VOLCAN CIA. MINERA SILVER AND HYDROELECTRIC PROJECTS ADD VALUE TO THE COMPANY. September 23, 2011

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1 VOLCAN CIA. MINERA September 23, 2011 DANIEL MORI: SILVER AND HYDROELECTRIC PROJECTS ADD VALUE TO THE COMPANY TARGET PRICE: S/.4.32 RATING: BUY+ INVESTMENT THESIS We are updating our valuation on Volcan Compañia Minera to include the company s aggressive silver projects portfolio as well as the planned investments on hydroelectric generation. We are increasing our 12-month fundamental target price for VOLCAN B shares from S/.3.60 to S/.4.32, maintaining our Buy+ rating. In line with most Peruvian equities, Volcan B shares experienced high volatility this year in the wake of the presidential elections and of the financial turmoil in global markets. The correction in Volcan s B shares has created an interesting upside potential as we consider that silver price fundamentals and the longterm outlook for base metal prices remain encouraging. The company has also unveiled an aggressive plan to expand its silver production capacity in the following years given the metal positive outlook. Meanwhile, new investments in hydroelectric generation will guarantee the energy supply for Volcan in the future, preventing an eventual bottleneck, as well as contributing to the company s operating margins through lower energyrelated costs. Finally, it is worth mentioning that Volcan is undergoing exploration works at several sites aiming to significantly increase its copper output capacity in the mid-term. Among these, the Rondoni project is the most promising. VALUATION CHANGES We have updated our assumptions on Cerro de Pasco s silver oxides plant. We have also added new silver projects such as Piritas and the expansion of Chungar. We have added Vocan s hydroelectric generation projects to our valuation. Market Indicators Shares outstanding (000) Dividend yield 1,869, % 52-w eek range day average volume (US$000) Float Market Cap. (US$m) Price to Book Value 1, % 3, x Rating Parameters Current Price Target price Yield 12 months Upside potential Rating Stock Ticker Sector rating S/ S/ % 64.1% Buy+ VOLCABC1 Market Perform Volcan B shares' price sensitivity (S/.) Zinc $/lb price vector -20.0% -10.0% 0.0% 10.0% 20.0% 11.4% W 11.9% A 12.4% C 12.9% C 13.4% Zinc $/lb price vector -20.0% -10.0% 0.0% 10.0% 20.0% We are updating the company s overall reserves and resources to reflect the latest data available. These numbers include Rondoni s copper resources as of Dec-10. We are adjusting our financial model to reflect the new windfall tax scheme approved.

2 Volcan s silver projects The company s management continues to make efforts to underline silver s weigh on Volcan s revenues. Indeed, despite being traditionally perceived as a zinc producer, silver was the second most important byproduct of the company in 2010, accounting for 30% of total sales. Moreover, given the sharp increase in silver prices and Cerro de Pasco s lower contribution (the company is currently performing optimization works at the site) silver sales accounted for 52% of IIQ11 total sales. Volcan ranks first in terms of silver output in Peru and it is among the top 10 silver producers in the world. Over the last months, the company has unveiled several silver projects: Volcan is working on a silver oxides plant in the Cerro de Pasco unit to treat 4.4m MT of stockpiles containing 7.2 oz/mt Ag as well as 5.2m MT (5.8 oz/mt Ag) in-situ resources. A 2,500tpd treatment facility will be built at a cost of $40m. Production will start in Piritas (Cerro de Pasco) is a two-stage project that will add value to 21.7m MT (5.5 oz/mt Ag) of existing stockpiles with no mining costs. The first stage (2012) involves a 3,000tpd flotation process that could produce up to 3m oz of silver per year. The total investment reaches $10m. The second stage (2014) involves the construction of a new plant to treat 4,000tpd of ore at a cost of $50m through a leaching process. Production from this stage would average 5m oz/year. Volcan plans to build a new 2,000tpd concentrator plant in Alpamarca by 2012, investing $50m. Silver output from Alpamarca could reach up to 2.0m oz Ag. Please note that the Alpamarca concentrator plant was already considered in our valuation. Nonetheless, the recently unveiled Rio Pallanga project, located 10km away from Alpamarca, could contribute with 1,000tpd of silver-rich ore. Current resources stand at 1.1m MT (15.7oz Ag/MT). Further drilling is undergoing at Rio Pallanga to expand the site s resources. The Chungar s expansion project contemplates increasing the concentrator plant capacity from current levels of 4,200tpd to 5,200tpd at a $7.0m cost by IIQ12. Chungar would increase its silver output by up to 2.0m oz Ag. Regarding Vinchos, the company expects to increase the unit s reserves and resources through intense exploration works. Volcan expects that Vinchos will add up to 2.0m oz Ag per year as soon as IIH11. Nevertheless, we are not including these figures in our valuation until new numbers on reserves and resources are made public. All in all, we expect Volcan s silver output to continue to increase its relevance in Volcan s revenues breakdown. Total capex in silver-related projects will reach approximately $160m over the next 3 years. Volcan's 2010 sales breakdown Volcan's IIQ11 sales breakdown Gold, 1% 28,000 Silver in concentrates Oz (000) 27,322 26,000 25,706 Silver, 30% Zinc, 36% 24,000 Copper, 3% Lead, 11% Zinc, 56% Silver, 52% Lead, 8% 22,000 20,000 21,343 20,083 20,873 Copper, 3% 18, Source: Volcan Source: Volcan Source: Inteligo 2

3 Volcan s Copper Projects and Reserves Adjustments The company is conducting an aggressive exploration program in order to support a significant increase in its copper output in the next four years. The most promising project is Rondoni, in Huanuco. Currently, Rondoni s resources reach 30m MT with 0.9% Cu. Volcan plans to transform Rondoni in a 40,000 Cu MT/year by In this sense, the company is investing $15m in a 70k drilling program in As the company needs to support such mining operation with large, and currently not-verified resources, we are only considering the previously mentioned 30m MT of ore in our financial model, adding approximately S/ per Volcan B share to our target price. Nevertheless, we believe Rondoni offers a significant upside potential to Volcan s value generation in the mid-term and will eventually drive us to increase our target price in light of further news. Volcan s Oyama project, in Junin, consists of a 4.5m MT deposit with 0.71% Cu that is currently undergoing exploration works. The company plans to build a 3,000tpd treatment plant at a cost of $60m. Oyama could add up to 7,000MT Cu/year, starting Since Oyama is at an early stage of development, we are only including the deposit s resources to our financial model calculations. According to the company s 2010 annual report, Volcan s reserves stand at 148.4m MT (0.06% Cu, 1.15% Pb, 3.85% Zn, 305 oz/tm Ag), while the company s resources reach 161.7m. It is also worth noticing that reserves have climbed regularly over the last years, signaling the company s extensive effort in exploration activities is paying off Volcan's Total Reserves and Resources (Millons MT) Source: Volcan Reserves C.A.G.R. 23.1% C.A.G.R. 16.8% Resources Volcan s concentrate sales volume and cash cost Volcan s zinc and lead concentrate sales volume should be boosted by the gradual normalization of mining activities at the Cerro de Pasco unit, in which the company is carrying out optimization works. Please note that contributions from Vinchos are expected to remain null in the short-term. Cash cost should grow slightly in coming years in line with cost inflation and higher energy costs. However, we expect that in the long term, Volcan s hydroelectric projects will offer a comparative advantage in relation to other large mining companies in terms of cost-savings. Cash Cost $/MT Concentrate Sales (MT 000) Zinc Lead Copper This number includes Oyama s known resources. 3

4 Volcan s hydroelectric projects The company has an aggressive investment portfolio of hydroelectric projects. Volcan s energy needs in 2010 reached 72MW, 85% of the energy was purchased from the national power grid. The company is seeking to ensure its future energy supply by increasing its energy generation capacity from the current 13MW to 318MW beyond 2015, when Volcan s annual demand for capacity is expected to reach roughly 120MW. The excess of energy produced will be re-directed and sold to the national Interconnected System, creating an additional cash-flow source for the company. Moreover, as purchasing energy is significantly more expensive than creating it, some of these projects will also contribute to reduce the operational cash-cost of mining. Given the rapid growth of energy consumption in Peru, we believe these projects are set to offer much value to the company in the long-term. All in all, Volcan s hydroelectric projects add S/ to our Volcan B target price. Volcan s two most important hydroelectric projects are: Chancay is a 100MW hydroelectric project. Energy output could reach 550GW per year. An EIA has already been filed to the Ministry of Energy and Mines, so the company is waiting for the final approval to start its construction. We are assuming that Chancay will enter operations by 2015 at a total capex of $190m. Belo Horizonte is a newly purchased 180MW hydroelectric project in Huanuco. Energy output could reach 1,220 GW per year. We are assuming Belo Horizonte begins operations beyond 2015 at a total cost of $270m. New windfall tax scheme In September, the Congress approved a new a new windfall tax scheme that will replace the existing royalty system (currently between 1% to 3% of sales) and voluntary contributions. The new system will be focused on operating margins. Under this new tax scheme, marginal rates will be divided in brackets ranging from 4.0% to 13.12% for companies with tax stability agreements. Marginal tax brackets for companies without tax stability contracts range between 1.0% and 12.0% and they will also be subject to a special mining tax ranging from 2.0% to 8.4%. Mining companies will pay to the Tax Agency (SUNAT) a fraction of operating profit, or effective tax rate. The new scheme is set to be progressive and cumulative; as a result, the effective tax rate charged is considerably lower than the marginal tax rate assigned to the specific bracket that matches the company s operating margin. As a general rule, companies with higher operating margins will pay higher taxes. Disbursements under this new scheme will be considered as tax shields for income tax purposes (30% under current legislation). Volcan holds no tax stability contracts. New Windfall Taxes Scheme applicable to Volcan Royalty for Cias without Tax Stability Agreements Special Mining Tax Operating Margin Marginal Tax Effective Tax Operating Margin Marginal Tax Effective Tax Nº Ranges Rate Rate* Nº Ranges Rate Rate* 1 0% 10% 1.00% 1.00% 1 0% 10% 2.00% 2.00% 2 10% 15% 1.75% 1.25% 2 10% 15% 2.40% 2.13% 3 15% 20% 2.50% 1.56% 3 15% 20% 2.80% 2.30% 4 20% 25% 3.25% 1.90% 4 20% 25% 3.20% 2.48% 5 25% 30% 4.00% 2.25% 5 25% 30% 3.60% 2.67% 6 30% 35% 4.75% 2.61% 6 30% 35% 4.00% 2.86% 7 35% 40% 5.50% 2.97% 7 35% 40% 4.40% 3.05% 8 40% 45% 6.25% 3.33% 8 40% 45% 4.80% 3.24% 9 45% 50% 7.00% 3.70% 9 45% 50% 5.20% 3.44% 10 50% 55% 7.75% 4.07% 10 50% 55% 5.60% 3.64% 11 55% 60% 8.50% 4.44% 11 55% 60% 6.00% 3.83% 12 60% 65% 9.25% 4.81% 12 60% 65% 6.40% 4.03% 13 65% 70% 10.00% 5.18% 13 65% 70% 6.80% 4.23% 14 70% 75% 10.75% 5.55% 14 70% 75% 7.20% 4.43% 15 75% 80% 11.50% 5.92% 15 75% 80% 7.60% 4.63% 16 Above 80% 12.00% 6.60% 16 80% 85% 8.00% 4.82% 17 Above 85% 8.40% 5.02% Source: Peruvian Congress, Bills 00193/2011-PE and 00191/2011-PE. *The effective tax rates are calculated using the correspondent bracket ceiling. The bottom line is calculated considering a 90% operating margin. Volcan's expected operating margin 54.0% 51.2% 52.0% 49.2% 50.0% 48.0% 44.7% 46.0% 43.7% 44.0% 42.0% 40.0% 38.0% Source: Inteligo We have adjusted our financial model to include the effects of this new tax scheme on the company s cash generation. We have also adjusted our assumptions on the company s long term cost structure given the increase in the country s overall tax burden. All in all, we believe that the new tax scheme reduces Volcan B s per share value by S/

5 Risk to our Valuation Any delay in Volcan s silver investment program could affect our projections about the company s silver sales and thus, overall revenues. Positive results from the drilling program performed at Rondoni and Oyama could add value to the company as the management advances on the development of these projects. Target Price Determination In order to determine our target price, we have used a DCF analysis. Our main valuation parameters are: Time horizon: We are projecting a 7 years horizon for our model, with 2017 as the last projected year. Weighted Average Cost of Capital (WACC): Our WACC stands at 12.4%. It considers a 5.50% overall risk free rate and a 6.5% equity premium. Perpetuity growth (g): We are estimating a perpetuity growth rate of 3.5%, based on our estimate of implied long-term growth of the firm. According to our analysis, we set a 12-month fundamental target price of S/ and a BUY+ rating for Volcan B shares. In this sense, we believe that current share prices are below its fundamental value. 5

6 US$m Average Prices Silver $/oz Copper $/lb Zinc $/lb Lead $/lb Source: Inteligo, Bloomberg 1, Profit & Margins 60.0% 50.0% 40.0% 30.0% 20.0% Gross Profit Net Income EBITDA Margin EBITDA Margin Income Statement (US$m) Revenues , , ,248.8 Gross Profit Operating Expenses EBIT EBITDA Net Income EPS DPS Growth and Margins Revenues growth 46.9% 30.8% 15.0% -14.7% EBIT growth 99.2% 47.5% 19.7% -25.5% EBITDA growth 78.1% 42.0% 18.8% -21.2% Net Income growth 59.9% 40.2% 18.9% -25.5% Gross Margin 54.3% 61.1% 62.5% 56.3% Operating Margin 43.7% 49.2% 51.2% 44.7% EBITDA Margin 51.3% 55.7% 57.5% 53.1% Net Margin 28.0% 30.0% 31.0% 27.1% Equity/Assets 69.5% 74.1% 74.9% 75.3% 740,000 Zinc concentreate output (MT) Balance Sheet (US$m) Cash Assets 1, , , ,053.8 Financial Debt Liabilities Equity 1, , , , ,000 Free Cash Flow (US$m) 700, , ,000 EBITDA CAPEX Taxes Working Capital Change Free Cash Flow Volcan B 12-month performance Price (S/.) ,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Volume (US$000) Value Indicators P/E (x) 10.9x 7.8x 6.5x 8.8x EV/EBITDA (x) 5.2x 3.7x 3.1x 4.0x P/BV (x) 2.7x 2.3x 2.1x 1.9x P/Sales (x) 3.0x 2.3x 2.0x 2.3x ROA 19.2% 23.6% 51.3% 33.6% ROE 27.6% 32.9% 33.9% 22.7% Sales Volume Zinc concentrate (MT) 686, , , ,679 Lead concentrates (MT) 132, , , ,269 Copper concentrates (MT) 21,750 22,423 22,584 21,324 Silver (000 ounces) 20,083 20,873 25,706 27,322 Oct-10 Nov-10 Dec-10 Feb-11 Mar-11 May-11 Jun-11 Jul-11 Sep-11 Volume Price Source: Elex, Economatica 6

7 Analyst Certification The Research Analyst that prepared this report hereby certifies that the views expressed in it accurately reflect his/her views about the subject companies and their securities. The Analyst also certifies that he/she has not been, is not, and will not be receiving direct or indirect compensation for expressing the specific view in this report. General The information in this report has been obtained from sources believed to be reliable; however, Inteligo SAB does not warrant its completeness or accuracy except with respect to any disclosures relative to Inteligo SAB and the analyst s involvement with the issuer. Inteligo SAB accepts no liability, of any type, for any direct or indirect losses arising from the use of the document or its contents. Opinions and estimates constitute our judgement as of the date of this material release and are subject to changes without further notice. Past performance is not indicative of future results. The market prices of securities or instruments or the results of investments could fluctuate against the interests of investors. Investors should be aware that they could even face a loss on their investment. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and the ratings herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Therefore, investors should make their own investment decisions considering the said circumstances and obtain such specialized advice as may be necessary. Neither shall this document nor its contents form the basis of any contract, commitment or decision of any kind. The recipient of this report must take its own independent decisions regarding any securities or financial instruments mentioned herein. Inteligo SAB, as well as their executives and employees may have a position in any of the securities or instruments referred to, directly or indirectly, in this document, or in any other related thereto. They may trade for their own account or for third-party accounts in those securities, provide consulting or other services to the issuer of the aforementioned securities or instruments or to companies related thereto or to their shareholders, executives or employees. They also may have interests or perform transactions in those securities or instruments or related investments before or after the publication of this report, to the extent permitted by the applicable law. Rating System Inteligo SAB s stock ratings are set on a twelve-month basis against relevant benchmarks. There are four stock ratings: BUY +: Upside potential above the normal risk-adjusted return of the ISBVL; BUY: Upside potential above the normal risk free rate for Peru; HOLD: Stock is expected to maintain investors capital relatively unchanged; SELL: Stock is expected to cause a capital loss for investors. Expected Return StockX<0% 0%<Expected Return StockX<11% 11%<Expected Return StockX<21% 21%<Expected Return StockX SELL HOLD BUY BUY+ Inteligo SAB s calculation of price targets is based on a combination of one or more methodologies generally accepted among financial analysts, including, but not limited to, comparable valuations, discounted cash flows, whether in whole or by parts, or any other method which may be applied. The determination of a price target does not imply any warrant that it will be attained, since this depends on other intrinsic and extrinsic factors that affect both the performance of the company and trends in the stock market on which it is based. Security Restrictions No part of this document may be (I) copied, photocopied or duplicated by any other form or means (ii) redistributed or (iii) quoted without the consent of Inteligo SAB. 7