost of approximately $150 million, the first stage of a four-year capital program currently estimated to total about $280 million, aimed at raising PT Inco’s annual production by 33 per cent from its current nameplate capacity of about 150 million pounds to about 200 million pounds of nickel-in-matte by 2009. PT Inco spent $58 million on this program in 2005 and is expected to spend an additional $60 million in 2006. Our development projects continue to be very important to our future given that (1) the Voisey’s Bay project currently represents a key source of intermediate nickel products for our Manitoba and Ontario operations, in particular our Manitoba operations given the decline in mine production which has been experienced over the past few years at this operation, and (2) these projects will be needed if we are to remain a leading nickel producer in an expected growing nickel market.
We currently plan to rely in part on, and accordingly, need to generate, very substantial cash flows from operations to meet sustaining capital expenditure requirements for our existing operations and the planned capital expenditures for our development projects. Our planned capital expenditures in respect of our current operations and development projects are expected to total approximately $1,820 million in 2006. Taking into account capital contributions expected to be made in 2006 by other shareholders in our Goro project, certain previously announced government assistance relating to our growth projects and other financing arrangements that are already in place for these projects, we currently project that of this $1,820 million total estimate, we have funded or will be required to fund about $1,340 million.
The following table shows our average realized price for nickel, the average LME cash nickel price and our cash flow from operations (which we refer to as our net cash provided by (or used for) operating activities) for each of the past ten years to show the relative correlation between nickel prices and our financial results:
The nickel industry is very competitive in all of its key parts, including the exploration for, and the development of, new sources of supply, the acquisition of mineral deposits, and the processing, distribution and marketing of nickel products. The level of production and export of primary nickel from Russia as well as the supply of secondary or nickel-containing scrap material, together with the continuing relatively limited level of domestic consumption of nickel in Russia, has had, and could continue to have, a significant affect on the nickel industry’s supply-demand balance. While we produce primary nickel, the other principal source or type of nickel used in stainless steel and certain other industrial applications, as noted above, is secondary nickel, which is also referred to as recycled or scrap nickel. Secondary nickel is recovered largely from austenitic stainless steel manufacturing and fabricating operations and nickel-containing scrap from obsolete facilities and equipment. In the recent past, secondary nickel has represented (1) between 44 and 49 per cent of the total nickel used in the production of nickel-bearing or austenitic stainless steels, with primary nickel accounting for between 51 and 56 per cent of such nickel use and (2) between 34 and 36 per cent of total nickel used in all applications. These percentages can vary based upon relative prices, the availability of scrap, technical ability of users to switch between primary and secondary nickel sources, and other factors. To the extent that the supply of such secondary nickel increases, such an occurrence could also adversely affect nickel prices and our results of operations, financial condition and cash flows.
2005 Nickel Market Highlights
The year 2005 was a year of two very distinct periods. The first half of the year reflected relatively strong demand for nickel, relatively tight supplies of nickel, nickel buying activity from Metals Trading Funds, falling LME nickel inventories and relatively strong nickel prices. However, by the start of the third quarter a significant negative shift began in the supply-demand fundamentals of the nickel market, as demand weakened, Metals Trading Funds sold the nickel positions they had acquired, LME inventories increased and prices fell. The significant deterioration in market conditions was, we believe, the result of a large reduction in global stainless steel production in the second half of the year, as discussed below. For 2005 as a whole, nickel demand grew by less than one per cent from 2004 levels. The non-stainless steel uses for nickel, in particular for high nickel alloys, plating and battery materials, were the only end uses for primary nickel to experience demand growth in 2005. Primary nickel demand in stainless steel applications experienced a sharp contraction in 2005, with global stainless steel production falling by one per cent in 2005 from 2004 levels, and primary nickel demand for this application declining by about six per cent. Demand was also negatively affected in this key application by substitution for nickel in certain stainless steel applications and a higher relative usage of secondary, or scrap, nickel.
The relatively low inventories of nickel, high prices and the active trading of Metals Trading Funds, factors which were also prevalent and, accordingly, affected the nickel markets in 2004, contributed to the continued volatile price conditions in 2005. The difference between the high and low daily LME cash nickel prices for 2005 was $6,250 per tonne ($2.83 per pound). We estimate that the global nickel market had a slight surplus for 2005 as the level of demand was more than covered by the level of supply. However, we believe that the level of demand was restrained by the relatively high nickel prices in at least the first half of 2005, and that demand would have been significantly stronger had prices been closer to historic averages.
The modest growth in primary nickel demand in 2005 was, as noted above, due to the strength in non-stainless steel uses for nickel, as demand from the stainless steel sector, the largest end use of primary nickel, was adversely affected by several factors as discussed below. Nickel demand growth for non-stainless steel uses increased by eight per cent in 2005, as demand for nickel for the production of high nickel alloys improved as a result of the continued strength in demand for high nickel alloys used in the aerospace industry and for land-based gas turbines, as well as growth in the oil and gas, liquid natural gas and battery applications for nickel. Nickel demand from battery applications improved in 2005, in part due to the increased production of hybrid electric vehicles that contain nickel in their battery systems.
World production of stainless steel increased by approximately seven per cent during the first half of 2005, consistent with the relatively strong growth rates seen in this production for 2003 and 2004. This growth was due, in part, to increased capacity utilization at several large-scale stainless steel manufacturing facilities, as well as new production capacity coming on stream, especially in China. The strong stainless steel production growth in the first half of 2005, combined with strength in the non-stainless steel market, led to nickel demand growth of approximately six per cent in the first half of the year. However, end-use consumption of stainless steel did not keep pace with stainless steel production and global inventories increased during the first half of the year. The increase in global stainless steel inventories was a sign of an oversupplied market that, in turn, triggered sharply falling stainless steel prices beginning in July 2005. At the beginning of the third quarter of 2005, almost all major stainless steel producers had begun to reduce production levels in an effort to reduce the relatively high global inventory levels of stainless steel and, through such supply reductions, correct this oversupply situation. Most of these production cuts were maintained through the end of 2005. We estimate that stainless steel production curtailments in the second half of the year led to an overall production decline in the second half of 2005
of nine per cent as compared with the second half of 2004. This sharp reduction in stainless steel production, in turn, led to a significant reduction in demand for primary nickel used in stainless steel. The global stainless steel market used relatively high amounts of secondary or scrap nickel in 2005 as compared with prior years, as well as increasing the production of stainless steels containing relatively low amounts or grades of nickel (one to four per cent) and grades containing no nickel compared with stainless steels with higher nickel grades (eight to ten per cent nickel).
The growth in the world supply of primary nickel in 2005 was adversely affected by several unexpected disruptions. While domestic production by certain producers did increase in certain countries, including China, New Caledonia and Norway, these increases were largely offset by reductions in output or lower than planned increases by producers in other countries. Overall production of primary nickel increased by approximately 2.4 per cent in 2005, about half of the long-term average production growth rate of four per cent. Several producers experienced production problems as labour disruptions or shortages, feed material shortages, inclement weather, technological challenges and extended maintenance shutdowns curtailed output below originally announced planned levels for 2005. Approximately two thirds of global nickel production growth was the result of a ramp-up in Chinese nickel production, in an effort to reduce that country’s nickel import requirements. World primary nickel supply increased by 30,000 tonnes to 1,285,000 tonnes in 2005. We believe that no stockpiles of nickel were released into the market in 2005 or 2004, in contrast to what occurred in 2003.
The slower than average growth in nickel demand for 2005, coupled with a relatively modest amount of growth in nickel supply for the year, created a surplus that we estimate to have been approximately 15,000 tonnes. However, as discussed above, we believe that the supply-demand relationship was in a deficit in the first half of the year and moved to a surplus in the second half of the year. Inventories of nickel on the LME, a physical market (i) where various metals, including nickel, can be bought or sold for prompt or future delivery and (ii) representing the principal terminal market for primary nickel in the world, decreased during the first half of 2005 to a low of 4,926 tonnes. However, the decline in demand in the second half of the year led to a steady increase in LME inventories during this period to a level of 36,042 tonnes at December 31, 2005. LME nickel inventories have decreased in the first 10 weeks of 2006, with such inventories totalling 34,266 tonnes as of March 13, 2006.
The two distinct periods of nickel demand and supply dynamics for 2005 as noted above were reflected in the LME cash nickel price movements. The LME cash nickel price opened the year at $14,035 per tonne ($6.37 per pound) and moved on a steady upward path during the first quarter, as strong demand for nickel in China and a sharp reduction in LME inventories during the first quarter to below 8,000 tonnes led to what we believed were tight market conditions. Nickel prices experienced an overall increase during the first quarter of 2005, with the LME cash price increasing to $16,250 per tonne ($7.37 per pound) at the end of the quarter. The LME cash price was $16,140 per tonne ($7.32 per pound) at the beginning of the second quarter, and LME inventories declined by 3,372 tonnes during that quarter. Continued strong demand in China and elsewhere as well as limited new nickel supply led to continued price strength through the middle of May. The LME cash nickel price reached the year high on May 12, 2005 of $17,750 per tonne ($8.05 per pound). From that point, we believe that market sentiment weakened as the scale of large stainless steel inventories became apparent and stainless steel production cuts began. LME stocks began to increase and we believe Metals Trading Funds started to liquidate the positions in nickel they had accumulated in the second quarter of 2005. The LME cash nickel price decreased during the balance of the second quarter and ended the second quarter of 2005 at $14,700 per tonne ($6.67 per pound). In the third quarter, the stainless steel production cuts began to have a negative effect on demand for primary nickel, resulting in a surplus of nickel. Some of this nickel was delivered to the LME as evidenced by a 11,310 tonne increase in LME stocks during this period. LME cash nickel prices increased modestly through the middle of September, as we believe Metals Trading Funds built speculative positions in advance of the expiration of our Manitoba operations’ collective agreement in anticipation of a possible labour disruption together with the expectation that the stainless steel industry was at or close to the end of its production curtailments. Having reached a new collective agreement covering the unionized hourly rated workforce at our Manitoba operations without a labour disruption in mid-September 2005, coupled with announcements of continued stainless steel production cuts and steadily increasing LME stocks to a quarter-end level of 13,488 tonnes, the nickel price fell for the remainder of September and ended the quarter at $13,600 per tonne ($6.17 per pound). Nickel prices continued to decline during the early part of the fourth quarter of 2005, reaching a low for the year of $11,500 per tonne ($5.22 per pound) on November 1, 2005. However, the nickel price increased through the remainder of the quarter due to, we believe, the expectation of improved stainless steel market conditions and increased nickel demand in the first quarter of 2006 and averaged $13,429 per tonne ($6.09 per pound) for December 2005. LME stocks increased steadily throughout the fourth quarter and ended the year at 36,042 tonnes. The LME cash nickel price ended the year at $13,380 per tonne ($6.07 per pound) compared with $15,205 per tonne ($6.90 per pound) at the end of 2004. The LME cash nickel price averaged $14,733 per tonne ($6.68 per pound) for 2005, higher than the 2004 average of $13,852 per tonne ($6.28 per pound) and the highest average annual benchmark nickel price ever based upon available data. The LME cash nickel price during the January 3 - March 13, 2006 period averaged $14,775 per tonne ($6.70 per pound) and was $14,780 per tonne ($6.70 per pound) on March 13, 2006. This increase in prices early in
2006 has been, we believe, related to the expectation of improved demand for nickel from the stainless steel sector, as well as increased purchases of nickel by Metals Trading Funds.
The following table summarizes certain world primary nickel market and LME statistics for the years indicated (either in tonnes or in dollars per tonne in the case of LME cash nickel prices):
(1)
Preliminary estimates.
(2)
Excludes Russia, other members of the former Commonwealth of Independent States, China, Cuba and Eastern Europe.
2004 Nickel Market Highlights
The year 2004 was one characterized by high nickel prices, which we believe were due principally to broad-based growth in global demand for nickel. The increase in demand was attributed to a recovery in non-stainless steel applications for nickel. Primary nickel demand in stainless steel applications experienced virtually no growth in 2004, despite strong global stainless steel production growth, due to a large increase in nickel-containing scrap consumption and substitution for nickel in certain stainless steel applications. The increase in nickel demand was driven by the strongest global industrial production growth in 10 years, led by continued economic growth in China, as well as economic growth in South Korea, Taiwan and Japan. The economies of the United States and Europe also exhibited growth above the levels seen in the recent 2000 - 2003 period. The global nickel market was in deficit for 2004 as the level of demand exceeded the level of supply. We believe that relatively low physical inventories, high prices and the active trading in nickel by Metals Trading Funds contributed to volatile price conditions in 2004.
The growth in primary nickel demand in 2004 was concentrated in the non-stainless steel sector, which increased by seven per cent, as demand for nickel for the production of high nickel alloys improved as the recovery of the aerospace industry continued. World production of stainless steel increased by eight per cent to approximately 24.6 million tonnes. Stainless steel production expanded in all major industrialized geographic regions and was particularly strong in South Korea where new production facilities operated at capacity during the year. However, primary nickel demand growth in the stainless steel sector was adversely affected by a large increase in stainless steel scrap consumption, as well as an increase in the production of stainless steels containing relatively low amounts or grades of nickel (one to four per cent of nickel) and grades containing no nickel compared with higher nickel containing stainless steel grades (eight to ten per cent).
World supply of primary nickel in 2004 was lower than world nickel supply in 2003, although production of primary nickel increased by four per cent in 2004, due to the relatively large stockpile releases in 2003. World primary nickel production in 2004 totalled 1,255,000 tonnes, an increase of 51,000 tonnes, of which approximately 50 per cent was the result of our recovery from our strike-impacted levels experienced in 2003. However, world primary nickel supply of 1,255,000 tonnes decreased from 1,264,000 tonnes in 2003, taking into account the release into the market in 2003 of 60,000 tonnes initially pledged by one producer as collateral for a loan.
The growth in nickel demand during 2004, coupled with the overall decline in supply for 2004, created a deficit between supply and demand of approximately 6,000 tonnes. Inventories of nickel on the LME decreased during 2004 by 3,174 tonnes to a relatively low level of 20,898 tonnes at December 31, 2004.
While 2004 represented a very strong year for the global nickel market given the demand-supply fundamentals described above, there was also, as noted above, a very significant amount of volatility in nickel prices. The LME cash nickel price opened the year at $16,690 per tonne ($7.57 per pound). On January 6, 2004 the LME cash nickel price reached its highest level since March 9, 1989, $17,770 per tonne ($8.06 per pound). The LME cash price then drifted lower in the first quarter and was $14,220 per tonne ($6.45 per pound) at the beginning of the second quarter. Continued concern over a possible economic slowdown in China led to ongoing price
volatility and overall declining LME cash nickel prices to the middle of May. From that point, LME stock withdrawals and positive demand growth contributed to the LME cash nickel price increasing. In the third quarter, trading activity by Metals Trading Funds in nickel was limited during the traditionally quiet summer months and with a 6,534 tonne increase in LME stocks during this period, nickel prices declined to $12,050 per tonne ($5.47 per pound) by September 9, 2004. Prices increased in late September, despite a rise in LME inventories, and ended the quarter at $15,100 per tonne ($6.85 per pound). LME stocks increased steadily throughout the fourth quarter and ended the year at 20,898 tonnes. The LME cash price ended the year at $15,205 per tonne ($6.90 per pound) compared with $16,650 per tonne ($7.55 per pound) at the end of 2003. The LME cash nickel price averaged $13,852 per tonne ($6.28 per pound) for 2004.
Results of Operations
2005 Compared with 2004
Earnings Summary
Net earnings for 2005 were $836 million, or $4.41 per share ($3.75 per share on a diluted basis), compared with net earnings of $619 million, or $3.30 per share ($2.95 per share on a diluted basis) in 2004. Results for 2005 relative to 2004 primarily reflect higher realized selling prices for substantially all metals, significantly lower asset impairment charges and a gain on the sale of a non-core investment. These favourable factors were partially offset by higher production costs for nickel and copper and lower deliveries of nickel, copper and certain PGMs and estimated pre-tax remediation costs of $20 million involving a property we retained from a disposed business unrelated to our current operations.
The following bar chart sets forth the dollar impact (in millions of dollars) of the principal factors, both favourable and unfavourable (the dollar amounts of unfavourable factors are shown in parentheses), affecting our 2005 net earnings compared with 2004, with the starting point (first bar on the left) being the level of net earnings for 2004:
Principal Factors Affecting 2005 Net Earnings in Comparison with 2004
(in millions of dollars)
Nickel Production
Nickel production decreased to 220,727 tonnes (487 million pounds) in 2005 compared with 236,817 tonnes (522 million pounds) in 2004. The decrease in nickel production was primarily due to a longer than planned major maintenance shutdown at our Ontario operations and a slower ramp-up after that shutdown caused, in turn, by a number of factors. These factors included labour productivity problems involving one contractor on the work undertaken during the shutdown, an increase in the scope of certain work undertaken as a result of the shutdown, the need to repair unanticipated leaks relating to the expansion of the acid plant at these
operations and a fire in one of the dust capture bag houses. In addition, we had a longer than usual major maintenance shutdown at our Manitoba operations during the third quarter which was necessary to prepare those operations for the arrival of Voisey’s Bay nickel concentrates late in the fourth quarter of 2005 and the processing of the additional cobalt contained in such concentrates and to have the ability to operate with a single furnace. Finished nickel production from PT Inco nickel-in-matte was comparable to 2004. Historically, we have believed that the minimum finished nickel inventories we generally need to run our business and meet customers’ requirements should be about 26,000 tonnes, depending upon the required product mix and other factors. We expect to continue to evaluate the factors to be considered in determining what this minimum inventory level should be. Our finished nickel inventories were 23,444 tonnes at December 31, 2005 compared with 27,334 tonnes at the end of 2004.
Copper Production
Finished copper production, including anode production for processing as discussed below under an agreement we entered into with Falconbridge, increased by one per cent to 125,595 tonnes (277 million pounds) in 2005 compared with 124,456 tonnes (274 million pounds) in 2004. In addition, production of copper in concentrates from our Voisey’s Bay operations was 4,406 tonnes (10 million pounds) in 2005. In May 2005, we announced the closure of our copper refinery in Sudbury based upon a number of factors, including that facility’s size and cost structure relative to the leading copper refineries in the world. In connection with our decision to close this facility, we recorded a charge of $25 million in the second quarter of 2005. The copper refinery was closed as planned in December 2005. We entered into a ten-year agreement in mid-2005 with Falconbridge under which we agreed to sell all our copper production from our Ontario operations in anode form to this company.
Commencement of Voisey’s Bay Operations
On December 1, 2005, the open pit mine and 6,000 tonnes-per-day concentrator at Voisey’s Bay began commercial production. For the year 2005, 10,450 tonnes (23 million pounds) of nickel in concentrates and 4,406 tonnes (10 million pounds) of copper in concentrate were produced at Voisey’s Bay and two shipments of concentrates were made in 2005, with the nickel concentrates being sent to our Ontario and Manitoba operations. The first copper in concentrates was sold in January 2006. We produced initial quantities of finished nickel from the Voisey’s Bay nickel concentrates in January 2006.
Net Sales
The following table sets forth deliveries and net sales of our principal metal products for the years indicated:
(1)
Excludes toll-refined materials.
Realized Prices
The following table sets forth our average annual realized prices for the years indicated for the metal products we produce and sell:
Net sales increased in 2005 due to higher selling prices for nickel, copper and certain PGMs partially offset by lower deliveries of nickel, copper and certain PGMs and lower average realized selling prices for cobalt.
Our nickel deliveries in 2005 represented an estimated 19 per cent share of the world market for primary nickel, compared with 20 per cent in 2004.
Our price realizations for nickel have tended to lag LME cash price changes. The premiums we realize over the prevailing LME cash price for our specialty or value-added and other nickel products are normally affected by (i) fluctuations in the LME cash nickel price, (ii) the effect these fluctuations have on the price we receive for the nickel-in-matte product produced by PT Inco, (iii) the lag effect that changes in the LME benchmark cash price have on the pricing of certain of our nickel products, (iv) how certain of our nickel products are priced and (v) the mix of our primary nickel products sold in the year. For 2005, the average realized price for our primary nickel products, including intermediates, was $14,842 per tonne ($6.73 per pound), compared with the LME cash nickel price which averaged $14,733 per tonne ($6.68 per pound). For 2004, the average realized price for our primary nickel products, including intermediates, was $13,906 per tonne ($6.31 per pound), compared with the LME cash nickel price which averaged $13,852 per tonne ($6.28 per pound).
The price realizations for our nickel and other metal products generally reflect LME or other metal market prices and, over the longer term, depend principally upon the balance between demand for our primary nickel products in the marketplace relative to supply available from us and our competitors, including for this purpose, supply of secondary or scrap materials containing metals in usable or recyclable form and supplies of other materials which do or may compete as substitutes for nickel and our other metal products. As noted above, the availability of nickel-containing stainless steel scrap, which competes directly with primary nickel as a source of nickel for use in the production of stainless steel, is particularly important to stainless steel primary nickel demand. The stainless steel scrap ratio was 49 per cent in 2005 compared with 47 per cent in 2004.
In 2005, our copper sales increased by 27 per cent from the previous year due to higher average realized selling prices, partially offset by lower deliveries. Sales of precious metals increased by nine per cent in 2005 due to higher realized selling prices for certain PGMs, partially offset by lower deliveries of certain PGMs.
Costs and Expenses/Other Income
The following table sets forth certain of our costs, principal expenses, other income, income and mining taxes and minority interest for the years indicated:
Cost of Sales and Other Expenses
Cost of sales and other expenses increased by 12 per cent in 2005, reflecting the adverse impact of a strengthening of the Canadian dollar relative to the U.S. dollar on our costs incurred in Canadian dollars, higher energy costs as a result of higher prices for and quantities of heavy fuel oil and diesel used at PT Inco, purchased electricity and natural gas used at our Ontario operations, higher spending on services and supplies and increased costs for and volume of purchased finished nickel. The cost of the nickel intermediates we purchase is based upon LME and other benchmark prices and is included in cost of sales and these costs increase as the benchmark prices increase as they did in the first half of 2005.
Selling, General and Administrative
Selling, general and administrative expenses increased by $15 million in 2005 compared with 2004. The increase was primarily due to higher capital taxes and higher expenses associated with share options granted in prior years, including share appreciation rights granted in association with such options, based upon the price of our common shares.
Currency Translation Adjustments
Currency translation adjustments represented primarily the effect of exchange rate movements on the translation of our Canadian dollar-denominated liabilities, post-retirement benefits, accounts payable and certain deferred income and mining taxes into U.S. dollars. Unfavourable currency translation adjustments were primarily due to the strengthening of the Canadian dollar as at December 31, 2005 relative to the U.S. dollar. The Canadian dollar - U.S. dollar exchange rate was 0.858 at the end of 2005 compared with 0.831 at the end of 2004, representing approximately a three per cent appreciation in the Canadian dollar relative to the U.S. dollar on a year-to-year basis.
Interest Expense
Interest expense for 2005 was lower than 2004 by $10 million. Interest expense excluded capitalized interest of $103 million in 2005 and $70 million in 2004. We expect that our total interest costs (expensed and capitalized) will increase to approximately $135 million in 2006, with approximately $55 million of that amount expected to be expensed and $80 million expected to be capitalized as part of our Goro project. The expected increase in interest expense for 2006 is primarily related to lower capitalized interest in respect of our Voisey’s Bay project as of December 1, 2005 when the project achieved commercial production.
Asset Impairment Charges
As noted above, we entered into a ten-year agreement in late June 2005 with Falconbridge under which we agreed to sell all of our copper production from our Ontario operations in anode form to this company beginning in 2006. As a result of this decision, we recorded a $25 million impairment charge before taxes in the second quarter of 2005 related to the closure, which occurred in December 2005, of our copper refining facility in Sudbury, Ontario.
Other Income, Net
Other income included a gain of $88 million in respect of the sale in the fourth quarter of 2005 of a non-core investment in a junior mining company.
Income and Mining Taxes
Our effective tax rate for 2005 of 31 per cent was lower than the combined statutory income and mining tax rate in Canada of about 39 per cent due principally to the non-taxable nature of the gain referred to above on the sale of a non-core investment, the
benefit of profits earned in jurisdictions having lower tax rates and the net tax benefits relating to certain tax rulings, interpretations or determinations relating to prior years partially offset by the net tax costs relating to currency translation adjustments.
Minority Interest
Our minority interest represents primarily the respective minority shareholders’ interests in the earnings of PT Inco, ITL, Jinco and Goro Nickel. For 2005, minority interest included a favourable adjustment of $25 million, reflecting the recovery of losses previously taken by Inco due to insufficient minority interest balances existing in 2004 to absorb the share by the minority interest of the impairment charge associated with the Goro project recorded in the second quarter of 2004. Excluding the impact of the $25 million favourable adjustment, minority interest decreased in 2005 compared with 2004 primarily due to the lower earnings at PT Inco. Although PT Inco experienced higher average realized prices for and higher deliveries of its nickel-in-matte product in 2005, these benefits were partially offset by higher energy and supplies costs and the write-downs of certain capital assets, resulting in an overall decline in net earnings compared with 2004.
Nickel Unit Cash Cost of Sales
The following table sets forth nickel unit cash costs of sales before and after by-product credits for the periods indicated:
Since this cost measure captures our key costs of production and the impact of prices for our by-products, nickel unit cash cost of sales after by-product credits represents a key performance measurement that management uses to manage our costs and operations. The following bar chart shows the principal factors (on a per pound basis), both favourable and unfavourable (favourable factors are shown in parentheses), affecting our 2005 nickel unit cash cost of sales after by-product credits, with the starting point (first bar on the left) being our nickel unit cash cost of sales after by-product credits for 2004:
Principal Factors Affecting Our 2005 Nickel Unit Cash Costs of Sales After By-Product Credits
in Comparison with Such Costs for 2004
Nickel unit cash cost of sales before by-product credits represents a calculation equal to the total of all cash costs incurred to produce a unit of nickel before the deduction of contributions from by-products sold divided by Inco-source nickel deliveries. For 2005 compared with 2004, the increase in nickel unit cash cost of sales before by-product credits was principally due to the higher average Canadian - U.S. dollar exchange rate which adversely affected our costs incurred in Canadian dollars, higher costs for heavy
fuel oil and diesel fuel at PT Inco, higher electricity and natural gas prices at our Ontario operations, higher spending on supplies and services and lower nickel production, partially offset by approximately $40 million of net cost reductions and related savings achieved in 2005. In addition, we experienced lower costs for purchased intermediates due to lower volumes processed at our Canadian operations in 2005 partially offset by higher benchmark prices upon which such purchases are made. For 2005 compared with 2004, the increase in nickel unit cash cost of sales after by-product credits was due to higher unit cash cost of sales before by-product credits, partially offset by an increase in by-product credits. The increase in by-product credits was primarily due to higher realized selling prices for copper and certain PGMs, partially offset by higher production costs for copper and lower deliveries of certain PGMs.
As discussed above, we have used, and expect to continue to use at least in 2006, purchased nickel intermediates to increase processing capacity utilization at our Canadian operations. While the cost of purchased nickel intermediates is higher than that for processing our own mine production and such costs increase as the prevailing prices, LME cash nickel or other benchmark prices, on which basis this material is purchased by us increases, the price realizations are also higher, resulting in margins on these purchases remaining relatively unchanged.
A reconciliation of our nickel unit cash cost of sales before and after by-product credits to cost of sales under Canadian GAAP is shown in the table entitled “Reconciliation of Nickel Unit Cash Cost of Sales Before and After By-Product Credits to Canadian GAAP Cost of Sales” under “Non-GAAP Financial Measure” below.
Energy Costs and Relative Advantages
Energy costs are a significant component of production costs in the nickel industry since nickel production is very energy-intensive, especially with respect to the costs of processing lateritic ores such as those processed at our PT Inco operations. Energy requirements for production from our Canadian sulphide ores are generally only about one-fifth of the energy required to process lateritic ores. In addition, low-cost energy is available from our hydroelectric facilities in Ontario and at PT Inco’s lateritic mining operations in Indonesia, and from purchased hydroelectric power at our Manitoba operations.
In 2005, our hydroelectric facilities in Ontario generated approximately 14 per cent of our Ontario operations’ electricity requirements, and PT Inco’s 165-megawatt hydroelectric generating-facility at Larona together with its 93-megawatt hydroelectric generating facility at Balambano generated virtually all of PT Inco’s 2005 electricity requirements. The Balambano facility has been able to generate power consistently above its design capacity due to improved water management practices and higher reservoir levels and other related factors than were assumed in developing its original design capacity. In 2005, energy costs at our Ontario and Manitoba operations were approximately 14 per cent of their total cash production costs, compared with 43 per cent for PT Inco. The availability of captive hydroelectric power decreased cash energy costs at PT Inco by about 47 per cent in 2005 and 53 per cent in 2004 relative to the energy costs that would have been incurred by PT Inco if its operations were dependent on fuel oil as the sole source to meet its energy requirements.
Intermediates Segment
Our intermediates segment represents the mining and processing operations of PT Inco in Indonesia where nickel-in-matte, an intermediate product, is produced and sold primarily into the Japanese market. Net sales by PT Inco of nickel-in-matte were $885 million in 2005 compared with $792 million in 2004. This increase in 2005 relative to 2004 was due to increased deliveries as a result of higher production rates and higher realized prices. PT Inco’s deliveries of nickel-in-matte totalled a record 76,100 tonnes (168 million pounds) in 2005 compared with 72,500 tonnes (160 million pounds) in 2004. PT Inco’s net realized price for nickel-in-matte in 2005 averaged $11,462 per tonne ($5.20 per pound) compared with $10,766 per tonne ($4.88 per pound) in 2004. The selling price of PT Inco’s nickel-in-matte is determined by a formula which is based upon the LME cash price for nickel. All of PT Inco’s production is sold in U.S. dollars under long-term contracts to us and Sumitomo Metal Mining Co., Ltd.
Nickel-in-matte production at PT Inco increased by six per cent to a record 76,400 tonnes (168 million pounds) in 2005 from 72,200 tonnes (159 million pounds) in 2004. PT Inco’s nickel unit cash cost of sales increased 25 per cent for 2005 compared with 2004 due to higher prices for heavy fuel oil, higher volumes of heavy fuel oil used in 2005 compared with 2004 due to higher production and more moisture in the ore from PT Inco’s Petea mining area and higher prices for diesel and higher volumes of diesel used in 2005 relative to 2004 due to a greater haulage distances, given the increased ore mined at PT Inco’s Petea mining area.
Development Projects Segment
Our development projects segment includes the Goro nickel-cobalt project in New Caledonia and work on the second and third phases of our Voisey’s Bay project.
Goro
Following the decision in October 2004 to proceed with the Goro project on the basis of a revised project scope resulting from a comprehensive review completed in September 2004, a phased execution approach was adopted. The first phase of this approach, focusing on process engineering definition, securing of all necessary permits, the appointment of leading construction firms to work with our own team to oversee construction and long-lead time procurement, continued through much of the first half of 2005. The second phase, which had been scheduled to commence in the second quarter of 2005 and would involve finalization of detailed engineering and procurement and negotiation of the remaining contracts for site mobilization and the start of construction, encountered a delay in its start pending the receipt of certain assurances from the New Caledonian government that we required in order to begin construction. These assurances related to a number of key construction permits, developing an agreed-upon process for revising the project’s required operating permit and implementation of a 60 hour site work week.
An acceptable outcome with respect to these assurances was finally achieved early in the third quarter of 2005, enabling site mobilization to begin as well as the award of major site-related construction contracts to proceed. By year-end 2005 overall engineering progress was about 70 per cent complete while the number of personnel on site totalled approximately 900. Major construction activities are currently focused on the port, earthworks, civil works and the establishment of temporary facilities. Project execution will make extensive use of modularization and the utilization of skilled construction labour from low cost locations. By year-end 2005 facilities in the Philippines had been selected to produce modules for the process plant and other key parts of the project facilities and the major construction contracts had been finalized. For the year 2005 capital expenditures on the Goro project totalled $355 million, bringing total capital spending on this project since the October 2004 decision to proceed to $378 million. During 2005 Goro encountered significant cost challenges as a result of sharply higher oil prices, the continued strength in other commodity prices as well as very competitive market conditions for supplies and services and these challenges are expected to continue in 2006 and likely through the balance of construction for those items which we have not yet purchased.
Taking into account these cost pressures for such construction materials and other input costs, the currently anticipated trends in such costs and the latest regulatory requirements for the configuration of the project’s tailings area, we currently believe that, if we were to formally update our latest estimate for the capital cost for Goro’s mine, process plant and infrastructure of $1.878 billion with a minus 5 per cent plus 15 per cent confidence level, such updated forecast would be expected to be at the high end of the plus 15 per cent confidence level. As part of our ongoing work on the project, we have implemented a number of systems to monitor all key costs trends which could affect the capital cost forecast. We currently expect to be in a position to have a definitive cost estimate, reflecting all relevant factors at that time, and which is currently expected to be subject to a confidence or accuracy level developed as part of that estimate, sometime in the second quarter of 2006 when engineering is expected to be at least 80 per cent complete and all major construction contracts will have been awarded.
In late 2005 a number of boycotts and other related actions in New Caledonia affected the operations of Eramet and its subsidiary, Société Le Nickel, and other local businesses as a result of labour and other disruptions and other developments. While those actions and developments did not affect the construction of the Goro project to any significant degree, such disruptions could have a substantial adverse effect on the project’s construction schedule and capital costs if they were to resume and continue for any extended length of time.
Voisey’s Bay
In 2005, we continued our exploration program in the Province, spending $5 million on this program. Late in 2005, we also commissioned the demonstration plant at Argentia in the Province of Newfoundland and Labrador to test hydrometallurgical processes to treat the Voisey’s Bay nickel concentrates as part of the initial phase of the project. This demonstration plant had a capital cost totalling about $80 million.
2004 Compared with 2003
Earnings Summary
Net earnings for 2004 totalled $619 million, or $3.30 per share ($2.95 per share on a diluted basis), compared with net earnings of $146 million, or 68 cents per share (64 cents per share on a diluted basis), in 2003. Results for 2004 included net income tax benefits totalling $23 million and the following pre-tax items: (1) an asset impairment charge of $201 million related to the write off of certain capitalized costs for our Goro nickel-cobalt project due to changes in project scope and other factors, and (2) unfavourable non-cash currency translation adjustments of $85 million. The unfavourable non-cash currency translation adjustments were due to the effect of a significant strengthening of the Canadian dollar relative to the U.S. dollar during the year principally on Canadian dollar-denominated post-retirement benefit liabilities.
Results for 2003 included net income tax benefits totalling $84 million and the following pre-tax items: (1) unfavourable non-cash currency translation adjustments of $177 million, (2) income of $24 million, representing a milestone payment received as part of the terms of the sale of a non-core exploration property in 1998, (3) a charge of $23 million for estimated remediation costs for certain former industrial sites in the United States we retained relating to a business sold in 1983, (4) an expense of $107 million associated with the three-month strike at our Ontario operations and (5) currency hedging gains net of suspension costs of $15 million relating to our Goro project. In addition, with respect to only the calculation of net earnings per share for 2003, a premium of $15 million was paid on the May 1, 2003 redemption of our 5.5 per cent Convertible Redeemable Preferred Shares Series E.
Nickel Production
Nickel production increased by 27 per cent to 236,817 tonnes (522 million pounds) in 2004, our highest annual production ever, exceeding our previous record of 510 million pounds in 1974, compared with 187,173 tonnes (413 million pounds) in 2003, primarily reflecting higher production at our Canadian and U.K. operations compared with 2003 when the three-month strike at our Ontario operations that began on June 1, 2003 and a difficult ramp-up of operations in September 2003 following the strike negatively affected production. PT Inco’s production increased by about 4 million pounds to 159 million pounds of nickel-in-matte in 2004 compared with 155 million pounds of nickel-in-matte in 2003. Finished nickel inventories were 27,334 tonnes at December 31, 2004 compared with 25,604 tonnes at the end of 2003 due to the timing of certain shipments in late 2004.
Copper Production
Copper production increased by 37 per cent to 124,456 tonnes (274 million pounds) in 2004 compared with 91,134 tonnes (201 million pounds) in 2003. Copper production in 2003 was negatively impacted by the three-month strike at our Ontario operations.
Net Sales
Net sales increased substantially in 2004 due to higher selling prices for substantially all the metals we produce, particularly for nickel and copper, as well as higher deliveries of Inco-source nickel, copper, cobalt and PGMs. Deliveries of Inco-source nickel in 2004 increased by 28 per cent compared with 2003 due to increased production at our Canadian and U.K. operations as well as at PT Inco. Production for all metals for 2003 was adversely affected by a three-month strike at our Ontario operations that began on June 1, 2003.
Primary nickel sales increased by 66 per cent in 2004 from the previous year due to a 41 per cent increase in our average realized nickel price and an 18 per cent increase in nickel deliveries given the effect in 2003 of the three-month strike at our Ontario operations noted above on deliveries.
Our nickel deliveries in 2004 represented an estimated 20 per cent share of the world market for primary nickel, compared with 17 per cent in 2003.
The average realized price for our primary nickel products, including intermediates, was $13,906 per tonne ($6.31 per pound) in 2004, compared with the LME cash nickel price which averaged $13,852 per tonne ($6.28 per pound). The average realized price for our primary nickel products, including intermediates, was $9,860 per tonne ($4.47 per pound) in 2003, compared with the LME cash nickel price which averaged $9,640 per tonne ($4.37 per pound).
In 2004, our copper sales increased by 113 per cent from the previous year due to a 34 per cent increase in deliveries compared with the strike-affected levels for 2003 and a 59 per cent increase in our average realized price. Sales of precious metals increased by 116 per cent in 2004 due to increased deliveries and increased selling prices in 2004 for substantially all of the precious metals we produce.
Cost of Sale and Other Expenses
Cost of sales and other expenses increased by 35 per cent in 2004, reflecting higher deliveries of the metals we produce, increased costs for and volumes of purchased nickel intermediates processed, the adverse impact of a strengthening of the Canadian dollar relative to the U.S. dollar on our costs incurred in Canadian dollars, higher spending on services and supplies primarily as a result of increased production rates, higher employment costs associated with higher earnings-based compensation payments, and increased prices for heavy fuel oil used at PT Inco, partially offset by cost reductions and related savings achieved in 2004. As noted above, the cost of the nickel intermediates we purchase is based upon LME and other benchmark prices and is included in cost of sales. Results for 2003 included a pre-tax expense of $107 million associated with the three-month strike at our Ontario operations. In addition, during the third quarter of 2003 our Ontario operations experienced a series of unanticipated problems associated with the ramp-up of certain of its facilities after the strike which resulted in an expense of $25 million.
Selling, General and Administrative
Selling, general and administrative expenses increased by $23 million in 2004 compared with 2003. The increase was primarily due to higher expenses associated with our earnings-based incentive compensation programs, partially offset by lower expenses associated with share appreciation rights which historically had been granted as part of certain share option awards. Selling, general and administrative expenses also included $6 million in 2004 spent on our program to evaluate and report on our internal control over financial reporting under the U.S. Sarbanes-Oxley Act and certain expenditures totalling $11 million in 2004 and $10 million in 2003 in support of our Goro and Voisey’s Bay projects.
Currency Translation Adjustments
Currency translation adjustments represented primarily the effect of exchange rate movements on the translation of Canadian dollar-denominated liabilities, post-retirement benefits, accounts payable and certain deferred income and mining taxes into U.S. dollars. Unfavourable currency translation adjustments were primarily due to the strengthening of the Canadian dollar as at December 31, 2004 relative to the U.S. dollar. The Canadian dollar - U.S. dollar exchange rate was 0.774 at the end of 2003 and 0.831 at the end of 2004, representing approximately a 7 per cent appreciation in the Canadian dollar relative to the U.S. dollar on a year-to-year basis.
Interest Expense
Interest expense for 2004 declined compared with 2003, primarily as a result of an increase in capitalized interest associated with our projects under development and lower interest rates on our outstanding debt for 2004 compared with 2003, taking into account refinancing activities in 2003 and our interest rate swaps we entered into with certain third party financial institutions. Interest expense excluded capitalized interest of $70 million in 2004 compared with $55 million in 2003.
Asset Impairment Charges
Changes in the planned Goro project configuration, including moving to direct heating of the ore feed and other changes intended to reduce the project’s capital cost and enhance the operating efficiency of the planned process plant and the process to be used to recover metals, resulted in certain capitalized costs incurred, principally for engineering and related work associated with the original project configuration and for equipment purchased for the indirect heating of ore feed, no longer having any value for the project or otherwise. As a result of these changes, an impairment charge covering capitalized expenditures of $201 million before minority interest and taxes was taken in the second quarter of 2004.
Other Income, Net
Other income decreased in 2004, compared with 2003. In 2004, other income included gains on foreign currency contracts in the amount of $10 million covering anticipated expenditures relating to the Goro project. We also realized a gain of $6 million on the sale of our interest in a Guatemalan subsidiary. In 2003, other income included gains of $35 million realized from the sale or transfer of
shares and other interests contributed to or received in conjunction with strategic and other collaborations relating to our primary metals operations, the receipt of a milestone payment of $24 million under the terms of sale reached in 1998 of a non-core exploration property and net gains of $12 million in connection with derivative positions in metals intended to meet future customer requirements. In addition, currency hedging gains of $11 million were realized in 2003 on the closing out of certain forward currency contracts as a consequence of the decision to suspend the Goro project made in late 2003.
Income and Mining Taxes
Our effective tax rate for 2004 of 37 per cent was slightly lower than the statutory rate due to (1) the benefit of losses not previously recognized, (2) the favourable outcome of tax matters related to prior years and (3) the benefit of lower tax rates on profits earned in low tax jurisdictions. These factors were partially offset by the negligible tax relief recorded on the $201 million non-cash impairment charge, before minority interest and taxes, recorded in the second quarter of 2004 and taxes provided on unrealized foreign exchange gains with respect to the Canadian parent’s U.S. dollar-denominated debt.
Minority Interest
Our minority interest represents primarily the respective minority shareholders’ interests in the earnings of PT Inco, ITL, Jinco and Goro Nickel. Minority interest increased in 2004 compared with 2003 primarily due to the higher earnings at PT Inco as a result of higher average realized prices for and higher deliveries of nickel-in-matte produced by PT Inco.
Nickel Unit Cash Cost of Sales
Nickel unit cash cost of sales before by-product credits increased to $5,732 per tonne ($2.60 per pound) in 2004 from $4,453 per tonne ($2.02 per pound) in 2003. Nickel unit cash cost of sales after by-product credits increased to $5,115 per tonne ($2.32 per pound) in 2004 from $4,740 per tonne ($2.15 per pound) in 2003.
The 2004 increase in nickel unit cash cost of sales before by-product credits was principally due to the higher cost for, and volumes of, purchased nickel intermediates, the higher average Canadian dollar exchange rate relative to the U.S. dollar exchange rate compared with 2003, higher costs for heavy fuel oil at PT Inco, higher spending on supplies and services primarily as a result of increased production rates and higher earnings-based compensation payments, partially offset by the absence of ramp-up costs which we incurred in the third quarter of 2003 after the end of the strike at our Ontario operations, and the cost reductions and related savings as discussed below.
The increase in nickel unit cash cost of sales after by-product credits for 2004 compared with 2003 was due to higher nickel unit cash cost of sales before by-product credits, partially offset by higher by-product credits as a result of higher realized selling prices for and higher deliveries of our principal by-products.
A reconciliation of our nickel unit cash cost of sales before and after by-product credits to cost of sales under Canadian GAAP is shown in the table entitled “Reconciliation of Nickel Unit Cash Cost of Sales Before and After By-Product Credits to Canadian GAAP Cost of Sales” under “Non-GAAP Financial Measure” below.
Energy Costs and Relative Advantages
In 2004, our hydroelectric facilities in Ontario generated approximately 19 per cent of our Ontario operations’ electricity requirements, and PT Inco’s 165-megawatt hydroelectric generating-facility at Larona together with its 93-megawatt hydroelectric generating facility at Balambano generated virtually all of PT Inco’s 2004 electricity requirements. In 2004, energy costs at our Ontario and Manitoba operations were approximately 12 per cent of total cash production costs, compared with 34 per cent for PT Inco. The availability of captive hydroelectric power decreased cash energy costs at PT Inco by about 53 per cent in 2004 and 51 per cent in 2003 relative to the energy costs that would have been incurred by PT Inco if its operations were dependent on fuel oil as the sole source to meet its energy requirements.
Intermediates Segment
Net sales by PT Inco of nickel-in-matte were $792 million in 2004 compared with $509 million in 2003. This increase in 2004 relative to 2003 was due to higher realized prices and increased deliveries as a result of then record production. PT Inco’s deliveries of nickel-in-matte totalled 72,500 tonnes (160 million pounds) in 2004 compared with 70,500 tonnes (155 million pounds) in 2003.
The increase in 2004 compared with 2003 was due to higher production. PT Inco’s net realized price for nickel-in-matte in 2004 averaged $10,766 per tonne ($4.88 per pound) compared with $7,117 per tonne ($3.23 per pound) in 2003. The selling price of PT Inco’s nickel-in-matte is determined by a formula which is based upon the LME cash price for nickel.
Nickel-in-matte production at PT Inco increased by three per cent to 72,200 tonnes (159 million pounds) in 2004 from 70,200 tonnes (155 million pounds) in 2003. Nickel unit cash cost of sales increased by 15 per cent in 2004 compared with 2003 due to increases in the price of heavy fuel oil as well as greater usage of mining-related services due to the higher production levels. In order to increase production to take advantage of the favourable nickel market conditions in 2004, we augmented PT Inco’s hydroelectric power generation by increasing the utilization of more expensive fuel-oil based power sources. PT Inco’s energy costs were up in 2004 due to increased consumption of heavy fuel oil as a result of the higher production rates and higher prices paid for such fuel oil to operate its dryers, kilns and other oil-fired facilities. Fuel oil costs were up nine per cent in 2004 compared with 2003. Fuel oil represented about 27 per cent of PT Inco’s cash costs of production of nickel-in-matte in 2004 compared with 31 per cent in 2003.
Cash Flows, Liquidity and Capital Resources
2005 Compared with 2004
The following bar chart presents the principal sources and uses of cash and cash equivalents for 2005 (uses of cash are shown in parentheses) with the starting point (first bar on the left) being the balance of cash and cash equivalents as at December 31, 2004:
Principal Sources and Uses of Cash in 2005
(in millions of dollars)
Operating Activities
The following table summarizes cash flow from operating activities for the periods indicated:
The decrease in net cash provided by operating activities in 2005 relative to 2004 was primarily due to higher working capital requirements in 2005. The increased working capital requirements were primarily related to reduced income and mining tax payable balances in view of the significant tax payments of $245 million made during the first quarter of 2005 in respect of the 2004 taxation year and higher tax instalments paid in 2005. In addition, inventory levels increased primarily as a result of increased production costs, increased finished copper inventories as a result of the previously indicated closure of the copper refinery in Ontario in the month of December 2005 and higher in-process inventories of Voisey’s Bay concentrates as well as the establishment of required supplies inventories at Voisey’s Bay as this project moved into production.
In 2005 and in 2004, contributions to our pension plans significantly exceeded our minimum required pension contributions due to voluntary contributions included in the total contributions made. These voluntary contributions were $130 million in 2005 and $144 million in 2004. Our total contributions were $271 million for 2005 compared with $265 million in 2004. We have had in effect for a number of years defined benefit pension plans principally in Canada, the United States and the United Kingdom. Each of the jurisdictions in which these plans are located has legislation and regulations which, among other statutory requirements, cover the minimum contributions to be made to these plans to meet their potential liabilities as calculated in accordance with such legislation and regulations. Based upon the value of the assets in these plans, as determined pursuant to applicable provincial legislation and
regulations in Canada and other factors to be taken into account under such legislative or regulatory requirements, we, in accordance with such applicable legislation or regulations, and in light of our relatively strong financial position, made voluntary contributions to such plans. We currently expect that our annual minimum pension contributions will be approximately $180 million in 2006. Since the liabilities associated with these pension plans are affected by changes in certain exchange rates, primarily the Canadian dollar, changes in such exchange rates could also significantly affect the level of contributions for future years.
Investing Activities
Net cash used for investing activities increased to $892 million in 2005 compared with $881 million in 2004. This increase was primarily due to higher capital spending, mainly in respect of our Goro project, and higher sustaining capital expenditures at our Canadian operations and PT Inco, partially offset by proceeds from the April 2005 sale of an interest in the Goro project company to a joint venture formed by Sumitomo Metal Mining Co., Ltd. and Mitsui & Co., Ltd. and subsequent pro rata capital contributions from that shareholder in the project, the proceeds from the sale of a non-core investment and lower capital spending for our Voisey’s Bay project. Reference is made to “Risks and Uncertainties - Other Risks and Uncertainties - Capital Requirements and Operating Risks” below for a discussion of the risks associated with our capital requirements. The following table sets forth our capital expenditures by principal operations and other investing activities for the years indicated:
Financing Activities
Net cash provided by financing activities in 2005 was $35 million compared with net cash provided by financing activities in 2004 of $146 million.
In 2005, we received approximately $49 million (2004 - $41 million) in respect of the French government-sponsored financing for the Goro project as described in note 12 to our 2005 consolidated financial statements.
Financing activities in 2005 included the use of $76 million in respect of the tender for conversion and settlement of such conversions in cash at our election of a portion of our LYON Notes. During 2005, LYON Notes representing approximately $163 million aggregate principal amount were tendered for conversion. At our option, we elected to settle a portion of such conversions in respect of these Notes in accordance with their terms for cash in lieu of shares in the amount of $76 million. The difference between the cash settlement price of $76 million and the book value of $41 million represents a charge of $35 million. For accounting purposes, the LYON Notes are bifurcated between debt and equity, the equity portion representing the value of the holders’ conversion options. Consequently, the charge of $35 million has been bifurcated between a charge to earnings of $9 million and a charge to retained earnings of $26 million. The remainder of the LYON Notes tendered for conversion in 2005 were, at our option, settled in shares with no impact on net earnings.
The table below summarizes our long-term borrowings and repayments of our long-term debt in 2005, 2004 and 2003:
During 2005, we drew down the remaining $200 million of our $400 million term facility entered into in late 2004 as part of the financing plan for our capital expenditure program for the Goro project intended to optimize certain tax benefits relating to the Girardin Act financing for this project. This term facility matures on December 23, 2011.
To continue to provide liquidity for our operations, on May 28, 2004 we concluded a $750 million syndicated revolving credit facility with a maturity date of May 28, 2009. This syndicated facility replaced several bilateral bank credit agreements under which we had an aggregate of $680 million of available credit as of year-end 2003, where $273 million of such $680 million would have otherwise expired on June 1, 2004 and the balance in either June 2005, June 2006 or June 2007. Subject to the approval of the lenders representing not less than 66 2/3 per cent in total commitments under this $750 million facility, the maturity date of the syndicated revolving credit facility may be extended for the commitments of those lenders who have approved such extension for an additional one-year period on each May 28 anniversary date. Effective May 28, 2005, the lenders under the $750 million facility agreed to extend the maturity date of the facility from May 28, 2009 by an additional year to May 28, 2010.
The borrowings under this facility may be made in either Canadian dollars in the form of (a) Prime Rate loans (as defined under the credit facility) or (b) in Bankers’ Acceptances (as defined under the credit facility) or in United States dollars in the form of (i) United States Base Rate loans (as defined under the credit facility) or (ii) London interbank offered rate loans (as defined under the credit facility). Borrowings under these facilities bear interest, when drawn, at a rate which varies based on the type of borrowing and our credit ratings at the time of borrowing. As of December 31, 2005, there were no amounts drawn under the facility.
This syndicated credit facility provides that, so long as advances are outstanding or any letters of credit or guarantees issued pursuant to the terms of the facility are outstanding, we will be required to maintain a ratio of Consolidated Indebtedness, as defined in the credit facility, to Tangible Net Worth, as defined in the credit facility, not to exceed 50:50. At December 31, 2005 this ratio of Consolidated Indebtedness to Tangible Net Worth was 25:75. The facility does not require any acceleration or prepayment of outstanding balances if our credit ratings on outstanding debt securities were downgraded or if there were a significant decline in our earnings, cash flow or in the price of our publicly traded common shares or other equity securities. A downgrade in our rating would, however, increase the interest rate payable on borrowings under the facility and, conversely, any upgrade in our rating would reduce the interest rate payable on borrowings. As of December 31, 2005, our outstanding debt securities were rated as investment grade by Moody’s Investors Service and Standard & Poor’s Ratings Services. After the announcement of our offer to purchase all of the common shares of Falconbridge on October 11, 2005, as referred to in note 23 to our consolidated financial statements, Standard & Poor’s Ratings Services placed our BBB- credit rating on credit watch with negative implications while Moody’s affirmed our Baa3 rating (with a stable outlook). These rating agencies apply their own criteria to determine their ratings and may change those criteria at any time. Such ratings do not represent a recommendation to buy, sell or hold our debt securities, may be subject to revision or withdrawal at any time by the particular rating organization, and each rating should be evaluated independently of any other rating.
In connection with our offer, on December 22, 2005 we entered into a loan agreement (the “Loan Agreement”) with a group of banks and financial institutions. The loan facilities under the Loan Agreement are in an amount sufficient for us to meet, directly or through subsidiaries who can borrow under the Loan Agreement, the total amount of cash of approximately $2.6 billion we would need to acquire all of the issued and outstanding common shares of Falconbridge (the “Falconbridge Shares”) pursuant to the terms of our pending offer made to acquire the Falconbridge Shares and pay the currently estimated fees and expenses associated with such offer. The Loan Agreement provides for a bridge loan facility which matures one year from the date of the final drawdown under the
bridge loan facility. The principal amount of the bridge loan facility is repayable in one payment on such maturity date but may also be prepaid prior to maturity at our option. Certain mandatory prepayments may also be required during the term of this facility out of net proceeds, if any, received from dispositions of certain assets, certain public or private issuances of debt and certain insurance proceeds received. The Loan Agreement also provides for a term loan facility which matures on the date that is five years plus one day following the date of the final drawdown under the term loan facility. The principal amount of the term loan facility is repayable in one payment on such maturity date but may also be prepaid prior to maturity at our option. Certain mandatory prepayments may also be required during the term of this facility out of certain net proceeds, if any, received from the divestiture of certain assets of Falconbridge, certain public or private issuances of debt related to the divestiture of certain assets of Falconbridge, and certain insurance proceeds received. The two loan facilities provided for in the Loan Agreement bear interest and are subject to fees at levels customary for credit facilities of this type and include covenants, representations, warranties, conditions and events of default consistent with the terms of our existing credit facilities or otherwise customary for loan facilities of this type, including acceleration of obligations if any specified events of default occur. The first drawdown under these loan facilities is currently available until August 10, 2006. Subsequent drawdowns are permitted within 140 days following the first drawdown. We are required to obtain the prior consent of the majority lenders under the loan facilities prior to amending, waiving, or making determinations relating to certain conditions with respect to the acquisition of the Falconbridge Shares under the terms of the Support Agreement dated as of October 10, 2005, as amended, between Inco and Falconbridge covering the offer.
Our total debt as a percentage of our total debt plus shareholders’ equity as of December 31 for the years indicated is set forth in the following table:
Recognizing the sensitivity of our cash flow to nickel and other metals prices, we currently believe that our level of cash and cash equivalents as of December 31, 2005, together with currently projected cash to be provided by operating activities, available cash from our unused lines of credit and the Loan Agreement and access to international capital markets, will be more than sufficient to meet our currently anticipated cash requirements of our current operations, our development projects at least for the 2006 - 2008 period and the cash portion of our offer to acquire all of the Falconbridge Shares and related expenses of the offer. Our requirements include ongoing cash needs for our existing operations as well as the cash required to finance currently planned expenditures on sustaining and other capital projects, including our Goro and Voisey’s Bay projects. As discussed above, our required capital expenditures continue to be very significant over the 2006-2008 period given the current spending plans for our Goro project and at PT Inco.
Our liquidity is affected by a number of key factors, including decreases in the amount of, and a change in the timing of, our production outlook at our existing operations as well as the timing of completion of our Voisey’s Bay and Goro projects. Reference is made to “Risks and Uncertainties - Other Risks and Uncertainties - PT Inco”, “Risks and Uncertainties - Other Risks and Uncertainties - Risks Associated with, and Importance of, Future Low-Cost Nickel Projects” and “Risks and Uncertainties - Other Risks and Uncertainties - Uncertainty of Production and Capital and Other Cost Estimates” below for detailed discussions of these factors and their impact on our liquidity.
Reinstatement of Common Shares Dividend
In April 2005, our Board of Directors reinstated a quarterly cash dividend on our common shares of $0.10 per share. The amount of this quarterly cash dividend was increased by our Board in early February 2006 to $0.125 for the dividend payable March 1, 2006.
2004 Compared with 2003
Operating Activities
Net cash provided by operating activities in 2004 totalled $1,393 million, which represented a significant increase from the $131 million in net cash provided by operating activities in 2003. The increase was primarily due to higher earnings, excluding asset impairment and other non-cash charges, and a reduction in working capital in 2004, compared with an increase in working capital in 2003. Increased investments in accounts receivable and inventories in 2004 were more than offset by higher balances of income and mining taxes payable in 2004. Accounts receivable at the end of 2004 increased due to significantly higher deliveries and prices for the metals we produced in the fourth quarter of 2004 relative to the corresponding period of 2003. Our investment in inventory increased at the end of 2004 relative to 2003 due principally to higher production costs associated with that inventory. In 2004,
working capital primarily benefitted from the delay in the payment of accrued income and mining tax liabilities as the minimum required income and mining tax instalments during the year were less than the amount of the full tax obligation ultimately payable in respect of 2004. The balance of tax payments in respect of 2004 was $245 million and was made in the first quarter of 2005. In 2004, pension payments totalled $265 million which was a significant increase compared with 2003 as a result of voluntary contributions in the amount of $144 million in addition to required contributions totalling $121 million.
Investing Activities
Net cash used for investing activities increased to $881 million in 2004 compared with $565 million in 2003. The increase was primarily due to higher capital spending, mainly in respect of our Voisey’s Bay project, compared with 2003.
Financing Activities
Net cash provided by financing activities in 2004 was $146 million compared with cash used for financing activities in 2003 of $235 million.
We received $41 million in respect of the French government-sponsored financing for the Goro project.
In late December 2004 we concluded a new $400 million term loan facility. Borrowings under this facility may be made up to December 23, 2005 and the amount of the loan available will be reduced to the aggregate amount of the advances at that date (the “Final Loan Amount”). Repayments of the Final Loan Amount outstanding at December 23, 2005 are as follows - 25 per cent of the Final Loan Amount will be due on December 31, 2009; 121/2 per cent of the Final Loan Amount on June 30, 2010; 121/2 per cent of the Final Loan Amount on December 31, 2010; 121/2 per cent of the Final Loan Amount on June 30, 2011; and the remaining amount still outstanding on the final maturity date of December 23, 2011. The borrowings under this facility may be made in U.S. dollars in the form of (i) loans based on a U.S. dollar base rate or (ii) loans based on certain London interbank offered rates. Borrowings under this facility bear interest, when drawn, at rates which vary based on the type of borrowing and our credit ratings at the time of borrowing. As of December 31, 2004, there was $200 million drawn under this new facility.
Off-Balance Sheet Arrangements and Aggregate Contractual Obligations
Contractual Obligations
This section summarizes as of December 31, 2005 certain of our contractual obligations and our off-balance sheet arrangements. The first table below sets forth our contractual obligations as of December 31, 2005. Certain of these contractual obligations, including long-term debt obligations and asset retirement obligations, are also reflected in our December 31, 2005 balance sheet (Reference is made to notes 9 and 11 to our 2005 consolidated financial statements), while the other obligations are off-balance sheet ones. In addition to these contractual obligations, we also have certain contingencies and guarantees, as discussed below. The majority of our derivative positions as at December 31, 2005 fall into the category of off-balance sheet arrangements and, consistent with the Canadian GAAP, are designated as effective hedging relationships. Our outstanding derivative positions as at December 31, 2005 and December 31, 2004 are summarized in the tables under “Derivative Instrument Positions” below.
(1)
These purchase obligations are largely related to the Goro project, with the balance comprising routine orders to purchase goods and services at our current operating locations.
(2)
We have only included these obligations in the table for one year since such obligations are calculated on an annual basis.
With respect to any mandatory redemption requirements covering our outstanding debt securities over the 2006 - 2010 period, reference is made to (i) note 13 to our 2005 consolidated financial statements for information on the special contingent conversion
right that holders of certain of our convertible debt have and (ii) note 9 to our 2005 consolidated financial statements for information on the redemption provisions of certain long-term debt.
The purchase obligations set forth in the table above include our commitments for the Goro project, as noted under “Outlook” below, as at December 31, 2005. Except for these commitments, this table does not include a significant portion of our expected capital expenditures over the next five years and thereafter since such expenditures do not represent contractual obligations. We currently estimate that our existing operations require, on an annual basis, on average approximately $230 million of capital expenditures to sustain their operations and to meet current environmental regulations and similar requirements at our currently planned production and/or utilization levels for these operations.
Amounts included in “Post-retirement benefit obligations” in the table above represent the contractual funding requirements for our pension plans in 2006. The required funding amounts for our pension plans are actuarially determined and are subject to future uncertainties, including whether the expected or assumed rate of return on plan assets and the discount rate on pension obligations we use will be higher or lower over time (each of which may change over time). We have only included these obligations in the table for one year since such obligations are calculated on an annual basis.
The amounts included in “Asset retirement obligations” in the table above represent our present legal obligations for closure and related costs at all our existing operating mines and non-operating mines and properties based upon the closure plans which we have developed in accordance with regulatory or our own internal requirements applicable to those mines and properties.
Our arrangements covering the Voisey’s Bay project entered into with the Province of Newfoundland and Labrador (“Province”) in 2002 provide that we are obligated to refine the nickel concentrates produced by the project in the Province beginning in 2012. As such refining facilities are not yet constructed, we are currently permitted to ship the nickel concentrates out of the Province for refining. Once we have constructed a refining facility in the Province, we are obligated over a specified period to return the equivalent amount of nickel in the concentrates shipped out of the Province for refining in the Province. Through December 31, 2005, 4,486 tonnes (10 million pounds) of nickel in concentrates have been shipped out of the Province.
Contingencies and Guarantees
In the course of our operations, we are subject to routine claims and litigation incidental to our business, to various environmental proceedings, and to other litigation related to such business. With respect to the environmental proceedings currently pending or threatened against us, they include (1) a proceeding brought under the Ontario class action legislation covering claims relating to the alleged decline in property values in a community where we had operated a nickel refinery over the 1918 - 1984 period, (2) claims for personal injuries, (3) enforcement actions, (4) alleged violations of, including exceeding regulatory limits relating to discharges under, certain environmental or similar laws and regulations applicable to our operations in Canada and elsewhere and (5) certain claims dating back a number of years in which one of our subsidiaries was designated, under the United States federal environmental law known as “Superfund” or “CERCLA”, as a potentially responsible party. We currently believe that the ultimate resolution of such proceedings, claims and litigation will not significantly impair our operations or have a material adverse effect on our financial position or results of operation.
In connection with our 1996 acquisition of Diamond Fields Resources Inc., we assumed an obligation to pay to a company retained by Diamond Field Resources Inc. to provide certain exploration and other services an annual royalty in the form of a net smelter return amounting to three per cent of the net proceeds received from the sale of ores, metals and other minerals produced from our Voisey’s Bay project, after deducting certain costs associated with the production and sale of the ores, metals and minerals produced. While no such royalty payments have been made given when the initial concentrates were produced by the Voisey’s Bay project and proceeds from the sale of such concentrates are to be received, these royalties will be payable quarterly beginning in 2006.
In addition, as discussed in notes 12 and 20 of the 2005 consolidated financial statements, in connection with a French government-sponsored financing program for which our Goro project qualified (the “Girardin Financing”), we provided certain guarantees on behalf of Goro Nickel covering payments due from Goro Nickel of up to a maximum amount of $100 million (“Maximum Amount”) in connection with an indemnity relating to certain potential liabilities that might occur associated with the loss or forfeiture by qualified French tax investors who participated in this program of certain tax benefits associated with the Girardin Financing (“Add-Back Indemnity”). We also provided an additional guarantee covering the payments due from Goro Nickel of (a) amounts exceeding the Maximum Amount in connection with the Add-Back Indemnity and (b) certain other amounts payable by Goro Nickel under the Girardin Financing relating to certain possible operational or other developments applicable to the Goro project.
We also provided a guarantee covering certain termination payments due from Goro Nickel to the supplier under an electricity supply agreement (“ESA”) entered into in October 2004 for the Goro project. The amount of the termination payments guaranteed depends upon a number of factors, including whether any termination of the ESA is as a result of a default by Goro Nickel and the date on which an early termination of the ESA were to occur. If Goro Nickel defaults under the ESA, the termination payment could reach Euros 145 million. This maximum amount could be payable if termination of the ESA occurred prior to the anticipated start date for supply of electricity under the ESA to the project. Once the supply of electricity to the project begins, the guaranteed amounts will decrease over the life of the ESA.
Derivative Instrument Positions
As discussed in “Risks and Uncertainties - Market Risk - Metals and Commodities Risk - Foreign Exchange Risk - and Interest Rate Risk” below, we engage in derivative instrument transactions to reduce the impact, to varying degrees, of certain market risks to which we are exposed on our earnings and cash flows from operations. Reference is made to these sections under “Risks and Uncertainties” below for further information on these transactions, as well as to note 19 to the 2005 consolidated financial statements.
The following table shows the notional amounts, average price, contract amount and fair value of our principal derivative instrument positions as at December 31, 2005:
(1)
In general, we do not use derivative instruments to hedge our exposure to fluctuating nickel prices. We do enter into LME forward purchase contracts which are substantially offset by fixed price customer contracts in order to more fully expose us to nickel price risk. We also enter into LME forward sales contracts to minimize nickel price risk associated with purchased nickel inventories of intermediates and finished nickel products.
(2)
We had outstanding put option contracts, giving us the right but not the obligation to sell copper, and sold call option contracts, giving the buyer the right but not the obligation, to purchase copper for time periods extending to 2008. We also enter into forward copper sell contracts based upon quotations for copper on the COMEX Division of the New York Mercantile Exchange.
(3)
Depending on market conditions, we enter into precious metals hedging contracts. These contracts, in the form of swap contracts (whereby we simultaneously sell at a fixed price and buy the same quantities for the same maturity dates at a floating price), are intended to provide certain minimum price realizations in respect of a portion of our future production of such metals. Under these swap contracts, we receive fixed prices for platinum and pay a floating price based on monthly average spot prices. We also had outstanding put option contracts, giving us the right but not the obligation to sell platinum and sold call option contracts, giving the buyer the right but not the obligation, to purchase platinum during the same time period.
(4)
We use fuel oil swap contracts to reduce the effect of fuel oil price changes in respect of a portion of our energy requirements at PT Inco. Under these swap contracts, we pay fixed prices for fuel oil and receive a floating price based on monthly average spot price quotations.
(5)
We use forward currency contracts to eliminate the risk of exchange rate movements on a portion of our future construction costs of capital assets at our Ontario operations and the planned production facilities for the Goro project.
(6)
As at December 31, 2005, we had an outstanding interest rate swap of a notional amount of $200 million on our term loan due 2011, whereby we initially receive a floating rate at 0.875 per cent over the 3-month London interbank offered rate and pay a fixed rate of 5.098 per cent.
The following table shows the notional amounts, average price, contract amount and fair value of our principal derivative instrument positions as at December 31, 2004:
Other Off-Balance Sheet Arrangements
During the past three years, we have had discussions with representatives of the Province of Manitoba regarding what amount of financial assurance covering future closure or similar requirements might be required for our Manitoba operations under applicable provincial regulations. Based upon those discussions, financial assurance in the form of a letter of credit of approximately $0.4 million covering certain long-term costs of maintaining certain of the Manitoba operations has been provided by us. We understand that the Province of Manitoba is currently reviewing changes it plans to make to its financial assurance requirements that would be applicable to our Manitoba operations. While we currently cannot predict what, if any, actual additional amount of financial assurance will be required by this Province, we do not believe that it will have a material effect on our results of operations, financial condition or liquidity.
As discussed under “Risks and Uncertainties - Environmental Risks” below, as of December 31, 2005 we had outstanding letters of credit in the amount of $23 million to secure a portion of our closure costs covering three mines in our Ontario operations. We have also provided a letter of credit in the amount of approximately $8 million covering certain remediation costs relating to the construction and operating phases of our Voisey’s Bay project. We understand that the Province of Newfoundland and Labrador is also reviewing changes to its financial assurance requirements that would apply to our Voisey’s Bay project. Based upon our understanding of what changes could be implemented, we could be required in 2006 to increase the letter of credit we have provided by an amount in the order of $60 million to cover future closure and related requirements applicable to these operations.
The off-balance sheet arrangements we currently have in place involve accounts receivable securitized financing arrangements in the United States and Asia with unrelated entities under which up to approximately $115 million in eligible receivables may be sold by us to these entities at any time. Under these accounts receivable financing arrangements, a significant deterioration in our credit rating and/or accounts receivable being sold could give the purchaser of such receivables the right not to renew the arrangements. We have accounted for these securitizations as asset sales since their inception but have recorded where relevant any loss retention reserves with respect to the sale. As at December 31, 2005, the aggregate amount of receivables sold was $39 million. We do not currently believe that our liquidity would be substantially reduced if these arrangements were not available to us.
There are no significant long-term contractual arrangements with any related parties that create or result in any obligations that are not on an arm’s length, negotiated basis.
Risks and Uncertainties
The following risks and uncertainties, among others, should be considered in evaluating our outlook and future prospects.
Market Risk
We define market risk as being the risk of potential economic loss arising from adverse changes in market rates and prices. Given the nature of our business and operations, the areas of highest market risk or exposure for us are nickel prices and, to a lesser extent, our prices of other metals and commodities that we produce or purchase (representing what we refer to as our metals and commodities risk), foreign currency exchange rates (representing what we refer to as our foreign exchange risk) and interest rates (representing what we refer to as our interest rate risk), all of which are as discussed below. In the case of our metals and commodities risk, we sell our products at prices based on world market prices and purchase fuel oil and other supplies at market prices since these supplies are essentially commodities which can be purchased from a large number of available sources. In addition to the two Australian suppliers of intermediate nickel products to our Canadian operations and certain previously announced purchase and sale, toll smelting and refining arrangements covering (1) our total planned copper production in anode form with Falconbridge and (2) intermediate nickel products to be smelted and refined into finished nickel by subsidiaries of Boliden AB and OM Group, Inc. that we entered into in 2005 and early 2006, we have a limited number of sole source suppliers of critical materials or services, including electricity in Canada and other locations. The metals and commodity risks relating to nickel and, to a lesser extent, other metals produced by us, given the significance of price realizations to us of such metals, are expected to continue to have a material impact on our results of operations, cash flow and financial condition. While the prices for our primary nickel and other metals produced are based largely on, and sold in, U.S. dollars, we are subject to foreign exchange risk because we incur a substantial portion of our costs and expenses in currencies other than the U.S. dollar, in particular the Canadian dollar. We are exposed to additional foreign exchange risk and are also exposed to interest rate risk because, to the extent that we fund our operations and capital expenditures, including non-U.S. dollar capital expenditures, through long-term and short-term borrowings, these borrowings are primarily in U.S. dollars. Based upon past movements of certain foreign currency exchange rates, as described below, and our current expectations of continued volatility in such
exchange rates for 2006, we believe that the potential near-term impact on future earnings and cash flows with respect to changes in foreign currency exchange rates could have a material effect on our financial condition, results of operations and cash flow. Based upon recent past movements in interest rates, as described below, and our current expectations of changes in interest rates in 2006, we currently believe that the potential near-term impact of such changes on future earnings will not have a material impact on our financial condition or results of operations.
The nickel industry has seen some substitution of other less costly metals or materials for nickel in certain applications. Any significant increases in such substitution, particularly if such changes represented a permanent shift away from the use of the primary nickel we produce, would be expected to adversely affect nickel demand and our results of operations, financial condition and cash flow from operations.
An uncertain global economic environment would be expected to have a significant adverse effect on our business, results of operations, financial condition and cash flows given, as indicated above, the historical correlation between industrial production and demand for primary nickel and the other products we produce. There can be no assurance that oversupply situations that existed in the past in the nickel markets could not reoccur in the future. Any excess supply condition would have an adverse effect on the prices realized by us for our nickel products. Other international economic trends, expectations of inflation and political events in major nickel producing and consuming countries could also adversely affect nickel prices and the prices of other metals produced by us. These factors are beyond our control and have resulted, and are expected to continue to result, in a high degree of price volatility for nickel and other primary metals produced by us.
There can be no assurance that the price for nickel or other metals produced by us will not decline significantly from current levels. A return to the relatively low nickel price realizations experienced in the late 1990s for us would have a material adverse effect on our results of operations, financial condition and cash flow.
If demand for nickel in China or other major nickel-consuming markets in Asia, or any other major consuming region, were to decline significantly, such an event would be expected to negatively affect nickel prices and our results of operations, financial condition and our cash flow from operations. If and to the extent that, given the positive correlation that has existed historically between demand for nickel and industrial production, other industrialized regions of the world were to experience slower economic growth or an actual decline in economic growth, such a development would also be expected to affect nickel prices and our results of operations, financial condition, and cash flow from operations. We have experienced periods of low nickel prices due to over-supply conditions and/or declines in nickel demand and, given the historically cyclical nature of nickel supply and demand, we expect that similar periods could reoccur in the future which could result in our experiencing unfavourable results of operations, including net losses and negative cash flows from operations.
We have engaged in transactions to reduce, to varying degrees, the impact of certain of these market risks to which we are exposed on our earnings and cash flow from operations. We have established policies and procedures governing the use of derivative instruments to address certain market risks. These policies and procedures are intended to reduce some of the uncertainties associated with the market risks specific to our business and operations and reduce the effect of market fluctuations relating to the metals we produce and supplies of products and services we need for our operations on our earnings and cash flows. We only use derivative instruments based on an economic analysis of the underlying exposures, factoring in the anticipated correlations of the underlying exposures, anticipating that adverse effects on future earnings and cash flows due to fluctuations in metals and commodities prices, foreign currency exchange rates and interest rates will be offset by proceeds from, and changes in the fair value of, the derivative instruments. We do not, however, hedge our exposure to all market risks and do not hedge our exposure to any market risk in a manner that completely eliminates the effects of changing market conditions on earnings or cash flows.
We have had in place an internal risk management committee for a number of years. This committee is comprised of senior financial and marketing executives and chaired by our Chief Executive Officer. This internal committee oversees our hedging activities, whereby we use derivative instruments to reduce market risks. The risk management committee’s oversight includes reviewing compliance with our risk management policies authorized by our Board of Directors. The risk management policies set forth the responsibilities of the internal risk management committee, its membership and conduct, reporting requirements, controls, maximum hedging limits and related authorizations delegated by our Board of Directors.
Under our risk management policies, hedging activities are restricted by maximum limits which are specifically approved by our Board of Directors. The maximum limits are usually tied to a maximum percentage of forecast annual production volume (or annual requirements, in the case of supplies or currencies, as the case may be) for current and future years, up to five years. Maximum limits are, subject to changes in, or stand-alone authorizations which Inco’s Board of Directors may approve from time to time, currently as
follows: for nickel (year 1: 35 per cent of forecast annual production, year 2: 25 per cent, year 3: 10 per cent); copper, platinum, palladium and gold (years 1 and 2: 75 per cent of forecast annual production, years 3 to 5: 50 per cent); certain supplies to our operations (such as oil, natural gas and electricity) (year 1: 75 per cent of forecast annual requirements, year 2: 50 per cent, years 3 to 5: 25 per cent); and foreign currency (year 1: 75 per cent of forecast annual requirements, years 2 and 3: 50 per cent, years 4 and 5: 20 per cent). To the extent that we do hedge for certain metals and for supplies and foreign currencies, we have historically hedged at levels below these limits absent specific circumstances where we believe that hedging up to or close to such limits would be appropriate.
In addition, pursuant to our annual financing plan approved each year by our Board of Directors, as well as specific debt financings authorized by our Board of Directors from time to time, interest rate swaps may be authorized to effectively convert the interest rate applicable to all or part of a debt financing from a fixed to a floating rate or vice versa at rates covered by such approvals or authorizations, including interest rate swaps entered into on a short-term basis in anticipation of the completion of a specific financing.
In addition to a quarterly review by our internal risk management committee of all hedging activities and hedge positions, each quarter all hedging activities and hedge positions are reviewed with and reported to our Audit Committee. Our internal audit group is also responsible for periodically examining internal controls, trade execution and monitoring, reporting and compliance with the risk management policy.
Metals and Commodities Risk
We are subject to metals and commodities risk because we sell our products and purchase fuel oil and other supplies or services at prices for the most part effectively determined through trading on major commodity exchanges, in particular the LME and the New York Mercantile Exchange. The prices offered on these exchanges generally reflect the global balance of supply and demand for the particular metal or commodity but are also influenced in the short-term by such factors as investment funds flow, speculative activity in the particular commodity and currency exchange rates.
The price of nickel, our principal product, continues to represent the major factor influencing our results of operations, financial condition and cash flow from operations. The selling prices for our primary nickel products are generally based on the LME cash nickel price. However, certain of our products are customarily sold at a premium over the LME cash price, particularly our specialty products such as nickel powders and foams. The markets for our products have been, and are expected to continue to be, cyclical in nature and prices have been, and are expected to continue to be, volatile. However, because we are one of the largest producers and marketers of primary nickel in the world, we have chosen, subject to certain limited exceptions as discussed below, not to hedge or otherwise attempt to mitigate to any significant degree the risk of fluctuations in the price of nickel. We review this policy from time to time and may choose to increase the currently limited use of derivative instruments to reduce such risks in the future. In the case of other metals produced by us, we have from time to time entered into derivative instruments to fix minimum realized prices. We do enter into LME forward purchase contracts which are substantially offset by fixed price customer contracts in order to more fully expose us to nickel price risk. We also enter into LME forward sales contracts to minimize nickel price risk associated with purchased nickel inventories of intermediates and finished nickel products.
Depending on market conditions, we enter into precious metals hedging contracts. These contracts, in the form of swap contracts (whereby we simultaneously sell at a fixed price and buy the same quantities for the same maturity dates at a floating price), are intended to provide certain minimum price realizations in respect of a portion of our future production of such metals.
We use fuel oil swap contracts to reduce the effect of fuel oil price changes in respect of a portion of our energy requirements at PT Inco. Under these contracts, we receive or make payments based on the difference between a fixed and a floating price for fuel oil.
With Voisey’s Bay having begun production and once the Goro project has started commercial production, we will become a significant producer of cobalt. When that occurs, we could be affected by the highly competitive market for cobalt that currently exists and is expected to continue to exist. Cobalt sold to customers is currently sold either on a fixed price basis using annual contracts for customers in certain industries or on the basis of prices as quoted in the Metals Bulletin and Platts, which are recognized metals industry publications that publish cobalt and other metal prices. Such published prices are generally accepted as representing the benchmark or market price indicator for cobalt. Cobalt, like nickel and copper, has historically been subject to significant price volatility and we currently expect that such volatility will continue. The financial analyses undertaken by us during 2004 in support of the substantial investment to be made with respect to our Goro project were based upon a long term price of cobalt of $19.85 per kilogram ($9.00 per pound). If realized cobalt prices, as well as realized prices for the other metals to be produced by our Voisey’s
Bay and/or Goro projects, were to be below the long-term prices assumed by us, the expected financial returns from, and expected cash and other costs for, these projects would be adversely affected.
At December 31, 2005, none of our currently planned nickel production is covered by, or subject to, derivative contracts. At December 31, 2005, we had entered into derivative contracts to hedge a portion of our planned copper and precious metals production over varying periods up to four years. Outstanding derivative contracts for copper cover 29 per cent, 49 per cent and 47 per cent of planned copper production in 2006, 2007 and 2008, respectively and for platinum the derivative contracts cover 21 per cent, 15 per cent and 21 per cent of planned platinum production in 2006, 2007 and 2008, respectively. Reference is made to note 19 to the 2005 consolidated financial statements. We currently expect to produce copper and precious metals from our estimated proven and probable ore/mineral reserves at our Ontario operations for a period in excess of twenty years, a period that extends well beyond the maturity of our current derivative contracts covering these metals. Reference is made to “Derivative Instruments” under “Off-Balance Sheet Arrangements and Aggregate Contractual Obligations” above.
Foreign Exchange Risk
By virtue of our international operations, we incur costs and expenses in a number of foreign currencies other than the U.S. dollar. The exchange rates covering such currencies have varied substantially in the last three years. A substantial portion of our revenue is received in U.S. dollars since the price of nickel and other metals we produce are generally referenced in U.S. dollars, while a significant portion of our costs and expenses are incurred in Canadian dollars. Fluctuations in exchange rates between the U.S. dollar and the Canadian dollar and between the U.S. dollar and certain other currencies give rise to foreign currency exposure, either favourable or unfavourable, which have materially affected and are expected to continue to materially affect our results of operations and financial condition.
Our primary foreign exchange risk is to changes in the value of the Canadian dollar relative to the U.S. dollar. We reduce, from time to time, the impact of this risk by entering into forward currency contracts and foreign currency options. However, these activities do not eliminate the potentially significant adverse effect that exchange rate fluctuations could have on our results of operations or financial condition. At the end of 2005, these contracts took the form of forward contracts, which establish a fixed exchange rate for the future purchases of the Canadian dollar and certain other currencies, principally the Australian dollar, Euro and Pound sterling. The purpose of these forward currency contracts is to eliminate the risk of foreign exchange movements on (i) a portion of future Canadian dollar expenditures relating to our sustaining and other capital projects in Canada and (ii) a portion of the future Australian dollar, Euro and Pound sterling denominated construction costs for the planned production facilities for the Goro project.
We are, to a substantially lesser extent, also subject to fluctuations in the value of the Indonesian rupiah relative to the U.S. dollar as a result of our operations in Indonesia. This impact is reduced by the fact that a significant portion of PT Inco’s costs and revenues are effectively denominated in U.S. dollars. Because of the limited nature of this exposure, we do not customarily hedge the value of the rupiah against the U.S. dollar and no such financial instruments were in effect at December 31, 2005.
We have experienced periods where the U.S. dollar has been relatively strong in relation to the Canadian dollar. Historically, the positive correlation between the Canadian dollar and metal prices has resulted in higher profit margins for us during periods when the Canadian dollar has been relatively strong against the U.S. dollar. Accordingly, while a stronger Canadian dollar has historically led to higher cash operating costs for us in U.S. dollar terms, the historical accompanying increase in metal prices has resulted in higher profit margins. Conversely, historically when the Canadian dollar has weakened relative to the U.S. dollar we have experienced lower cash operating costs in U.S. dollar terms and the historical accompanying decrease in metal prices has resulted in lower profit margins for us. Due to this correlation and the historical responsiveness of nickel prices to cyclical supply-demand factors, we do not currently anticipate that the impact of fluctuations in the Canadian dollar over the relevant period for which we use the average exchange rates in estimating our ore/mineral reserves will affect the quantities of our estimated proven and probable ore/mineral reserves given the relative importance of factors, including the nature of the mineralization in our deposits, other than metals prices and exchange rates on the estimation of our ore/mineral reserves. Reference is made to “Ore Reserves” above for a description of the assumptions used in developing these estimates. However, there can be no assurance that the historical correlation between the change in the value of the Canadian dollar relative to the U.S. dollar and metal prices will continue and if it fails to do so our estimates of proven and probable ore/mineral reserves could be adversely affected by a significant strengthening of the Canadian dollar compared with the U.S. dollar. To the extent that we would use other expected metal prices and exchange rates for our estimated proven and probable ore/mineral reserves, these estimates could change significantly.
While the U.S. dollar is the functional currency in our Canadian operations, we are required, for income tax purposes, to report income subject to Canadian tax in Canadian dollars. We have a number of long-term debt obligations denominated in currencies other than Canadian dollars. Fluctuations in the value of the relevant foreign currencies in relation to the Canadian dollar can give rise to capital and/or income gains or losses for Canadian income tax purposes on the repayment of any such foreign currency-denominated long-term debt obligations. Since the U.S. dollar is both our functional and reporting currency, no gains or losses on the settlement or marking to market of U.S. dollar-based obligations (representing the primary dollar denomination of our long-term debt obligations) is reported in computing income reported in our 2005 consolidated financial statements. For reporting purposes, we reflect the Canadian taxes potentially payable on the settlement of our non-Canadian dollar-denominated debt in computing our long-term deferred tax assets and liabilities for unrealized gains and losses and as a current tax expense for realized gains and losses. No taxable event in respect of the debt occurs until the debt is settled by payment or other form of discharge for Canadian tax purposes.
Should a fluctuation in the value between the Canadian dollar and the relevant foreign currencies result in us being subject to reporting a capital and/or income gain for Canadian income tax purposes when a debt were repaid, we would report as either a current tax expense in respect of realized gains, or a deferred tax expense in respect of unrealized gains, for the Canadian income taxes payable, in respect of such a gain. This increase in our tax provision may distort our effective tax rate, since no such foreign currency gain would be reported in our consolidated financial statements.
Interest Rate Risk
Our exposure to changes in interest rates results from investing and borrowing activities undertaken to manage our liquidity and capital requirements. We generally have used fixed-rate debt to finance long-term investments, while variable-rate debt has been used to meet working capital requirements and related requirements on a more near-term basis. At December 31, 2005, taking into account our interest rate swap discussed below, approximately 14 per cent of our total debt was subject to variable interest rates. Based upon the level of floating or variable-rate debt at December 31, 2005, the impact of a 10 per cent change in underlying interest rates, or 45 basis points, would change interest expense by about $1 million over a full year. As noted under “Cash Flows, Liquidity and Capital Resources - 2005 Compared with 2004” above, we could be required to raise additional debt in the future to meet our capital expenditures and other requirements, and we could experience higher interest costs as a result of a downgrade in our credit ratings and, accordingly, in such cases our results of operations and cash flow from operations could be materially adversely affected by changes in interest rates in the future despite any interest rate swaps we might then have in effect.
As at December 31, 2005, we had an outstanding interest rate swap in respect of our $200 million term loan due 2011 whereby we receive a floating rate of interest at certain London interbank offered rates plus 0.875 per cent and pay a fixed rate of 5.098 per cent.
Counterparty Risk
Our interest rate swap, metals and foreign currency risk management activities expose us to the risk of default by the counterparties to such arrangements. Any such default could have a material adverse effect on our results of operations and financial condition. We do not obtain collateral or other security to support derivative instruments subject to credit risk but mitigate this risk by dealing only with counterparties that we believe, based upon an assessment of each such counterparty’s financial history and experience, to be financially sound and, accordingly, we do not anticipate a loss for non-performance by any counterparty with whom we have a commercial relationship.
Environment Risk
Environmental legislation and regulations affect nearly all aspects of our operations and development projects worldwide. Such legislation and regulations apply to us along with other companies in the mining and metals industry. These types of legislation and regulations require us to obtain operating licences, permits and other approvals and impose standards and controls on activities relating to mining, exploration, development, production, reclamation, closure and the refining, distribution and marketing of nickel and other metal products. Environmental assessments are required before initiating most new projects or undertaking significant changes to existing operations. In addition to current requirements, we expect that additional environmental regulations will likely be implemented to protect the environment and quality of life, given issues of sustainable development and other similar requirements which governmental and supragovernmental organizations and other bodies have been pursuing. Some of the issues currently under review by environmental regulatory agencies include (i) further reductions in, or requiring enhanced stabilization of, various emissions, including sulphur dioxide, metals and greenhouse gas emissions, (ii) additional mine reclamation and restoration, and (iii) more restrictive water, air and soil quality and waste, tailings and other materials treatment and disposal.
We account for asset retirement obligations as discussed in note 2 to the consolidated financial statements. The estimate of the total liability for asset retirement obligations has been developed from independent environmental studies, which include an evaluation of, among other factors, information available at that time with respect to closure plans and closure alternatives, the anticipated method and extent of site restoration using current costs and existing technology, and compliance required by presently enacted laws, regulations and existing industry standards. The total liability for asset retirement obligations represents estimated expenditures associated with closure, progressive rehabilitation and post-closure care and maintenance. Potential recoveries of cash or other payments from the future sale of assets upon the ultimate closure of operations have not been reflected in the estimate of the total liability or related annual provisions or charges. Future changes, if any, to the estimated total liability, as a result of changes in requirements, laws, regulations and operating assumptions may be significant and would be recognized prospectively as a change in accounting estimate, when applicable. Although the ultimate amount to be incurred is uncertain, the total present value of the liability for asset retirement obligations in respect of our worldwide operations to be incurred primarily after cessation of operations was estimated to be $171 million (including a current portion of such total obligation of $3 million) at December 31, 2005 based upon certain discount rates and timing with respect to when these costs would be expected to be incurred.
Changes made in 2000 to mining regulations in the Province of Ontario require us to provide letters of credit or other forms of financial assurance intended to secure our ability to meet future reclamation and restoration costs, which are not expected to be incurred for many years, if we were to no longer meet certain minimum investment grade credit ratings for our outstanding publicly traded debt securities. Although our debt securities are currently rated investment grade, they were rated below investment grade in recent times and there can be no assurance that this situation will not reoccur. If we are not able to maintain the minimum investment grade credit ratings, it is currently estimated that letters of credit or other forms of financial assurance associated with the currently estimated costs of the eventual future closure of our mines and other facilities in Ontario would have to cover approximately $790 million in such closure costs on an undiscounted basis. Due to the closure of three mines in Ontario, in 2002 we were required under such mining regulations to provide letters of credit in the amount of $23 million at that time to secure these near-term closure costs as discussed below. In addition, we are subject to certain Indonesian regulations which require us to provide security for the reclamation of land areas that have been mined. In the case of our Manitoba operations, in 2003 we submitted closure and reclamation plans for all our operations in that province and in 2004 we provided financial assurance in the form of a letter of credit in the amount of approximately $0.4 million for certain future reclamation and restoration costs in that province. In 2005 the reclamation and closure plan for the mine and concentrator and related facilities at Voisey’s Bay was approved by the Province of Newfoundland and Labrador, resulting in an increase in the financial assurance covering both the construction and operating phases of the initial phase of the project to $8 million. As discussed above, we believe that the financial assurance in the form of one or more letters of credit we will be required to provide to the Province of Newfoundland and Labrador will increase to in the order of $60 million. We do not currently know what, if any, changes in the security for reclamation costs in Indonesia or Manitoba might be made in the future. However, beyond the expected increase for our Voisey’s Bay project referred to above, it is not currently expected that such financial assurance as might be required to be provided for our Indonesian, Manitoba and Voisey’s Bay operations will be of a material amount. These potential costs might not be incurred until many years in the future. If these requirements for letters of credit or other forms of financial security had to be satisfied, they could have an adverse effect on the amounts available for borrowing by us under our bank credit facilities.
In February 2002, the Ontario government issued a control order (“February 2002 Order”) that requires us to reduce sulphur dioxide emissions by 34 per cent from the current limit of 265,000 tonnes to 175,000 tonnes at our Ontario smelting operations by the end of 2006. We are currently implementing an investment of approximately $90 million in fluid bed roaster off-gas scrubbing technology intended to reduce sulphur dioxide emissions to the new levels mandated by this new control order by the end of 2006. As part of the control order, we will also be required to (i) reduce ground level concentrations of sulphur dioxide, (ii) continue research into the technology and economics of further reductions in sulphur dioxide emissions and (iii) report annually to the Ontario Ministry of the Environment and the public on the progress of this research program. The February 2002 Order calls for a final report on achieving the additional reductions to be submitted by December 31, 2010. We do not currently expect that compliance with the annual sulphur dioxide emission levels from our smelter operations or ground level concentrations as set forth in the February 2002 Order will have any significant effect on our costs, operating procedures or annual production of nickel and other primary metals from our Ontario operations.
In October 2005, the Ontario government enacted legislation that created new ceilings or caps on sulphur dioxide emissions from our Sudbury smelter to be applicable over the 2006 - 2015 period. This legislation also established emission allowances that could be banked or traded (bought or sold) in an emissions trading market. In 2006 the ceiling or cap under this legislation that applies to our Sudbury smelter is approximately 256,000 tonnes. This cap declines to no higher than 175,000 tonnes in 2007 and could be lower depending upon actual production rates over the 2004 - 2006 period. Beyond 2007 and through 2014, this annual cap could be lower than 175,000 tonnes depending upon actual production rates over a three year rolling period. In 2015, this cap will fall to 66,000
tonnes. We believe that, given the implementation of the fluid bed roaster technology referred to above and our ability to bank and purchase emission allowances over this period, we will be able to meet the caps over the 2006 - 2014 period without seriously affecting our currently planned production rates at our Ontario operations or requiring significant capital expenditures beyond what we currently estimate. We cannot, however, predict at this time what additional capital expenditures would be required and the technology that could be implemented to meet the 2015 cap and what impact that cap would have on our production in Ontario, results of operations and cash flow from operations.
In September 2004, the Canadian federal environmental agency, Environment Canada, published a notice indicating its intention, under the requirements of the Canadian Environmental Protection Act (“CEPA”), to control emissions from base metal smelters and refineries using pollution prevention planning and a code of best practices for this sector. The notice also indicated a set of emission targets that each smelter in Canada, including our facilities in Ontario and Manitoba, would be expected to meet. Environment Canada provided for an eighteen-month period from September 2004 for companies to indicate whether they could develop a plan to meet their proposed new targets on certain emissions. In response to this initiative, we have proposed that target levels for such emissions to be established by Environment Canada for our Ontario operations mirror the target levels developed by the Ontario Government and for our Manitoba operations they defer any reduced target levels until 2020. We do not know at this time what target levels Environment Canada may decide to set for our Canadian operations and over what period of time. Depending upon the difference in those target levels from what currently applies to our Ontario and Manitoba operations for the currently applicable periods and beyond, we may not be able to meet such levels without making very significant capital expenditures, and compliance with such levels could materially adversely affect our production levels, our financial results and cash flow from operations.
As of December 31, 2005, we had outstanding letters of credit in the amount of $23 million to secure a portion of our closure costs related to the closure of three mines in Ontario. These letters of credit have a term of one year and will automatically renew without any action by either us or the counterparty until the earlier of (i) Inco having complied with the terms of the certified closure plans or (ii) funds from such letters of credit being utilized by the Ontario Ministry of Northern Development and Mines, the ministry responsible for overseeing such closure plans, to perform rehabilitation work if we did not meet the requirements with respect to such closure plans. We are required to submit annual updates on changes to the closure plans, including any decommissioning and rehabilitation work completed during the previous year. We have also provided letters of credit or similar forms of financial assurance to secure future closure costs associated with certain other operations or projects in North America and elsewhere which currently have, or are expected to have, fairly extended useful lives. As noted above, we have also provided a letter of credit in the amount of approximately $8 million covering certain remediation costs covering the construction and current operating phases of our Voisey’s Bay project.
Canada signed and ratified the Kyoto Protocol to the United Nations Framework Convention on Climate Change (“Kyoto Protocol”) in December 2002. The Kyoto Protocol calls for significant reductions in the emissions of greenhouse gases, such as carbon dioxide, and nationwide ceilings on such emissions. In November 2002, the federal government of Canada released an initiative to address certain causes of climate changes. The specific requirement of this initiative is also to limit the discharge of carbon dioxide and other greenhouse gases. Neither the Kyoto Protocol nor this other initiative has as yet established what the specific allocation of reductions among various sources of greenhouse gases would be. In August 2003, the federal government of Canada released certain principles covering the Kyoto Protocol intended to be used to implement the objective of having the oil and gas, thermal energy and mining and manufacturing sectors reduce greenhouse gases by certain specified limits. While during 2004 there was relatively little progress made by the federal government of Canada on advancing the implementation of greenhouse gas emission reductions as part of the Kyoto Protocol, in April 2005 Canada announced its so-called Project Green as part of the federal budget, intended to implement at least certain aspects of the Kyoto Protocol. This project provided for the overall reduction of greenhouse gases (“GHGs”) by so-called large final emitters (“LFEs”) such as leading metals and mining, energy and other companies, including ourselves, by 45 million tonnes. In July 2005 the federal government published a notice intended to outline certain principles for this project, including exactly what types of companies would be viewed as LFEs, and the level of GHGs reductions to be implemented by LFEs over the 2008 - 2012 first phase of the Kyoto Protocol. It is currently expected that we, as an LFE, could be required to reduce our GHGs intensity (based upon direct energy used and actual production) by 12 to 17 per cent from the base year of 2000 to be calculated for and applicable only for smelting and refining emissions. This reduction could result in a cost to us, based upon how these reductions are to be assessed, of in the order of $2 million. In November 2005, the federal government designated GHGs as toxic under CEPA, thus giving it the authority to regulate GHGs such as carbon dioxide under CEPA. We do not know what additional steps the federal government might take through CEPA to reduce GHGs and the impact those steps could have on our operations and cash flow.
While the precise impact of the Kyoto Protocol on our operations in Canada and the operations of others who provide energy or other products or services to us is uncertain at this time, we anticipate that compliance with these requirements could have a significant adverse effect on our results of operations and costs.
In 2002, the Danish Environmental Protection Agency (the “Danish EPA”), as part of the authority granted to it under certain environmental regulations of the European Union Commission intended to control the risk to humans and the environment from certain chemicals and other substances, published draft risk assessment reports, including certain conclusions concerning potential human health hazards associated with nickel metal and certain soluble nickel compounds, including nickel sulphate, nickel chloride and nickel nitrate. Under this European regulatory framework, there are generally four stages associated with the risk assessment process covering substances such as chemicals and other materials: data collection, priority setting, risk assessment and risk reduction. The Danish EPA determined that, based on certain animal studies, soluble nickel is a reproductive toxin and has proposed certain product labelling requirements as a result of this determination. It has also assessed certain other environmental issues. In addition, based upon the draft reports released in 2002 and taking into consideration certain studies, the Danish EPA has proposed that soluble nickel be classified under its hazard classification system as a known human carcinogen. In 2004, European Union member states agreed that soluble nickel compounds should be classified as a category 1 (known human carcinogen) carcinogen and a category 2 (based on animal studies) reproductive toxin. It was also proposed that metallic nickel will be classified as a category 3 (suspected) carcinogen. These revised classifications would mean changes in product labelling, communication to workers and customers and the development of risk management measures for these forms of nickel. The Danish EPA has, however, concluded that there was insufficient information to complete its environmental risk assessment, and in 2004 collaborative studies were undertaken to collect data on the behaviour of nickel in the environment and European background levels and emission sources. The environmental section of the risk assessment was initiated after the human health risk assessment. The environmental risk assessment consists of a hazard identification section, an exposure section, and an effects section and will conclude with a risk assessment section. The hazard identification and exposure sections were finalized in September 2005, with the exception of minor areas of clarification. The results of these sections have focused on data collection and analysis. The remaining sections of this risk assessment process are scheduled for completion in 2006. Once these sections of this risk assessment are completed, the next stage in this regulatory process will be the implementation of risk management and risk reduction practices for those nickel substances considered in the risk assessment. In the development of such requirements, the authorities are obligated to take into account technical feasibility and socio-economic considerations. Some of the risk reduction practices that may be considered include modifications to material safety data sheets, the introduction of labelling describing the hazards and more restrictive packaging of soluble nickel compounds, lowering of the European occupational exposure limit for nickel and stricter engineering controls, including total containment of nickel processes. If the requirements currently being considered as part of such risk assessments were to come into effect, it could result in use restrictions and other requirements which could have a material adverse effect on certain nickel producers and end users of the forms of nickel covered by such classifications, and on our business, results of operations, financial condition and liquidity. The revised classification would also mean changes in labelling, communication to workers and customers and the development of risk management measures. Member states of the European Union will have until 2010 to achieve certain target limit values for nickel, after which more stringent binding limit values may be considered. The technical and socio-economic feasibility of meeting such limits are currently being considered by the European Union Commission and those industries that would be affected, including nickel producers.
Further changes in environmental laws, restrictions on our discharge of GHGs as a result of Canada’s program to comply with the Kyoto Protocol and similar developments that may be imposed, as well as the collection of new information on existing environmental conditions and other events, including legal proceedings brought based upon such conditions or an inability to obtain necessary permits, could require us to make significant other expenditures or could otherwise have a material adverse effect on our business, results of operations, financial condition and liquidity.
The changes outlined above and other changes in environmental legislation could have a material adverse effect on demand for our products, product quality and methods of production and distribution. The complexity and breadth of these issues make it extremely difficult to predict their future impact on us. We currently anticipate capital expenditures and operating expenses will increase in the future as a result of the implementation of existing and new and increasingly stringent environmental regulations. Compliance with environmental legislation can require significant expenditures and failure to comply with environmental legislation may result in the imposition of fines and penalties, liability for clean up costs, damages and the loss of important permits.
There can be no assurance that we will at all times be in compliance with all environmental regulations or that steps to bring us into compliance would not materially adversely affect our business, results of operations, financial condition or liquidity. We may also be subject to claims from persons alleging that they have suffered significant damages as a result of the environmental impact of our operations, including facilities that have ceased to operate for many years.
Other Risks and Uncertainties
PT Inco
Our investment in PT Inco at book value as of December 31, 2005 totalled $392 million. In addition, a lender to PT Inco currently has the right, under certain circumstances, to require one of our wholly-owned subsidiaries to purchase approximately $6 million in debt extended to PT Inco by that lender. In 1999, to meet PT Inco’s cash shortfalls attributable principally to the increase in the capital cost of the Balambano hydroelectric facilities which were part of PT Inco’s expansion project, the relatively low nickel prices, and constraints on PT Inco’s production attributable to the then reduced hydroelectric power generation caused by below average rainfall, we advanced $88 million to PT Inco. These advances were effectively repaid in 2002. To the extent that PT Inco would experience cash shortfalls in the future, particularly if there were to be a significant decline in primary nickel demand and nickel prices, we may again conclude that it would be necessary to advance cash to PT Inco in order to meet PT Inco’s cash needs.
For 2006, PT Inco’s production is expected to represent about 30 per cent of our total planned production. The uncertain political situation and security concerns in Indonesia, primarily as a result of the ongoing economic, political and social problems facing that country, could adversely affect PT Inco’s ability to operate. Based upon recent regulations issued by the Indonesian Minister of Forestry relating to mining activities in areas designated as protected forests, PT Inco could be restricted from mining in certain areas it is authorized to mine under its Contract of Work with the Indonesian government and such a development could adversely affect PT Inco’s long-term mine plans and overall production levels. In addition, PT Inco is awaiting receipt of an amendment to a forestry permit in connection with its new dam and related project. While there has been no indication that the Government of the Republic of Indonesia is considering currency controls, nationalization of certain properties or facilities or other similar actions, regional and local governmental authorities have sought to take greater control of the development of their resources and these or other political developments, including, but not limited to, the possibility of disruptions in PT Inco’s operations arising out of the actions of non-governmental organizations or community activist groups, could have a material adverse effect on PT Inco’s, and our overall, nickel production levels, business, results of operations, financial condition and cash flow from operations.
Risks Associated with, and Importance of, Future Low-Cost Nickel Projects
As part of our strategy to be the world’s lowest cost and most profitable nickel producer, we have continued our efforts to develop new low-cost sources of nickel. Following the completion of the PT Inco expansion project in late 1999, we have focused, as discussed above, on our Voisey’s Bay nickel-copper-cobalt project and our Goro nickel-cobalt project. A number of risks and uncertainties are associated with the development of these projected low-cost sources of nickel and other metals, including political, regulatory, design, construction, labour, operating, technical and technological risks, uncertainties relating to capital and other costs and financing risks and, in the case of Goro, risks related to the possible future transition to independence of New Caledonia. There have been periodic attempts by certain local groups in the area of the Goro project site to disrupt operations and activities at that site and related areas, most recently in late 2005. We cannot predict whether these local groups will continue to seek to disrupt such operations and activities and what effect, if any, such actions will have on the construction and start-up of the Goro project.
In addition to the risks and uncertainties referred to above, there are certain issues that must be resolved to enable the commercial development of the Goro project. We still need to receive certain remaining construction, environmental and operating permits. While we currently anticipate that we will be able to obtain all such remaining permits on a timely basis, any failure to obtain, or delay in the issuance of, such permits could adversely affect the construction and initial operation of the Goro project. In addition, we will need to continue to meet the terms and conditions under the definitive agreements covering the development of the Voisey’s Bay project reached in October 2002 between the Government of Newfoundland and Labrador and us. Depending upon the levels of cash flows we are able to generate, we may also need to secure financing for the completion of the Goro project on acceptable terms.
In connection with the significant financing required for completion of the development of the Goro project, we currently expect that, in order to be able to meet such financing needs, we could be required to borrow additional funds, issue additional equity, and/or enter into strategic or other arrangements. As discussed under “Uncertainty of Production and Capital and Other Cost Estimates” below, while we have certain potential new mine development projects at our existing operations in Canada, as well as additional resources that could be developed in Indonesia in addition to the Voisey’s Bay and Goro projects, if sufficient new low-cost sources of nickel were not developed by us on a timely basis, we currently believe that our overall nickel production, particularly at our Manitoba operations notwithstanding certain projects at those operations such as the development of the 1D Lower orebody, as noted below, could decline beginning as early as 2012 and our nickel unit cost of production could increase significantly with any material decline in mine production from our Ontario and Manitoba operations if such operations were not significantly restructured. These developments could materially adversely affect our business, results of operations, financial condition and liquidity.
Uncertainty of Production and Capital and Other Cost Estimates
A decrease in the amount of and a change in the timing of our production outlook for the metals we produce, in particular nickel, will directly impact the amount and timing of our cash flow from operations. A 10 per cent reduction in the amount of consolidated planned production of all metals produced would decrease cash flow from operations estimated for 2006 by approximately $240 million based on metal prices and costs at December 31, 2005. The actual impact of such a decrease on such cash flow from operations would depend on the timing of any changes in production and on actual prices and costs. In the case of our Canadian and United Kingdom operations, the time from initial production to collection of cash from the sale of nickel products produced by these operations is approximately 20 weeks, while the time between production of copper and cash collection from copper sales is about 19 weeks. The production of most of our precious metals requires the transfer of precious metals-containing materials to our Acton refinery in the United Kingdom and the processing time at that facility generally results in cash collection taking about 27 weeks from first production of such materials in our Ontario operations. In the case of PT Inco, the time between nickel-in-matte production, refining of that intermediate product through our Asian refineries and collection of cash from the sale of such refined products is approximately 9 weeks. Any change in the timing of these cash flows that would occur due to production shortfalls or labour disruptions would, in turn, result in delays in receipt of such cash flows and in using such cash to reduce debt levels and may require additional borrowings to fund capital expenditures, including capital for our development projects, in the future. In addition, a number of these and other developments or events, including changes in credit terms, product mix, demand for our products and production disruptions, could make historic trends in our cash flows lose their predictive value.
The level of production and capital and operating cost estimates relating to our Goro and Voisey’s Bay projects and other projects, which are used in establishing ore/mineral reserve estimates and for determining and obtaining financing and other purposes, are based on certain assumptions and are inherently subject to significant uncertainties. It is very likely that actual results for our Voisey’s Bay and Goro projects will differ from our current estimates and assumptions, and these differences may be material. In addition, as discussed below, experience from actual mining or processing operations may identify new or unexpected conditions which could reduce production below, and/or increase capital and/or operating costs above, our current estimates. If actual results are less favorable than we currently estimate, our business, results of operations, financial condition and liquidity could be materially adversely impacted.
Goro
In October 2004, we announced that, having completed and successfully achieved the key objectives of the second phase, or Phase 2, of the Goro project review, we would proceed with the development of our Goro nickel-cobalt project in New Caledonia. A key objective of this second phase of the Goro review was to achieve a reliable and acceptable capital cost estimate for the project. This review, which proceeded in two phases, had begun following the decision made in December 2002 to suspend the project. The final results of the review included an updated capital cost estimate of $1,878 million for the mine, process plant and related infrastructure, within a minus 5 per cent to plus 15 per cent confidence level. This estimate included $294 million for mine, process plant and related infrastructure capital expenditures that had already been made through September 30, 2004 and which will continue to have use in the reconfigured project scope. This capital cost estimate also included $40 million for assumed escalation in costs during the construction phase of the project, an amount that was not in previous capital cost estimates, and also reflected favourable currency hedging gains realized by Inco of about $31 million which were also not included in previous estimates. The principal reasons for the increase from the $1,850 million capital cost estimate we had announced on May 25, 2004 were for a range of construction materials and labour required for construction and the incorporation of a new tailings storage area as part of the project. The project experienced cost pressures in 2005 and continues to experience cost pressures related principally to commodities and other materials required for construction, including fuel and hydro carbon-based products. We currently believe that, if we undertook an updated capital cost estimate at this time for the Goro mine, process plant and infrastructure, it would expect to be $1,878 million plus at the upper end of the plus 15 per cent confidence level. As discussed above, we expect to have a definitive cost estimate, subject to such qualifications as may apply, in the second quarter of 2006, when engineering will be at least 80 per cent complete and all major contracts will have been awarded.
Phase 2 of the project review also focused on a number of other key objectives, including (1) a viable project implementation schedule and clear project execution plan, (2) a prudent financing plan taking into account Inco’s projected cash flow potential to fund its expected share of the capital costs of the project, (3) an experienced and dedicated team for both the construction and operating phases and (4) optimizing the Goro project’s planned process plant design and engineering requirements while also meeting specific objectives on project operability, maintainability, risk mitigation and environmental protection. The final results of Phase 2 of the review met all of these key objectives. The project’s process plant footprint area was reduced by approximately 50 per cent from its
original plan, reducing the quantities of bulk materials required, enhancing the efficiency of the planned process plant from an operational and maintenance perspective, and reducing any potentially adverse environmental effects.
We currently plan that, as part of the project schedule, the Goro project would reach about 75 per cent of its expected annual capacity of 60,000 tonnes of nickel within 12 months after initial production, and would be at approximately 90 per cent of that expected annual nickel capacity within two years after initial production. As part of the results of the Phase 2 review, the Goro project’s expected cobalt capacity was revised to a current range of 4,300 to 5,000 tonnes per year to take into account the optimized mine plan for the project.
Operations
Since 2002, as mine production at our Manitoba operations transitioned from the Thompson Mine to the lower grade Birchtree Mine, we experienced lower mine production. We have relied upon the availability of purchased nickel intermediates to maintain Manitoba’s nickel production at around the 45,000 tonne annual level. With the availability of Voisey’s Bay nickel concentrates for processing at our Manitoba operations, these operations are expected to produce finished nickel products at or above the 45,000 tonne annual level over at least the 2006 - 2011 period. In August 2005, we announced plans to develop the 1D Lower orebody at the Thompson Mine. Work has commenced on the development of the 1D Lower orebody, which would increase the availability of local concentrates and, assuming the current diamond drilling program for lateral and deeper extensions is successful, would provide a platform for ongoing production once Voisey’s Bay concentrates are no longer supplied to Manitoba. The cost to develop the 1D Lower orebody is approximately $34 million and production is expected to begin in 2008.
Starting in early 2006, we will be relying on our Voisey’s Bay nickel concentrates to maintain production at or near capacity at our Manitoba and Ontario operations. If our Voisey’s Bay operations experience problems in producing or shipping to Sudbury or Thompson its nickel concentrates, these events would have an adverse effect on our ability to produce and sell the nickel products we plan to produce in 2006 and would adversely affect our results of operations, financial condition, profitability and cash flows. Extended strikes, such as the one we experienced at our Ontario operations in 2003, other labour disruptions and unforeseen events would also adversely affect our production plans and costs and these developments would also adversely affect our results of operations, financial condition and cash flows.
Construction Risks and Technological Risks
The mine, processing plant and related infrastructure required for the development of the Goro project has not yet been constructed and no commercial mining has commenced. Certain of the necessary construction permits remain to be obtained in respect of the Goro project. While detailed exploration and related studies with respect to the Goro project have been completed based on (1) significant surface exploratory drilling, (2) extensive investigations of certain of the mineralization delineated to date, (3) construction and mine plans, and (4) production and cost estimates, we are not currently in a position to predict with certainty when all of the required remaining approvals would be in place for us to complete and start up the Goro project by late 2007.
Unforeseen conditions or developments could arise during the construction period which could delay or prevent completion, and/or substantially increase the cost of construction of the necessary facilities and infrastructure to develop the project. Such events may include, without limitation, shortages of equipment, materials or labour, delays in delivery of equipment or materials, labour disruptions, political events, local or political opposition, civil disturbances, litigation, adverse weather conditions, unanticipated increases in costs, natural or man-made disasters, accidents and unforeseen engineering, technical and technological, design, environmental, geological or geotechnical problems. Any delay in construction would delay the production of nickel and other products from the Goro project, and the expected significant source of revenue for us that production from this project would represent. Any such delay could also materially adversely impact our business, results of operations, financial condition and liquidity. Our Goro project will involve the application of new processing and other technologies and, depending upon the results of the hydrometallurgical research and development program we are conducting for our Voisey’s Bay project, the remaining phases of that project could also utilize new processing and other technologies to produce one or more refined or finished nickel products. There can be no assurance that these technologies will be successfully developed and applied on a commercial basis or that the costs associated with and/or the timing of their implementation will not have a material adverse effect on the timing of the start-up of commercial production, the capital and/or operating costs for either or both projects and on other factors impacting the profitability of these projects. These events could materially adversely impact our business, results of operations, financial condition and liquidity.
Governmental Regulations
In addition to environmental regulations referred to above, the mining and metals industry in Canada operates under federal, provincial and municipal legislation, regulation and intervention by governments in such matters as land tenure, limitations on areas in which mining can be conducted, production rates, income and other taxes and the export of ore and other products, as well as other matters. Our operations in Indonesia, the United Kingdom, New Caledonia and in other countries outside Canada are also subject to various environmental, operating and other applicable laws and regulations and governmental interventions, some of which are similar to those in Canada and all of which are subject to change. The mining and metals industry is also subject to regulation and intervention by governments in such matters as control over the development and abandonment of mine sites (including restrictions on production) and possible expropriation or cancellation of contract and mineral rights. Before proceeding with major projects, including significant changes to existing operations, we must obtain certain regulatory approvals. The regulatory approval process can involve stakeholder consultation, environmental impact assessments and public hearings, among other things. In addition, regulatory approvals may be subject to conditions, including the obligation to post security deposits and other financial commitments. Failure to obtain regulatory approvals, or failure to obtain them on a timely basis, could result in delays and abandonment or restructuring of projects and increased costs, all of which could negatively affect our profitability and cash flows. In addition, such regulations may be changed from time to time in response to economic or political conditions, and the implementation of new regulations or the modification of existing regulations affecting the mining and metals industry could increase our costs and have a material adverse impact on business, results of operations, financial condition and liquidity.
There can be no assurance that we will be in compliance with all applicable laws or regulations at all times or that steps to bring us into compliance would not materially adversely impact our business, results of operations, liquidity or financial condition. Reference is made to “Risks and Uncertainties - Environmental Risks” above.
Capital Requirements and Operating Risks
As discussed under “Cash Flows, Liquidity and Capital Resources” and “Off-Balance Sheet Arrangements and Aggregate Contractual Obligations” above, each of our two current principal primary metals business units, the Canadian and United Kingdom operations and PT Inco, has required, and is expected to continue to require, certain levels of investment to sustain their current levels of production. For 2006, as discussed under “Outlook - 2006 Planned Capital Expenditures” below, we currently forecast capital expenditures totalling approximately $1,820 million, covering sustaining capital expenditures for our current primary metals business units as well as planned expenditures for our Goro project and the additional phases of our Voisey’s Bay project and other development projects. This total amount assumes a level of capital expenditures, including capitalized interest, in 2006 for our Goro project of $1,140 million of which we expect our share of funding such total amount to be about $670 million. To meet such capital expenditures requirements for 2006 and at least for 2007 in the case of the Goro and Voisey’s Bay projects and for our PT Inco expansion program to increase its production as discussed above given the current projected total capital expenditures for these development projects and programs, we must generate sufficient internal cash flows and/or be able to utilize available financing sources.
If we do not realize satisfactory prices for the nickel and other metals that we produce, we could be required to raise very significant additional capital through the capital markets and/or incur significant borrowings to meet our capital requirements. These financing requirements could adversely affect our credit ratings and our ability to access the capital markets in the future to meet any external financing requirements we might have.
If there are significant delays in when these projects are completed and are producing on a commercial and consistent scale, and/or their capital costs were to be significantly higher than estimated, these events could have a significant adverse effect on our results of operations, cash flow from operations and financial condition.
In addition, our mining operations and processing and related infrastructure facilities are subject to risks normally encountered in the mining and metals industry. Such risks include, without limitation, environmental hazards, industrial accidents, labour disputes, changes in laws, technical difficulties or failures, late delivery of supplies or equipment, unusual or unexpected geological formations or pressures, cave-ins, pit-wall failures, rock falls, unanticipated ground, grade or water conditions, flooding, periodic or extended interruptions due to the unavailability of materials and force majeure events. Such risks could result in damage to, or destruction of, mineral properties or producing facilities, personal injury, environmental damage, delays in mining or processing, losses and possible legal liability. Any prolonged downtime or shutdowns at our mining or processing operations could materially adversely affect our business, results of operations, financial condition and liquidity.
The wholesale electricity markets in Ontario were deregulated for a portion of 2002 and as a result we have experienced fluctuations in our electricity costs primarily at the Ontario operations. On February 9, 2006 the Ontario government announced new electricity rates for industrial users for electricity produced from certain of the Province’s power generating assets. These new rates, representing about a two per cent reduction from the rates that prevailed in 2005 for power produced and sold from these assets, are expected to come into effect on May 1, 2006. These rates are expected to increase by about 2 per cent as of May 1, 2007, with a further increase of about two per cent in April 2008. Depending upon future changes in the regulatory environment for electricity markets, we could experience future fluctuations in such costs. We have from time to time experienced adverse production and production cost trends at our operations in Canada and elsewhere and could experience similar adverse trends in the future.
Labour Relations
On September 16, 2005, a new three-year collective agreement with our unionized workers at our Manitoba operations was successfully negotiated. This agreement expires in September 2008. New collective agreements with unionized hourly production and maintenance workers at our Ontario operations were entered into on August 29, 2003 and will expire on May 31, 2006. These agreements were reached following a three-month strike that had a material adverse effect on our 2003 production of nickel, copper and certain other metals and our results of operations, financial condition, profitability and cash flow from operations for 2003. A three-year collective agreement with our unionized office, clerical and technical employees at our Ontario operations was negotiated in the first quarter of 2004 and remains in effect until March 31, 2007. Our PT Inco subsidiary entered into a new two-year collective labour agreement with its union in the fourth quarter of 2004 which expires in December 2006. While there were no significant problems in reaching this latest agreement with PT Inco’s labour force, with the increased potential for actions of non-government organizations and other activist groups, the continuing uncertain economic and political situation in Indonesia and the general increase in labour activism in that country, there can be no assurance that such activism will not adversely affect PT Inco’s ability to successfully operate. Any disruption in PT Inco’s operations as a result of labour issues or other issues may adversely affect its operations and could materially adversely impact our business, results of operations, financial conditions and liquidity. At Goro, we currently have two unions representing some of our employees. In early September 2002, Goro experienced labour disruptions by personnel associated with certain project construction subcontractors. As a result of these disruptions, the decision was made in late September 2002 to curtail certain activities at the project’s site to enable the project company, Goro Nickel S.A.S., contractors, subcontractors and other interested parties to develop procedures to avoid future disruptions. A number of procedures were put in place prior to the start of the Goro project comprehensive review in late 2002 and over the past three years we have been seeking to complete the implementation of these and other procedures as part of the negotiation of labour, site or other accords to help minimize any such disruptions in the future. Through an employer’s association, of which we are the controlling member, we negotiated a collective agreement effective September 2002 covering the construction of the first phase of the Voisey’s Bay project. Currently, we are in the process of negotiating the first collective agreement with operations employees at Voisey’s Bay.
There can be no assurance that we will be able to maintain positive relationships with our employees at our operations in Canada, Indonesia, New Caledonia, and elsewhere or that new collective agreements will be entered into without work interruptions as in the case of the three-month strike at our Ontario operations in 2003. We could also be adversely affected by labour disruptions involving third parties who may provide us with goods or services at our operations in Canada and elsewhere. For example, as discussed above, our Goro project experienced labour disruptions by certain employees of the project’s construction subcontractors. Strikes and other labour disruptions at any of our operations and lengthy work interruptions at our Goro project could materially adversely affect the timing of completion and the cost of that project, as well as our business, results of operations, financial condition and liquidity.
Uncertainty of Ore/Mineral Reserve Estimates
Our reported ore/mineral reserves as of December 31, 2005 are estimated quantities of proven and probable ore that, under present and anticipated conditions, can be legally and economically mined and processed by the extraction of their mineral content. The volume and grade of reserves actually recovered and rates of production from our present ore reserves may be less than geological measurements of the reserves. Furthermore, market price fluctuations in nickel, other metals and exchange rates, and changes in operating and capital costs may in the future render certain ore/mineral reserves uneconomic to mine and could, accordingly, result in significant reductions in our reported estimates of proven and probable ore/mineral reserves. We determine the amount of our estimated ore/mineral reserves in accordance with the requirements of the applicable securities regulatory authorities and established industry practices. To the extent that we are required by regulatory authorities to change the metal prices, expenditures and other assumptions we use in preparing these estimates, then these estimates could change significantly.
No assurance can be given that the indicated amount of ore will be recovered or that it will be recovered at the rates anticipated by us. Our ore/mineral reserve estimates are based on limited sampling and, consequently, are uncertain because the samples may not be
representative of the entire orebody. As more knowledge and understanding of the orebody is obtained, the reserve estimates may change significantly, either positively or negatively.
The Falconbridge Transaction
The completion of the pending acquisition of Falconbridge is dependent upon a number of conditions, including receipt of certain remaining regulatory clearances. We may not be able to obtain the required approvals or clearances from regulatory and other agencies and bodies on a timely basis, or divestitures or other remedies required by regulatory agencies may not be acceptable or may not be completed in a timely manner, and we may not meet the other remaining conditions of our offer. We may not realize the anticipated annualized benefits and operational and other synergies and cost savings from the acquisition or related divestitures, restructurings, integration and other initiatives associated with the planned combination of Inco and Falconbridge and we may realize unanticipated costs and/or delays or difficulties relating to such integration. Certain other risks and uncertainties relating to this pending transaction include those associated with the level of cash payments to common shareholders of Falconbridge who exercise their statutory dissenters’ rights in connection with the expected eventual combination of the two companies and the possible delay in the completion of the steps required to be taken for the eventual combination of the two companies.
Sensitivities
Our financial results are sensitive to, among other things, changes in prices for nickel and other metals, the Canadian-U.S. dollar exchange rate and interest rates and certain energy costs. Our financial results are also affected by changes in the Indonesian rupiah-U.S. dollar exchange rate, but to a lesser extent since PT Inco’s revenues and many of its expenses are denominated in U.S. dollars. We have calculated the impact on our basic net earnings per share of a 10 per cent change in the market risk exposures that we believe have the most significant impact on our net earnings. The following table shows the approximate full-year impact of a 10 per cent change in our principal market risk exposures on our basic net earnings per share based on planned 2006 deliveries of Inco-source metals and after taking into consideration our principal derivative instrument positions as of December 31, 2005. These market risk exposures have been selected as management believes they have had, and are currently expected to continue to have, the most significant impact on our net earnings per share:
(1)
Canadian GAAP basic net earnings per share. Each sensitivity assumes other factors are held constant.
(2)
Represents the impact on Canadian dollar-denominated operating costs and excludes the translation effect relating to the Canadian dollar-denominated liabilities and to accrued taxes for Canadian dollar currency translation effects associated with U.S. dollar-denominated liabilities.
As indicated in the table above, the most significant sensitivities in terms of the effect on our basic net earnings per share are nickel prices and the Canadian dollar-U.S. dollar exchange rate.
Cash expenditures for our development projects will be incurred primarily in Australian dollars and Euros for our Goro project. Although changes in these currencies will affect the ultimate carrying value of the related assets in U.S. dollar terms, they will not have any impact on our earnings until such projects are fully developed and operating. A 10 per cent change in each of the value of the Australian dollar and Euro relative to the U.S. dollar as at December 31, 2005 would change currently planned 2006 capital
expenditures for the Goro project by $10 million and $12 million, respectively, after taking into consideration outstanding derivative contracts as at December 31, 2005. Reference is made to “Foreign Exchange Risk” under “Risks and Uncertainties” above.
The following represents the sensitivity analysis as of December 31, 2004 prepared using the same methodology as above for comparative purposes:
(1)
Canadian GAAP basic net earnings per share. Each sensitivity assumes other factors are held constant.
(2)
Represents the impact on Canadian dollar-denominated operating costs and excludes the translation effect relating to the Canadian dollar-denominated liabilities and to accrued taxes for Canadian dollar currency translation effects associated with U.S. dollar-denominated liabilities.
While the sensitivity analyses presented in the tables above represent our best estimate of the impact of specified assumed changes in the identified market risk scenarios, actual results could differ from those reflected. The sensitivity analyses presented are subject to various limitations and uncertainties which may affect the impact on basic net earnings per share.
These sensitivity analyses have been prepared based on a change of 10 per cent in the market rates or prices at December 31, 2005 and 2004. The impact on basic net earnings per share has been determined based on discrete changes in the identified risks. If there are changes in two or more of the identified risks, the above impact on basic net earnings per share may not accurately reflect the actual impact on our net earnings per share.
These sensitivity analyses also include assumptions relating to our current projected operations during 2006 in the case of the sensitivity analyses as of December 31, 2005 and our original plan for 2005 in the case of the sensitivity analysis as of December 31, 2004. As we are affected and influenced by changes in the business and economic environments in which we operate, the changes reflected in the sensitivity analyses above may be different or may prove to be inaccurate, including in relation to their impact on basic net earnings per share. The most significant assumptions which may be affected relate to levels of production, consumption rates, forecasted costs of production, tax rates and deliveries.
These sensitivity analyses provided are not intended to fully reflect the net market risk exposures since certain exposures would encompass events that are uncertain or could not be foreseen. Some of these events are outlined in our discussion above on “Risks and Uncertainties” affecting our business. For example, with respect to metal prices, extended declines in prices, particularly nickel prices, due to unusual economic developments or other unforeseen events would have a material adverse effect on our results of operations, financial condition and cash flows. In addition, unusual or irrational actions by competitors could, for example, change the nickel market supply-demand relationship and other factors fundamental to our business causing declines in metal prices. In addition, significant and prolonged increases in energy prices and/or the Canadian dollar relative to the U.S. dollar would have a material adverse effect on our costs of production, results of operations and financial condition. There are also a wide range of other uncertainties in the business environment including the impacts of the proposed acquisition of Falconbridge that could result in material limitations with respect to the accuracy of the sensitivity analyses for net market risk exposures, including cost inflation, relations with our employees, avoidance of major accidents at our producing locations, and the average grades of ore mined and the certainty of estimated proven and probable ore reserves at our operations. Unanticipated changes in environmental laws and regulations could also result in limits on production and/or significantly increased capital spending to meet such changes.
Critical Accounting Policies and Estimates
The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Critical accounting estimates are those that require us to make assumptions about matters (a) that are highly uncertain at the time the accounting estimate is made, (b) for which we could have reasonably used a different estimate in the current period and/or (c) where changes in the accounting estimate are reasonably likely to occur from period to period and such changes would have a material impact on the presentation of the Company’s financial condition, changes in financial condition or results of operations. Our estimates are based upon historical experience and on various other assumptions that we believe to be reasonable under the circumstances. The results of our ongoing evaluation of these estimates form the basis for making judgments about the carrying value of assets and liabilities and the reported amounts for revenues and expenses. Actual results may differ from these estimates. A summary of our significant accounting policies, including critical accounting policies that require critical accounting estimates, is set forth in note 1 to our 2005 consolidated financial statements.
Depreciation and Depletion
Expenditures for new facilities or equipment and expenditures that extend the useful lives of existing facilities or equipment are capitalized and depreciated using the declining balance or straight-line method at rates sufficient to depreciate such costs over the estimated future lives of such facilities or equipment. These lives do not exceed the estimated operating mine life based upon estimated proven and probable ore/mineral reserves unless we believe the asset can be utilized in another facility after the mining operations have ended.
Depletion of the deferred mine development costs is calculated on a units-of-production basis over the estimated proven and probable ore/mineral reserves which relate to the particular category of development, either “life of mine plan” or “area specific”. No future development costs are taken into account in calculating the amortization charge.
Life of mine plan development costs represent capital expenditures that will be utilized in the extraction of all the estimated proven and probable ore/mineral reserves in the current detailed mine plan. These expenditures are predominantly incurred up front and in advance of any ore extraction or in advance of major expansions. The types of development costs included in this category include mine acquisitions costs, ore haulage shafts, initial decline, ore passes and chutes and underground ore crusher cavities and are intended to be used for the extraction of all ore within the current mine plan. These costs are depleted on a units-of-production basis over the total estimated proven and probable ore/mineral reserves in the current mine plan.
Area specific development costs consist of capital expenditures to provide access to various areas within the mine to allow the extraction of ore to commence. The types of development costs that are within this category include access and perimeter drives, ventilation drives and rises, and progressive declining subsequent to initial contact with the ore body. These costs are depleted on a units-of-production basis over the related production from our estimated proven and probable ore/mineral reserves that can be currently accessed without future capital development costs being incurred.
The calculation of the units-of-production rate of depletion and, accordingly, the annual depletion charge to operations, could be materially affected to the extent that actual production in the future is different from current forecasts of production based on estimated proven and probable ore/mineral reserves. This would generally be the case where there were significant changes in any of the factors or assumptions used in estimating proven and probable ore/mineral reserves. These factors could include (i) an expansion of estimated proven and probable ore/mineral reserves through exploration activities, (ii) differences between estimated and actual cash costs of mining, due to differences in grade, metal recovery rates and foreign currency exchange rates from those assumed, and (iii) differences between actual commodity prices and the commodity price assumptions used in the estimation of proven and probable ore/mineral reserves. Such changes in estimated ore/mineral reserves could similarly impact the useful lives of assets depreciated on a straight-line basis, where those lives are limited to the life of the mine. The accounting estimates related to depreciation and depletion are critical accounting estimates and are influenced by our estimates of proven and probable ore/mineral reserves. Historically, the Company has been successful in replacing a portion of the ore/mineral reserves depleted through mining operations. During the past six years, excluding major development projects, on average about one-half of the aggregate ore mined from our sulphide mineral deposits has been replaced through further exploration and development activities. Depreciation and depletion charges are adjusted prospectively based on annual year-end assessments of our estimated proven and probable ore/mineral reserves. If our estimated proven and probable ore/mineral reserves were to be decreased by 10 per cent, there would be an increase of $35 million in our annual depreciation and depletion expense.
Impairment
We review and evaluate our long-lived assets for impairment when events or changes in circumstances indicate the related carrying amounts may not be recoverable. An asset impairment is considered to exist if the total estimated future cash flows on an undiscounted basis are less than the carrying amount of the asset. An impairment loss is measured and recorded based on discounted estimated future cash flows. Future cash flows are estimated based on estimated quantities of recoverable minerals, expected commodity prices (considering current and historical prices, price trends and related factors), production levels, cash costs of production, capital and reclamation costs, all based on detailed life-of-mine plans. The term “recoverable minerals” refers to the estimated amount of nickel or other commodities that will be obtained from estimated proven and probable ore/mineral reserves and all related mineral interests, after taking into account losses during ore processing and treatment. Significant management judgment is involved in estimating these factors, which include inherent risks and uncertainties. The assumptions we use are consistent with our internal planning. Management periodically evaluates and updates the estimates based on the conditions that influence these factors. The variability of these factors depends on a number of conditions, including uncertainty about future events, and thus our accounting estimates may change from period to period. If other assumptions and estimates had been used in the current period, the balances for non-current assets could have been materially impacted. Furthermore, if management uses different assumptions or if different conditions occur in future periods, future operating results could be materially impacted.
In estimating future cash flows, assets are grouped at the lowest levels for which there are identifiable cash flows that are largely independent of future cash flows from other asset groups, taking into consideration movements of intermediate products to ensure the utilization of available capacity across our operations. All assets at a particular operation are considered together for purposes of estimating future cash flows.
We periodically review our equity method investments to determine whether a decline in fair value below the carrying amount is other than temporary. In making this determination, we consider a number of factors related to the financial condition and prospects of the investee, including (i) a decline in the valuation of the equity investee for an extended period of time, (ii) an inability to recover the carrying amount of the investment or inability of the equity investee to sustain an earnings capacity which would justify the carrying amount of the investment, and (iii) the period of time over which we intend to hold the investment. If the decline in fair value is deemed to be other than temporary, the carrying value is written down to fair value. In situations where the fair value of an investment is not evident due to a lack of a public market price or other factors, we use our best estimates and assumptions to arrive at the estimated fair value of such investment, based on future cash flows of the equity investee and other relevant factors. As significant judgment is required in assessing these factors, it is possible that changes in any of these factors in the future could result in an other than temporary decline in value of an equity investment and could require us to record an impairment charge to operations in future periods.
In the second quarter of 2005, we recorded a $25 million impairment charge with respect to the planned closure of our copper refining facility at our Ontario operations in December 2005 following a decision to cease production of copper cathode.
In 2004, we recorded an impairment loss in respect of our Goro project in the amount of $201 million. This loss was determined based on management’s judgment regarding the net realizable value for supplies and equipment that no longer had any use for the project. A 10 per cent reduction in the assumed net recoverable value for these items would have increased the impairment charge by $2 million.
There were no impairment losses on long-lived assets recorded in 2003.
Asset Retirement Obligations
Our mining operations involve activities that have a significant effect on the area surrounding such operations. We estimated that our ultimate reclamation and closure costs on an undiscounted basis would total $1.1 billion as of December 31, 2005. We record the fair value of our estimated asset retirement obligations when a legal obligation is incurred. These liabilities are accreted to full value over time through charges to income.
These estimates related to reclamation and closure costs are critical accounting estimates because (i) we will not incur most of these costs for a number of years, requiring us to make estimates over a relatively long period; (ii) reclamation and closure laws and regulations could change in the future or circumstances affecting our operations could change, either of which could result in significant changes to our current plans and future costs; (iii) calculating the fair value of our asset retirement obligations requires us to make long-term assumptions about inflation rates, to determine our long-term credit-adjusted, risk-free interest rates and to
determine market risk premiums that are appropriate for our operations over long periods of time; and (iv) given the magnitude of our estimated reclamation and closure costs, changes in any or all of these estimates could have a material impact on our results of operations and/or our financial condition.
To calculate the fair value of these obligations, we discounted the projected cash flows at our estimated credit-adjusted, risk-free interest rates which ranged from 4 per cent to 8 per cent for the corresponding time periods over which these costs would be incurred. The inflation rates and discount rates we used to calculate the fair value of our asset retirement obligations are critical factors in the calculation of future value and discounted present value costs. We estimated the cash flows for our asset retirement obligations assuming a single set of assumptions. In general, given the nature of our business and specificity of our assets, there are very restrictive ways in which to retire our assets and conform to the applicable environmental regulations, including closure and related requirements. Therefore, in such instances, a range of likely outcomes was not used because multiple approaches to retire our assets were not appropriate. We applied a market risk premium to the total obligations to reflect what a third party might demand to assume our asset retirement obligations. The market risk premium was based on market-based estimates of rates that a third party would have to pay or insure its exposure to possible future increases in the value of these obligations. The extent and timing of expenditures on closure and reclamation activities are critical estimates for the determination of our asset retirement obligations and the related annual charges to earnings. These are also influenced by our estimates of our proven and probable ore/mineral reserves. As the closure period for a substantial portion of our mines is not for a number of years, we have no historical experience which would indicate that our current asset retirement obligations are either understated or overstated. We continue to believe that our current closure cost estimates represent our best estimates. If we were to advance the date of retirement of our assets by 10 per cent from our current estimate, the impact would be an increase in our asset retirement obligations of $25 million and the annual charge to earnings would have increased by $1 million per year. If our estimates of the cost of closure and reclamation activities were to change by 10 per cent, our ultimate reclamation and closure costs would change by $109 million.
In addition, there are certain environmental issues pertaining to former industrial sites that were retained by us relating to former businesses that had been sold by us. In determining whether a liability exists in respect of these environmental issues, we apply the criteria for liability recognition set forth in applicable accounting standards. We regularly review the status of environmental issues to determine whether a liability should be established or an additional liability recognized with the corresponding charge to our earnings.
Future Employee Benefits and Costs
Pension expense is determined separately for each of our pension plans and other post-retirement arrangements based on the principles outlined in the applicable accounting standards. Assets are valued using a market-related value, determined based on the current market value and the market values in the previous four years (that is, with an averaging of experience gains and losses over the five year period). As discussed in note 10 to our 2005 consolidated financial statements, we determine our return on plan assets using a formula approach. The expected return on plan assets assumption is based on current bond yields, an expected equity risk premium and an allowance for expected value added as a result of active management, where applicable. Each year we update our return on plan assets for the most recent historical benchmarks. Application of the respective historical benchmarks to our formula resulted in a decrease in the assumed rate of return on assets from 8 per cent in 2004 to 7.75 per cent in 2005 and to 7.5 per cent for 2006.
Liabilities are determined as a present value of future anticipated cash flows using a discount rate based on corporate AA bond yields at the valuation date and an inflation expectation consistent with the corporate AA bond yield curve. Differences between the estimated future results and actual future results are amortized (to the extent that the cumulative experience gain or loss is in excess of the permitted 10 per cent corridor under Canadian GAAP) over the expected average remaining service life of the active members. This 10 per cent corridor, as defined by Canadian GAAP, represents 10 per cent of the greater of the post-retirement benefits obligations and the fair value of plan assets. The return on plan assets assumption and the discount rate, salary and inflation assumptions used to value the liabilities are reviewed annually and are determined based on a consistent framework from year-to-year. The most significant risk is that the assumptions will prove to be either too high or too low in the long term. It is reasonable to assume that there will be a significant variation between the assumptions and actual experience in any one year. Over the long-term, cumulative pension expense is expected to produce an appropriate reflection of the costs associated with the pension program.
The expense for other post-retirement benefits or non-pension benefits is based on a similar methodology and similar determination of the liability value. The discount rate used is the same as that determined for the pension obligations. The inflation rate assumed for medical costs is based on our history of healthcare spending. The assumption for the ultimate health care trend rates relates to the overall economic trends and takes into consideration that the health care expenditure growth rate is currently expected to be 1.5 to 2.0 per cent higher than the inflation rate over the long-term.
We currently estimate that a 0.5 per cent increase or decrease in the return on plan assets assumption would result in a corresponding $13 million decrease or increase, in annual pension expense. Changes to the return on plan assets assumption would have no significant effect on required funding requirements, as our required contributions are primarily determined based on the applicable Canadian regulatory solvency funding requirements (that is, the windup valuation). Under this valuation methodology, liabilities for solvency valuation are based on market bond yields and the excess of liabilities over assets must be amortized over a five-year period. We estimate that a 0.5 per cent increase or decrease in the discount rate assumption would result in a corresponding $12 million decrease or increase in annual pension expense. We estimate that a 0.5 per cent decrease in the long-term bond yield would result in a corresponding $6 million increase in our required contributions.
Income and Mining Taxes
Significant judgment, estimates and assumptions are required in determining the Company’s consolidated tax provision. In addition, in evaluating the ability of the Company to realize the deferred tax assets, significant judgment, estimates and assumptions are required in establishing deferred income tax asset valuation allowances.
The provision or relief for income and mining taxes is calculated based on the expected tax treatment of transactions recorded in our 2005 consolidated financial statements. The objectives of accounting for income and mining taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in our 2005 consolidated financial statements or tax returns. In determining both the current and future components of income and mining taxes, we interpret tax legislation in a variety of jurisdictions, recognize liabilities for anticipated tax audit issues based on estimates of whether additional taxes would be payable as well as make assumptions about the expected timing of the reversal of future tax assets and liabilities. If our interpretations differ from those of tax authorities or if the timing of reversals is not as anticipated, the provision or relief for income and mining taxes could increase or decrease in future periods.
In estimating deferred income and mining tax assets, a valuation allowance is determined to reduce the future income tax assets to the amount that is more likely than not to be realized. This valuation allowance for 2005 amounted to $23 million, representing (i) $3 million in respect of non-capital losses available to Goro Nickel S.A.S., (ii) $11 million in respect of net capital losses available in the United Kingdom, (iii) $3 million in respect of reduction in the benefits of write-downs of certain investments and (iv) $6 million reduction in the benefit of alternative minimum tax relating to our subsidiaries in the United States. This valuation allowance for 2004 amounted to $29 million, representing (i) $6 million in respect of non-capital losses available to Goro Nickel S.A.S., (ii) $12 million in respect of net capital losses available in the United Kingdom, (iii) $5 million in respect of reduction in the benefits of write-downs of certain investments and (iv) $6 million reduction in the benefit of alternative minimum tax relating to our subsidiaries in the United States. This valuation allowance for 2003 amounted to $27 million, representing (i) $3 million in respect of non-capital losses available to Goro Nickel S.A.S., (ii) $12 million in respect of net capital losses available in the United States and United Kingdom, and (iii) $12 million in respect of unrealized capital losses arising from the write-down of certain investments and other assets. These valuation allowances have been provided for as it is more likely than not that these non-capital and net capital losses will not be realized for tax purposes in the future. In each year, the amount of the valuation allowance reduces the future income tax assets and effectively increases the amount of the net deferred income tax liabilities and, accordingly, the provision for income and mining taxes on the earnings statement. Additional information regarding our accounting for income and mining taxes is contained in note 5 to our 2005 consolidated financial statements.
Accounting Changes
In 2005, on a retroactive basis, we adopted revisions to CICA Section 3860, Financial Instruments - Disclosure and Presentation. The revisions related to the accounting for instruments for which the issuer has the right to settle in cash or its own shares. Such an instrument must be bifurcated between debt and equity in accordance with this revised standard. This change impacted the accounting treatment for our LYON Notes, Convertible Debentures due 2023 and 3 1/2% Subordinated Convertible Debentures due 2052 which were previously treated as equity in accordance with EIC-71, Financial Instruments that may be Settled at the Issuer’s Option in Cash or its own Equity Instruments. Consistent with this change, we record interest expense in lieu of accretion charges with respect to these convertible debt securities. We also adopted EIC No. 155, The Effects of Contingently Convertible Instruments on the Computation of Diluted Earnings Per Share. This abstract requires that the effects of contingently convertible instruments be included in the computation of diluted earnings per share regardless of whether the market price trigger for conversion has been met.
In 2004, we adopted three new accounting pronouncements for the purposes of our Canadian GAAP reporting. These new pronouncements related to the accounting for variable interest entities, the application of Canadian GAAP and hedging relationships.
In 2004, we also changed our methodology used to calculate depletion and depreciation expense. A similar change was made for United States GAAP reporting effective January 1, 2003, therefore, the 2004 adoption of this change for Canadian GAAP purposes eliminated a significant GAAP difference between United States and Canadian GAAP. Accounting changes made to our consolidated financial statements during 2005, 2004 and 2003 are discussed further in note 2 to our consolidated financial statements.
For a complete discussion of current and future accounting changes as they relate to our United States GAAP reporting, reference is made to note 24 to our 2005 consolidated financial statements.
Outlook
Nickel Market Conditions
Over the past few years, particularly in 2005 and as currently projected for 2006, the stainless steel industry, the principal end-use market for nickel, has been making significant investments, or has announced commitments to projects, to increase production capacity to meet continued and projected demand growth, especially in China. Demand for stainless steel is currently expected to remain strong over at least the next few years based upon the expected strong growth in industrial production in a number of geographic regions, in particular continued strong growth in China and other parts of Asia. We believe that strong nickel demand, driven by stainless steel production growth in China and the completion of the correction in inventories in stainless steel which began in the second half of 2005, a number of non-stainless steel end uses for nickel such as nickel-based alloys for the aerospace market, coupled with relatively low total (LME and producer) nickel inventories, tighter stainless steel scrap conditions and limited production growth, are currently expected to result in a continuation of relatively high and volatile nickel prices in 2006.
With most nickel producers having operated at or near capacity in 2005 and taking into account that there currently exists, we believe, no shutdown capacity available to be restarted and there are only limited new projects or expansions expected to bring on new supply in 2006, we currently estimate that, as discussed above, there will be an insufficient amount of additional nickel supply prior to at least 2008 to meet the expected growth in underlying nickel demand which would occur at long-term nickel prices.
Nickel demand in 2006 is currently anticipated to be relatively strong for several reasons. First, the production of nickel-containing stainless steel in China is expected to continue to increase due to the ramp-up in production of several new large stainless steel production facilities in that country in an effort to meet expected strong economic growth and demand for stainless steel in China. Nickel demand growth in China is expected to be supported by the increased growth in non-stainless nickel demand, driven by domestic growth in, and western-world relocation of, plating facilities as well as continued growth in battery applications. For 2006, the currently projected strong nickel demand in China is expected to be complemented by the continued economic strength in other Asia regions as well as in the United States and the beginning of an economic recovery in the European Union. Second, the continued strength in nickel-based alloys for the aerospace, the oil and gas and liquid natural gas and land-based gas turbine applications and other energy-related markets is expected to generate an increase in demand for nickel. Third, reported nickel inventories, both producer and LME, are at relatively low levels relative to prior nickel cycles. We currently estimate that total LME and producer inventory levels at December 31, 2005 represented approximately six weeks of demand, which is considered relatively low. Fourth, the availability of nickel-containing stainless steel scrap, as an alternative source of nickel for the stainless steel industry, is not expected to keep pace with nickel demand growth in 2006. We anticipate that the above average growth in stainless steel scrap collection in prior years, as well as the expected increase in stainless steel production, will create relatively less scrap supply than existed in 2005. The expected supply-demand imbalance for such scrap is due to the strong growth experienced in the usage and liquidation of inventories of such scrap in 2004 and 2005, which we believe will not be sustainable.
Operations
Our 2006 nickel production is currently expected to be approximately 256,000 tonnes (565 million pounds), up from the 220,727 tonnes (487 million pounds) level in 2005. The increase in production is primarily due to finished nickel products produced from our Voisey’s Bay nickel concentrates at our Canadian operations and to the toll smelting and refining arrangements covering purchased intermediates with certain third parties as noted above. We expect our purchases of nickel intermediates processed through our Canadian operations to decrease by 45 per cent from 2005 levels to approximately 15,400 tonnes (34 million pounds) in 2006. Finished copper production for 2006, including anodes production, is currently expected to be approximately 124,700 tonnes (275 million pounds) compared to 125,595 tonnes (277 million pounds) in 2005. Production of copper in concentrate at Voisey’s Bay is currently expected to be approximately 29,500 tonnes (65 million pounds) compared with 4,406 tonnes (10 million pounds) of copper in concentrate in 2005. Total production of PGMs is expected to be 400,000 troy ounces for 2006.
2006 Planned Capital Expenditures
Our total 2006 capital expenditures for our existing operations and development projects, as discussed above, are currently expected to total $1,820 million before any contributions that may be made by the other shareholders in Goro Nickel and receipt of certain government assistance under programs relating to our development projects. This estimate includes, as discussed above, approximately $1,140 million for the Goro project, including capitalized interest, $55 million for Voisey’s Bay, $60 million for the program to increase production at PT Inco and approximately $80 million for mine development, $120 million for environmental measures, $50 million for discretionary capital expenditures and $315 million for sustaining capital. Total depreciation, depletion and amortization expenses for our existing operations are currently projected to be $455 million in 2006, including an estimated $175 million in respect of the Voisey’s Bay operations.
Pending Acquisition of Falconbridge
We believe that the successful completion of the pending acquisition of Falconbridge and subsequent combination of Inco and Falconbridge will create significant benefits and opportunities that will allow the combined company to better serve its customers, to provide it with enhanced financial and other resources and to better compete in the global metals and mining industry than either company could alone.
The combined company would be one of the world’s largest metals and mining companies, ranking as the second largest North American metals and mining company in terms of enterprise value based upon the respective share prices of the two companies as of early October 2005, shortly before our offer to acquire all of the Falconbridge Shares was announced. The combined company would be the world’s largest producer of nickel and a leading producer of copper and cobalt. It would also become the world’s third largest producer of zinc, and would also supply approximately l0 per cent of current annual aluminum consumption in the United States. The combined company would have processing facilities around the world and the ability to enhance efficiency by directing ore and intermediate products to facilities on a global basis.
Inco and Falconbridge have jointly identified the potential to realize annual pre-tax operating and corporate synergies. Both companies believe that a significant portion of these synergies are available only from a combination of Inco and Falconbridge given the contiguous nature of their nickel mining operations within the Sudbury basin and, to a lesser extent, the proximity of each company’s headquarters in Toronto. Operating synergies are expected to consist mainly of (i) optimization of material feeds and other intermediate product flows and processing facilities, (ii) cost improvements from the more efficient operations, streamlined procurement practices and economies of scale, and (iii) maximizing throughput by accelerating mine development to match assets to processes and feeds. Corporate synergies consist primarily of cost savings relating to reduction of overhead and support services. We believe that these synergy estimates for this transaction are realistic, although there can be no assurance that they will ultimately be realized, or that they will not be materially different than estimated.
The combined company would also feature enhanced production and geographic diversification. The combined company’s production and marketing operations would also become more geographically diversified. The combined company’s marketing offices would span over 40 countries, giving it a presence in North and South America, Asia, the South Pacific and Europe. As a result, it would also be better able to serve the world’s most attractive markets, particularly in new and emerging regions such as China.
Due to its increased size and diversification, the combined company should have greater flexibility and financial resources to pursue future growth opportunities than either Inco and Falconbridge would have alone. In addition, the combined company would be better positioned to compete for acquisition opportunities, which has become increasingly important as the global metals and mining industry continues to consolidate.
Non-GAAP Financial Measure
We have referred to nickel unit cash cost of sales before and after by-product credits because we understand that certain investors use this information to assess our performance and also determine our ability to generate cash flow for use in investing activities. The inclusion of these two unit cost measurements, nickel unit cash cost of sales before and after by-product credits, enables investors to better understand our year-to-year changes in production costs using metrics that reflect our key ongoing cash production costs which, in turn, affect our profitability and cash flows. These measurements capture all of the important components of our production and related costs. The reason for providing the nickel unit cash cost of sales on the basis of before as well as after by-product credits is to allow investors to see the impact on these metrics of changes in copper, cobalt and precious metals contributions which have
historically largely been driven by the prices for these metals. In addition, as discussed above, management utilizes these metrics as an important management tool to monitor cost performance of each of our key operations relative to planned and prior period results. These measurements are intended to provide additional information and should not be considered in isolation or as a substitute for measures of performance prepared in accordance with Canadian GAAP.
The following table provides for the periods indicated a reconciliation between nickel unit cash cost of sales before and after by-product credits, two key measurements we use to monitor our cost performance, and Canadian GAAP cost of sales:
Reconciliation of Nickel Unit Cash Cost of Sales Before and After By-Product Credits
to Canadian GAAP Cost of Sales
(1)
Post-retirement benefits other than pensions.
(2)
Relates to certain assets at PT Inco that had no future value to PT Inco’s operations and the write-off of the book values of certain equipment assessed to be beyond economic repair and to PT Inco’s change in accounting for asset sales and other dispositions.
(3)
Nickel cash cost of sales before and after by-product credits includes costs for both Inco-source and purchased nickel intermediates.
Other Information
Reference is made to “Other Information” above for certain information on governmental and other policies and factors affecting our operations and investments by non-Canadians in our securities. Reference is also made to “Quarterly Financial Information” below for our quarterly net sales, net earnings and earnings per share data for 2005 and 2004.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The information under “Risks and Uncertainties” and “Sensitivities” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under Item 7 of this Report is incorporated herein by reference to such information.
Item 8.
Item 8. Financial Statements and Supplementary Data
Management’s Report on Internal Control Over Financial Reporting
The management of Inco Limited is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is a process designed under the supervision and with the participation of our management to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our consolidated financial statements, for external purposes, in accordance with generally accepted accounting principles in Canada.
As of December 31, 2005, management conducted an assessment of the effectiveness of our internal control over financial reporting based on the framework established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2005.
Our internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets, provide reasonable assurances that transactions are recorded as necessary to permit the preparation of our consolidated financial statements in accordance with generally accepted accounting principles in Canada, and that receipts and expenditures are being made only in accordance with authorizations of management and our Board of Directors, and provide reasonable assurance regarding the prevention or timely detection of an unauthorized acquisition, use or disposition of assets that could have a material effect on our consolidated financial statements.
Our internal control over financial reporting and management’s assessment of the effectiveness of internal control over financial reporting as of December 31, 2005 have been audited by our auditors, PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is set forth below.
Auditors’ Report
To the Shareholders of Inco Limited
We have audited the accompanying consolidated balance sheets of Inco Limited (the “Company”) as at December 31, 2005, 2004 and 2003 and the related consolidated statements of earnings, retained earnings (deficit) and cash flows for each of the years in the three-year period ended December 31, 2005. In addition, we have audited Schedule VIII - Valuation Accounts and Reserves under Item 8 of this Report. We have also audited the effectiveness of the Company’s internal control over financial reporting as at December 31, 2005, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) and management’s assessment thereof included in Management’s Report on Internal Control Over Financial Reporting, appearing above. The Company’s management is responsible for these financial statements and the financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on the Company’s December 31, 2005, 2004 and 2003 consolidated financial statements and the financial statement schedule, an opinion on management’s assessment as at December 31, 2005 and an opinion on the effectiveness of the Company’s internal control over financial reporting as at December 31, 2005 based on our audits.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
We conducted our audits of the Company’s financial statements in accordance with Canadian generally accepted auditing standards and the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”). Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. A financial statement audit also includes assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We conducted our audit of the effectiveness of the Company’s internal control over financial reporting and management’s assessment thereof in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
In our opinion, the consolidated financial statements referred to above, after the restatements described in Notes 2 and 24, present fairly, in all material respects, the financial position of the Company as at December 31, 2005, 2004 and 2003 and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2005 in accordance with Canadian generally accepted accounting principles. In addition, in our opinion, Schedule VIII - Valuation Accounts and Reserves presents fairly, in all material respects, the financial information set forth therein when read in conjunction with the related consolidated financial statements. Also, in our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as at December 31, 2005 is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the COSO. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as at December 31, 2005 based on criteria established in Internal Control - Integrated Framework issued by the COSO.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
PRICEWATERHOUSE COOPERS LLP
Chartered Accountants
Toronto, Ontario
February 28, 2006
Consolidated Statement of Earnings
Consolidated Statement of Retained Earnings (Deficit)
The Notes to Consolidated Financial Statements below are an integral part of these statements.
Consolidated Balance Sheet
The Notes to Consolidated Financial Statements below are an integral part of these statements.
Consolidated Statement of Cash Flows
The Notes to Consolidated Financial Statements below are an integral part of these statements.
Notes to Consolidated Financial Statements
(Tabular amounts in millions of United States dollars except number of shares and per share amounts)
Note 1. Summary of significant accounting policies
The consolidated financial statements of Inco Limited (“Inco”) and its subsidiaries (referred to as “we”, “us” and “our”) are prepared in accordance with generally accepted accounting principles (“GAAP”) in Canada, consistently applied which, in our case, conform in all material respects with GAAP in the United States, except as explained in Note 24.
Principles of consolidation
The financial statements of entities which are controlled by Inco either directly or indirectly are consolidated. Control is established by our ability to determine strategic, operating, investing and financing policies without the co-operation of others. The criteria we use include an analysis of our level of ownership, voting rights and our level of representation on the board of directors. We evaluate these criteria in terms of determining whether the existence of one of the criteria alone (such as a majority ownership of all voting securities), or a combination of the criteria when taken together, would result in having control, or the ability to exercise control, of the management, business focus or strategy and/or critical policies of the particular entity. The financial statements also include the financial statements of entities that are considered variable interest entities (“VIE”s) for which we are the primary beneficiary. The primary beneficiary is the variable interest holder obligated to absorb a majority of the risk of loss from the VIE’s activities, or is entitled to receive the majority of the VIE’s residual returns, or both. We have no entities for which we own greater than 50 per cent of all voting securities but do not consolidate. We do not have subsidiaries or joint ventures for which we use the proportionate consolidation method. Entities which are not controlled and for which our ownership in all voting securities is greater than 20 per cent and we are able to exercise significant influence are accounted for using the equity method and are included in deferred charges and other assets. We have no entities for which we have used the equity method and own less than 20 per cent of all voting securities. Investments in other entities are accounted for using the cost method.
Estimates
Financial statements prepared in accordance with GAAP in Canada require management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Translation of consolidated financial statements into United States dollars
These consolidated financial statements are expressed in United States dollars. The United States dollar is our functional currency. As our operations are considered integrated for accounting purposes, we use the temporal method of translation. Monetary assets and liabilities are translated into United States dollars using year-end rates of exchange. All other assets and liabilities are translated at applicable historical rates of exchange. Revenues, expenses and certain costs are translated at monthly average exchange rates except for inventoried costs, depreciation and depletion which are translated at historical rates. Realized foreign currency exchange gains and losses are included in other income (expense) and currency translation adjustments are included in earnings as a separate line item.
Cash and cash equivalents
Cash and cash equivalents comprise cash, time deposits and other interest bearing instruments with original maturity dates of less than three months.
Inventories
Inventories consist of finished metal products, work in process and operating supplies. Inventories are stated at the lower of cost and estimated net realizable value.
The point in our production cycle that costs related to mine and other property, plant and equipment begin to be capitalized as a cost of inventory is at the mine head. In-process includes inventory at all stages in the production process. Broken ore in our mines is not recognized as inventory until delivered to the mine head or temporary storage areas for blending. Cost includes all direct costs
incurred through to the applicable stage of production, including direct labour and materials, depreciation and depletion as well as an allocated portion of acquisition costs and overheads. Costs are allocated based on contained metal.
The costing of metals produced at our Ontario and Voisey’s Bay operations is primarily to establish values for metals in inventory and cost of sales. Copper and nickel are treated as co-products and share expenses pro rata based on pounds of metal produced unless a plant is specifically used for the upgrading of only one metal or the other. Common costs incurred by nickel and copper mined are apportioned between the metals on the basis of pounds of metal produced through the common mine and mill processes. Once expenditures are required to further finish a particular metal, all such expenditures are assigned to that metal. The remaining metals (cobalt and precious metals) are by-products and incur expenses only when some specific steps are taken towards their recovery. Co-product costing for copper is used because of the significant quantities of copper contained in the ores at our Ontario and Voisey’s Bay operations.
We do not have significant quantities of stockpiled ore on hand due to the integrated nature of our operations. In addition, we do not use leach pads as a processing method at any of our operations.
Period costs such as shutdown expenses, standby costs, property write-offs, costs of delivering the product to the end customer, including freight and sales administration and strike expenses, if any, are not allocated to inventory but charged directly to cost of sales and other expenses. Strike expenses are those ongoing costs, such as salaries and certain employment benefits, depreciation, property taxes, utilities and maintenance incurred during the strike period which would normally be treated as production costs and charged to inventory but, in the absence of production, are expensed because commercial production at the related facilities over the period of the strike is not achieved.
Property, plant and equipment
Property, plant and equipment are stated at cost. Such cost, in the case of mines, mineral rights and undeveloped properties, represents related acquisition and development expenditures. Costs are capitalized for an undeveloped property when it is probable that such costs will be recovered from the exploitation of the property. Financing costs, including interest, are capitalized when they arise from indebtedness incurred to finance the development, construction or expansion of significant mineral properties and facilities. Certain currency translation gains and losses have been capitalized in respect of Voisey’s Bay mineral properties in the development phase. Capitalization of such gains and losses ceases when the development phase of the mineral property is substantially complete and ready for use. Development costs are charged as an expense in the period incurred unless we believe a development project meets generally accepted criteria for deferral and amortization.
Research and development costs
Research costs are expensed in the period in which they are incurred. Development costs are deferred where the product or process is clearly defined, the technical feasibility has been established and we are committed to, and have the resources to, complete the project.
Asset impairment
When the net carrying value of an item or group of items of property, plant and equipment, less its related provision for asset retirement obligations and deferred income and mining taxes, exceeds the estimated undiscounted future net cash flows (which includes payments required to meet asset retirement obligations) together with its residual value, the excess of the carrying value over the fair value is charged to earnings. Evaluation of the future cash flows from major development projects such as the Goro project entails a number of assumptions regarding project scope, the timing, receipt and terms of regulatory approvals, estimates of future metals prices, estimates of the size of the deposits, ore grades and recoverability, timing of commercial production, commercial viability of new technological processes, production volumes, operating and capital costs, and foreign currency exchange rates. In estimating future net cash flows, assets are grouped at the lowest level for which there are identifiable cash flows that are largely independent of cash flows from other asset groups taking into consideration movements of intermediate products to ensure the utilization of available capacity across our operations. Generally, all assets at a particular operation are used together to generate cash flow. Estimates of future cash flows are subject to risks and uncertainties.
We periodically review our equity method investments to determine whether a decline in fair value below the carrying amount is other than temporary.
Revenue recognition
Our primary products are nickel and copper. Most of our nickel is sold as refined nickel and our copper is predominantly sold as copper anode or, prior to the closure of our copper refinery in December 2005, as cathode. Copper is also sold as copper concentrates from our Voisey’s Bay operations. We also sell precious metals, cobalt and other by-products. Sales of all commodities are recognized as revenue when title has passed under the terms of the relevant contracts or sale, which is generally when shipped. Net sales include revenues from the sale of all metals produced by us, including metals which we refer to as by-products as well as sulphuric acid and liquid sulphur.
For most of our sales, the price is fixed at the time revenue is recognized, and is based on quoted commodity prices on recognized exchanges. At the end of each period, a portion of our revenues are provisionally priced. For provisionally priced sales, final settlement is generally based on the average London Metal Exchange (“LME”) cash or other such benchmark price for a specified future period generally after the month of arrival at the customer’s facility which is generally within 60 to 90 days of sale. As such any proceeds received represent provisional sales proceeds and not final sales proceeds.
Exploration
Exploration properties that contain estimated proven and probable ore/mineral reserves, but for which a development decision has not yet been taken, are subject to periodic review for impairment in accordance with our accounting policy when events or changes in circumstances indicate the related carrying value may not be recoverable.
Exploration expenditures are expensed as incurred except in areas currently under development, where production is probable, or in areas under feasibility study, where there is a reasonable expectation to convert existing estimated mineral resources to estimated ore/mineral reserves and add additional mineral resources with additional drilling and evaluations in areas near existing ore/mineral reserves, and existing or planned production facilities, in which case they are capitalized and amortized using the units-of-production method.
Depreciation and depletion
Property, plant and equipment is generally depreciated on a straight line basis over the following estimated economic lives:
The estimated economic life is assessed on an annual basis, taking into account the state of the equipment, technological changes and the related facilities or the estimated proven and probable ore/mineral reserves where the equipment is located. Some equipment has an estimated economic life in excess of 20 years, and is being amortized on a 5 per cent declining balance basis. When an assessment is made that the remaining life of that equipment is less than 20 years, the depreciation method is switched to straight line. Depreciation starts when an asset is ready for use or, in the case of a new mining operation, when an asset achieves commercial production.
Depletion of deferred mine development costs, including costs of acquired mineral rights, is calculated on a units-of-production basis over the estimated proven and probable ore/mineral reserves which relate to the particular category of development, either life of mine plan or area-specific. No future development costs are taken into account in calculating the depletion charge.
Life of mine plan development costs represent capital expenditures that will be utilized in the extraction of all the estimated proven and probable ore/mineral reserves in the current detailed mine plan. These expenditures are predominantly incurred up front and in advance of any ore extraction or in advance of major expansions. The types of development included in this category are acquisition costs, ore haulage shafts, initial decline, ore passes, ventilation, and chutes and underground ore crusher cavities and are intended to be used for the extraction of all ore within the current mine plan. These costs are depleted on a units-of-production basis over the total estimated proven and probable ore/mineral reserves.
Area-specific development costs, which are depleted over the related production from estimated proven and probable ore/mineral reserves for which no further capital is required, consist of capital expenditures to provide access to various areas within the mine to allow the extraction of ore to commence. The types of development costs that are within this category include: access and perimeter drives, ventilation drives and rises, and progressive declining subsequent to initial contact with the orebody. Annual deferred mine development costs incurred to access specific ore blocks or areas are depleted on a units-of-production basis over the estimated proven and probable ore/mineral reserves that can be currently accessed in those areas without future capital development costs being incurred.
Ongoing mine development costs that provide access to ore for less than two years’ production are expensed as incurred.
Asset retirement obligations
The accounting for asset retirement obligations encompasses the accounting for legal obligations associated with the retirement of a tangible long-lived asset that results from the acquisition, construction or development and/or the normal operation of a long-lived asset. The retirement of a long-lived asset is its other than temporary removal from service, including its sale, abandonment, recycling or disposal in some other manner.
We recognize asset retirement obligations as liabilities when a legal obligation with respect to the retirement of an asset is incurred, with the initial measurement of the obligation at fair value calculated based on discounted cash flows. These obligations are accreted to full value over time through charges to cost of sales and other expenses. In addition, an asset retirement cost equivalent to the liabilities is capitalized as part of the related asset’s carrying value and is subsequently depreciated or depleted over the asset’s useful life. A liability for an asset retirement obligation is incurred over more than one reporting period when the events that create the obligation occur over more than one reporting period. Any incremental liability incurred in a subsequent reporting period is considered to be an additional layer of the original liability. Each layer is initially measured at fair value. As required, a separate layer is measured, recognized and accounted for prospectively. Our asset retirement obligations consist primarily of costs associated with mine reclamation and closure activities.
Our operations have been, and may in the future be, affected from time to time in varying degrees by changes in environmental laws and regulations, including those for asset retirement obligations. Both the likelihood of future changes in laws and regulations and their overall effect upon us vary greatly from country to country and are not predictable. Our policy is to meet or, if possible, surpass environmental standards set by relevant legislation, by the application of technically proven and economically feasible measures.
For environmental issues that may not involve the retirement of an asset, where we are a responsible party and it is determined that a liability exists, and amounts can be quantified, we accrue for the estimated liability. In determining whether a liability exists in respect of such environmental issues, we apply the criteria for liability recognition under applicable accounting standards.
Income and mining taxes
Income and mining taxes comprise the provision (relief) for taxes actually paid or payable (received or receivable) and deferred taxes. Deferred income and mining taxes are computed using the asset and liability method whereby deferred income and mining tax assets and liabilities are recognized for the expected future tax consequences attributable to temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred income and mining tax assets and liabilities are computed using current foreign currency exchange rates and using income tax rates in effect when the temporary differences are expected to reverse. The effect on deferred income and mining tax assets and liabilities of a change in tax rates is recognized in earnings in the period of substantive enactment. The provision (relief) for deferred income and mining taxes is based on the changes in deferred income and mining tax assets and liabilities during the period. In estimating deferred income and mining tax assets, a valuation allowance is determined to reduce the deferred income tax assets to the amount that is more likely than not to be realized.
Investment tax credits are accounted for by the cost reduction method whereby investment tax credits related to the acquisition of assets are deferred and recognized in earnings as the related assets are depreciated, while those related to research and development expenses are included in earnings.
Financial instruments and commodities contracts
Hedge accounted financial instruments are documented and periodic effectiveness tests are performed. Absent such documentation and testing, changes in the fair value of financial instruments are recorded in earnings. Forward, option and swap contracts may be used to hedge the effect of exchange rate changes on our future currency requirements. In addition, forward, option and swap contracts may be used to hedge the effect of price changes on a portion of the metals we sell. Fuel oil swap contracts may be used to hedge the effect of price changes in respect of a portion of our energy requirements in Indonesia. Gains and losses on these contracts are deferred and recognized as a component of the related transaction. Interest rate swaps may be used to hedge interest rate risk exposure. Amounts receivable or payable related to the swaps are recorded in interest expense concurrently with the interest expense of the underlying debt. We also purchase and sell foreign currencies and metals by using forward contracts which have not been specifically identified as hedges. The values of these contracts are marked to market with resulting gains and losses included in earnings.
Post-retirement benefits
The cost of providing benefits through defined benefit pensions and post-retirement benefits other than pensions is actuarially determined and recognized in earnings using the projected benefit method prorated on service. Differences arising from plan amendments are recognized in earnings over the expected average remaining service life of employees. Differences arising from changes in assumptions, experience gains and losses and investment gains and losses are recognized in earnings by amortizing the excess of the net actuarial and investment gains and losses over 10 per cent of the greater of the post-retirement benefits obligation and the fair value of plan assets over the expected average remaining service life of employees. The cost of providing benefits through defined contribution pension plans is charged to earnings in the period in respect of which contributions become payable.
Stock compensation plans
In respect of our stock options, we recognize an expense based on the estimated fair value of the stock options over the vesting period. The fair value of each stock option granted is estimated on the date of the grant using an option-pricing model. Cash received from employees upon exercise of options to purchase Common Shares is credited to then issued and outstanding Common Shares. In respect of Common Share appreciation rights, compensation expense is determined and accrued over the vesting period of the options based on the excess of the quoted market value of the respective shares over the exercise price.
Net earnings per Common Share
Basic earnings per Common Share is computed by dividing net earnings applicable to Common Shares by the weighted-average number of Common Shares issued and outstanding for the relevant period. Diluted earnings per Common Share is computed by dividing net earnings applicable to Common Shares, as adjusted for the effects of dilutive convertible securities, by the sum of the weighted-average number of Common Shares issued and outstanding and all additional Common Shares that would have been outstanding if potentially dilutive Common Shares had been issued. For convertible securities we use the “if-converted” method whereas the “treasury stock method” is used for stock options and warrants.
Note 2. Changes in accounting policies and restatements
Changes in accounting policies
(a) Convertible Debentures
Effective January 1, 2005, on a retroactive basis, we adopted revisions to Canadian Institute of Chartered Accountants (“CICA”) Section 3860, Financial Instruments - Disclosure and Presentation. The revisions relate to the accounting for instruments for which the issuer has the right to settle in cash or its own shares. Such an instrument is bifurcated between debt and equity in accordance with this revised standard. This change impacted the accounting treatment for our LYON notes, Convertible Debentures due 2023 (“Convertible Debentures”) and 3 1/2% Subordinated Convertible Debentures due 2052 (“Subordinated Debentures”) which were previously treated as equity in accordance with EIC No. 71, Financial Instruments that may be Settled at the Issuer’s Option in Cash or its own Equity Instruments. Consistent with this change, we record interest expense in lieu of accretion charges with respect to these convertible debt securities. The impact on our balance sheet as at December 31, 2004 was an increase in long-term debt of $210 million (2003 - $194 million), an increase in deferred income and mining taxes of $11 million (2003 - $12 million), a decrease in
convertible debt classified as equity of $201 million (2003 - $188 million), an increase in deferred charges of $7 million (2003 - $7 million) and a reduction in retained earnings of $13 million (2003 - $11 million). In addition, as the revisions resulted in the retroactive restatement of our interest expense, there was an increase in the amount of interest capitalized in respect of our Voisey’s Bay and Goro projects. The impact in respect of the adjustment to capitalized interest was an increase in property, plant and equipment of $7 million (2003 - $2 million); an increase in deferred income and mining taxes of $1 million (2003 - nil) and an increase in retained earnings of $6 million (2003 - $2 million).
(b) Earnings per share
We adopted EIC No. 155, The Effects of Contingently Convertible Instruments on the Computation of Diluted Earnings per Share, on a retroactive basis. The new abstract, which is effective for interim and annual periods beginning after October 1, 2005, requires that the effects of contingently convertible instruments be included in the computation of diluted earnings per share regardless of whether the market price trigger has been met. The impact on 2004 earnings per share was a reduction of 12 cents (2003 - 2 cents).
(c) Variable interest entities
Effective January 1, 2004, we early adopted Accounting Guideline No. 15, Consolidation of Variable Interest Entities, (“AcG No. 15”). AcG No. 15 provides a new framework for identifying variable interest entities (“VIEs”) and determining when a company should include the assets, liabilities, non-controlling interests and results of operations of a VIE in its consolidated financial statements. In general, a VIE is a legal structure used to conduct activities or hold assets that either (i) has insufficient equity to carry out its principal activities without additional subordinated financial support, (ii) has a group of equity owners that do not have sufficient rights or the ability to make significant decisions about the VIE’s activities, or (iii) has a group of equity owners that do not have the obligation to absorb losses or the right to receive returns generated by its operations. AcG No. 15 requires a VIE to be consolidated if a party with an ownership, contractual or other financial interest in the VIE (a “variable interest holder”) is obligated to absorb a majority of risk of loss from the VIE’s activities, or is entitled to receive a majority of the VIE’s residual returns (if no party absorbs the majority of the VIE’s losses), or both. A variable interest holder that consolidates the VIE is called the primary beneficiary.
We early adopted AcG No. 15 as a result of the French government-sponsored Girardin Act financing arrangements (See Note 12). The effect of adopting the provisions of AcG No. 15 is to increase both total assets and total liabilities by approximately $41 million as of December 31, 2004. Reference is made to Note 12 for further information.
(d) Depreciation and depletion expense
Effective January 1, 2004, on a retroactive basis, we changed the method by which we calculate depreciation and depletion expense. Under the previous method, we depleted mine development costs on a composite basis. Total historical capitalized costs and estimated future development costs relating to our developed and undeveloped estimated proven and probable ore/mineral reserves were depleted using the units-of-production method based on total developed and undeveloped estimated proven and probable ore/mineral reserves. Under the new method, depletion of the deferred mine development costs is calculated on a units-of-production basis over the estimated proven and probable ore/mineral reserves which relate to the particular category of development, either life of mine plan or area-specific. No future development costs are taken into account in calculating the depletion charge. In addition, the depreciation method covering certain other assets of our 61 per cent owned subsidiary, PT International Nickel Indonesia Tbk (“PT Inco”), has been changed to a straight line basis to conform its depreciation method used to the depreciation methods used for similar assets in other company locations.
The impact of this change on 2003 depreciation and depletion expense was a reduction of $38 million.
(e) Generally accepted accounting principles
Effective January 1, 2004, we adopted CICA Section 1100, Generally Accepted Accounting Principles. CICA 1100 describes what constitutes GAAP in Canada and its sources. Adoption of this standard did not have a significant impact on our results of operations or financial condition for 2004.
(f) Hedging Relationships
Effective January 1, 2004, we adopted AcG No. 13, Hedging Relationships which provides guidance concerning documentation and effectiveness testing for derivative contracts. Adoption of this guideline did not have a significant impact on our results of operations or financial condition for 2004.
(g) Stock-based compensation
Effective January 1, 2003, we changed our accounting for stock options from the intrinsic value method to one that recognizes as an expense the cost of stock-based compensation based on the estimated fair value of new stock options granted to employees in 2003 and in future years. The fair value of each stock option granted is estimated on the date of the grant using an option-pricing model. As a result of this change in accounting policy, which was applied prospectively, an expense of $3 million was recorded in 2003, to reflect the fair value of stock options granted to employees in 2003.
(h) Impairment of long-lived assets
Effective January 1, 2003, we adopted CICA Section 3063, Impairment of Long-Lived Assets. This section establishes standards for the recognition, measurement and disclosure of the impairment of long-lived assets that are held for use. An impairment loss would be recognized if the carrying amount of a long-lived asset was not recoverable from its undiscounted cash flows and would be measured as the difference between the carrying amount and the fair value of the asset. The initial adoption of the new standard had no impact on our results of operations or financial condition.
(i) Asset retirement obligations
Effective January 1, 2003, on a retroactive basis, we adopted CICA Section 3110, Asset Retirement Obligations. This standard significantly changed the method of accounting for asset retirement obligation costs. Under this new standard, asset retirement obligations are recognized when incurred and recorded as liabilities at fair value. The liability is accreted over time through periodic charges to earnings. In addition, the asset retirement cost is capitalized as part of the asset’s carrying value and depreciated or depleted over the asset’s useful life.
Recent Accounting Pronouncements
In January 2005, the CICA issued three new standards relating to financial instruments. Section 3855, Financial Instruments - Recognition and Measurement, prescribes when a financial asset, financial liability, or non-financial derivative is to be recognized on the balance sheet and at what amount - sometimes using fair value; other times using cost-based measures. It also specifies how financial instrument gains and losses are to be presented. Section 3865, Hedges, is applicable whenever a company chooses to designate a hedging relationship for accounting purposes. It builds on AcG No. 13, Hedging Relationships, and Section 1650, Foreign Currency Translation, by specifying how hedge accounting is applied and what disclosures are necessary when it is applied. Section 1530, Comprehensive Income, introduces new rules for the reporting and display of comprehensive income. Comprehensive income, which we currently report for United States GAAP, is the change in equity (net assets) of an enterprise during a reporting period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.
These standards are applicable for fiscal years beginning on or after October 1, 2006. If a company elects to early adopt such standards the early adoption election must be applied to all three standards at the same time. We are currently reviewing the impact of these new standards.
Restatements
Effective January 1, 2005, on a retroactive basis, we restated our minority interest and current deferred income taxes to correct an error in the allocation of net earnings to minority interests. The impact of the correction for our December 31, 2004 balance sheet was a decrease in minority interest of $59 million (2003 - $38 million), a decrease in current deferred taxes of $21 million (2003 - $14 million) and an increase in retained earnings of $38 million (2003 - $24 million). The net impact on 2004 net earnings was an increase of $14 million (2003 - $10 million), or 7 cents per share (2003 - 5 cents per share).
Note 3. Asset impairment charges
During 2005, we announced that we had entered into a long-term agreement with Falconbridge Limited under which we would sell all of our copper production from our Ontario operations in anode form to them. In connection with this decision, a pre-tax impairment charge of $25 million was recorded which primarily relates to a reduction in the carrying value of our copper refining facility in Sudbury, Ontario since this facility was closed at the end of 2005.
On May 25, 2004 we announced the preliminary findings reached to that date as part of the second phase, or Phase 2, of the comprehensive review of our then approximately 85 per cent owned Goro nickel-cobalt project in New Caledonia. We also announced that the principal changes in the planned Goro project configuration resulting from such findings as part of Phase 2 of our review, moving from indirect to direct heating of ore feed and other changes intended to reduce the capital cost estimate and enhance the operating efficiency of the planned process plant and the process to be used to recover nickel and cobalt, would result in certain assets being written off in the second quarter of 2004. Following our review of the affected assets, we recorded a non-cash charge of $201 million. The affected assets were primarily comprised of engineering and related work associated with the original project configuration and equipment purchased for the indirect heating of ore feed which no longer had future use to the Goro project or otherwise.
Note 4. Other income, net
Other income, net is comprised of the following:
In 2005, a gain in the amount of $88 million was realized from the sale of a non-core investment in a junior mining company.
In 2004, gains in the amount of $10 million were realized on certain foreign currency derivative contracts entered into in anticipation of the expenditures on the Goro project. Gains from sales of securities and other assets of $9 million includes a gain of $6 million which was realized on our sale of a subsidiary operation in Guatemala.
In 2003, gains from sales of securities and other assets included a milestone payment received in the fourth quarter of 2003 under the terms of sale of a non-core exploration property in 1998 in the amount of $24 million as well as $35 million realized from the sale or transfer of shares and other interests contributed to or received in conjunction with strategic and other collaborations relating to our primary metals operations.
Note 5. Income and mining taxes
In carrying on our Canadian mining operations, we are subject to both income and mining taxes. The amount of such taxes will vary depending on the provisions set out by the relevant legislative authority. Generally, most expenditures incurred by us are deductible in computing income tax, whereas mining tax legislation, although based on a measure of profitability from carrying on mining operations, is more restrictive in respect of the deductions permitted in computing income subject to mining tax. In most jurisdictions deductions for financing expenses, such as interest and royalties, are not allowed to be claimed in computing income subject to mining tax. In addition, income unrelated to carrying on mining operations would not be subject to mining tax.
The provision (relief) for income and mining taxes was as follows:
Earnings before income and mining taxes and minority interest, by geographic source, were as follows:
The reconciliation between taxes at the combined Canadian federal-provincial statutory income tax rate and the effective income and mining tax rate was as follows:
Deferred income and mining tax liabilities and assets consisted of the following:
During 2001, tax legislation was passed in New Caledonia covering projects meeting certain criteria. Goro Nickel S.A.S. qualifies for certain tax incentives under this legislation in connection with its Goro project. These incentives include an income tax holiday during the construction phase of the project and throughout a 15-year period commencing in the first year in which commercial production, as defined by the applicable legislation, is achieved followed by a five-year, 50 per cent income tax holiday. In addition, Goro Nickel S.A.S. qualifies for certain exemptions from indirect taxes such as import duties during the construction phase and throughout the commercial life of the project. Certain of these tax benefits, including the income tax holiday, are subject to an earlier phase out should the project achieve a specified cumulative rate of return. We are subject to a branch profit tax commencing in the first year in which commercial production is achieved, as defined by the applicable legislation. To date, we have not realized any net income for New Caledonia tax purposes. The benefits of this legislation are expected to apply with respect to any taxes otherwise payable once the Goro project is in operation.
In determining the likelihood of realizing an income tax asset we take into account a number of factors, including current conditions and anticipated changes in mine or production plans.
We have tax loss carryforwards in the amount of $325 million available for New Caledonia income and branch profit tax purposes. Of these total tax loss carryforwards, the benefit of losses in the amount of $57 million have not been recognized.
We have capital loss carryforwards in the amount of $37 million available for United Kingdom income tax purposes to reduce taxable income in certain circumstances. The capital losses may be carried forward indefinitely. The benefits of these tax loss carryforwards have not been recognized for accounting purposes.
In computing our income tax liability, no amount has been recorded in respect of additional potential taxes which might arise should we distribute income realized in certain of our foreign subsidiaries on the basis that it is our intention to reinvest such income in the foreign operations of the relevant subsidiary. Should management’s intentions change in respect of such distribution, additional taxes, if any, would be recorded in respect of the distribution from, or disposition or liquidation of, the relevant foreign entity. For those foreign entities from which distributions occur on a regular basis, any additional taxes that would arise on such distributions, if any, have been included in deriving the annual income tax provision for the year in which the income is earned by the foreign subsidiary.
Note 6. Net earnings per Common Share
The computation of basic and diluted earnings per share was as follows:
At December 31, 2005, options on nil Common Shares (2004 - nil; 2003 - 819,000) were excluded from the computation of diluted earnings per Common Share because their effects were not dilutive.
We adopted EIC No. 155, The Effects of Contingently Convertible Instruments on the Computation of Diluted Earnings per Share, on a retroactive basis (see Note 2).
Note 7. Inventories
Inventories consisted of the following:
Note 8. Property, plant and equipment
Property, plant and equipment consisted of the following:
At December 31, 2005, property, plant and equipment, at cost included capitalized development costs relating to infill drilling, gathering geological and geotechnical data, further reserve and other mineralized material evaluation and other related activities of $35 million (2004 - $29 million; 2003 - $27 million).
In December 2005, coincident with the achievement of commercial production, a significant portion of the Voisey’s Bay assets were reclassified from Voisey’s Bay project under development to mines and mining plants and to processing facilities. As at December 31, 2005, Voisey’s Bay under development represents the carrying value of underground mineral properties. At December 31, 2005, the net carrying value of property, plant and equipment under construction or development not subject to amortization, depreciation or depletion was $2,777 million (2004 - $5,230 million; 2003 - $4,722 million) which is comprised of amounts for the Voisey’s Bay project totalling $1,371 million (2004 - $4,348 million; 2003 - $3,777 million), the Goro project of $1,085 million (2004 - $703 million; 2003 - $804 million) and other assets under construction at our operations of $321 million (2004 - $179 million; 2003 - $141 million). Depreciation, depletion and amortization for the open pit mine, concentrator and related facilities completed under phase one of the Voisey’s Bay project commenced in 2005. It is currently expected that depreciation, depletion and amortization for the Goro project will commence in 2008 in line with the planned start of operations. Capitalized interest costs included in capital expenditures were $103 million in 2005 (2004 - $70 million; 2003 - $55 million).
Note 9. Long-term debt
Long-term debt consisted of the following (repayment periods or maturities are shown in parentheses):
(a) The 15.75 per cent Sterling Unsecured Loan Stock is redeemable in 2006 in sterling or, at the option of the holders, in U.S. dollars at a fixed exchange rate of one pound sterling to $1.98. In 1981, we issued Pound Sterling 25 million aggregate principal amount of unsecured bonds which were called “unsecured loan stock” in the United Kingdom. These bonds were issued under a Trust Deed which contained many of the same provisions that are included in a trust indenture covering the issuance of unsecured bonds in the United States. These bonds rank equally and ratably with all of Inco’s other unsecured and unsubordinated debt. Holders of these debt securities were defined as bondholders under the Trust Deed. Under United Kingdom law, unsecured loan stock represent an unsecured bond issued in bearer form.
(b) On December 23, 2004, we concluded a $400 million term loan facility that matures on December 23, 2011. The borrowings under the facility may be made in United States dollars in the form of (i) United States Base Rate loans or (ii) London Interbank Offered Rate (“LIBOR”) loans. Borrowings under this facility bear interest, when drawn, at a rate which varies based on the type of borrowing and our credit ratings at the time of borrowing. As of December 31, 2005, there was $400 million drawn under the facility. The floating rate interest payments with respect to $200 million of the facility were swapped in exchange for a fixed rate of 5.098 per cent. As described in part (j) below, the term loan facility requires that we maintain a ratio of Consolidated Indebtedness, as defined in the term loan facility, to Tangible Net Worth, as defined in the term loan facility, not to exceed 50:50.
(c) On May 13, 2002, we issued and sold through an underwritten public offering in the United States $400 million aggregate principal amount of 7.75% Notes due 2012 (“Notes”). The Notes are redeemable, at our option, at any time at a price equal to the greater of the principal amount of the Notes and the sum of the present values of the remaining scheduled payments of principal and interest. The interest payments under the Notes were swapped in exchange for a floating rate equal to LIBOR plus 3.25 per cent up to June 7, 2005. During the second quarter of 2005, we terminated our interest rate swap in respect of these Notes (see Note 19).
(d) On September 26, 2003, we issued and sold through an underwritten public offering in the United States $300 million aggregate principal amount of our 5.70% Debentures due 2015 (“Debentures”). The Debentures are redeemable, at our option, at any time at a price equal to the greater of the principal amount of the Debentures and the sum of the present values of the remaining scheduled payments of principal and interest. The interest payments under the Debentures were swapped in exchange for a floating rate equal to LIBOR plus 0.57 per cent up to June 7, 2005. During the second quarter of 2005, we terminated our interest rate swap in respect of our Debentures (see Note 19).
(e) In March 2001, we issued and sold $438 million amount payable at maturity of LYON Notes. During 2005, a portion of the LYON Notes were settled. Reference is made to Note 13 for the details of the LYON Notes and the settlement. The remaining balance of the LYON Notes payable at maturity is $75 million.
(f) In March 2003, we issued and sold $273 million amount payable at maturity of Convertible Debentures due 2023. Reference is made to Note 13 for the details of the Convertible Debentures.
(g) On September 23, 2002, we issued and sold through an underwritten public offering in the United States $400 million aggregate principal amount of 7.20% Debentures due 2032 (“7.20% Debentures”). The 7.20% Debentures are redeemable, at our option, at any time at a price equal to the greater of the principal amount of the Debentures and the sum of the present values of the remaining scheduled payments of principal and interest.
(h) In March 2003, we issued and sold $227 million aggregate principal amount of 31/2% Subordinated Convertible Debentures due 2052. Reference is made to Note 13 for the details of the Subordinated Debentures.
(i) Our 61 per cent-owned subsidiary, PT Inco, had outstanding at December 31, 2005 loan facilities aggregating $38 million consisting of a $26 million expansion loan (2004 - $78 million; 2003 - $131 million); a $6 million loan (2004 - $19 million; 2003- $31 million) and a second $6 million loan (2004 - $18 million; 2003 - $30 million). All loans under the loan facilities are repayable in 13 equal semi-annual instalments commencing March 31, 2000. The expansion loan and the first $6 million loan bear interest, when drawn, equal to LIBOR plus 7/8 per cent in the first five years and LIBOR plus one per cent in the last five years. The second $6 million loan bears interest equal to LIBOR plus 11/2 per cent. As security for these loans, PT Inco has assigned and pledged certain of its cash and cash equivalents, sales agreements, service agreements and insurance policies.
(j) On May 28, 2004, we concluded a $750 million syndicated revolving credit facility with a maturity date of May 28, 2009. This syndicated facility replaced several bilateral bank credit agreements under which we had an aggregate of $680 million of available credit as of year-end 2003, where $273 million of such $680 million would have otherwise expired on June 1, 2004 and the balance in either June 2005, June 2006 or June 2007. Subject to the approval of the lenders representing not less than 66 2/3 per cent in total commitments under this $750 million syndicated facility, the maturity date of the syndicated revolving credit facility may be extended for the commitments of those lenders who have approved such extension for an additional one-year period on each May 28 anniversary date, beginning May 28, 2005. Effective May 28, 2005, the lenders under the $750 million syndicated revolving credit facility agreed to extend the maturity date of the facility from May 28, 2009 by an additional year to May 28, 2010.
The borrowings under the facility may be made in either Canadian dollars in the form of (a) Prime Rate loans (as defined under the credit facility) or (b) in Bankers’ Acceptances (as defined under the credit facility) or in United States dollars in the form of (i) United States Base Rate loans (as defined under the credit facility) or (ii) London Interbank Offered Rate (“LIBOR”) loans (as defined under the credit facility). Borrowings under these facilities bear interest, when drawn, at a rate which varies based on the type of borrowing and our credit ratings at the time of borrowing. As of December 31, 2005, there were no amounts drawn under the facility.
This syndicated credit facility provides that, so long as advances are outstanding or any letters of credit or guarantees issued pursuant to the terms of the facility are outstanding, we will be required to maintain a ratio of Consolidated Indebtedness, as defined in the credit facility, to Tangible Net Worth, as defined in the credit facility, not to exceed 50:50. At December 31, 2005 the ratio of Consolidated Indebtedness to Tangible Net Worth was 25:75. The syndicated facility does not require any acceleration or prepayment of outstanding balances if our credit ratings on outstanding debt securities were downgraded or if there were a significant decline in our earnings, cash flow or in the price of our publicly traded common shares or other equity securities. A downgrade in our rating would, however, increase the interest rate payable on borrowings under the facility and, conversely, any upgrade in our rating would reduce the interest rate payable on borrowings. As of December 31, 2005, our outstanding debt securities were rated as investment grade by Moody’s Investors Service and Standard & Poor’s Ratings Services, with the specific ratings being Baa3 (stable outlook) by Moody’s Investors Service and BBB- (positive outlook) by Standard & Poor’s.
(k) After the announcement of our offer to purchase all of the common shares of Falconbridge Limited on October 11, 2005, as referred to in Note 23 below, Standard & Poor’s Rating Services placed our rating on credit watch with negative implications while Moody’s affirmed our Baa3 rating (with a stable outlook). In connection with this offer, we have arranged debt financing sufficient to fund the cash portion (approximately $2.4 billion) of the offer we have made. In connection with this offer, on December 22, 2005, we entered into a loan agreement (the “Loan Agreement”) with a group of banks and financial institutions. The loan facilities under the Loan Agreement are in an amount sufficient for us to meet, directly or through subsidiaries who can borrow under the Loan Agreement, the total amount of cash, approximately $2.6 billion, we would need to acquire all of the issued and outstanding common shares of Falconbridge Limited (the “Falconbridge Shares”) pursuant to the terms of our pending offer made to acquire the Falconbridge Shares and pay the fees and expenses associated with such offer.
Interest expense on long-term debt for the years 2005, 2004 and 2003 was $19 million, $29 million and $48 million, respectively. Taking into account the aforementioned interest rate swaps, the weighted average effective interest rate on long-term debt at December 31, 2005 was 6.1 per cent and approximately 14 per cent of long-term debt bears interest at rates that are subject to periodic adjustments based on market interest rates. Approximately 96 per cent of long-term debt is effectively payable in U.S. dollars.
At December 31, 2005, long-term debt maturities for each of the five years through 2010 are: 2006 - $122 million; 2007 - $20 million; 2008 - $15 million; 2009 - $113 million; 2010 - $113 million.
Note 10. Post-retirement benefits
Our pension plans cover essentially all employees. We also provide certain health care and life insurance benefits for retired employees.
The change in the funded status of post-retirement defined benefit plans was as follows:
The net post-retirement benefits asset (liability) is reflected in the Consolidated Balance Sheet as follows:
Post-retirement benefits expense included the following components:
The weighted-average assumptions used in the determination of the post-retirement benefits expense and obligation were as follows:
Effective December 31, 2005, the assumption for the discount rates used to determine the pension benefits obligation were changed to 5.0 per cent for Canadian plans and 5.5 per cent for United States plans. Effective January 1, 2006, the assumption for the expected return on plan assets for the Canadian plans was changed to 7.5 per cent.
The pension plan weighted-average asset allocations, by asset category were as follows:
For the year ending December 31, 2006, we currently expect that our employer contributions will amount to approximately $180 million. Estimated benefit payments for each of the next five years through 2010 and the aggregate of the five years thereafter are as follows:
The measurement date for the post-retirement benefits obligations and the fair value of plan assets for all plans was December 31, 2005. The most recent actuarial valuation for purposes of calculating funding requirements for all significant plans was completed during 2005 based on the plan positions at December 31, 2004. The next planned actuarial valuation for purposes of calculating funding requirements for all significant plans will be completed during 2006 based on the plan positions at December 31, 2005.
The asset allocation policy for the plans is 40 per cent fixed income and 60 per cent equities for all of the Company’s pension plans with the exception of the plan at PT Inco. The actual asset mix is maintained fairly close to the policy mix at most times by the use of a rigorous rebalancing policy.
Equity securities include Inco Limited common shares in the amount of $3 million (2004 - $7 million; 2003 - $7 million). The decision to invest in Inco Limited shares is made by independent investment managers acting at their own discretion.
The return on plan assets assumption has been based on an estimate of the future long-term average return that can reasonably be earned on the assets of the pension fund. The starting point for the calculation of this assumption is the current yield obtainable from the fixed income portion of the portfolio. The yield available on the benchmark used, the Scotia Capital Universe Bond Index (50% of the bond component) and the Scotia Capital Long Bond Index (the remainder of the bond component), is used as the expected return on the bond indices since, in our view, this represents the best estimate of long-term future returns for the fixed income portion of the portfolio. Equity investments are assumed in aggregate to have an expected long-term future return of 3% in excess of the yield available on long-term Government of Canada bonds; for 2003 the 10-Year+ index was used, and for 2004 and 2005 the 10-Year benchmark bond yield was used (this change reflects the marketplace change and significant lack of issuance for 30 year maturities). For the portion of the assets that are invested actively with investment managers, an additional return expectation is included to recognize each manager’s target anticipated long-term value added above the index return. We note that actual added value over the past periods has, in aggregate, been substantially in excess of this amount. The weighted average of the returns determined for each portion of the fund becomes the return on assets assumption (rounded to the nearest 0.25%).
The projected pension benefits obligation and fair value of plan assets for pension plans with accumulated benefits obligations in excess of plan assets were as follows:
The composite health care cost trend rate used in measuring post-retirement benefits other than pensions was assumed to begin at 7.0 per cent, gradually declining to 4.0 per cent by 2014 and remaining at that level thereafter.
A one per cent change in the assumed composite health care cost trend rate would have the following effects:
Note 11. Asset retirement obligation
The estimation of asset retirement obligation costs depends on the development of environmentally acceptable closure and post-closure plans, which, in some cases, may require significant research and development to identify preferred methods for such plans which are economically sound and which, in many cases, may not be implemented for several decades. We have continued to utilize appropriate technical resources, including outside consultants, to develop specific site closure and post-closure plans in accordance with the requirements of the various jurisdictions in which we operate. Typical closure and progressive rehabilitation activities include, where applicable, demolition of buildings, removal of underground equipment, sealing of mine openings, treatment to reduce or prevent acid generation from stockpiled waste materials such as tailings, general clean-up activities aimed at returning the area to an environmentally acceptable condition, and post-closure care and maintenance.
Although the ultimate amount to be incurred is uncertain, the total amount for asset retirement obligations in respect of worldwide operations, to be paid primarily after cessation of operations, is estimated to be approximately $1.1 billion at December 31, 2005 on an undiscounted basis. The estimate of the total liability for asset retirement obligations has been developed from independent
environmental studies including an evaluation of, among other factors, currently available information with respect to closure plans and closure alternatives, the anticipated method and extent of site restoration using current costs and existing technology, and compliance with presently enacted laws, regulations and existing industry standards. The total liability represents estimated expenditures associated with closure, progressive rehabilitation and post-closure care and maintenance.
Asset retirement obligations are recognized when incurred and recorded as liabilities at fair value assuming credit-adjusted risk-free interest rates which ranged from four per cent to eight per cent for the corresponding time periods over which these costs would be incurred. Due to the nature of our closure plans, the timing of such cash expenditures is expected to occur over a significant period of time being from one year for plans which are already in progress and over 100 years for the longest plan. The following table shows the movement in the liability for asset retirement obligations.
As of December 31, 2005, we had outstanding letters of credit in the amount of $23 million to secure a portion of our closure costs related to the closure of three mines in Ontario. These letters of credit have a term of one year and will automatically renew without any action by either Inco or the counterparty until the earlier of (i) Inco having complied with the terms of the certified closure plans or (ii) funds from such letters of credit being utilized by the government authority responsible for overseeing such closure plans, to perform rehabilitation work if we did not meet the requirements with respect to such closure plans. We are required to submit annual updates on changes to the closure plans, including any decommissioning and rehabilitation work completed during the previous year.
In view of the uncertainties concerning environmental remediation, the ultimate cost of asset retirement obligations could differ materially from the estimated amounts provided. The estimate of the total liability for asset retirement obligation costs is subject to change based on amendments to laws and regulations and as new information concerning our operations becomes available. Future changes, if any, to the estimated total liability as a result of amended requirements, laws, regulations and operating assumptions may be significant and would be recognized prospectively as a change in accounting estimate, when applicable. Environmental laws and regulations are continually evolving in all regions in which we operate. We are not able to determine the impact, if any, of environmental laws and regulations that may be enacted in the future on our results of operations or financial condition due to the uncertainty surrounding the ultimate form that such future laws and regulations may take.
Note 12. Girardin Act financing
On December 30, 2004, we entered into agreements covering the Girardin Act tax-advantaged lease financing program (“Girardin Financing”) sponsored by the French Government for the Company’s nickel-cobalt project in New Caledonia. The Girardin Financing is subject to a ruling issued by the French Minister of Economy, Finance and Industry (the “Ruling”). The Ruling provides that certain investors who are French qualified investors under the Girardin Financing (“Tax Investors”) may utilize certain tax deductions in connection with assets representing a portion of the Goro nickel-cobalt project’s processing plant which are financed by the Girardin Financing (“Girardin Assets”). The Ruling requires that Goro Nickel S.A.S. (“Goro”), our subsidiary, and Inco, satisfy certain conditions, including operating the Goro nickel-cobalt project for a minimum of five years.
As part of the Girardin Financing, a special purpose entity (“SPE”), a variable interest entity, was formed by the Tax Investors to finance the purchase, construction and installation of the Girardin Assets. As we are the primary beneficiary of the SPE, our consolidated accounts include the accounts of the SPE. The purchase, construction and installation of the Girardin Assets by the SPE is funded by a combination of (a) non-refundable loans (“Tax Advances”) provided by the Tax Investors pursuant to a tax loan agreement (“Tax Loan Agreement”) between the Tax Investors and the SPE, and (b) loans provided to the SPE by a subsidiary of ours pursuant to a loan agreement (“Loan Agreement”).
Under a construction agreement between the SPE and Goro (“Construction Agreement”), Goro has been appointed the construction agent on behalf of the SPE and is responsible for the purchase, construction, installation and commissioning of the Girardin Assets. The costs for the construction, installation and commissioning of the Girardin Assets total approximately $500
million and are payable in three instalments. In the event of a cost overrun, a fourth instalment would be made to Goro with the additional funds provided pursuant to the Loan Agreement. Goro is required to give notice of substantial completion of the Girardin Assets to the SPE by December 31, 2008 or such later date as may be approved by the French tax authorities. Upon such substantial completion, the SPE will lease the Girardin Assets to Goro under an agreement between the SPE and Goro (“Lease Agreement”). While the term of the Lease Agreement is twelve years, the related agreements covering the Girardin Financing extend certain call and put options to Goro and the SPE, respectively, covering both the Girardin Assets and the ownership interests in the SPE whereby, assuming no default by Goro under the arrangements covering the Girardin Financing, one of these options is expected to be exercised after five years, resulting in the termination of the Lease Agreement and the ownership of the Girardin Assets reverting to Goro.
The Construction Agreement and the Lease Agreement contain certain events of default and termination rights for the benefit of the SPE, including the failure of Goro to meet certain terms and conditions of the Ruling. Following any termination of the Lease Agreement, (1) certain termination compensation could be payable by Goro to the Tax Investors pursuant to the Add-Back Indemnity (as defined below) and (2) Goro would be required to either (a) repay the entire then outstanding amount drawn under the Loan Agreement or (b) assume all of the SPE’s obligations under the Loan Agreement. Upon the occurrence of such events, Goro would continue to have the right to use the Girardin Assets, with the SPE retaining ownership thereof until all termination compensation due by Goro under the Lease Agreement is paid. In addition, each of the Lease Agreement and the Construction Agreement provides that Goro must indemnify the SPE and the Tax Investors with respect to (1) the Add-Back Indemnity (as defined below), (2) increased taxes incurred by the SPE or Tax Investors in respect of certain changes in tax laws or the imposition of certain unanticipated taxes in New Caledonia and (3) operational losses incurred by the SPE or Tax Investors arising out of third party claims in their capacity as owners of the Girardin Assets. In the event of a termination of the Construction Agreement or the Lease Agreement or in the event that the Tax Investors exercise their put option upon the occurrence of certain material adverse environmental events relating to Goro prior to the fifth anniversary of substantial completion of the Goro project, it is possible that the Tax Investors could lose their tax deductions in respect of the Girardin Assets, thereby triggering an indemnity whereby Goro would be required to reimburse the Tax Investors for the denial or reversal of their tax deductions under the Girardin Financing by the French tax authorities and for any interest and penalties levied thereon by such authorities (the “Add-Back Indemnity”). In connection with any termination event, the Tax Investors will receive certain priorities relating to Goro’s assets over other creditors.
Cumulative to December 31, 2005, the Tax Investors provided $90 million in Tax Advances. It is currently estimated that such Tax Advances will total $148 million, before fees to be paid to the Tax Investors, with the balance of the Girardin Financing to be provided under the Loan Agreement. The SPE expects to receive the balance of the Tax Advances in December 2006 pursuant to the terms of the Tax Loan Agreement. Of the remaining Tax Advances to be made in 2006, approximately 65 per cent of these amounts have been committed by the Tax Investors, with the balance expected to be placed with additional investors. Tax Advances are initially shown in deferred credits as the advances represent government assistance in the form of a forgivable loan. The Tax Advances are then reclassified from deferred credits to property, plant and equipment as they are expended on the project on a prorated basis.
Included in Other Deferred Credits of $131 million is $58 million in respect of the Girardin Financing.
Note 13. Convertible debt
Changes in the equity component of convertible debt were as follows:
(a) On March 29, 2001, we issued and sold, on a bought deal basis, zero-coupon convertible notes (“LYON Notes”), representing an aggregate amount payable at maturity of $438 million, which are due and payable March 29, 2021, for net cash proceeds of $226 million. No interest is payable on the LYON Notes prior to maturity except in connection with any term or condition where the holder receives the then accreted value of the LYON Notes.
The LYON Notes are convertible, at the option of the holder, at any time on or prior to their maturity date into Common Shares at a fixed conversion rate of 26.5530 Common Shares per LYON Note, representing an initial conversion price of $19.76 per share, with such conversion rate and price being subject to certain anti-dilution adjustment provisions. Holders of LYON Notes also have a special conversion right, exercisable on March 29 in 2007, 2011 and 2016, giving such holders the right to convert the then accreted value of their LYON Notes into Common Shares based upon the then market price for such shares. The LYON Notes are also subject to redemption at our option on or after March 29, 2007 at their then accreted value.
We have the right, subject to certain conditions, in connection with the exercise by a holder of such conversion or special conversion rights, to pay such holders cash, in whole or in part, in lieu of Common Shares. We also have the right, subject to certain conditions, in connection with any redemption or certain purchases of the LYON Notes, to pay the redemption or purchase price in Common Shares, based upon the then market price thereof, or in cash or any combination of Common Shares and cash. We are required to offer to purchase the LYON Notes if there is a change in control of Inco, as defined in the Trust Indenture dated as of March 29, 2001 between Inco and The Bank of New York, as Trustee, occurring before March 29, 2007.
In 2004 and prior years, the LYON Notes were not dilutive for purposes of calculating diluted earnings per share based on our right to and then current intention that we would eventually meet the redemption and conversion terms of these LYON Notes in cash.
During 2005, LYON Notes representing approximately, $163 million aggregate principal amount were tendered for conversion. At our option, we elected to settle a portion of the obligations in respect of these notes in accordance with their terms for cash in lieu of shares in the amount of $76 million. The difference between the cash settlement price of $76 million and the book value of $41 million represents a charge of $35 million. For accounting purposes, the LYON notes are bifurcated between debt and equity, the equity portion representing the value of the holders’ conversion options. Consequently, the charge of $35 million has been bifurcated between earnings and a direct charge to retained earnings. The split is a charge to earnings of $9 million and a charge to retained earnings of $26 million. The remainder of the LYON Notes tendered for conversion were, at our option, settled in shares with no impact on net earnings.
(b) In March 2003, we issued and sold in concurrent private offerings (i) $273 million amount payable at maturity of Convertible Debentures due March 14, 2023 (“Convertible Debentures”), representing $249 million in gross proceeds to us, and (ii) $227 million aggregate principal amount of Subordinated Convertible Debentures due March 14, 2052 (“Subordinated Convertible Debentures”). The total combined gross proceeds were $476 million from these two issues of convertible debt securities and the net cash proceeds were $470 million after deduction of commissions and other after-tax expenses. The Convertible Debentures and Subordinated Convertible Debentures pay a cash coupon of 1.0943 per cent and 3.5 per cent, respectively.
The Convertible Debentures and the Subordinated Convertible Debentures are convertible at the option of the holders into Common Shares at the conversion rates referred to below, subject to certain anti-dilution adjustment provisions, only in the following circumstances: (i) if our Common Share price, calculated over a specified period, has exceeded 120 per cent of the effective conversion price of the Convertible Debentures or the Subordinated Convertible Debentures, as applicable; (ii) if the trading price of the Convertible Debentures or the Subordinated Convertible Debentures, as applicable, over a specified period has fallen below 95 per cent of the amount equal to our then prevailing Common Share price times the applicable conversion rate; (iii) if we were to call the Convertible Debentures or the Subordinated Convertible Debentures, as applicable, for redemption; or (iv) if certain specified corporate events were to occur. Each Convertible Debenture will be convertible into 31.9354 Common Shares, representing an initial conversion price of approximately $28.61 per Common Share, and each Subordinated Convertible Debenture will be convertible into 38.4423 Common Shares, representing a conversion price of approximately $26.01 per Common Share.
Holders of the Convertible Debentures have the right to have us redeem these debentures at their issue price plus accrued interest on March 14 in each of 2010, 2014 and 2018. We have the right to redeem the Convertible Debentures at any time on or after March 19, 2010. We have the right to redeem the Subordinated Convertible Debentures on or after March 19, 2008 if our Common Shares trade over a specified period above 125 per cent of the conversion price for these securities. Holders of the Subordinated Convertible Debentures have no right to require us to redeem these subordinated securities. In meeting the conversion, redemption, payment at maturity and other related terms of these convertible debt securities, we have the right, at our option, to satisfy these obligations in cash, Common Shares or any combination thereof.
In the case of the Convertible Debentures, these securities rank equally and rateably with all of our existing and future unsecured and unsubordinated indebtedness. The Subordinated Convertible Debentures are subordinated to all of our senior indebtedness, which includes, among other obligations, all of our existing and future unsecured and unsubordinated indebtedness.
Effective January 1, 2005, on a retroactive basis, we adopted revisions to CICA Section 3860, Financial Instruments - Disclosure and Presentation (See Note 2).
Note 14. Preferred shares
On March 28, 2003, we announced that we would exercise our optional right to redeem all of our issued and outstanding Preferred Shares Series E having a $472 million aggregate liquidation preference and which were subject to mandatory redemption in 2006, with such redemption to be effective May 1, 2003. Pursuant to their terms, we redeemed the Preferred Shares Series E by paying the optional redemption price of $51.10 per share plus all accrued and unpaid dividends to the May 1, 2003 redemption date. Holders of the Preferred Shares Series E had the right to convert their shares into Common Shares at a fixed conversion rate of 1.19474 Common Shares for each Preferred Share Series E held at any time prior to the May 1, 2003 redemption date. The conversion rate represented an effective conversion price of $41.85 per Common Share. The total aggregate redemption price for the Preferred Shares Series E was $487 million, including a redemption premium of $11 million based upon the $50 issue price per Preferred Share Series E and $4 million in accrued dividends.
Changes in the Preferred Shares Series E were as follows:
Note 15. Warrants
On December 14, 2000, we issued warrants upon the redemption of our Class VBN Shares. Each Common Share purchase warrant (a “Warrant”) has an exercise price, for each whole Warrant, of Cdn.$30.00 (or the equivalent in U.S. dollars) for the purchase of one Common Share at any time on or before August 21, 2006. The exercise price and/or the number and kind of securities issuable on the exercise of the Warrants are subject to adjustment in certain events, as set forth in the Warrant Agreement dated as of December 1, 2000 among Inco Limited, CIBC Mellon Trust Company and Chase Mellon Shareholder Services, LLC, as Canadian and U.S. Warrant Agents, respectively, covering the issuance of the Warrants. These adjustments include, among others, certain changes in our capital structure such as any subdivision or consolidation of Common Shares, stock dividends or other distributions, the consolidation, amalgamation or merger of Inco with another company, or the transfer of all or substantially all of our assets.
Changes in the Warrants were as follows:
Note 16. Common shares
We are authorized to issue an unlimited number of Common Shares without nominal or par value.
Changes in the Common Shares were as follows:
In September 1998, our Board of Directors, given the expiration of a shareholder rights plan which had been implemented in October 1988, adopted a new shareholder rights plan that took effect on October 3, 1998. This new plan, set forth in a Rights Plan Agreement entered into between Inco Limited and CIBC Mellon Trust Company, as Rights Agent, is designed to (i) encourage the fair and equal treatment of shareholders in connection with any take-over offer for Inco by providing them with more time than the minimum statutory period during which such bid must remain open in order to fully consider their options, and (ii) provide the Board of Directors with additional time, if appropriate, to pursue other alternatives to maximize shareholder value.
The new plan, amended in certain respects by the Board of Directors in February 1999, was approved by shareholders at the 1999 Annual and Special Meeting of Shareholders and was recently reconfirmed by the shareholders at the 2005 Annual and Special Meeting and will remain in effect until October 2008. The following represents a summary of some of the key terms of the plan.
The rights issued under the plan will attach to and trade with the Common Shares and no separate certificates will be issued unless an event triggering these rights occurs. Certificates evidencing Common Shares will be legended to reflect that they evidence the rights until the Separation Time (as defined below). Holders of the Convertible Debentures, Subordinated Convertible Debentures and LYON Notes and the certificates of entitlement attached thereto (which entitle their holders to receive rights in the event that the related security is converted into Common Shares) will generally be entitled to receive, upon conversion of the relevant security and presentment of the certificate of entitlement, respectively, rights in an amount equal to the number of Common Shares issued upon conversion of such securities.
The rights will separate from the Common Shares (“Separation Time”) and be transferable, trade separately from the Common Shares and become exercisable only when a person, including any party acting jointly or in concert with such person, acquires, or announces its intention to acquire, beneficial ownership of 20 per cent or more of (i) the then outstanding Voting Securities, or (ii) the then outstanding Common Shares alone, in either case without complying with the “permitted bid” provisions of the plan (as summarized below), or without the approval of the Board of Directors. Should such an acquisition occur, each right would entitle its holder, other than the acquiring person or persons related to or acting jointly or in concert with such person, to purchase additional Common Shares at a 50 per cent discount to the then current market price. The acquisition by any person (an “Acquiring Person”) of
20 per cent or more of the Common Shares or Voting Securities, other than by way of a permitted bid, is referred to as a “Flip-in-Event”. Any rights held by an Acquiring Person will become void upon the occurrence of a Flip-in-Event.
A “permitted bid” is a bid made to all holders of the outstanding Voting Securities that is open for at least 60 days. If, at the end of such 60-day period, more than 50 per cent of the then outstanding Common Shares, other than those securities owned by the party making the bid and certain related persons, have been tendered, such party may take up and pay for the Common Shares but must extend the bid for a further 10 business days to allow other shareholders to tender, thus providing shareholders who had not tendered to the bid with enough time to tender to the bid once it is clear that a majority of Common Shares have been tendered.
Under this plan, we can (i) waive our application to enable a particular takeover bid to proceed, in which case the plan will be deemed to have been waived with respect to any other takeover bid made prior to the expiry of any bid subject to such waiver or (ii) with the prior approval of the holders of Voting Securities or rights, redeem the rights for nominal consideration at any time prior to a Flip-in-Event.
Note 17. Stock compensation plans
The stock option plans authorize the granting of options to key employees to purchase Common Shares at prices not less than 100 per cent of their market value on the day the option is granted. The 2005 employee plan, which will replace the 2001 employee plan, has a term of five years and authorizes the granting of options to purchase up to 6,000,000 Common Shares. A Non-Employee Director Share Option Plan, which came into effect in April 2002 and has a term of five years, authorized the granting of options to the non-employee members of our Board of Directors to purchase up to 300,000 Common Shares. In February 2004, our Board of Directors suspended the operation of this plan. The stock option plans provide that no shares subject to any options granted shall be purchasable after 10 years from the date of grant and also include an anti-dilution provision to protect the option holder in the event of stock splits or other significant capital changes.
At December 31, 2005, outstanding options for 799,300 Common Shares also carry share appreciation rights (“SARs”). These SARs entitle an optionee, in lieu of exercising an option to purchase Common Shares, to surrender all or a portion of the related option in exchange for an amount equal to the difference between the then market price per share and the exercise price per share specified in the stock option, multiplied by the number of shares covered by the stock option, or portion thereof so surrendered. We may elect to deliver Common Shares, cash, or a combination of Common Shares and cash, equal in value to such difference. Compensation expense in respect of SARs for the years 2005, 2004 and 2003 was $8 million, $(3) million and $36 million, respectively.
One-half of stock options granted are exercisable on or after six months from the grant date, with the remaining options exercisable on or after 18 months from the grant date.
Pursuant to our mid-term incentive plans (MTIPs), awards in the form of Common Shares are made to certain key employees subject to transfer, sale and encumbrance restrictions for a three-year period from the date of the award. In the year ended December 31, 2005, 61,698 Common Shares were awarded in respect of MTIPs (2004 - 39,865; 2003 - 40,249).
Changes in Common Share options outstanding are summarized as follows:
Changes in the weighted-average exercise price of Common Share options are summarized as follows:
The following table summarizes information about Common Share options outstanding at December 31, 2005.
The following table summarizes information about Common Share options outstanding at December 31, 2005.
The expiration dates of Common Share options outstanding at December 31, 2005 ranged from June 3, 2006 to February 21, 2015. At December 31, 2005, there were 633 employees participating in the Common Share option plans.
For 2005, an expense of $12 million (2004 - $10 million; 2003 - $3 million) was charged to earnings with an equivalent offset credited to contributed surplus to reflect the fair value of stock options granted to employees. For 2005, a transfer of $5 million (2004 - $1 million; 2003 - nil) was made from contributed surplus to common shares in respect of exercised options. The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:
Note 18. Nature of operations and segment information
We are a leading producer of nickel and an important producer of copper, precious metals and cobalt. Our operations consist of the finished products segment, which comprises the mining and processing operations in Ontario, Manitoba and Newfoundland and Labrador, Canada, and refining operations in the United Kingdom and interests in refining operations in Japan and other Asian countries, and the intermediates segment, which comprises the mining and processing operations in Indonesia, where nickel-in-matte, an intermediate product, is produced and sold primarily into the Japanese market. In addition, we hold mineral claims and licenses for the Goro nickel-cobalt project under development in the French Overseas Territory of New Caledonia and have certain mineral deposits under development at Voisey’s Bay.
Net sales to customers by product were as follows:
Net sales to customers include sales at market prices to affiliates in Taiwan and South Korea aggregating $738 million in 2005, $759 million in 2004 and $547 million in 2003. No single non-affiliated customer accounted for more than 10 per cent of total sales in 2005, 2004 or 2003. At December 31, 2005, accounts receivable included amounts due from affiliates of $157 million (2004 - $202 million; 2003 - $100 million).
At December 31, 2005, we had provisionally priced sales of 57 million pounds of nickel and 21 million pounds of copper.
Data by operating segments
Reference is made to Note 3 which discusses an asset impairment charge included above under loss before income and mining taxes and minority interest for Development Projects in 2004.
For Development Projects, in respect of Voisey’s Bay, capital expenditures includes those expenditures incurred up to the date of achieving commercial levels of production. The balance remaining in identifiable assets for Voisey’s Bay relates to the carrying value of a portion of the mineral properties which remain in the development phase.
Other assets, which are not allocated to operating segments, consist of corporate assets, principally cash and cash equivalents, investments, deferred charges, pension assets and certain receivables.
Data by geographic location
Net sales to customers by geographic location are based on the location in which the sale originated.
Note 19. Financial instruments and commodities contracts
The carrying values and fair values for all financial instruments and commodities contracts are as follows:
The fair value of financial instruments at December 31 is based on relevant market information, the contractual terms of the applicable instrument or contract and, in some cases the application of a financial model. The fair value of investments, including debt securities and equity investments, is based on market prices at the reporting date for those or similar investments. The fair value of long-term debt, platinum put and call options, copper put and call options and the interest rate swaps are estimated based on market prices. The fair value of LME forward nickel, fuel oil swaps, palladium swaps, platinum swaps, gold swaps and forward currency contracts generally reflect the estimated amounts that we would receive (pay) to terminate such contracts at the reporting date, thereby taking into account the current unrealized gains or losses in respect of open contracts.
We are exposed to credit risk in the event of non-performance by counterparties in connection with our derivative contracts. We do not obtain collateral or other security to support derivative instruments subject to credit risk but mitigate this risk by dealing only
with financially sound counterparties and, accordingly, do not anticipate loss for non-performance. There is no substantial concentration of credit risk resulting from these contracts.
We had a limited recourse liability in respect of the sale of undivided interests in certain accounts receivable in the amount of $39 million at December 31, 2005.
The following table shows the notional amounts, average price, contract amount and fair value of our principal derivative instrument positions as at December 31, 2005:
(1)
In general, we do not use derivative instruments to hedge our exposure to fluctuating nickel prices. We do enter into LME forward purchase contracts which are substantially offset by fixed price customer contracts in order to more fully expose us to nickel price risk. We also enter into LME forward sales contracts to minimize nickel price risk associated with purchased nickel inventories of intermediates and finished nickel products.
(2)
We had outstanding put option contracts, giving us the right but not the obligation to sell copper, and sold call option contracts, giving the buyer the right but not the obligation to purchase copper, during the period extending to 2008. We also enter into forward sell contracts based upon quotations for copper on the COMEX Division of the New York Mercantile Exchange.
(3)
Depending on market conditions, we enter into precious metals hedging contracts. These contracts, in the form of swap contracts (whereby we simultaneously sell at a fixed price and buy the same quantities for the same maturity dates at a floating price), are intended to provide certain minimum price realizations in respect of a portion of our future production of such metals. Under these swap contracts, we receive fixed prices for platinum and pay a floating price based on monthly average spot prices. We also had outstanding put option contracts, giving us the right but not the obligation to sell platinum and sold call option contracts, giving the buyer the right but not the obligation, to purchase platinum during the same time period.
(4)
We use fuel oil swap contracts to reduce the effect of fuel oil price changes in respect of a portion of our energy requirements at PT Inco. Under the swap contracts, we pay fixed prices for fuel oil and receive a floating price based on monthly average spot price quotations.
(5)
We use forward currency contracts to eliminate the risk of exchange rate movements on a portion of our future construction costs of capital assets at our Ontario operations and the planned production facilities for the Goro project.
(6)
As at December 31, 2005, we had an outstanding interest rate swap of a notional amount of $200 million on our term loan due 2011, whereby we initially receive a floating rate at 0.875 per cent over 3-month LIBOR and pay a fixed rate of 5.098 per cent.
During 2005, we terminated our interest rates swaps in respect of our 7.75% Notes due 2012 and our 5.70% Debentures due 2015. The termination of these swaps resulted in payments to us totalling approximately $23 million which is included in cash from financing activities on our consolidated statement of cash flows under “Financing activities - Other”. For accounting purposes, the gain realized from the termination of these swaps will be amortized over the respective remaining terms of the related debt instruments.
Note 20. Commitments and contingencies
(a) Commitments
The following table summarizes as of December 31, 2005 certain of our long-term contractual obligations and commercial commitments for each of the next five years and thereafter:
(1)
These purchase obligations largely relate to the Goro project with the balance comprising routine orders to purchase goods and services at current operating locations.
In connection with our 1996 acquisition of Diamond Fields Resources Inc., we assumed an obligation to pay to a company retained by Diamond Field Resources Inc. to provide certain exploration and other services an annual royalty amounting to three per cent of the net proceeds received from the sale of ores, metals and other minerals produced from our Voisey’s Bay project, after deducting certain costs associated with the production and sale of the ores, metals and minerals produced. We have not paid any such royalty amounts in 2005.
(b) Contingencies
In the course of our operations, we are subject to routine claims and litigation incidental to our business, to various environmental proceedings, and to other litigation related to such business. With respect to the environmental proceedings currently pending or threatened against us, they include (1) a proceeding brought under the Ontario class action legislation covering claims relating to the alleged decline in property values in a community where we had operated a nickel refinery over the 1918 - 1984 period, (2) claims for personal injuries, (3) enforcement actions, (4) alleged violations of, including exceeding regulatory limits relating to discharges under, certain environmental or similar laws and regulations applicable to our operations in Canada and elsewhere and (5) certain claims dating back a number of years in which one of our subsidiaries was designated, under the United States federal environmental law known as “Superfund” or “CERCLA”, as a potentially responsible party. We believe that the ultimate resolution of such proceedings, claims and litigation will not significantly impair our operations or have a material adverse effect on our financial position or results of operations.
In connection with the Girardin Financing described under Note 12, we provided certain guarantees on behalf of Goro pursuant to which we guaranteed payments due from Goro of up to a maximum amount of $100 million (“Maximum Amount”) in connection with the Add-Back Indemnity. We also provided an additional guarantee covering the payments due from Goro of (a) amounts exceeding the Maximum Amount in connection with the Add-Back Indemnity and (b) certain other amounts payable by Goro under the Lease Agreement covering the Girardin Assets.
We provided a guarantee covering certain termination payments due from Goro to the supplier under an electricity supply agreement (“ESA”) entered into in October 2004 for the Goro nickel-cobalt project. The amount of the termination payments guaranteed depends upon a number of factors, including whether any termination of the ESA is as a result of a default by Goro and the date on which an early termination of the ESA were to occur. If Goro defaults under the ESA, the termination payment could reach up to an amount of 145 million euros. This maximum amount could be payable if termination of the ESA occurred prior to the anticipated start date for supply of electricity to the project. Once the supply of electricity under the ESA to the project begins, the guaranteed amounts will decrease over the life of the ESA.
Note 21. Supplemental information
Supplemental information in connection with the Consolidated Statement of Cash Flows follows:
Note 22. Sale of Interests in Goro Nickel S.A.S. (“Goro Nickel”)
(a) For 2005, minority interest included a recovery in respect of Goro Nickel of $25 million, reflecting the recovery of losses previously taken by us due to insufficient minority interest balances existing in 2004 to absorb the share by the minority interest of the previously recorded impairment charge associated with the Goro project in the second quarter of 2004.
(b) On February 18, 2005, a company formed by the three provinces of New Caledonia, Société de Participation Minière du Sud Calédonien S.A.S. (“SPMSC”), acquired all of the shares of Goro Nickel, the project company for our Goro project, then held by a subsidiary of a French government agency, Bureau des Recherches Géologiques et Minières. These shares represented, after the capitalization by Goro Nickel of certain shareholder advances as of February 18, 2005, approximately a 9.71 per cent ownership interest in Goro Nickel. At the same time, we sold shares in Goro Nickel to SPMSC representing approximately a 0.29 per cent interest such that SPMSC would own, as of February 18, 2005, approximately a 10 per cent ownership interest in Goro Nickel. SPMSC also entered into a shareholders agreement (the “SPMSC Shareholders Agreement”) with us on February 18, 2005 setting forth its rights and obligations as a shareholder in Goro Nickel. Under the SPMSC Shareholders Agreement, SPMSC has the right, but not the obligation, to make capital contributions on a pro rata basis as required to meet the funding requirements of Goro Nickel until such time as the Goro project meets certain minimum commercial production and related performance tests (the “SPMSC Threshold Performance Tests”). If SPMSC does not make such capital contributions, then Inco has agreed to provide such capital contributions in addition to its own pro rata contributions, subject to certain limitations, and SPMSC would, accordingly, suffer dilution of its ownership interest, with the dilution formula to be subject to a penalty if SPMSC’s interest by virtue of dilution were to fall below five per cent. Once the SPMSC Threshold Performance Tests are met, to the extent that SPMSC has elected not to make its pro rata capital contributions and, accordingly, has suffered dilution of its interest in Goro Nickel, SPMSC has under the SPMSC Shareholders Agreement agreed to purchase from Inco, based upon the price paid by Inco for such shares plus interest thereon based upon a formula tied to Inco’s then applicable long-term weighted average cost of capital, a sufficient number of shares such that SPMSC will then hold a 10 per cent ownership interest in Goro Nickel. SPMSC has through the end of 2005 elected not to make any such pro rata capital contributions as and when required by Goro Nickel.
On April 8, 2005 Sumitomo Metal Mining Co., Ltd. (“Sumitomo Metal Mining”) and Mitsui & Co., Ltd. (“Mitsui”), through a jointly owned company they formed, Sumic Nickel Netherlands B.V. (“Sumic Nickel”), acquired a 21 per cent ownership interest in Goro Nickel. Under the terms of a share purchase agreement entered into with us covering this transaction, Sumitomo Metal Mining and Mitsui paid to us in total $150 million for the 21 per cent interest. This amount included their pro rata share of certain project capital and other expenditures made since we announced our initial decision in July 2001 to proceed with the Goro project and certain advances made by us to fund the project. Under the terms of a shareholders agreement entered into as of April 8, 2005 (the “Sumic Shareholders Agreement”), setting forth the rights and obligations Sumic Nickel (and Sumitomo Metal Mining and Mitsui) would have as a shareholder in Goro Nickel, including the right to elect two directors to the board of directors of Goro Nickel so long as Sumic Nickel holds at least a 16 per cent ownership interest in Goro Nickel and the right to elect one director so long as it holds at least an eight per cent ownership interest, Sumic Nickel is also obligated to make capital contributions on a pro rata basis, subject to certain limitations and adjustments tied to the actual capital cost of the project, as required to meet the funding requirements of Goro Nickel until such time as the Goro project meets certain minimum commercial production and related performance tests (the “Sumic Threshold Performance Tests”). If Sumic Nickel does not make such capital contributions, it will suffer dilution of its ownership interest based upon a penalty dilution formula. If the capital cost of the Goro project exceeds a threshold above the current capital cost estimate prior to when the Sumic Threshold Performance Tests are met, then Sumic Nickel will not have any obligation to provide capital contributions to meet the Goro project’s funding requirements and we would, subject to certain terms and conditions under the Sumic Shareholders Agreement, be required to provide certain funding to meet such requirements, up to a specified level, in the form
of interest-bearing debt repayable by Goro Nickel. In addition, under the Sumic Shareholders Agreement, Sumic Nickel has the right to participate on a pro rata basis in any future expansion of the Goro project and also has certain rights to approve certain expenditures and other actions relating to Goro Nickel or the Goro project that would be outside the currently planned scope and operation of the project. As of April 8, 2005, we, Sumic Nickel, Sumitomo Metal Mining and Mitsui also entered into an operations agreement which sets forth Goro Nickel’s role and responsibilities as the operator of the Goro project and its financial and other reporting obligations to its shareholders and a product offtake agreement was also executed under which Sumic Nickel has the right and obligation to purchase its pro rata share of Goro’s production of nickel product and cobalt product based on its ownership interest in Goro Nickel, with a subsidiary of ours under a separate product offtake agreement having the right and obligation to purchase all of Goro Nickel’s production not purchased by Sumic Nickel (which would currently represent 79 per cent of such eventual production).
The transaction with Sumitomo Metal Mining, Mitsui and Sumic Nickel, which had no significant effect on our net earnings for 2005, was substantially completed as of March 31, 2005 and, accordingly, the sale of 21 per cent of Goro Nickel was recorded in the period ended March 31, 2005. At December 31, 2005, as a result of SPMSC’s election not to make any pro rata capital contributions, the shares of Goro Nickel were held approximately 71 per cent by Inco Limited, 21 per cent by Sumic Nickel and approximately nine per cent by SPMSC.
Note 23. Outstanding offer to purchase Falconbridge Limited
Inco Limited announced on October 11, 2005 an offer to purchase all the outstanding common shares of Falconbridge Limited (“Falconbridge”) by way of a friendly take-over bid. On October 24, 2005 Inco mailed its offer to purchase to Falconbridge common shareholders and related take-over bid circular (“Offer Documents”). Inco has offered Cdn. $34.00 in cash or 0.6713 of an Inco Common Share plus Cdn. $0.05 in cash for each Falconbridge common share. Under the terms of this offer, the maximum amount of cash to be paid by us is approximately Cdn. $2.87 billion, and the maximum number of our common shares to be issued is approximately 201 million. The consideration payable under the offer will be prorated as necessary to ensure that the total aggregate consideration will not exceed these maximum amounts. The offer is subject to certain conditions of completion, including receipt of all necessary regulatory clearances and acceptance of the offer by Falconbridge common shareholders owning not less than 66 2/3% of the Falconbridge common shares on a fully diluted basis (as defined in the Offer Documents). Once the conditions to the offer have been met (or waived by Inco) and Inco has taken up and paid for at least 66 2/3% of Falconbridge’s common shares as described in the Offer Documents, Inco currently expects, but is not required, to take certain steps to acquire all of the remaining outstanding Falconbridge common shares.
On December 8, 2005 we announced that our offer to purchase all of the common shares of Falconbridge would remain open for acceptance until January 27, 2006 to allow more time for the receipt of all necessary regulatory clearances. On January 12, 2006 we announced a further extension to keep our offer open until February 28, 2006 and on February 21, 2006 we announced a third extension to keep our offer open until June 30, 2006. These extensions were required to allow more time to meet one of the conditions of our offer, the receipt of all necessary regulatory clearances.
Reference should also be made to Note 9 for information on the definitive loan agreements we have entered into relating to the financing of the cash portion of our offer.
Note 24. Significant differences between Canadian and United States GAAP
Our consolidated financial statements are prepared in accordance with Canadian GAAP. The significant differences between Canadian and United States GAAP, insofar as they affect our consolidated financial statements are discussed below.
The following table reconciles results as reported under Canadian GAAP with those that would have been reported under United States GAAP:
(a) Post-retirement benefits
For Canadian reporting purposes, we amortize the excess of the net actuarial and investment gains and losses over 10 per cent of the greater of the post-retirement benefits obligation and the fair value of plan assets over the expected average remaining service life of our employee group. For United States reporting purposes, we amortize all actuarial and investment gains and losses systematically over the expected average remaining service life of employees.
United States GAAP also requires the recognition of a minimum additional pension liability in the amount of the excess of the unfunded accumulated benefits obligation over the recorded pension benefits liability/asset; an offsetting intangible pension asset is recorded equal to the unrecognized prior service costs, with any difference recorded as a reduction in accumulated other comprehensive income. At December 31, 2005, the minimum additional pension liability would have been $1,053 million (2004 - $984 million; 2003 - $937 million) and the intangible pension asset would have been $76 million (2004 - $78 million; 2003 - $84 million), resulting in a $611 million reduction, after taxes, (2004 - $569 million; 2003 - $515 million) in accumulated other comprehensive income. Refer to a discussion regarding restatements below.
(b) Currency translation gains (losses)
Previously, the principal unrealized non-cash currency translation adjustments included in the determination of earnings arose from the translation into United States dollars of the Canadian dollar denominated deferred income and mining tax liabilities established in 1996 upon the acquisition of the Voisey’s Bay deposits. For Canadian GAAP reporting purposes, these deferred income and mining tax liabilities have been deferred and included in property, plant and equipment as part of development costs in respect of the Voisey’s Bay mineral properties in the development phase. Capitalization of such gains and losses ceases when the development phase of the mineral properties are substantially complete and ready for use.
In 2005, although not significant, for comparative purposes, we have restated our prior period currency translation gains and losses to also include the currency translation gains and losses on other foreign currency denominated assets and liabilities as determined under United States GAAP, primarily post-retirement benefits and the corresponding tax balances. Refer to a discussion regarding restatements below.
(c) Intangible assets
Previously, we reported that, under United States GAAP, mineral rights were intangible assets with respect to balance sheet classification. During the second quarter of 2004, for United States GAAP the Emerging Issues Task Force (“EITF”) of the FASB released Issue No. 04-2 which reached the decision that mineral rights should be reported as tangible assets and disclosed as a separate component of property, plant and equipment. A FASB staff position paper dated April 30, 2004 also validated this change by means of amendments to Statement of Financial Accounting Standards (“SFAS”) Nos. 141 and 142. As a result of this change, we have reclassified, for United States GAAP purposes, intangible assets to property, plant and equipment. We have also, effective January 1, 2004, ceased amortization of the residual value of intangible assets referred to in our 2003 Annual Report on Form 10-K, as amended.
As of December 31, 2005, property, plant and equipment included mineral rights of $2,456 million (2004 - $2,467 million; 2003 - $2,467 million).
(d) Research and development expense
Under Canadian GAAP, development costs are deferred and amortized if the development project meets certain generally accepted criteria for deferral and amortization. In addition, fixed assets including equipment may be acquired or constructed in order to provide facilities or carry out a research and development project. The use of such assets will extend over a number of accounting periods and, accordingly, are capitalized and amortized over their useful lives. Under United States GAAP, research and development costs are charged to expense in the period incurred.
(e) Exploration expense
Under Canadian GAAP, capitalized exploration expenditures are classified under property, plant and equipment with the related mineral claim. For United States GAAP, exploration expenditures are not capitalized unless proven and probable reserves have been established by a feasibility study.
(f) Asset impairment charges
Net earnings for 2004 under Canadian GAAP included an asset impairment charge in the amount of $201 million before income and mining taxes and minority interest. Reference is made to Note 3 above. This charge included the write-off of certain capitalized costs which, in accordance with (d) above, were previously expensed for United States GAAP purposes. In addition, it included an adjustment to reduce minority interest to nil. For United States GAAP, the 2004 asset impairment charge would decrease by $11 million. The adjustment to reduce minority interest to nil would also be adjusted with a corresponding increase to minority interest expense of $7 million.
(g) Convertible debt
Under Canadian GAAP, convertible debt is bifurcated between debt and equity, the equity portion representing the value of the holder conversion options. Under United States GAAP, convertible debt would be accounted for as debt and, accordingly, the measurement of interest and the amortization of debt issuance costs are not the same. During 2005, as described in Note 13, certain LYON Note holders tendered for conversion their LYON Notes. At our option, we elected to settle a portion of the conversion of these notes for cash in lieu of shares which amounted to $76 million. The difference between the $76 million and the book value of $41 million represents a charge of $35 million. As the LYON notes are bifurcated between debt and equity under Canadian GAAP, the charge of $35 million has been bifurcated between a direct charge to earnings of $9 million and a direct charge to retained earnings of $26 million. Under United States GAAP, the entire $35 million loss is a charge to net earnings.
Under United States GAAP, each of our convertible debt securities meets the conditions necessary as set out in paragraphs 12-33 of EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, for the embedded conversion option to be exempt from the requirement to be treated as a derivative under SFAS No. 133.
(h) Derivative instruments
Under United States GAAP, all derivatives, whether designated in hedging relationships or not, are required to be recorded in the balance sheet at fair value. A derivative must be designated in a hedging relationship in order to qualify for hedge accounting. These standards include a determination of what portions of hedges are deemed to be effective versus ineffective. In general, a hedging relationship is effective when a change in the fair value of the derivative is offset by an equal and opposite change in the fair value of the underlying hedged item. In accordance with these standards, effectiveness tests are performed in order to assess effectiveness and quantify ineffectiveness for all designated hedges. At December 31, 2005, we had outstanding fair value hedges and cash flow hedges. A fair value hedge is a hedge of the change in the fair value of an asset, liability or firm commitment. If a derivative is designated as a fair value hedge, changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. A cash flow hedge is a hedge of the exposure in variability in expected future cash flows that is attributable to a particular risk such as a forecasted purchase or sale. If a derivative is designated as a cash flow hedge, the effective portions of the changes in the fair value of the derivative are recorded in other comprehensive income and are recognized in earnings when the hedged item affects earnings. Ineffective portions of changes in the fair value of the derivatives designated as hedges are recognized in earnings. Under Canadian GAAP, we continue to recognize gains and losses on derivative contracts in income concurrently with the recognition of the transactions being hedged. The requirements for documentation and effectiveness testing, however, are substantially the same under both Canadian and United States GAAP. Under United States GAAP, if a portion of a derivative contract is excluded for purposes of effectiveness testing, such as time value, the value of such excluded portion is included in earnings. Under Canadian GAAP, the excluded portion is not included in earnings if the derivative contract is otherwise determined to be effective. At December 31, 2005, unrealized net losses in respect of derivative instruments which were not specifically designated as hedges or not qualifying for hedge accounting under United States GAAP amounted to $15 million.
LME forward nickel contracts are used to hedge the effect of fluctuations in the price of nickel with respect to sales of nickel to customers for delivery three or more months in the future. These LME forward nickel contracts have been designated as fair value hedges in connection with firm sale commitments. For the year ended December 31, 2005, a gain of $0.9 million was credited to net sales due to the ineffectiveness of such fair value hedges and $1 million was charged to other income, net due to hedged firm commitments no longer qualifying as a fair value hedge.
At December 31, 2005, we have an interest rate swap outstanding to manage the variability in cash flows associated with changes in interest rates on a floating rate term loan, which has been designated as a cash flow hedge.
Depending on market conditions, we enter into metals fixed price swap and option contracts with various financial counterparties who must meet certain established criteria. These contracts, which have been designated as cash flow hedges, are intended to provide certain minimum price realizations in respect of a portion of forecasted sales. We have also entered into forward currency contracts to hedge a portion of the future construction costs of our planned production facilities in New Caledonia and at our Ontario operations that will be denominated in currencies other than the U.S. dollar. In addition, we have also entered into fuel oil swaps to manage the cost of a portion of our energy requirements in Indonesia. At December 31, 2005, $27 million of deferred net losses on derivative instruments recorded in other comprehensive income are expected to be reclassified to net sales during the next 12 months. The maximum term over which cash flows are hedged is 36 months.
(i) Income and mining taxes
There is a difference in the carrying value of the Voisey’s Bay project due to the impairment charge recorded in 2002. Under both Canadian and United States GAAP, deferred income and mining taxes are recorded at the expected rate of reversal. In 2003, there was a change in tax rates in the jurisdiction of the Voisey’s Bay project. The impact of this change in tax rates is different for Canadian and United States GAAP due to the temporary difference created by the asset impairment charge.
(j) Asset retirement obligations
Effective January 1, 2003, we adopted, for United States reporting purposes, SFAS No. 143, Accounting for Asset Retirement Obligations and CICA 3110, Asset Retirement Obligations, which are substantially identical. Under SFAS No. 143, asset retirement obligations are recognized when incurred and recorded as liabilities at fair value. The liability is accreted over time through periodic charges to earnings. In addition, the asset retirement cost is capitalized as part of the asset’s carrying value and depreciated using either the straight-line method or the units-of-production method using estimated proven and probable ore reserves depending on the nature of the asset being retired. The cumulative effect of adopting SFAS No. 143 was an increase to our deficit of $17 million, or nine cents per share, in 2003, which is shown as a cumulative effect of a change in accounting principle. As at January 1, 2003, property, plant and equipment increased by $39 million, deferred income and mining taxes decreased by $11 million, and asset retirement obligations increased by $67 million. For Canadian GAAP reporting purposes, financial results of comparative periods have been restated.
(k) Investments
United States accounting standards for equity investments, which are set forth in SFAS No. 115, require that certain equity investments not held for trading be recorded at fair value with unrealized holding gains and losses excluded from the determination of earnings and reported as a separate component of other comprehensive income. At December 31, 2005, deferred charges and other assets would have increased by $33 million (2004 - $80 million; 2003 - $69 million) with a corresponding change in accumulated other comprehensive loss before taxes.
(l) Comprehensive income
United States accounting standards for reporting comprehensive income are set forth in SFAS No. 130. Comprehensive income represents the change in equity during a reporting period from transactions and other events and circumstances from non-owner sources. Components of comprehensive income include items such as net earnings (loss), changes in the fair value of investments not held for trading, minimum pension liability adjustments, derivative instruments and certain foreign currency translation gains and losses.
(m) Earnings (loss) per share
The computation of basic and diluted earnings (loss) per share under United States GAAP was as follows:
At December 31, 2005, convertible debt which is convertible into nil Common Shares (2004 - nil; 2003 - 17,440,696), options on nil Common Shares (2004 - nil; 2003 - 4,572,605) and Warrants exercisable for nil Common Shares (2004 - nil; 2003 - 11,023,064) were excluded from the computation of diluted earnings (loss) per Common Share because their effects were not dilutive.
The following tables compare results reported under Canadian GAAP with those that would have been reported under United States GAAP, together with the cumulative effect on balance sheet accounts. Restatements are discussed in Note 2 above and in the discussion below.
Changes in retained earnings and accumulated other comprehensive loss under United States GAAP were as follows:
Restatements
As discussed in Note 24(b), we have restated our prior period results to reflect currency translation gains and losses on other foreign currency denominated assets and liabilities as determined under United States GAAP, primarily post-retirement benefits and the corresponding tax balances. Previously, these currency translation effects were not recorded due to their insignificance but they have become more significant due to the continued strengthening of the Canadian dollar. The impact of this restatement was a decrease in net earnings of $8 million and $12 million in 2004 and 2003, respectively. Also, we have corrected errors in the determination of post-retirement benefits expense and the minimum additional pension liability. Post-retirement benefits expense was increased by $14 million and $8 million and the related tax recoveries were increased by $6 million and $3 million in 2004 and 2003, respectively. Such adjustments impacted the determination of other comprehensive losses (by $33 million and $30 million in 2004 and 2003, respectively) and such balances were restated accordingly.
Recent Accounting Pronouncements
In February 2006, SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, was issued. This standard (1) permits fair value measurement for any hybrid financial instrument that contains an embedded derivative (2) clarifies which interest-only strips and principal-only strips are not subject to SFAS No. 133 (3) establishes a requirement to evaluate interests in securitized financial
assets to identify interests that are free standing derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation (4) clarifies that concentrations of credit risk in the form of subordination are not derivatives and (5) amends certain aspects of SFAS No. 144. This standard is effective for fiscal years beginning on or after September 15, 2006. We are currently studying the impact of this standard.
Effective January 1, 2006, we will adopt, for United States reporting purposes, SFAS No. 151, Inventory Costs - An Amendment of ARB No. 43, Chapter 4. Under SFAS No. 151, abnormal amounts of idle facility expense, freight, handling costs and spoilage should be recognized as current period charges. We do no anticipate that the application of SFAS No. 151 will have a material impact on our results of operation.
During June 2005, the FASB issued SFAS No. 154, Accounting for Changes and Error Corrections. The new standard requires that entities which make a voluntary change in accounting principle to apply that change retroactively to prior period financial statements, unless this would be impracticable. Another significant change in practice under SFAS No. 154 is that if an entity changes its method of depreciation, amortization or depletion for long-lived assets, the change must be accounted for prospectively, as a change in estimate. SFAS No. 154 is effective for our 2006 financial statements and is not expected to have a significant impact on earnings.
During December 2004, the FASB issued revisions to SFAS No. 123, Share-Based Payments, which will be effective for 2006. The primary impact of the revisions is the elimination of the intrinsic value method for valuing stock-based employee compensation. The revisions will also impact the manner in which expense is determined for stock appreciation rights. As we adopted the fair value method in 2003 and ceased issuing stock appreciation rights in 2004, we do not expect that such revisions will have a significant impact on earnings.
SCHEDULE VIII
INCO LIMITED AND SUBSIDIARIES
VALUATION ACCOUNTS AND RESERVES
(in thousands)
SUPPLEMENTAL FINANCIAL INFORMATION
Quarterly Financial Information
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Management’s Report on Internal Control over Financial Reporting and the Report of the Independent Registered Public Accounting Firm thereon are set forth in Item 8 of this Report.
As of the end of the period covered by this Report, an evaluation was carried out by Inco’s management, with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the U.S. Securities Exchange Act of 1934). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that these disclosure controls and procedures were effective as of the end of the period covered by this Report. In addition, no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the U.S. Securities Exchange Act of 1934) occurred during the fourth quarter of our fiscal year ended December 31, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of Inco Limited
Directors
The information under “Election of Directors”, “Board Committees”, and “Audit Committee Report” in Inco’s Proxy Circular and Statement dated February 17, 2006 (the “2006 Proxy Statement”), filed as Exhibit 99 hereto, is incorporated herein by reference to such information.
Executive Officers
The names, offices held and ages as of the date of this Report of the executive officers of Inco Limited are shown below.
(1)
Mr. Jones plans to retire from all of his positions with the Company when the pending acquisition of Falconbridge is completed.
(2)
Mr. Feiner will be succeeded in this position by Simon A. Fish in late March 2006 when he will then serve as Executive Vice-President, Corporate Affairs, until his planned retirement in mid-2006. Prior to joining Inco in December 2005, Mr. Fish held senior management positions, most recently Vice-President, General Counsel and Secretary, with Shell Canada Limited, an integrated oil and gas company based in Calgary, Alberta from January 2003 until November 2005, and from July 2000 until January 2003, Mr. Fish was Secretary to the Committee of Managing Directors of Royal Dutch Shell plc based in London, England.
Each executive officer is elected by the Board of Directors of Inco Limited annually, at the first meeting of such Board (“Annual Board Meeting”) after the annual meeting of shareholders, for a term of one year or until a successor shall have been duly chosen and qualified, except in those cases where an executive officer is elected at other than the Annual Board Meeting, in which event such executive officer’s tenure will expire at the next Annual Board Meeting unless re-elected. Such tenure is subject to an officer’s resignation or removal as provided in Inco’s By-law No. 1, its sole by-law, and Inco’s standing resolution adopted pursuant thereto.
Except for the officers mentioned below, each executive officer named above has been an officer or executive or key managerial employee of Inco Limited or one of its subsidiaries during the past five years. From December 2002 until October 2005, Mr. Davies was Chief Financial Officer of Alumina Limited, the Australian partner in the Alcoa World Alumina and Chemicals business that was formed after the December 2002 demerger of WMC Limited, a base metals and phosphate company based in Melbourne, Australia, and from February 1997 until November 2002 Mr. Davies held senior management positions with WMC Limited, most recently
General Manager Treasury, Tax and Investor Relations. From February 2000 until February 2003, Mr. Cutifani was Managing Director of Sons of Gwalia Ltd., a tantalum, gold and industrial minerals mining company based in Perth, Western Australia, and from January 1998 until January 2000 he was Group Executive responsible for all of the gold operations, project development and technical support for Normandy Mining Ltd., a gold and base metals mining company based in Adelaide, South Australia. From May 1997 until January 2000, Mr. du Toit was Operations Director, Voest Alpine Industries Inc., an engineering company based in Poole, England, and from February 2000 until April 2003 he held senior management positions, most recently President, with Diavik Diamond Mines Inc., a diamond mining company based in Yellowknife, Northwest Territories. From October 2004 until October 2005, Dr. Filmer was an advisor providing assistance with respect to the development of mining projects to Ma’aden, the Saudi Arabian state-owned mining company based in Riyadh, Saudi Arabia, and from October 1981 until September 2004 he held a number of senior positions with RioTinto, a diversified mining company based in London, England and Melbourne, Australia; most recently, from July 1997 until October 2002 he was Managing Director of Rio Tinto’s Comalco Smelting operation and from October 2002 until September 2004 was seconded to CSIRO, an Australian research institute, to lead its Light Metal Flagship Initiative. During the five-year period prior to joining Inco, Mr. Bassett served as Executive Vice-President of SNC Lavalin Inc., an engineering company based in Montreal, Quebec; Mr. Bhandari held senior management positions, most recently General Manager, Purchasing and Information Systems, with Toyota Motor Manufacturing Canada Ltd., an automobile manufacturing company based in Cambridge, Ontario; Mr. Kaiway held senior management positions, most recently Vice-President, Taxation, with Placer Dome Inc., a gold mining company based in Vancouver, British Columbia; and Mr. Sheard held senior management positions, most recently as Global Exploration Manager, with MIM Holdings Pty Ltd., a base metals, gold and coal mining company based in Brisbane, Australia acquired by Xstrata plc.
The dates shown in the table extend from the first date of election as an executive officer of Inco. There are no family relationships among the directors and executive officers of Inco, and no arrangements or understandings between any executive officer and any other person pursuant to which he was elected as an executive officer.
Code of Ethics
Inco has adopted a Code of Ethics for Financial Personnel governing its senior officers and employees with financial reporting and related responsibilities and has posted such code on its web site, www.inco.com. Within the time period required by the SEC and the New York Stock Exchange, we will post on our website any amendment to the Code of Ethics for Financial Personnel and any waiver applicable to our senior financial officers and our executive officers or directors. We have also posted on our website the Board of Directors’ Guidelines on Corporate Governance and the charters of our Audit Committee, Corporate Governance and Nominating Committee, Management and Resources and Compensation Committee, Pension Committee, Environment, Health and Safety Committee and Capital Projects Committee. Any of the foregoing documents are available in print upon request of any shareholder to our investor relations personnel through our website or by telephone at (416) 361-7670.
Item 11.
Item 11. Executive Compensation
The information under “Executive Compensation”, “Report on Executive Compensation” and “Comparative Shareholder Return” in the 2006 Proxy Statement is incorporated herein by reference to such information. Reference is also made to “Directors and Executive Officers of Inco Limited - Executive Officers” above.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Security Ownership of Certain Beneficial Owners and Management
The information under “Ownership of Securities” in the 2006 Proxy Statement is incorporated herein by reference to such information. Reference is also made to “Directors and Executive Officers of Inco Limited - Executive Officers” and “Securities Authorized for Issuance under Equity Compensation Plans” above.
Changes in Control
There are no arrangements known to Inco the operation of which may at a subsequent date result in a change of control of the Company.
Item 13.
Item 13. Certain Relationships and Related Transactions
None.
Item 14.
Item 14. Principal Accountant Fees and Services
The information under “Auditors’ Fees” in the 2006 Proxy Statement is incorporated herein by reference to such information.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(1)
Indicates a management contract or compensatory plan or arrangement.
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, in Toronto, Ontario, on the 16th day of March, 2006.
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 16th day of March, 2006.
Signature
Title
(Signed) SCOTT M. HAND
Chairman and Chief Executive Officer
Scott M. Hand
and Director
(Principal Executive Officer)
(Signed) ROBERT D.J. DAVIES
Executive Vice-President and
Robert D.J. Davies
Chief Financial Officer
(Principal Financial Officer)
(Signed) RONALD A. LEHTOVAARA
Vice-President and Comptroller
Ronald A. Lehtovaara
(Principal Accounting Officer)
*
Pursuant to powers of attorney executed by the directors named above whose names are preceded by an asterisk, Stuart F. Feiner, as attorney-in-fact, does hereby sign this Report on behalf of each of such directors, in each case in the capacity of director, on the 16th day of March, 2006.
(Signed) STUART F. FEINER
Stuart F. Feiner, attorney-in-fact
Consent of Independent Auditors
We hereby consent to the incorporation by reference in the Registration Statements on Form S-3 (Nos. 33-22435 and 33-50816), on Form S-8 (Nos. 33-71298, 333-7798, 333-13714, 333-98601 and 333-125955), on Form (No. 333-129218) and on Form (Nos. 333-13470, 333-12588, 333-104688 and 333-104687) of Inco Limited of our report dated February 28, 2006 relating to the financial statements, the financial statement schedule, management’s assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting which appears in this Annual Report on Form 10-K. We also consent to the reference to us under the heading “Experts” in each such Registration Statement on Form S-3 and Form.
PRICEWATERHOUSECOOPERS LLP
Chartered Accountants
Toronto, Ontario
March 16, 2006
INCO LIMITED
EXHIBIT INDEX
TO ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2005
Portions of the Proxy circular and Statement are incorporated by reference in Part III of this Report.