MANAGEMENT S DISCUSSION AND ANALYSIS

Transcription

1 MANAGEMENT S DISCUSSION AND ANALYSIS This Management s Discussion and Analysis ( MD&A ) of the financial position and results of operations of Noranda Income Fund (TSX: NIF.UN) is the responsibility of management and has been prepared as at February 12, The board of trustees of Noranda Operating Trust carries out its responsibility by reviewing this disclosure principally through its audit committee and it approves this disclosure prior to its publication. This MD&A provides a review of the consolidated financial position, results of operations and performance of Noranda Income Fund (the Fund ), Noranda Operating Trust (the Operating Trust ), Ontario Inc. ( Ontario Inc ), Canadian Electrolytic Zinc Limited (the Manager and alternatively, the Administrator ) and the Noranda Income Limited Partnership (the Partnership ) for the years ended December 31, 2012 and It should be read in conjunction with the Fund s audited consolidated financial statements and notes to those statements. The Fund has prepared its consolidated financial statements for the years ended December 31, 2012 and 2011 in accordance with International Financial Reporting Standards ( IFRS ). All amounts are expressed in Canadian dollars, the Fund s reporting currency, except where indicated. Additional information regarding the Fund, including the Fund s Annual Information Form dated March 21, 2012, is available on SEDAR at This MD&A contains forward-looking information and forward-looking statements within the meaning of applicable securities laws. See Forward Looking Information below HIGHLIGHTS AND SUBSEQUENT EVENTS The Fund completed an internal reorganization that eliminated the requirement for an inkind distribution, starting in fiscal The Fund issued a monthly cash distribution of $ per unit to Priority Unitholders in each of the twelve months of The Fund increased its 2013 capital investment program by $20 million to improve the Processing Facility s silica removal capability. The Board of Trustees, through its Independent Committee, has retained the services of an industry consultant to assist in identifying possible alternative sources of zinc concentrate after the expiry of the Supply and Processing Agreement in May Earnings before finance costs and income taxes were $66.7 million compared to $59.9 million in Zinc premiums were 25% or $8.6 million higher than in The Processing Facility received an increased supply of zinc concentrate in the fourth quarter. 1

2 This allows for greater flexibility in blending the new with the current feed mix ensuring a gradual transition. At the same time, the Processing Facility is positioning itself to be able to treat a more varied feed quality mix, prior to the expiration of the Supply and Processing Agreement in OVERVIEW The Fund is an unincorporated open-ended trust, established under the laws of Ontario, whose priority units (the Priority Units ) trade on the Toronto Stock Exchange ( TSX ) under the symbol NIF.UN. The Fund was created to acquire Noranda Inc. s CEZinc electrolytic zinc plant and processing facility (together with the associated roasters, acid plants, remediation facilities, settling ponds, wastewater treatment plants and related assets and equipment) (the Processing Facility ), located in Salaberry-de-Valleyfield, Québec, in As at June 30, 2005, Noranda Inc. changed its name to Falconbridge Limited ( Falconbridge ) pursuant to a corporate amalgamation. Falconbridge subsequently changed its name to Xstrata Canada Corporation ( Xstrata Canada ) after being acquired by Xstrata plc ( Xstrata ). In November 2012, Xstrata s shareholders approved the proposed all-share merger of Xstrata and Glencore International plc. The Administrator, a wholly-owned subsidiary of Xstrata Canada (through its Xstrata Zinc Canada division), operates and manages the Operating Trust and the Partnership and administers the Fund. The board of trustees of the Operating Trust (the Board or the Trustees ), the majority of whom are independent from Xstrata Canada, oversees the Fund. The Fund is, in turn, the sole unitholder of the Operating Trust. Concurrently with the creation of the Fund and the acquisition of the Processing Facility by the Partnership from Noranda Inc. in 2002, the Administrator entered into various 15-year agreements with the Fund and/or the Operating Trust relating to the management, administration and operation of the Fund, the Operating Trust, the Partnership and the Processing Facility. The initial term of these agreements will end on May 2, 2017 and will automatically renew for a fiveyear term thereafter, unless terminated in accordance with the terms. Upon the termination of the operating and management agreement, the Partnership will acquire the Manager from Xstrata Canada. 1. Pursuant to an administration agreement dated April 18, 2002 between the Fund and the Administrator (the Administration Agreement ), Computershare Trust Company of Canada, the sole trustee of the Fund (the Sole Trustee ), has delegated all of its power and authority to the Administrator, and the Administrator provides administrative and support services to the Fund. 2

3 2. Pursuant to a management services agreement dated April 18, 2002 between the Operating Trust and the Manager (the Management Services Agreement ), the Manager provides management services to the Operating Trust. 3. Pursuant to an operating and management agreement dated May 3, 2002 between the Manager and the Partnership (the O&M Agreement ), the Manager operates and maintains on an ongoing basis, the Processing Facility owned by the Partnership and provides management services to the Partnership. 4. In addition, Xstrata Canada and the Partnership are parties to a supply and processing agreement dated May 3, 2002 (the Supply and Processing Agreement ), pursuant to which Xstrata Canada is obligated, except in certain circumstances, to sell to the Partnership until May 2017 all of its zinc concentrate requirements up to 550,000 tonnes of zinc concentrate per year at a concentrate price based on the price of zinc metal on the London Metal Exchange ( LME ) for the payable zinc metal contained in the concentrate, less a fixed, escalating processing fee (calculated in Canadian dollars). Pursuant to the Supply and Processing Agreement, Xstrata Canada acts as exclusive agent for the Partnership to arrange for purchases of any additional zinc concentrate in excess of the 550,000 tonne amount described above, and for sales of zinc metal and byproducts and related hedging and derivative arrangements. The initial term of the Supply and Processing Agreement will end on May 2, 2017 and will automatically renew for a five-year term thereafter, unless Xstrata Canada provides the Partnership with written notice to the contrary at least 180 days prior. Under any renewal, Xstrata Canada would act as agent for the Partnership for the purchase of zinc concentrate and the Partnership would pay the market cost of the zinc concentrate that it receives. Xstrata Canada would also act as exclusive sales agent for the purchase of zinc concentrate and the sale of zinc metal and by-products and related hedging and derivative arrangements. Further details concerning these arrangements relating to the management, administration and operation of the Fund and its subsidiaries, and the supply and processing of concentrate at the Processing Facility are described under Transactions with Related Parties below. The Processing Facility, which the Fund indirectly owns through the Partnership, produces refined zinc metal and various by-products from zinc concentrate purchased from mining operations and sells refined zinc products to customers in the open market. The Fund earns a processing fee for transforming zinc concentrate into zinc metal and it earns additional revenue from premiums, by-product revenues and metal gains. The Processing Facility is favourably located along major transportation networks which connect it to its principal markets in the United States and Canada. Zinc is central to our daily lives. Its main use is to galvanize steel for the construction and automotive industries. Zinc is also used in the production of die-castings and brass. Zinc powders, oxide and dust are used in the manufacture of batteries, rubber tires, pigments and various creams. 3

4 Long-Term Strategy The Board is charged with evaluating the Fund s long-term strategy, and for evaluating and supervising the formulation and execution of the Fund s business and operating plans, which the Manager prepares. The main issue facing the Fund is the continued source of zinc concentrate to keep the Processing Facility running at full capacity after the expiry of the Supply and Processing Agreement in May of The Supply and Processing Agreement will be automatically renewed with Xstrata Canada for successive periods of five years unless Xstrata Canada provides the Partnership with written notice to the contrary at least 180 days prior to the expiry of the applicable term (by November 2016), of its decision with respect to an extension, if any, beyond May In order to prepare for the potential non-renewal of the Supply and Processing Agreement by Xstrata Canada and given the uncertainty regarding zinc concentrate supply, the Board, under the guidance of its Independent Committee, undertook a review in 2011 to determine the availability of funds for future distributions while at the same time, to determine whether the Fund would be able to secure zinc concentrate in the market, should the Supply and Processing Agreement not be renewed. The resulting report indicated, without concluding and subject to certain major assumptions, that the Processing Facility could operate profitably after May 2017 if the Fund was able to secure zinc concentrate in the market. In 2012, the Board, through its Independent Committee, felt it would be prudent to identify possible alternative sources of zinc concentrate after the expiry of the Supply and Processing Agreement, knowing that the Partnership may be required to commit funds to ensure its continued supply. There can be no assurance that alternative sources of zinc concentrate will be available or, if available, would be available in sufficient quantities to run the plant at full capacity and on terms and conditions, including pricing, that will allow the Processing Facility to continue to operate profitably. Another step that was taken in 2012 was the commitment to increase the 2013 capital investment program, enabling the Processing Facility to treat a more varied feed quality mix. During the year, the Fund was advised that with the closure of Brunswick Mine, the Processing Facility may be required to treat concentrate containing higher levels of impurities. In order for the Processing Facility to be able to treat a more varied feed quality mix in the future, it is important that it increase its silica removal capabilities. Approximately $20 million will be invested in 2013 to do so. Also in the fourth quarter of 2012, the Processing Facility received an increased supply of zinc concentrate. Over the next year, the increased concentrate availability will allow greater 4

5 flexibility in blending the new with the current feed mix ensuring a gradual transition. At the same time, the Processing Facility is positioning itself to be able to treat a more varied feed quality mix, prior to the expiration of the Supply and Processing Agreement in Other Developments In 2012, the Board, through its Independent Committee, felt it would be prudent, and has since retained the services of an industry consultant to assist in identifying possible alternative sources of zinc concentrate after the expiry of the Supply and Processing Agreement. Cash Distributions In 2012, the Board approved a monthly cash distribution of $ per Priority Unit in each of the twelve months of the year. There is no assurance that monthly distributions will continue in the future; nor is there any assurance that, if they do continue, the level or frequency of such monthly distributions will not vary from the level of the most recent monthly cash distribution. The Fund s distribution policy and practices are impacted by various risks, uncertainties and other factors, which are discussed in greater detail in this section and in the sections entitled Distribution Policy, Liquidity and Capital Resources and Forward-Looking Information below. Reorganization The Independent Committee of the Board, together with the Board, reviewed the tax impact and other consequences to the Fund and its Unitholders for the Fund to convert to a corporation, while considering the impact of remaining as a trust. The Independent Committee engaged Canaccord Genuity to act as an independent advisor to assist them in this regard. In 2012, the Independent Committee decided not to pursue a conversion of the Fund to a corporation. The conversion could only have been completed on terms that were acceptable to both unitholders of the Fund and Xstrata Canada, the holder of the Ordinary Units of the Partnership. The Independent Committee and Xstrata Canada discussed the terms on which such a conversion could occur, but they were unable to reach an agreement. As an alternative to a conversion to a corporation, the Trustees, with the support of Xstrata Canada, approved an internal reorganization that eliminated the need for the Fund to declare an annual in-kind distribution to reduce its effective tax rate, commencing in fiscal On December 7, 2012, the Fund completed the internal reorganization. Upon completion of the reorganization, the Operating Trust owns all the shares of a newly-formed company, Ontario Inc. Ontario Inc., in turn, owns the Partnership s Class A Partnership Units that were previously owned by the Operating Trust. As a result of this reorganization, it is expected that unitholders will be taxed only on the income received as cash distributions. 5

6 The reorganization did not affect any of the arrangements between Xstrata Canada and the Fund or the Partnership, including the subordination of distributions on Xstrata Canada's Ordinary Units. RESULTS OF OPERATIONS Selected Financial Highlights ($ millions, except per-unit amounts) Sales $594.6 $663.0 $659.1 Revenues less raw material purchase costs Earnings before income taxes Increase in net assets atttributable to Unitholders Total assets Bank and other loans Cash distributions declared per Priority Unit In-Kind Distributions declared per Priority Unit Distributions declared per Ordinary Unit $ - $ - $ - In 2012, sales were $594.6 million or 10% lower than the $663.0 million which was recorded in The main factors explaining this drop include: Zinc metal revenues in 2012 were lower because of an 11% reduction in the average LME zinc price and a 2% reduction in zinc metal sales volumes compared to By-product revenues from sulphuric acid and copper in cake decreased to $43.4 million in 2012 from $50.4 million in The decrease was mainly due to lower copper sales and prices. These results were partially offset by higher zinc premiums, processing fee and recoveries. In 2012, zinc premiums rose to US$0.075 per pound, up from US$0.059 per pound in The increase in realized 2012 zinc premiums compared to the previous year reflects the impact of improved annual contract terms. Transportation and distribution costs in 2012 of $16.9 million were lower than the $18.7 million recorded in In 2012, zinc metal deliveries to customers and copper in cake shipments to Europe for treatment were lower. Raw material purchase costs in 2012 were $288.1 million compared to $340.4 million in The decrease was mainly due to the lower average LME zinc metal price and lower volumes of zinc metal sales. Revenues less raw material purchase costs ( Net Revenues ) in 2012 were $289.6 million compared to $303.8 million in The $14.2 million decrease was mainly due to lower by- 6

7 product revenues and the provisional pricing feature of the Supply and Processing Agreement which decreased the raw material purchase costs in 2011, partially offset by the impact of higher premiums. Production costs before change in inventory in 2012 were $169.9 million compared to $179.4 million recorded in The decrease in costs in 2012 was mostly due to lower labour, contractor and energy costs, partially offset by higher operating supplies costs. In 2011, there was a non-recurring $6.4 million labour cost increase for additional pension benefits and early retirement provisions in the new three-year collective agreement. Production Cost Breakdown Increase/ ($ millions) (decrease) Labour $ 57.3 $ 62.9 $ (5.6) Energy (0.7) Operating supplies Other (4.7) Production cost before change in inventory (9.5) Change in inventory (0.9) 1.8 (2.7) $ $ $ (12.2) Selling and administration costs in 2012 were $21.1 million compared to $20.1 million in 2011 due to higher labour and insurance costs. The foreign currency gain in 2012 was $0.7 million compared to a loss of $0.9 million in The foreign exchange gain in 2012 was primarily a result of the impact of the strengthening Canadian dollar on the Fund s net US monetary liabilities. The foreign exchange gain was largely offset by a decrease in the value of in-process and finished inventory. The decrease in the value of inventory is realized in Net Revenues as the metal is sold to customers (thereby decreasing the Net Revenue recorded by the Fund). The Fund s main US denominated balances are comprised of cash and cash equivalents, accounts receivable, accounts payable and a portion of its debt. In 2012, the gain on the derivative financial instruments was $1.0 million. In 2011, the loss on the derivative financial instruments was $3.5 million. During these periods, the change in the market value of the Fund s financial instruments resulted in these amounts being recorded. In 2012, depreciation was $33.5 million compared to the $34.1 million recorded in The higher depreciation in 2011 was due to the reduction in zinc metal inventory, as depreciation that was previously recorded in inventory was realized upon the sale of the zinc metal. In 2012, the rehabilitation expense was $3.2 million lower at $0.9 million, compared to $4.1 million in The expenses were due to a decrease in the risk-free interest rate used to discount the liabilities, resulting in an increase in the liabilities. 7

8 In 2012, net finance costs were $8.0 million compared to $16.1 million in The decrease was due to lower average debt outstanding and due to a $5.5 million reduction in the accretion of deferred financing fees during the year. The current income tax expense was $15.3 million in 2012 compared to $19.0 million in Prior to the Fund s reorganization in December 2012, the Fund was required to record tax expense using the undistributed rate for both its current and deferred taxes, being the highest marginal personal tax rate of approximately 48%. Upon the distribution of taxable income, the income tax provision was adjusted on the distribution to a tax rate of 26.9%. The impact of this adjustment in 2012 was $4.1 million. As a result of the reorganization, deferred tax assets and liabilities were re-measured using the tax rate applicable to a corporation, which does not vary depending on whether income is distributed or not. The effect of the change in the tax rate was to reduce the deferred tax liability by $9.1 million, which was recorded as a deferred income tax recovery. Summary of Quarterly Results The following table provides a summary of quarterly results for the two years ended December 31, 2012 and 2011: Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Revenues $150.7 $128.6 $152.6 $145.8 $137.8 $160.9 $164.6 $181.0 Increase (decrease) in net assets attributable to Unitholders $22.2 $2.3 $3.5 $6.5 $ (13.5) $9.3 $6.0 $10.7 Production (tonnes) 74,748 60,615 65,521 62,813 67,504 63,923 67,906 63,953 * 1 tonne = 2, pounds Fourth-Quarter 2012 Results The Fund reported earnings before finance costs and income taxes of $24.3 million in the fourth quarter of 2012 compared to $2.4 million in the same quarter a year ago. The $21.9 million increase was mainly due to higher revenues being realized in 2012 compared to In addition, in 2011 a non-recurring $7.1 million cost increase was recorded for additional pension benefits and early retirement provisions in the new three-year collective agreement. Revenues in the fourth quarter of 2012 were $150.7 million, up from the $137.8 million recorded in the same quarter of Much of this increase was due to higher zinc metal and copper in cake sales, and higher premiums and copper prices, partially offset by lower sulphuric acid sales. 8

9 Q Q Zinc metal production (tonnes) 74,748 67,504 Zinc metal sales (tonnes) 67,511 63,655 Zinc metal premium (US$/pound) By-product revenues ($ millions) Copper in cake production (tonnes) Copper in cake sales (tonnes) Sulphuric acid production (tonnes) 99, ,798 Sulphuric acid sales (tonnes) 97, ,541 Average LME copper price (US$/pound) Sulphuric acid netback (US$/tonne) * 1 tonne = 2, pounds In the fourth quarter of 2012, zinc metal production was a record 74,748 tonnes compared to 67,504 tonnes in the same quarter of Zinc metal production was higher because of a significant reduction in the third quarter work-in-process inventory. Zinc recoveries in the fourth quarter of 2012 were 97.6% compared to 96.6% in the fourth quarter of Fourth quarter 2012 sales were 67,511 tonnes versus 63,655 tonnes in the fourth quarter of In the fourth quarter of 2012, zinc metal demand from the galvanizing and the die cast alloy sectors was supported by improved automotive sales and a recovery in private construction. Zinc metal premiums were US$0.075 per pound in the fourth quarter of 2012 compared to US$0.058 per pound in the same quarter of 2011, primarily due to higher premiums realized on contract sales. In the fourth quarter of 2012, the Fund generated $12.2 million in revenue from the sale of its copper in cake and sulphuric acid compared to $11.2 million achieved in the fourth quarter of Revenues from the sale of sulphuric acid were $7.7 million in the fourth quarter of 2012, up from $7.5 million in the fourth quarter of 2011, as a result of higher netbacks. Sulphuric acid sales totalled 97,419 tonnes in the fourth quarter of 2012, compared to 100,541 tonnes in the fourth quarter of Copper in cake revenues were $3.4 million in the fourth quarter of 2012 compared to $3.7 million in the fourth quarter of 2011, as a result of a negative provisional pricing settlement in 2012 compared to a positive provisional pricing settlement in 2011, offset by higher copper prices and sales volumes. Copper in cake sales volumes in the fourth quarter of 2012 totalled 734 tonnes compared to 585 tonnes in the corresponding period of Cash provided from operating activities, before net changes in non-cash working capital items in the fourth quarter of 2012, was $17.4 million compared to $18.0 million in the fourth quarter of During the fourth quarter of 2012, non-cash working capital increased by $36.5 million. The increase in working capital resulted primarily from an increase in inventories, accounts 9

10 receivable and income taxes payable, partially offset by an increase in accounts payable and accrued liabilities. The increase in inventories in the fourth quarter was a result of additional deliveries of zinc concentrate that were received. The increased concentrate availability allows for more flexibility in blending the various feeds, ensuring a gradual transition to the new feed mix in Capital expenditures in the fourth quarter of 2012 were $9.0 million, compared to $9.1 million in the fourth quarter of Sustaining capital accounted for almost all of the expenditures in the last quarter of Cash distributions paid to Priority Unitholders during the fourth quarter of 2012 totalled $4.7 million, unchanged from the fourth quarter of KEY PERFORMANCE DRIVERS The principal factor affecting the Fund s performance is the processing of zinc concentrates into zinc metal. This activity results in the Fund earning a processing fee. In 2012, the processing fee accounted for 74% of the Fund s Net Revenues ( %). A second key factor affecting the performance of the Fund is the premiums that are realized on the sale of zinc products to customers. Zinc metal is sold to customers on the basis of an LME zinc price plus a premium that is negotiated between the buyer and seller. Premiums can vary according to various factors including product form, quantity, quality and payment terms. In 2012, product premiums accounted for 10% of the Fund s Net Revenues (2011 6%). By-product revenues (copper in cake and sulphuric acid) and zinc metal recovery gains generated 14% and 2%, respectively, of the Fund s Net Revenues in 2012 ( % and 2%). The Canada/US exchange rate also impacts the Fund s performance through premiums, byproduct revenues and zinc recovery gains which, collectively, represented 26% of the 2012 Net Revenues ( %). As the processing fee is earned in Canadian dollars, 74% of the Fund s Net Revenues are not exposed to currency risk. Two other performance drivers that impact the Fund are managing costs and a disciplined use of capital. The Fund provides annual guidance for a number of its key performance drivers, including production, sales, processing fee and capital expenditures. Guidance for 2013 key drivers can be found in Outlook below. The following table provides a summary of the performance of these key drivers for the years ended December 31, 2012 and The discussion of key performance drivers that follows is subject to various risks and uncertainties, some of which are discussed under Risks and Uncertainties and Forward-Looking Information below, which investors are encouraged to read carefully. 10

11 Year Zinc concentrate processed (tonnes) 497, ,851 Zinc grade (%) Zinc recovery (%) Zinc metal production (tonnes) 263, ,286 Zinc metal sales (tonnes) 260, ,814 Processing fee (cents/pound) Zinc metal premium (US$/pound) By-product revenues ($ millions) Copper in cake production (tonnes) 2,202 2,604 Copper in cake sales (tonnes) 1,951 3,396 Sulphuric acid production (tonnes) 408, ,003 Sulphuric acid sales (tonnes) 410, ,010 Average LME copper price (US$/pound) Sulphuric acid netback (US$/tonne) Average LME zinc price (US$/pound) Average US/Cdn. exchange rate * 1 tonne = 2, pounds Zinc Metal Production Capacity The amount of zinc metal produced in a year is a function of four main factors: (1) the volume of zinc concentrate processed; (2) the grade of the zinc concentrate processed; (3) the zinc recoveries; and (4) changes to work-in-process inventory levels. In 2012, 497,183 tonnes of zinc concentrate was processed compared to 504,851 tonnes in In 2012, the average concentrate grade was 54.0% and zinc recovery was 97.2% compared to 54.1% and 96.8%, respectively, in While the quantity of zinc concentrate processed in 2012 was lower than in 2011, zinc metal production in 2012 was 263,697 tonnes, unchanged from the 263,286 tonnes produced in 2011 because zinc recoveries were higher and because of a drawdown of work-in-process inventories, particularly in the fourth quarter of The Fund pays for 96% of the zinc in the concentrate it purchases; therefore, any recovery over 96% results in additional revenue for the Fund. In 2012, the bulk of the zinc concentrate came from six mines: Brunswick, Antamina, Perseverance, Kidd Creek, Langlois and Mount Isa. Five of the six mines are owned or partlyowned by entities within the Xstrata Zinc group. The Processing Facility Transitions to a New Feed Mix In March 2012, Xstrata Zinc Canada announced that Brunswick Mine was expected to close no later than March This Mine has been a major supplier to the Processing Facility for most 11

12 of the fifty years that the Processing Facility has operated. With the closure of Brunswick Mine, the future feed mix to the Processing Facility may contain an increased level of impurities. During 2012, there was no material change to the level of impurities in the concentrate that was treated. While future feeds are expected to still be within the specifications set out in the Supply and Processing Agreement, the Processing Facility may experience an increase in its operating costs, working capital requirements and/or capital expenditures as a result of being required to treat a more varied feed quality stream. Higher amounts of impurities may also negatively impact the volume of zinc concentrate that can be processed, resulting in a lower overall production. In December 2012, the Fund announced that it was making a capital investment of $20 million in 2013 to increase the Processing Facility s capability for removing silica, an impurity in the zinc concentrate. Approximately $5 million has been approved to procure long-delivery items, conduct a pilot plant study and complete feasibility engineering on the project. The bulk of the investment is expected to occur in 2013 and the project is scheduled to be completed by June In addition, as a result of the expected feed changes noted above, the Processing Facility received increased deliveries of zinc concentrate in the fourth quarter of The additional concentrate will be used for blending with the new feed mix, ensuring a gradual transition. The additional concentrate deliveries increased inventories by approximately $28.1 million in Most of this additional concentrate is expected to be processed by the third quarter of Going forward, inventory levels are expected to be more variable, as larger and more irregular seaborne deliveries of concentrate will replace some of the regular rail deliveries from Ontario, Québec and New Brunswick. The fact that the Processing Facility successfully treated higher levels of silica in concentrate feeds in December 2012 was very encouraging. Going forward, the ability of the Processing Facility to treat a wide variety of zinc concentrate feeds is required so that it can continue to operate at full capacity. Liner Replacement Project In 2010, the Processing Facility began a project to replace the liners protecting the concrete walls in the cell house. It was expected to be completed by mid-2013, however, the Fund announced in the third quarter 2012 MD&A, the decision to delay the completion of the project until the end of The rationale was to maximize zinc metal production during the fourth quarter of This, in fact, occurred with fourth quarter production reaching a new record of 74,748 tonnes. The delay in the completion of the project is not expected to impact the overall capital expenditure for the project. The project requires that two cells are always off-line for rehabilitation, thereby reducing availability of the cell house by approximately 2%. The target for 2013 annual production is 265,000 tonnes. The annual zinc metal production capacity of the Processing Facility, under normal operating conditions, is 270,000 tonnes of zinc. The Fund continues to believe that the Supply and Processing Agreement will provide sufficient 12

13 concentrate to run the Processing Facility at its productive capacity until its anticipated expiry in The targets for annual zinc metal production and the timing of the completion of the replacement of the cell house liners, and future expected annual production capacity, operating costs, working capital, capital expenditures, the level of impurities in the concentrate and the level of the zinc concentrate inventory are subject to various risks and uncertainties, some of which are set out under Forward-Looking Information below. Sales Zinc metal is used in a wide range of industries. Its major use is in the production of galvanized steel. Sales in 2012 were 260,401 tonnes compared to 266,814 tonnes in During the year, zinc metal inventories increased by approximately 3,300 tonnes. Processing Fee In 2012, the processing fee was $0.392 per pound ($864 per tonne), compared to $0.389 per pound ($858 per tonne) in The processing fee is adjusted annually: (i) upward by 1% and (ii) upward or downward by 10% of the year-over-year percentage change in the average cost of electricity per megawatt hour for the Processing Facility. Based on the annual 1% increase and the average increase in electricity costs, the processing fee for 2013 is expected to be $0.395 per pound. Premiums Zinc metal premiums averaged US$0.075 per pound in 2012 compared to US$0.059 per pound in The increase in realized premiums compared to last year reflected the impact of improved annual contract and spot premiums in North America. By-products The Fund produces copper in cake and sulphuric acid as by-products from refining zinc concentrate. In 2012, the Fund generated $43.4 million in revenue from the sale of its copper in cake and sulphuric acid compared to $50.4 million in Copper in Cake Copper in cake revenues in 2012 were lower at $11.1 million compared to $20.4 million in The main reason for the significant drop in revenue was the decline in copper in cake sales volumes to 1,951 tonnes in 2012 from 3,396 tonnes in the prior year. This result was because of the lower copper content in the 2012 feed mix. In 2012, copper prices were also lower at $3.61 per pound, compared to $4.00 per pound in Sulphuric Acid Revenues from the sale of sulphuric acid rose to $31.0 million in 2012 from $29.5 million in Sulphuric acid netbacks in 2012, which were supported by higher spot and contract pricing, rose to US$76 per tonne from US$72 per tonne in Sales volumes were lower in 2012 at 410,358 tonnes compared to 414,010 tonnes a year ago. Although sulphuric acid market fundamentals weakened towards the end of 2012, contract 13

14 pricing which applied to about 85% of sales, kept the Fund s sulphuric acid netback strong for the year. Exchange Rate The stronger Canadian dollar has had a negative impact on the Fund s financial results. In 2012, a one-cent Canadian strengthening in the average Canadian/US exchange rate would have negatively impacted the Fund s earnings before finance costs and income taxes by approximately $0.8 million. In 2012 and 2011, the Canadian dollar remained stable at an annual average of $1.00 per US dollar. See also Risks and Uncertainties below. Costs Production costs before change in inventory in 2012 were $169.9 million compared to $179.4 million recorded in The decrease in costs in 2012 was mostly due lower labour, contractor and energy costs, partially offset by higher operating supplies costs. In 2011, there was a nonrecurring $6.4 million labour cost increase for additional pension benefits and early retirement provisions in the new three-year collective agreement. Capital Expenditures Capital spending was $27.0 million in 2012 compared to $27.3 million in Most of the annual 2012 capital investment was spent on sustaining the Fund s operations, including $3.7 million on the cell house rehabilitation project and $9.0 million on replacement anodes for the cell house. Adjusted Earnings before Distributions to Unitholders, Finance Costs, Income Taxes, Depreciation and Amortization ( Adjusted EBITDA ) Adjusted EBITDA is used by the Fund as an indication of cash generated from operations. Adjusted EBITDA is not a recognized measure under IFRS and therefore the Fund s method of calculating Adjusted EBITDA is unlikely to be comparable to methods used by other entities. The Fund s Adjusted EBITDA is calculated by adjusting earnings before finance costs and income taxes for all of the non-cash items such as depreciation, rehabilitation expense, net change in employee benefits, loss on the sale of assets, changes in fair value of embedded derivatives and non-cash gains/(losses) on derivative financial instruments. The Fund s Adjusted EBITDA is currently supported by the stability provided in the Supply and Processing Agreement. It may be subject to more variability when this agreement expires in A reconciliation of Adjusted EBITDA in 2012 and 2011 is provided below: 14

15 Adjusted EBITDA ($ thousands) Earnings before finance costs and income taxes $ 66,654 $ 59,860 Depreciation of property, plant and equipment 33,502 34,126 Net change in rehabiliation liability 521 4,111 (Gain) loss on derivative financial instruments (2,899) 3,757 Change in fair value of embedded derivatives 5,593 (11,254) (Gain) loss on sale of assets (380) 746 Net change in employee benefits (2,331) 6,245 $ 100,660 $ 97,591 OPERATING CASH FLOWS Cash provided by operating activities in 2012, before net changes in non-cash working capital items, was $64.6 million compared to $71.5 million in During 2012, non-cash working capital increased by $39.3 million due to an increase in accounts receivable and inventories and an increase in the income taxes payable. During 2011, non-cash working capital decreased by $55.3 million due to a decrease in accounts receivable and inventories and an increase in the income taxes payable. DISTRIBUTION POLICY Distribution Policy When not restricted and when possible, and as may be considered appropriate by the Board, the Fund s policy is to make distributions at sustainable levels to Unitholders equal to distributable cash flows from operations (as discussed below). The Fund determines the cash available for distribution, if any, on a monthly basis for the Unitholders of record of the Fund on the last business day of each calendar month and these distributions are to be paid on or about 25 days thereafter. In 2012, the Board approved monthly cash distributions of $ per Priority Unit in each of the twelve months of the year. The Board has determined that monthly distributions of $ can be sustained for the present time. Cash distributions on the Ordinary Units of the Partnership held indirectly by Xstrata Canada are subordinated to distributions on Priority Units of the Fund until May 2017, except upon the occurrence of certain events. In the event of an exchange of Ordinary Units on a one-for-one basis for Priority Units on or after May 2, 2017, or earlier upon the occurrence of an early exchange event, any accumulated deficiency amount related to the Ordinary Units prior to the exchange is not accrued by the Fund until such time that excess cash is available for distribution above the monthly cash distribution of $ per Priority Unit, and a cash distribution is approved by the Board. Upon the 15

16 exchange, the holder of Ordinary Units has the right to receive any distribution declared but not paid on the Ordinary Units as at that time and a promissory note in the amount of the outstanding accumulated deficiency amount. Subsequent to an exchange, there is no further accumulation of the deficiency amount. As a result of Xstrata Canada s subordination, no distributions have been declared to the Ordinary Units since January The accumulated distribution deficiency amount was $10.8 million as at December 31, 2012 and $11.4 million as at February 12, For further details on the terms of the subordination, reference should be made to the Fund s Partnership Agreement dated May 1, 2002, which is available on SEDAR at There is no assurance that monthly distributions will continue in the future; nor is there any assurance that, if they do continue, the level or frequency of such monthly distributions will not vary from the level of the most recent monthly cash distribution. The Fund, as a specified investment flow-through ( SIFT ), is subject to tax on its "non-portfolio earnings" (as defined in the Income Tax Act (Canada) (the ITA )) (the "NPE") at the same rate as a Canadian corporation provided it distributes a sufficient portion of such earnings to Unitholders. The Fund is required by its Trust Indenture to distribute each year amounts equal to the sum of its non-npe and a specified percentage of its NPE ( %; %) for the year so as, to the extent possible, minimize its liability for tax under the ITA in the year. Such distributions are to be made in cash, unless the Fund is restricted from distributing cash or sufficient cash is not available, in which case such distributions are to be satisfied in whole or in part by the issuance of additional Priority Units having a value equal to the amount of cash which is unavailable for distribution. Following such an in-kind distribution, the Priority Units are automatically consolidated such that each certificate representing a number of units prior to the in-kind distribution of additional units is deemed to represent the same number of units after the distribution of additional units and the consolidation. In December, 2012, the Fund completed an internal reorganization which eliminated the requirement for an in-kind distribution commencing in fiscal On December 12, 2011, the board of trustees of the Operating Trust approved an in-kind distribution of $21.7 million or $0.58 per unit to the Fund s Priority Unitholders of record as at December 31, 2011, in accordance with the provisions of the Trust Indenture. The Fund s distribution policy and practices are impacted by various risks, uncertainties and other factors, which are discussed in greater detail in this section and in the sections entitled Liquidity and Capital Resources and Forward-Looking Information below. Cash Available for Distribution The Fund s objective is to maximize unitholder value and, when possible, make a sustainable level of distributions to Unitholders. 16

17 Cash available for distribution is used by the Fund as an indication of cash generated from operations that is available for distribution to Unitholders. Cash available for distribution is not a recognized measure under IFRS and therefore the Fund s method of calculating cash available for distribution is unlikely to be comparable to methods used by other entities. Cash available for distribution is calculated by taking cash provided by (used in) operating activities before distributions to Unitholders and changes in non-cash working capital, and by subtracting purchases of equipment, debt financing cost and permanent debt repayments, cash provided by the Manager s operating activities and amounts retained for reserves. Distributable cash per Priority Unit and Ordinary Unit is calculated as distributable cash divided by the number of Priority and Ordinary Units outstanding, respectively at the end of the year. Reserves reflect amounts that may be required to pay for potential closure costs at the Processing Facility and other amounts as considered necessary by the Board. The closure costs include estimated severance payments, pension and retirement benefit plans and site rehabilitation costs. The amounts required to fund such reserves have been established by third-party independent professionals based on certain assumptions. Should these assumptions need to be modified due to changing circumstances, the amount of the necessary reserves may increase or decrease, with a corresponding effect on cash available for distribution. The Fund is also subject to the Operating Trust maintaining a minimum excess availability of cash per the asset-based revolving credit facility (the ABL Facility ) and other customary restrictions pursuant to the terms of both its ABL Facility and the senior secured notes ( the Notes ) (as discussed below under Liquidity and Capital Resources ). A reconciliation of cash provided by operations to cash available for distribution for the periods January 1, 2012 to December 31, 2012 and July 1, 2011 to December 31, 2011 is provided below: 17

18 January 1, 2012 July 1, 2011 to to ($ thousands) December 31, 2012 December 31, 2011 Cash provided by operating activities $ 25,314 $ 68,387 Capital adjustments: Purchase of property, plant and equipment (27,013) (14,303) Debt financing costs - (5,088) Total capital adjustments (27,013) (19,391) Other adjustments: Distributions declared to Priority Unitholders 18,750 6,249 Scheduled debt repayment (15,000) (7,500) Increase/(decrease) in non-cash working capital 39,297 (31,510) Elimination of the Manager's cash provided by operating activities (193) (99) Total other adjustments $ 42,854 $ (32,860) Distributable Cash before reserve $ 41,155 $ 16,136 Increase in reserve (22,405) (9,887) Distributable Cash $ 18,750 $ 6,249 Weighted average number of Priority Units outstanding (basic and diluted) 37,497,975 37,497,975 Distributable cash per Priority Unit $ $ Distributions declared per Priority Unit $ $ Weighted average number of Ordinary Units outstanding (basic and diluted) 12,500,000 12,500,000 Distributions declared per Ordinary Unit $ - $ - Tax Pools The Fund has certain tax pools available to shelter taxable income. The largest of these tax pools are capital cost allowance ( CCA ) deductions. These pools are available to the Unitholders in proportion to their respective interest in the Partnership. As at December 31, 2012, the CCA tax pools available were as follows: 18

19 Class Federal Québec Rate ($ thousands) 1 $ 8,511 $ 8,510 4% 1 7,538 7,538 6% % % % % % % % , ,675 25% Total $ 127,233 $ 134,662 LIQUIDITY AND CAPITAL RESOURCES As at December 31, 2012, the Fund s debt was $95.5 million (net of deferred financing fees), up from $94.2 million at the end of December The Fund s cash as at December 31, 2012 totalled $1.3 million. Long-Term Refinancing Senior Secured Notes As at December 31, 2012, the Operating Trust had $67.5 million of Notes outstanding. Prior to December 28, 2016, the Notes are being amortized by an amount of $7.5 million on a semiannual basis on June 28 and December 28 of each year. The $15 million remaining principal balance will be repayable at maturity on December 28, Under the Notes governing trust indenture, the Fund is permitted to distribute excess cash flows to its Unitholders subject to compliance with certain financial covenants and other customary restrictions. The Notes trust indenture lists events that constitute an event of default, should they occur. They include the non-payment by the Operating Trust of principal, interest or other obligations of the Operating Trust in respect of the Notes and a breach of any covenant pursuant to the ABL Facility credit agreement (discussed below), subject to customary cure periods where applicable. If any event of default occurs under the Notes trust indenture, the holders of the Notes may require the Operating Trust to repay any outstanding obligations pursuant to the Notes trust indenture, which would, among other things, negatively impact the Operating Trust s ability to make cash distributions. ABL Facility The Operating Trust s ABL Facility provides availability of up to $150 million with a maturity date of July 28, Under the credit agreement entered into in connection with the ABL Facility, the Fund is permitted to distribute excess cash flows to its Unitholders subject to 19

20 maintaining a minimum excess availability and other customary restrictions. The borrowing base is tested on a monthly basis so long as excess availability is equal to or greater than $15 million and on a weekly basis if excess availability over the most recent 45-day period is less than $15 million. As at December 31, 2012, the borrowing base on the ABL Facility based on the Fund s working capital position was $113.7 million: $30.4 million was drawn (including $0.1 million letters of credit), leaving an excess availability of $83.3 million. The ABL Facility credit agreement lists events that constitute an event of default, should they occur. They include the non-payment by the Fund of principal, interest or other obligations of the Fund in respect of the ABL Facility credit agreement, a default under the Notes trust indenture that permits, or has resulted in, the acceleration of the obligations owing to the holders of Notes, and a breach of any covenant pursuant to the ABL Facility credit agreement, subject to the customary cure periods where applicable. If any event of default occurs under the ABL Facility credit agreement, the ABL Facility lenders will be under no further obligation to make advances to the Fund and may require the Fund to repay any outstanding obligations pursuant to the ABL Facility credit agreement, which would, among other things negatively impact the Fund s ability to make cash distributions. The Notes and the ABL Facility are fully and unconditionally guaranteed, on a senior secured basis (subject to the terms of an intercreditor agreement with the lenders under the ABL Facility), by the Fund, the Manager, the Partnership and NILP General Partner Ltd., the Partnership s general partner. Financial Security In May 2011, the provincial government of the province of Québec introduced Bill 14 which, if enacted, would have amended the Mining Act (Québec) (the Mining Act ). With the election of the new government in Québec in September 2012, Bill 14 died on the Order Paper. The new government has yet to decide whether such a bill will be re-introduced in 2013 or at some time in the future, and whether or not its content would be modified. It was also expected that there would be a three-year transition period after the date of Bill 14 would have become law. The financial security was expected to be in the form of cash, letter of credit, or another acceptable form. Under the current Mining Act, the Fund posted financial security, in the form of letters of credit, starting with $0.1 million in This financial security is expected to increase over the next several years until it reaches a cumulative total of $11.7 million in Any financial security that is posted under the current legislation or any amended legislation is expected to reduce the excess availability on the ABL Facility, and may negatively impact cash available for distribution, if any, to Unitholders. 20