UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

___________________

 

FORM 20-F

___________________

 

  REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934

 

OR

 

  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2018

 

OR

 

  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

OR

 

  SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission File Number 1-11176

_________________________________

 

GRUPO SIMEC, S.A.B. de C.V.

(Exact name of registrant as specified in its charter)

 

_________________________________

 

GROUP SIMEC

(Translation of registrant’s name into English)

 

 

UNITED MEXICAN STATES

(Jurisdiction of incorporation or organization)

_________________________________

 

Calzada Lázaro Cárdenas 601
Colonia La Nogalera, Guadalajara,
Jalisco, México 44440

(Address of principal executive offices)


Mario Moreno Cortez, telephone number 011-52-33 3770-6700, e-mail mmoreno@gruposimec.com.mx

(Name, telephone, e-mail and/or facsimile number and address of company contact person)

_________________________________

 

Securities registered or to be registered pursuant to Section 12(b) of the Act:

 

Title of Each Class

 

Trading Symbol(s)

Name of Each Exchange on Which Registered

American Depositary Shares (each representing one Series B share)

Series B Common Stock

SIMEC B

NYSE Amex LLC

NYSE Amex LLC*

 

 

  * Not for trading, but only in connection with the registration of American depositary shares.

 

 

Securities registered or to be registered pursuant to Section 12(g) of the Act: None

 

Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act: None

 

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report.:

 

Series B Common Stock — 466,643,007 shares as of December 31, 2018

_________________________________

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes  No 

 

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. Yes  No 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes   No 

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  No  (note: not required of registrant)

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or an emerging growth company. See definition of “large accelerated filer,” “accelerated filer,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.:

     
Large accelerated filer     Accelerated filer    

Non-accelerated filer    

Emerging growth company    

If an emerging growth company that prepares its financial statements in accordance with U.S. GAAP, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.    

The term “new or revised financial accounting standard” refers to any update issued by the Financial Accounting Standards Board to its Accounting Standards Codification after April 5, 2012.

 

If “Other” has been checked in response to the previous question, indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:

 

U.S. GAAP International Financial Reporting Standards as issued
by the International Accounting Standards Board
Other

 

Indicate by check mark which financial statement item the registrant has elected to follow. Item 17  Item 18 

 

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  No 

 

 

 

Table of Contents

Page

PART I 1
   
Item 1.   Identity of Directors, Senior Management and Advisers 1
   
Item 2.   Offer Statistics and Expected Timetable 1
   
Item 3.   Key Information 1
   
Item 4.   Information on the Company 25
   
Item 4A.   Unresolved Staff Comments 52
   
Item 5.   Operating and Financial Review and Prospects 52
   
Item 6.   Directors, Senior Management and Employees 78
   
Item 7.   Major Shareholders and Related Party Transactions 85
   
Item 8.   Financial Information 86
   
Item 9.   The Offer and Listing 89
   
Item 10.   Additional Information 90
   
Item 11.   Quantitative and Qualitative Disclosures About Market Risk 102
   
Item 12.   Description of Securities Other than Equity Securities 103
   
PART II 104
   
Item 13.   Defaults, Dividends Arrearages and Delinquencies 104
   
Item 14.   Material Modifications to the Rights of Security Holders and Use of Proceeds 104
   
Item 15.   Controls and Procedures 105
   
Item 16.   Reserved 117
   
Item 16A.   Audit Committee Financial Expert 117
   
Item 16B.   Code of Ethics 117
   
Item 16C.   Principal Accountant Fees and Services 117
   
Item 16D.   Exemptions from the Listing Standards for Audit Committees 118
   
Item 16E.   Purchases of Equity Securities by the Issuer and Affiliated Purchasers 118
   
Item 16F.   Change in Registrant’s Certifying Accountant 118
   
Item 16G.   Corporate Governance 118
   
PART III 120
   
Item 17.   Financial Statements 120
   
Item 18.   Financial Statements 120
   
Item 19.   Exhibits 120

 

 

 

CERTAIN TERMS

Grupo Simec, S.A.B. de C.V. is a corporation (sociedad anónima bursátil de capital variable) organized under the laws of the United Mexican States (“Mexico”). Unless the context requires otherwise, when used in this annual report, the terms “we,” “our,” “the company,” “our company” and “us” refer to Grupo Simec, S.A.B. de C.V., together with its consolidated subsidiaries.

 

References in this annual report to “U.S. dollars” or “U.S.$” are to the lawful currency of the United States. References in this annual report to “pesos” or “Ps.” are to the lawful currency of Mexico. References to “tons” in this annual report refer to tons; a metric ton equals 1,000 kilograms or 2,204 pounds. We publish our financial statements in pesos.

 

The terms “special bar quality steel” or “SBQ steel” refer to steel that is hot rolled or cold finished into round square, or hexagonal steel bars that generally contain higher proportions of alloys than lower quality grades of steel. SBQ steel is produced with precise chemical specifications and generally is made to order following client specifications.

 

This annual report contains translations of certain peso amounts to U.S. dollars at specified rates solely for your convenience. These translations do not mean that the peso amounts actually represent such dollar amounts or could be converted into U.S. dollars at the rate indicated. Unless otherwise indicated, we have translated these U.S. dollar amounts from pesos at the exchange rate of Ps. 19.6566 per U.S.$1.00, the interbank transactions rate in effect on December 31, 2018. On July 30, 2019, the interbank transactions rate for the peso was Ps. 19.0900 per U.S.$1.00.

 

FORWARD LOOKING STATEMENTS

This annual report contains certain statements regarding our business that may constitute “forward looking statements” within the meaning of the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. When used in this annual report, the words “anticipates,” “plans,” “believes,” “estimates,” “intends,” “expects,” “projects” and similar expressions are intended to identify forward looking statements, although not all forward looking statements contain those words. These statements, including, but not limited to, our statements regarding our strategy for raw material acquisition, products and markets, production processes and facilities, sales and distribution and exports, growth and other trends in the steel industry and various markets, operations and liquidity and capital resources, are based on management’s beliefs, as well as on assumptions made by, and information currently available to, management, and involve various risks and uncertainties, some of which are beyond our control. Our actual results could differ materially from those expressed in any forward looking statement. In light of these risks and uncertainties, we cannot assure you that forward looking statements will prove to be accurate. Factors that might cause actual results to differ materially from forward looking statements include, but are not limited to, the following:

 

  factors relating to the steel industry (including the cyclicality of the industry, finished product prices, worldwide production capacity, the high degree of competition from Mexican, U.S. and foreign producers and the price of ferrous scrap, iron ore and other raw materials);

 

  our inability to operate at high capacity levels;

 

  the costs of compliance with Mexican and U.S. environmental laws;

 

  future capital expenditures and acquisitions;

 

  future devaluations of the peso;

 

  the imposition by Mexico of foreign exchange controls and price controls;

 

  the influence of economic and market conditions in other countries on Mexican securities; and

 

  the factors discussed in Item 3.D – “Risk Factors” below.

 

Forward looking statements speak only as of the date they were made, and we undertake no obligation to update publicly or to revise any forward looking statements after the date of this annual report because of new information, future events or other factors. In light of the risks and uncertainties described above, the forward looking events and circumstances discussed in this annual report might not occur.

 

 

PART I 

 

  Item 1. Identity of Directors, Senior Management and Advisers

 

Not applicable.

 

  Item 2. Offer Statistics and Expected Timetable

 

Not applicable.

 

  Item 3. Key Information

 

  A. Selected Financial Data

 

This annual report includes our consolidated financial statements as of December 31, 2017 and 2018 and for each of the three years ended December 31, 2016, 2017 and 2018, as adopted by the International Financial Reporting Standards Board (IFRS), and its amendments and interpretations, as issued by the International Accounting Standard Board (IASB). We have adjusted the financial statements of our subsidiaries to conform to IFRS, and we have translated them to Mexican pesos. See Note 4 to our consolidated financial statements included elsewhere herein.

 

When preparing the financial statements for our individual subsidiaries and transactions in currencies other than our functional currency, the first step to convert financial information from operations abroad is the determination of the functional currency. The functional currency is the currency of the primary economic environment of the foreign operation or, if different, the currency that mainly impacts its cash flows. The U.S. dollar was considered as the functional currency of all the U.S. subsidiaries and the Brazilian Real was considered as the functional currency for all the Brazil plants; therefore, the financial statements of these subsidiaries were translated into Mexican pesos by applying:

 

  - The exchange rates at the balance sheet date, to all assets and liabilities.

 

  - The historical exchange rate at stockholders’ equity accounts and revenues, costs and expenses.

 

Translation differences are carried directly to the consolidated statements of comprehensive income as other comprehensive income under the caption “translation effects of foreign subsidiaries.” Translation differences were carried directly to the consolidated statement of comprehensive income as part of the income of the year under the caption foreign exchange gain (loss).

 

The translation effect in the results of operations for the years ended December 31, 2018, 2017 and 2016 resulted from applying the following exchange rates (peso/dollar) to the active or passive monetary position in foreign currency:

 

Year ended Exchange Rate (pesos to US$1.00) Change
December 31, 2016 20.6640 3.3242
December 31, 2017 19.7354 (0.9286)
December 31, 2018 19.6566 (0.0788)

 

 

1 

 

The following tables present the selected consolidated financial information as of and for each of the periods indicated. The selected financial and operating information as of December 31, 2014 and 2015 and for each of the years ended December 31 2014 and 2015 has been derived in part from our consolidated financial statements, which have been reported on by Castillo Miranda y Compañía, S.C., a member practice of BDO International Limited (“BDO”), and the selected financial and operating information as of and for the years ended December 31, 2016, 2017 and 2018 set forth below has been derived in part from our consolidated financial statements, which have been reported on by Marcelo de los Santos y Cía., S. C. a practice member of Moore Stephens International Limited (“Moore Stephens”). BDO has relied on the audited consolidated financial statements of Corporación Aceros DM., S.A. de C.V. (“Aceros DM”) subsidiaries and affiliates, reported on by Marcelo de los Santos y Cía., S. C. a practice member of Moore Stephens. The financial and operating information of GV do Brasil Industria e Comercio de Aço LTDA, as of December 31 2014 and 2015 and for each of the years ended December 31, 2014 and 2015, have been reported by BDO RCS Independent Auditors SS and for the years ended December 31, 2016, 2017 and 2018, the financial and operating information of GV do Brasil Industria e Comercio de Aço LTDA have been reported by Moore Stephens Lima Lucchesi, member of Moore Stephens International Limited. The selected financial information should be read in conjunction with, and is qualified in its entirety by reference to, our consolidated financial statements included elsewhere herein.

 

 

    As of and for Year Ended December 31,
   

2014

 

2015

 

2016

 

2017

 

2018

 

2018 (1)

    (Millions of pesos, except per share and ADS data and operational data)   (Millions of U.S.
dollars)
Income Statement                        
Data:                        
                         
Net sales   26,829   24,476   27,516   28,700   35,678   1,815
Cost of sales   25,492   23,097   22,776   23,994   30,563   1,555
Impairment of property, plant and equipment   -   2,072   -   -   -   -
Gross profit (loss)   1,337   (693)   4,740   4,706   5,115   260
Administrative expenses   801   1,163   879   954   923   47
Depreciation and amortization   393   419   398   285   157   8
Other (expense) income, net   61   173   (36)   7   15   1
Interest income   25   34   140   252   313   16
Interest expense   23   40   40   54   17   1
Foreign exchange gain (loss)   474   (382)   1,775   (654)   (147)   (8)
Income (loss) before taxes   680   (2,490)   5,301   3,017   4,199   213
Income tax expense   162   771   936   1,123   752   38
Net income (loss)   518   (3,261)   4,365   1,895   3,447   175
Non-controlling interest income (loss)   (686)   (2,047)   1,458   -   (206)   (11)
Controlling interest income (loss)   1,204   (1,214)   2,906   1,895   3,653   186
Net income (loss) per share(2)   2.44   (2.47)   5.97   3.84   7.46   0.38
Net income (loss) per ADS(2)   7.33   (7.40)   17.92   11.52   22.38   1.14
Weighted average shares outstanding (thousands)(2)   492,781   492,421   486,516   493,918   489,537   489,537
Weighted average ADSs outstanding (thousands)(2)   164,260   164,140   162,172   164,639   163,179   163,179
Balance Sheet Data:                        
                         
Total assets   35,896   32,244   41,880   45,977   48,854   2,485
Total short-term liabilities   5,821   5,588   5,738   7,480   8,992   458
Total long-term liabilities(3)   2,295   1,535   2,910   4,179   4,353   221
Total stockholders’ equity   27,780   25,121   33,232   34,318   35,509   1,806
                         
Cash Flow Data:                        
                         
Cash provided by operating activities   1,370   (382)   5,706   3,184   3,224   164
Cash provided by (used in) financing activities   (48)   (285)   898   (374)   (2,641)   (134)

2 

 

 

Cash (used in) provided by investing activities   (2,060)   (655)   (5,443)   (3,118)   (820)   (42)
                         
Other Data:                        
                         
Capital expenditures   1,858   648   3,100   3,040   1,994   101
Adjusted EBITDA(4)   1,261   1,058   4,892   4,933   5,147   262
Working capital(5)   11,852   11,392   14,497   15,386   17,109   870
Depreciation and Amortization   1,118   1,261   1,429   1,466   1,112   57
Dividends declared   0   0   0   0   0   0
                         
Operational Data:                        
(capacity and production in thousands of tons):                        
Annual installed capacity(6)   3,830   4,330   4,132   4,001   4,480   N/A
Mexico   1,419   1,452   1,495   1,404   1,374   N/A
United States, Canada, Brazil and elsewhere outside Mexico   778   574   590   687   818   N/A
Total tons shipped   2,197   2,026   2,085   2,091   2,192   N/A
SBQ steel   1,131   929   761   733   706   N/A
Structural and other steel products   1,066   1,097   1,324   1,358   1,486   N/A
Number of employees   4,861   4,420   3,973   3,767   4,685   N/A
Per ton data                        
                         
Net sales per ton(7)   12,212   12,081   13,197   13,725   16,276   828
Cost of sales per ton(7)   11,603   11,400   10,924   11,475   13,943   709
Adjusted EBITDA(4) per ton(7)   574   522   2,346   2,359   2,348   119

 

 

     

 

  (1) Peso amounts have been translated into U.S. dollars solely for the convenience of the reader, at the exchange rate of Ps. 19.6566 per U.S.$1.00, the interbank transactions rate in effect on December 31, 2018.

 

  (2) Our series B shares are listed on the Mexican Stock Exchange, and the ADSs are listed on the New York Stock Exchange. One American depositary share, or “ADS,” represents three series B shares.

 

  (3) Total long-term liabilities include amounts relating to deferred taxes.

 

  (4) Adjusted EBITDA is not a financial measure computed under U.S. GAAP or IFRS. Adjusted EBITDA is derived from our IFRS financial information and means net income (loss) excluding: (i) depreciation, amortization and impairment expense; (ii) financial income (expense), net (which is composed of net interest expense and foreign exchange gain or loss); (iii) other income (expense); and (iv) income tax expense and employee statutory profit-sharing expense.

 

Adjusted EBITDA does not represent, and should not be considered as, an alternative to net income, as an indicator of our operating performance, or as an alternative to cash flow as an indicator of liquidity. You should bear in mind that Adjusted EBITDA is not defined and is not a recognized financial measure under MFRS, U.S. GAAP or IFRS and that it may be calculated differently by different companies and must be read in conjunction with the explanations that accompany it. Adjusted EBITDA as presented in this table does not take into account our working capital requirements, debt service requirements and other commitments.

 

We believe that Adjusted EBITDA can be useful to facilitate comparisons of operating performance between periods and with other companies in our industry because it excludes the effect of: (i) depreciation, amortization and impairment loss which represents a non-cash charge to earnings; (ii) certain financing costs, which are significantly affected by external factors, including interest rates and foreign currency exchange rates, which can have little bearing on our operating performance; (iii) other income (expense) that are non-recurring operations; and (iv) income tax expense and employee statutory profit-sharing expense. However, Adjusted EBITDA has certain significant limitations, including that it does not include the following:

 

  taxes, which are a necessary and recurring part of our operations;

 

  depreciation, amortization and impairment loss which, because we must utilize property, equipment and other assets in order to generate revenues in our operations, is a necessary and recurring part of our costs;

 

  comprehensive cost of financing, which reflects our cost of capital structure and assisted us in generating revenues; and

 

 

3 

 

  other income and expenses that are part of our net income.

 

Adjusted EBITDA should not be considered in isolation or as a substitute for net income, net cash flow from operating activities or net cash flow from investing and financing activities. Reconciliation of net income (loss) to Adjusted EBITDA is as follows:

 

   

Year Ended December 31,

 
    2014     2015     2016     2017     2018     2018(1)  
    (millions of pesos)     (millions of
U.S. dollars)
 
                                                 
Net income (loss)     518       (3,261)       4,365       1,895       3,447       175  
Impairment of property, plant and equipment     -       2,072       -       -       -       -  
Depreciation and amortization     1,118       1,261       1,429       1,466       1,112       57  
Other (expense) income     61       173       (36)       7       15       1  
Interest income     25       34       140       252       313       16  
Interest Expense     23       40       40       54       16       1  
Foreign exchange gain (loss)     474       (382)       1,775       (654)       (147)       (8)  
Income tax expense     162       771       936       1,123       752       38  
Adjusted EBITDA     1,261       1,058       4,892       4,933       5,147       262  

 

  (5) Working capital is defined as excess of current assets over current liabilities.

 

  (6) Installed capacity is determined at December 31 of the relevant year.

 

  (7) Data in pesos and U.S. dollars, respectively, not in millions.

 

Exchange Rates

 

The following table sets forth, for the periods indicated, the high, low, average and period-end free-market exchange rate expressed in Mexican pesos per U.S. dollar. The average annual rates presented in the following table were calculated by using the average of the exchange rates on the last day of each month during the relevant period. The data provided in this table is based on noon buying rates published by the U.S. Federal Reserve Board for cable transfers in Mexican pesos. We have not restated the rates in constant currency units. All amounts are stated in pesos. We make no representation that the Mexican peso amounts referred to in this annual report could have been or could be converted into U.S. dollars at any particular rate or at all.

 

Year Ended December 31

High

Low

Average(1)

Period End

2014 14.79 12.85 13.30 14.75
2015 17.36 14.56 15.87 17.20
2016 20.84 17.19 18.67 20.62
2017 21.89 17.48 18.88 19.64
2018 20.67 17.97 19.22 19.63

 

Month in 2019

High

Low

Average(1)

Period End

January 19.61 18.93 19.17 19.05
February 19.41 19.04 19.20 19.27
March 19.58 18.86 19.24 19.40
April 19.22 18.76 18.96 18.99
May 19.65 18.85 19.11 19.65
June 19.77 18.99 19.27 19.21
July (through July 26) 19.23 18.89 19.04 19.07

 

 

  (1) Average of month-end or daily rates, as applicable.

 

 

Except for the period from September through December 1982, during a liquidity crisis, the Mexican Central Bank has consistently made foreign currency available to Mexican private-sector entities (such as us) to meet their foreign currency obligations. Nevertheless, in the event of renewed shortages of foreign currency, we cannot assure you that foreign currency would continue to be available to private-sector companies or that foreign currency needed by us to service foreign currency obligations or to import goods could be purchased in the open market without substantial additional cost or at all.

4 

 

 

Fluctuations in the exchange rate between the peso and the U.S. dollar will affect the U.S. dollar value of securities traded on the Mexican Stock Exchange, including our series B shares and, as a result, will likely affect the market price on the New York Stock Exchange of the ADSs that represent the series B shares. Such fluctuations will also affect the U.S. dollar conversion by the depositary of any cash dividends paid in pesos on series B shares represented by ADSs.

5 

 

 

 

  B. Capitalization and Indebtedness
    Not applicable.
  C. Reasons for the Offer and Use of Proceeds
    Not applicable.
  D. Risk Factors

Investing in our series B shares and the ADSs involves a high degree of risk. You should consider carefully the following risks, as well as all the other information presented in this annual report, before making an investment decision. Any of the following risks, if they were to occur, could materially and adversely affect our business, results of operations, prospects and financial condition. Additional risks and uncertainties not currently known to us or that we currently deem immaterial may also materially and adversely affect our business, results of operations, prospects and financial condition. In either event, the market price of our series B shares and ADSs could decline significantly, and you could lose all or substantially all of your investment.

 

Risks Related to Our Business

 

Our results of operations are significantly influenced by the cyclical nature of the steel industry.

 

The steel industry is highly cyclical and sensitive to regional and global macroeconomic conditions. Global demand for steel as well as global production capacity levels significantly influence prices for our products, and changes in global demand or supply for steel in the future will likely impact our results of operations. The steel industry has suffered in the past, especially during downturn cycles, from substantial over-capacity. Currently, as a result of the increase in steel production capacity in recent years, there are signs of excess capacity in steel markets, which is impacting the profitability of the steel industry. Global steel prices decreased in 2013, 2014 and 2015, and in 2016, 2017 and 2018 global steel prices began to recover. We cannot give you any assurance as to prices of steel in the future.

 

We may not be able to pass along price increases for raw materials to our customers to compensate for fluctuations in price and supply.

 

Prices for raw materials necessary for production of our steel products have fluctuated significantly in the past and may do so in the future. Significant increases in raw material prices could adversely affect our gross profit. During periods when prices for scrap metal, iron ore, ferroalloys, coaking coal and other raw materials have increased, our industry has historically sought to maintain profit margins by passing along increased raw material costs to customers by means of price increases. For example, prices of scrap metal in 2014 increased approximately 7%, in 2015 decreased approximately 16%, in 2016 increased approximately 2%, in 2017 increased approximately 31% and in 2018 increased approximately 19%; prices of ferroalloys in 2014 increased approximately 16%, in 2015 decreased approximately 9%, in 2016 decreased approximately 13%, in 2017 increased approximately 22% and in 2018 increased approximately 10%. We may not be able to pass along these and other cost increases in the future and, therefore, our profitability may be materially and adversely affected. Even when we can successfully increase our prices, interim reductions in profit margins frequently occur due to a time lag between the increase in raw material prices and the market acceptance of higher selling prices for finished steel products. We cannot assure you that our customers will agree to pay increased prices for our steel products that compensate us for increases in our raw material costs.

 

We purchase our raw materials either in the open market or from certain key suppliers. Both scrap metal and ferroalloy prices are negotiated on a monthly basis with our suppliers and are subject to market conditions. We cannot assure you that we will be able to continue to find suppliers of these raw materials in the open market, that the prices of these materials will not increase or that the quality will remain the same. In addition, if any of our key suppliers fails to deliver or we fail to renew our supply contracts, we could face limited access to some raw materials, or higher costs and delays resulting from the need to obtain our raw materials requirements from other suppliers.

 

The inability to use our existing inventory in the future or impairments in the valuation of our inventory could adversely affect our business.

 

As of December 31, 2018, we had 136,541 metric tons of coaking coal inventory, which is one of the principal raw materials used in blast furnaces. We have not used this raw material in recent years because our Lorain, Ohio blast furnace facility has been idle since 2008. We intend to start using coaking coal as a substitute for coal in our productive process in our other plants in Mexico and the United States. However we cannot assure you that we will be able to effectively utilize such inventory.

6 

 

 

We have assigned a fair market value of Ps. 953 million (U.S.$48.5 million) to our coaking coal inventory. However, prices for coaking coal have fluctuated significantly in the past and could continue to do so in the future and significant fluctuations in coaking coal prices could adversely affect the value of our existing inventory.

 

The energy costs involved in our production processes are subject to fluctuations that are beyond our control and could significantly increase our costs of production.

 

Our production processes are dependent on adequate supplies of electricity and natural gas. A substantial increase in the cost of electricity or natural gas could have a material adverse effect on our gross profit. In addition, a disruption or curtailment in supply could have a material adverse effect on our production and sales. Prices for electricity increased approximately 7% in 2014, decreased approximately 12% in 2015, in 2016 increased approximately 1.5%, in 2017 increased approximately 22% and in 2018 increased approximately 14%, and prices for natural gas increased approximately 25% in 2014, decreased approximately 23% in 2015, increased approximately 8% in 2016, increased approximately 22% in 2017 and increased approximately 28% in 2018. Moreover, energy costs constitute a significant and increasing component of our costs of operations. Our energy cost was 12.4% of our manufacturing conversion cost for 2018 compared to 13.1% for 2017, 13.5% for 2016, 13% for 2015 and 14% for 2014.

 

We pay special rates to the Mexican federal electricity commission (Comisión Federal de Electricidad or “CFE”) for electricity. We also pay special rates to Pemex, Gas y Petroquímica Básica, (“PEMEX”), the national oil company of Mexico, for natural gas used at our facilities in Mexico. We cannot assure you that these special rates will continue to be available to us or that these rates may not increase significantly in the future, particularly in light of recent energy reforms in Mexico. In the United States, we have contracts in place with special rates from the electric utilities. We cannot assure you that these special rates will continue to be available to us or that these rates may not increase significantly in the future. In certain deregulated electric markets in the United States, we have third party electric generation contracts under a fixed price arrangement. These contracts mitigate our price risk for electric generation from the volatility in the electric markets. In addition, we purchase natural gas from various suppliers in the United States. These purchase prices are generally established as a function of monthly New York Mercantile Exchange settlement prices. We also contract with different natural gas transportation and storage companies to deliver the natural gas to our facilities. In addition, we enter into futures contracts to fix and reduce volatility of natural gas prices both in Mexico and the United States, as appropriate. As of December 31, 2018, we have not entered into derivative financial instruments in Mexico, the United States or Brazil. We have not always been able to pass the effect of increases in our energy costs on to our customers and we cannot assure you that we will be able to pass the effect of these increases on to our customers in the future. We also cannot assure you that we will be able to maintain futures contracts to reduce volatility in natural gas prices. Changes in the price or supply of electricity or natural gas would materially and adversely affect our business and results of operations.

 

We face significant competition from other steel producers, which may adversely affect our profitability and market share.

 

Competition in the steel industry is intense, which exerts a downward pressure on prices, and, due to high start-up costs, the economics of operating a steel mill on a continuous basis may encourage mill operators to establish and maintain high levels of output even in times of low demand, which further decreases prices and profit margins. The recent trend of consolidation in the global steel industry may further increase competitive pressures on independent producers of our size, particularly if large steel producers formed through consolidations, which have access to greater resources than us, adopt predatory pricing strategies that decrease prices and profit margins. If we are unable to remain competitive with these producers, our profitability and market share would likely be materially and adversely affected.

 

A number of our competitors in Mexico and the United States have undertaken modernization and expansion plans, including the installation of production facilities and manufacturing capacity for certain products that compete with our products. As these producers become more efficient, we will face increased competition from them and may experience a loss of market share. In each of Mexico and the United States we also face competition from international steel producers. Increased international competition, especially when combined with excess production capacity, would likely force us to lower our prices or to offer increased services at a higher cost to us, which could materially reduce our profit margins.

 

Competition from other materials could significantly reduce demand and market prices for steel products.

 

In many applications, steel competes with other materials that may be used as steel substitutes, such as aluminum (particularly in the automobile industry), cement, composites, glass, plastic and wood. Additional substitutes for steel products could significantly reduce demand and market prices for steel products and thereby affect our results of operations.

 

A sudden slowdown in consumption in or increase in exports from China could have a significant impact on international steel prices, therefore affecting our profitability.

 

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As demand for steel has surged in China, steel production capacity in that market has also increased, and China is now the largest worldwide steel producing country, accounting for approximately half of the worldwide steel production. Due to the size of the Chinese steel market, a slowdown in steel consumption in that market could cause a sizable increase in the volume of steel offered in the international steel markets, exerting a downward pressure on sales and margins of steel companies operating in other markets and regions, including us.

 

Implementing our growth strategy, which may include additional acquisitions, may adversely affect our operations.

 

As part of our growth strategy, we may seek to expand our existing facilities, build additional plants, acquire additional steel production assets, enter into joint ventures or form strategic alliances that we expect will expand or complement our existing business. If we undertake any of these transactions, they will likely involve some or all of the following risks:

 

  disruption of our ongoing business;

 

  diversion of our resources and of management’s time;

 

  decreased ability to maintain uniform standards, controls, procedures and policies;

 

  difficulty managing the operations of a larger company;

 

  increased likelihood of involvement in labor, commercial or regulatory disputes or litigation related to the new enterprise;

 

  potential liability to joint venture participants or to third parties;

 

  difficulty competing for acquisitions and other growth opportunities with companies having greater financial resources; and

 

  difficulty integrating the acquired operations and personnel into our existing business.

 

We will require significant capital for acquisitions and other strategic plans, as well as for the maintenance of our facilities and compliance with environmental regulations. We may not be able to fund our capital requirements from operating cash flow and we may be required to issue additional equity or debt securities or obtain additional credit facilities, which could result in additional dilution to our shareholders. We cannot assure you that adequate equity or debt financing would be available to us on favorable terms or at all. If we are unable to fund our capital requirements, we may not be able to implement our growth strategy.

 

We intend to continue to pursue a growth strategy, the success of which will depend in part on our ability to acquire and integrate additional facilities. Some of these acquisitions may be outside of Mexico and the United States. Acquisitions involve a number of special risks, in addition to those described above, that could adversely affect our business, financial condition and results of operations, including the assumption of legacy liabilities and the potential loss of key employees. We cannot assure you that any acquisition we make will not materially and adversely affect us or that any such acquisition will enhance our business. We are unable to predict the likelihood of any additional acquisitions being proposed or completed in the near future or the terms of any such acquisitions.

 

We and our auditors have identified material weaknesses in our internal controls over financial reporting, for each of the last eight years, and if we fail to remediate these material weaknesses and achieve an effective system of internal controls, we may not be able to report our financial results accurately, and current and potential shareholders could lose confidence in our reporting, which would harm our business and the trading price of our Series B shares or the ADSs.

 

In connection with the preparation of our financial statements as of and for each of the years ended December 31, 2011, 2012, 2013, 2014, 2015, 2016, 2017 and 2018, we and our auditors identified material weaknesses (as defined under standards established by the Public Company Accounting Oversight Board, (United States of America)) in our internal controls over financial reporting (our management did not assess the effectiveness of our internal controls over financial reporting as of December 31, 2016). A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis.

 

Fiscal Year Ended December 31, 2011. On January 12, 2012, our audit and corporate practices committee (“Audit Committee”) received a formal complaint from the General Accounting and Treasury Services Manager of Republic Engineered Products, Inc. (“Republic”), stating that he had identified, during his review of the financial statements of SimRep and its subsidiaries for the year ended December 31, 2011, what he considered to be material accounting errors, and potential “management override of

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internal controls” at SimRep. In response, our Audit Committee instructed our internal audit department to perform a review, and subsequently engaged outside counsel to conduct an internal investigation concerning the accounting matters and potential management overrides of internal controls at SimRep. As a result of our investigation, we identified material weakness at SimRep, finding that, with respect to SimRep and its subsidiaries, management did not design and maintain effective controls relating to the year-end closing and financial reporting process, resulting in accounting errors with respect to the reconciliation of certain balance sheet accounts, and a failure to timely review and control the preparation and closing of SimRep’s consolidated financial statements. In addition, SimRep also had insufficient personnel resources and technical accounting and reporting expertise to appropriately address certain accounting and financial reporting matters in accordance with generally accepted accounting principles.

 

In addition, our external auditors notified our management that, during their audit of our consolidated financial statements for the year ended December 31, 2011, it identified what it considered to be, under standards established by the Public Company Accounting Oversight Board, material weaknesses in internal controls over financial reporting:

 

  Significant deficiencies were detected regarding entity-level controls and control environment which, in the aggregate, constitute a material weakness, and which include (i) ineffective controls in the patents registry; (ii) inadequate resources and inadequate distribution of duties among personnel, resulting in too many functions centralized among too few personnel; (iii) out-of-date accounting and human resources policies and information technology procedures, and a lack of proper monitoring of the foregoing; (iv) a lack of adequate implementation of our ethical code; (v) failure to integrate all control processes into an Enterprise Resource Planning (ERP) system; (vi) a lack of an accounting manual (including instructions on accounting recordkeeping) for the entire company; (vii) failure to create and implement a training plan for management personnel preparing financial records; and (viii) failure of audit personnel to report periodically to the Audit Committee in order to monitor the remediation procedures previously adopted with respect to previous accounting periods;

 

  A lack of appropriate accounting resources, which led to inadequate supervision and controls within the accounting department and therefore prejudiced the financial statement closing process, the deferred income tax process and the conversion of foreign subsidiaries process, resulting in material accounting errors;

  

  A lack of an appropriate consolidation system to allow management to supervise properly the preparation of consolidated financial information. Financial information of subsidiaries was presented at a level of detail that was insufficient to allow for a clear and precise understanding of operations; and

 

  A lack of appropriate accounting resources at SimRep, which led to material weaknesses with respect to SimRep’s internal controls over financial reporting, which resulted in material corrections to its consolidated financial statements. Such material weaknesses included: (i) a lack of proper controls to reconcile certain balance sheet accounts at a detailed level, including certain accounts payable debit balances that could not be substantiated, resulting in audit adjustments; (ii) financial close control failure due to lack of timely review of monthly financial statements; (iii) a necessity to perform several reclassifications to basic financial statements and adjustments to the footnotes after the auditors’ review of such financial statements; and (iv) a lack of appropriate expertise at SimRep to address technical accounting and financial reporting matters.

 

  Significant deficiencies were detected also at our subsidiary Corporación Aceros DM, S.A. de C.V. which, in the aggregate, constitute a material weakness. These significant deficiencies include (i) lack of physical inventory of fixed assets; (ii) lack of proper segregation of duties analysis and authorization of personnel access to main information systems (iii) lack of evidence of reconciliation of physical and accounting information of raw material inventory; (iv) lack of evidence of review of interim financial statements; and (v) failure to document and communicate adequately responsibilities and authority of key financial roles.

 

Fiscal Year Ended December 31, 2012. In our assessment of our internal controls over financial reporting for the year ended December 31, 2012, we and our external auditors identified the following material weaknesses:

  Significant deficiencies were detected regarding entity-level controls and control environment which, in the aggregate, constitute a material weakness, and which include: (i) failure to keep all our policies and procedures, including IFRS accounting policies, updated; (ii) limited IFRS understanding within our Internal Audit department; (iii) inadequate controls in the review and approval process of the disclosures of our financial statements; (iv) poor maintenance of our whistleblower line for the Mexican subsidiaries; (v) ineffective controls in our patents registry; (vi) inadequate distribution and segregation of duties within our accounting department; (vii) deficient distribution

 

 

9 

 

 

  to employees and officers of our code of ethics; (viii) failure to integrate all control processes into an Enterprise Resource Planning (ERP) system; (ix) lack of an accounting manual with accounting instructions for our most important transactions; (x) failure to create and implement a training plan for our management personnel preparing financial records; and (xi) incomplete monitoring of certain control deficiencies identified on previous years;

 

  Inadequate supervision and controls within our accounting department which prejudiced the financial statement closing process, conversion of foreign subsidiaries, presentation of financial statements and assets valuation, resulting in material accounting errors;

 

  A lack of an appropriate consolidation system to allow our management to supervise properly the preparation of consolidated financial information with the required detail;

 

  Deficient and not standardized controls in SimRep related to the physical inventory counts and a very vulnerable procedure to determine costs due to manual calculations, and;

 

  Significant deficiencies were also detected at our subsidiary Corporación Aceros DM S.A. de C.V. which in the aggregate, constitute a material weakness. These significant deficiencies include: (i) failure to timely approve our policies and procedures to prepare financial statements in accordance with IFRS and limited knowledge of those standards, (ii) undocumented process and deficient controls in the control access to information systems, (iii) deficient controls to review and approve cost calculation of finished goods, (iv) lack of physical inventory of fixed assets; and (v) failure to document and communicate adequately responsibilities and authority of key financial roles.

 

Fiscal Year Ended December 31, 2013. In our assessment of our internal controls over financial reporting for the year ended December 31, 2013, we and our external auditors identified the following material weaknesses:

 

  Significant deficiencies were detected regarding entity-level controls and control environment which, in the aggregate, constitute a material weakness, and which include: (i) inadequate controls in the review and approval process of the disclosure in the financial statements and our annual report on form 20-F, (ii) out of date whistleblower line for the Mexican subsidiaries, (iii) ineffective controls in our patents registry, (iv) inadequate distribution and segregation of duties within the accounting department in the Mexican subsidiaries, (v) deficient distribution to employees and officers of our code of ethics and poor promotion of strong control environment and internal controls, (vi) failure to integrate all control processes into an Enterprise Resource Planning (ERP) system, (vii) lack of an accounting manual with accounting instructions for our most important transactions, (viii) lack of specific procedures to authorize and register intercompany transactions, (ix) failure to create and implement a complete training plan for our management personnel preparing financial records, (x) limited IFRS and consolidation process understanding and reduced personnel within our Internal Audit department which limited the scope of the management assessment, also the internal audit plan was not carried out in full and did not include test about risk assessment, environmental, fraud and compliance with law, and only included a limited review of the consolidated financial statements, (xi) lack of committees to review and approve all our contracts and to make risk assessments, these activities are currently executed by selected persons only, (xii) lack of a transition plan for the establishment of the new COSO 2013; and (xiii) insufficient resources to implement and follow up on the remedial measures identified in previous years for the Mexican subsidiaries due to the prevalence of such deficiencies, and informal communication of deficiencies and remediation plans;

 

  Inadequate supervision and controls within our accounting department which prejudiced the financial statement closing process, conversion of foreign subsidiaries, presentation of financial statements, assets valuation and deferred taxes, resulting in material accounting errors;

 

  A lack of an appropriate consolidation system to allow our management to supervise properly the preparation of consolidated financial information with the required detail;

 

  Deficient and not standardized controls in SimRep related to authorization, control and accounting of capitalized expenditures and related fixed assets, and;

 

  Significant deficiencies were also detected at our subsidiary Corporación Aceros DM, S.A. de C.V. which in the aggregate, constitute a material weakness. These significant deficiencies include (i) incomplete procedures for the review process over financial closings; (ii) incomplete documental support for authorization and extension of customer credit lines, (iii) deficient controls in the control access to the information systems, (iv) deficient controls to review and approve inventory valuation, cost of production calculation and cost of sales computation, (v) lack of physical inventory of fixed assets; and (vi) failure to document and communicate adequately responsibilities and

 

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  authority of key financial roles.

 

Fiscal Year Ended December 31, 2014. In our assessment of our internal controls over financial reporting for the year ended December 31, 2014, we and our external auditors identified the following material weaknesses:

 

  Insufficient resources applied to the remediation and appropriate monitoring of internal control weaknesses, most of which were identified in previous years and continue to be unresolved.

 

  Inadequate distribution and segregation of duties within the accounting department in the Mexican Subsidiaries due to insufficient resources. Additionally, the internal audit staff was reduced and considered insufficient to fulfill their role.

 

  Significant deficiencies were detected regarding entity-level controls and control environment which, in the aggregate, constitute a material weakness, and which include: (i) inadequate controls for the definition, review and approval process of the disclosure in the financial statements and our annual report on form 20-F, (ii) non-operating and outdated whistleblower line for the Mexican subsidiaries, (iii) ineffective controls in our patents registry, (iv) deficient distribution of our code of ethics to employees and officers and poor promotion of strong control environment and internal controls in accordance with the COSO model, (v) failure to integrate all control processes into one Enterprise Resource Planning (ERP) system, (vi) lack of an accounting manual with accounting instructions on most of accounting records, (vii) lack of specific procedures for the approval of transactions with related parties, (viii) failure to create and implement a complete training plan for management personnel preparing financial records, (ix) limited IFRS and consolidation process understanding and reduced personnel within our Internal Audit department which limited the scope of the management assessment; the internal audit plan was not carried out in full and did not include tests about risk assessment, including environmental, fraud, compliance with laws and review of the consolidated financial statements; (x) lack of committees to review, approve and make risk assessments of all our contracts, and (xii) informal communications of deficiencies and remediation plan to the areas and managers involved.

 

  Inadequate supervision and controls within the accounting department which impacted the financial statement closing process, conversion of foreign subsidiaries and intercompany reconciliations, resulting in material accounting errors.

 

  A lack of an appropriate consolidation system to allow management to properly supervise the preparation of consolidated financial information with the detail required.

 

  SimRep did not maintain effective controls relating to accounting of certain capital expenditures and related fixed assets were found. Lastly, the evaluation for impairments is not reasonable given actual results of such Subsidiary.

  

  Significant deficiencies were also detected at our subsidiary Corporación Aceros DM, S.A. de C.V. which in the aggregate, constitute a material weakness. These significant deficiencies include (i) ineffective controls and insufficient supporting documentation for closings of periods end and financial statements review and authorization; the related procedures were incomplete and do not include specific procedures to enter transactions into the general ledger, to select and apply accounting policies and have not been updated in the last 3 years, which such controls are necessary to give reasonable assurance of compliance with IFRS, (ii) no evidence of review of some account balances, such as fixed assets, sales and tax calculations by the responsible individuals; there is also no evidence of review of the financial statements by the General Manager of Corporación Aceros DM, S.A de C.V., (iii) undocumented processes and deficient controls in the access to the information systems, (iv) deficient controls to review and approve cost calculations of finish goods, period end costs and inventories and cost of sales report, (v) lack of physical inventory of fixed assets in several years; and (vi) failure to document and communicate adequately responsibilities and authority of key financial roles.

 

Fiscal Year Ended December 31, 2015. In our assessment of our internal controls over financial reporting for the year ended December 31, 2015, we and our external auditors identified the following material weaknesses:

 

  The internal audit department did not develop its functions to comply with the analysis of the controls during 2015. Consequently, this limited the functions of the Audit Committee.

 

  Insufficient resources applied to the remediation and appropriate monitoring of internal control weaknesses, most of which were identified in previous years and continue to be unresolved.

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  Inadequate distribution and segregation of duties within the accounting department in our Subsidiaries due to insufficient resources. Additionally, the internal audit staff was considered insufficient to fulfill their role.

 

  Significant deficiencies were detected regarding entity-level controls and control environment which, in the aggregate, constitute a material weakness and create a reasonable likelihood that a material misstatement of our annual and interim financial statements will not be prevented or detected on a timely basis. Such deficiencies include: (i) inadequate controls for the definition, review and approval process of the disclosure in the financial statements and our annual report on form 20-F, (ii) whistleblower line for our Mexican subsidiaries was not fully operational, our website information is outdated and does not include information about our Brazilian operations, (iii) ineffective controls in our patents registry, (iv) deficient distribution of our code of ethics to employees and officers and poor promotion of strong control environment and internal controls in accordance with the COSO model, (v) failure to integrate all control processes into one Enterprise Resource Planning (ERP) system, (vi) lack of an accounting manual with accounting instructions on most of accounting records, (vii) lack of specific procedures for the approval of transactions with related parties, (viii) failure to create and implement a complete training plan for management personnel preparing financial records under IFRS, (ix) limited IFRS and consolidation process understanding and reduced personnel within our Internal Audit department which limited the scope; also the internal audit plan was not carried out, and therefore the audit department did not perform risk assessment an environmental, fraud, compliance with laws, review of the consolidated financial statements and review of our annual report on form 20-F; (x) lack of committees to review, approve and make risk assessments of all our contracts; and (xi) informal communications of deficiencies and remediation plan to the areas and managers involved.

 

  Inadequate supervision and controls within the accounting department which impacted the financial statement closing process, conversion of foreign subsidiaries, intercompany reconciliations and a lack of controls for the issuance and authorizations of journal entries, resulting in material accounting errors.

 

  A lack of an appropriate consolidation system to allow management to properly supervise the preparation of consolidated financial information with the detail required.

 

  SimRep did not maintain personnel with the appropriate level of knowledge and experience of accounting and training required to comply with financial reporting requirements. This material weakness led to the certain control deficiencies, each of which are considered to be a material weakness.

 

  Failure to provide our external auditors with evidence of the evaluation of the effectiveness of internal controls in our Brazilian subsidiary, in addition of not hiring an external auditor for this evaluation.

 

  Significant deficiencies were also detected at our subsidiary Corporación Aceros DM, S.A. de C.V. which in the aggregate, constitute a material weakness.

 

Fiscal Year Ended December 31, 2016. Our external auditors incorporated into their “Attestation Report of the Independent Registered Public Accounting Firms” for the year ended December 31, 2016, the following assessment of our internal controls, which included the following material weaknesses:

 

  Regarding the control environment and entity level controls, the following material weaknesses were identified: (i) lack of a whistleblower tool that covers the entirety of the company; (ii) regarding the distribution of the code of ethics, certain sectors of the employees did not recognize the code of ethics; (iii) ineffective control of the patent registration process, which lacks a policy and a procedure; (iv) lack of a policy and procedure for the valuation of assets and the company’s physical inventories; (v) lack of a policy and procedure governing the extensions of credit to the clients; (vi) lack of a policy and procedure for the registration of related parties and the approval of transactions with related parties.

 

  Lack of an appropriate consolidation system to allow management to properly supervise the preparation of consolidated financial information with the detail required.

 

  In connection with certain financial reporting processes, lack of a robust role-segregation model for the creation, editing, deletion, display only, and modification of such processes.

 

  Lack of communication between the internal audit team, which impacted time of test execution, leaving out of scope cycles such as income, human resources, general controls of information technology and costs and inventories.

 

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  Lack of documentation setting out the procedure in the event of a disaster (Disaster Recovery Plan) and documentation setting out the procedure in order to continue the operations of the business (Business Continuity Plan).

 

Fiscal Year Ended December 31, 2017. In our assessment of our internal controls over financial reporting for the year ended December 31, 2017, we and our external auditors identified the following material weaknesses:

  · Insufficient training on, and knowledge of, COSO and the related operation of the control environment for mid-level personnel of the Company.
  · A lack of a formalized policy related to the delegation of authority clearly defining the roles and responsibilities for employees.
  · The Company lacks a system of assessing and monitoring employee performance to increase their skills to be prepared for the complexity of the Company´s operation.
  · The Company does not maintain a detailed accounting manual and closing checklists. The lack of such procedures reduces the likelihood of detecting errors on a timely basis during the financial close. Similarly, there is a lack of documents supporting the existence of supervisory review over accounting entries recorded by the Company.
  · The Company does not maintain appropriate evidence over records supporting certain matters in regards to fixed assets:
  · There is insufficient data to support certain adjustments to fixed assets recorded on the books of the Company.
  · The Company does not have an appropriate system to properly store records in regards to significant acquisitions of fixed assets.
  · The Company failed to reconcile their recorded fixed assets to the underlying support.
  · The Company did not document appropriate authorizations in regards to capital investments or to increases in the planned size of an ongoing investment project.
  · The Company has neither a system of tagging and tracking fixed assets nor a process for taking periodic inventories to determine the continued existence of recorded fixed assets.
  · The Company lacks sufficient documentation and internal controls related to the process of obtaining credit. The Company also lacks sufficient training for personnel responsible for monitoring such credit facilities in regards to fraud detection and ongoing compliance matters.
  · The Company lacks a program to ascertain that the administrative staff with access to accounting records are sufficiently trained and monitored.
  · The Company lacks an appropriate environment to ensure that the financial records are closed in accordance with

 

 

13 

 

 

  International Financial Reporting Standards properly and in a timely manner. Items identified included:
  o A lack of appropriate accounting resources at the corporate level which adversely impacted the operation of key supervision controls over the accounting department, the financial statement closing process, and the process of computing and authorizing journal entries.
  o A lack of appropriate procedures to analyze the results of the business units prior to consolidation.
  o A lack of a unified computerized general ledger or enterprise resource planning system among the business units. There is also a lack of a common chart of accounts which would simplify the consolidation process.
  o A lack of an appropriate consolidation system allowing management to properly supervise the preparation of consolidated financial information. The system is highly manual, increasing the risk of human error and lacking sufficient oversight as the process is largely performed by a single member of the accounting staff.
  · An audit performed on the information technology systems of the Company determined that approximately 25% of controls over the information technology infrastructure were either deficient in design or missing. Additional findings include:
  o A lack of an internal reference framework methodology to ascertain and assess information technology risks.
  o The lack of a methodology to evaluate the design and operational effectiveness of key controls over critical business processes.
  o No system of verification of the access profiles of personnel or a process to verify that accounts of former employees are properly closed.
  · In the case of GV do Brasil Indústria e Comércio de Aco Ltda in Brasil we observed an inadequate segregation of duties, in respect to system access and activities related to:
  o The person with final responsibility for the preparation of the financial reports is also responsible for the corporate tax area, financial management (approval of payments and receipts, analysis of client credit risks including credit limits still not established, and negotiations with clients), monthly calculation of the costs of the products sold (and, consequently, of the value of the inventories of finished products), and assessment of the amount of physical impurities contained in scrap inventories, which also determines the valuation.
  o The person responsible for supervising the physical movements of raw materials and finished products also has the following duties: authorization to issue sales invoices, the authority to adjustment quantities of inventory items, and also responsibility for planning and authorizing the movements of the physical inventory of between inventory locations.
  · In the case of SimRep Corporation and Subsidiaries in the United States we identified that as a component of the financial control process, certain accounts are not being reconciled quarterly to the underlying details and

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  the components of certain other accounts are not being reviewed by management.
  · In the case of SimRep Corporation and Subsidiaries in the United States we identified that a control requiring the signatures of the vice-president of Finance, head of information technology and the General Manager to authorize all expenditures over $25,000 was not operating effectively. A number of the purchases lacked the required supporting signatures.
  · In the case of SimRep Corporation and Subsidiaries in the United States we identified that the controller at one of the production plants failed to properly perform all required tests to review the inventories to be sure they are properly recorded at the lower of cost or market, and also failed to obtain approval for a journal entry which should be generated from the analysis.

Fiscal Year Ended December 31, 2018. In our assessment of our internal controls over financial reporting for the year ended December 31, 2018, the following material weaknesses were identified:

 

·Transactions with related parties:
oLack of evidence of how transactions with third parties are documented and authorized.
oLack of policy regulating the way in which transactions with third parties should be documented and authorized.
·Information Technology Systems:
oLack of backup-generation controls for computer equipment that contains key company information.
oInsufficient Information Technology infrastructure to support the Company’s growth when required.

 

By letter dated February 13, 2017, the Securities and Exchange Commission (the “SEC”) notified us that the SEC was conducting an informal, and non-public, inquiry into the Company in connection with our internal controls. After cooperating with the SEC, we settled internal controls charges with the SEC on January 29, 2019. We agreed to retain an independent consultant and to pay a civil monetary penalty in the amount of US$200,000.

 

Any failure to implement and maintain the needed improvements in the controls over our financial reporting, or difficulties encountered in the implementation of these improvements in our controls, could result in a material misstatement in our annual or interim financial statements that would not be prevented or detected, or cause us to fail to meet our reporting obligations under applicable securities laws. Any failure to improve our internal controls to address the identified weaknesses could result in our incurring substantial liability for not having met our legal obligation and could also cause investors to lose confidence in our reported financial information, which could have a material adverse impact on the trading price of our Series B shares or the ADSs.

 

For further details, see Items 15.B “Controls and Procedures—Management’s Annual Report on Internal Control Over Financial Reporting – Material Weaknesses,” 15.C “Attestation Report of the Independent Registered Public Accounting Firms” and 15.D “Changes in Internal Control over Financial Reporting.”

 

Tariffs, anti-dumping and countervailing duty claims imposed in the future could harm our ability to export our products outside of Mexico, and changes in Mexican tariffs on steel imports could adversely affect the profitability and market share of our Mexican steel business.

 

On October 14, 2014, the United States International Trade Commission (USITC) determined that the U.S. steel industry is materially injured by reason of imports of steel concrete reinforcing bars from Mexico, that are sold in the United States at less than fair value, and from Turkey, that are subsidized by the government of Turkey. As a result of the USITC’s affirmative determinations, the U.S. Department of Commerce issued an antidumping duty order on imports of this product from Mexico and a countervailing duty order on imports of this product from Turkey. The U.S. government imposed tariffs of 66.7% against imports for rebar from Deacero, S.A.P.I de C.V. and us and tariffs of 20.58% for rebar imports from all other producers in Mexico. On June 8, 2017, the US Department of Commerce issued a final resolution in which it determined that the tariff would be 0%.

Recent events, including the results of the 2016 U.S. presidential election and the lack of progress in Brexit negotiations in the U.K., have resulted in substantial regulatory uncertainty regarding international trade and trade policy. On March 1, 2018, U.S. President Trump announced a 25% tariff on all steel products and a 10% tariff on all aluminum products imported into the United States for an indefinite amount of time under Section 232 of the Trade Expansion Act. On May 1, 2018, the Trump administration issued two proclamations authorizing modifications of the Section 232 tariffs on steel and aluminum. In its May 1, 2018 proclamations, the Trump administration also extended negotiations with Canada, Mexico, and the EU for a final 30 days and, effective June 1, 2018, the Trump administration implemented 25% tariffs on imports from the EU, Canada and Mexico. It is unclear what impact these protectionist measures will have in 2019, whether they will be effective in increasing or maintaining steel prices in the adopting country or countries and whether they will have an overall negative impact on global macroeconomic conditions.

In addition, the Trump administration and the U.S. Congress may make substantial changes in legislation, regulation and government policy directly affecting our business or indirectly affecting the Company because of impacts on its customers and suppliers. In particular, the Company’s exports from Mexico into the United States may be negatively affected by the implementation of the Trump administration's replacement of the NAFTA trade agreement with Canada and Mexico. More generally, actions further to President Trump’s suggestions that he may seek to renegotiate other free trade agreements or withdraw the United States from the

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World Trade Organization could have an adverse effect on the Company's operations. All of the above, including escalating tariffs on steel imports or a more general trade war, pose a degree of uncertainty which could have a significant adverse effect on steel demand, our results of operations and global macroeconomic conditions generally.

 

Many of our products are subject to existing duties, tariffs, anti-dumping duties and quotas that may limit the quantity of some types of goods that we import into the United States. Furthermore, certain of our competitors may be better positioned than us to withstand or react to border taxes, tariffs or other restrictions on global trade and as a result we may lose market share to such competitors. Due to broad uncertainty regarding the timing, content and extent of any regulatory changes in the U.S. or elsewhere, we cannot predict the impact, if any, that these changes could have to our business, financial condition and results of operations. See “—Risks Related to Mexico—Developments in other countries could adversely affect the Mexican economy, our financial performance and the price of our shares.”

 

The operation of our facilities depends on good labor relations with our employees.

 

As of December 31, 2018, approximately 87% of our non-Mexican and 44% of our Mexican employees were members of unions. The compensation terms of our labor contracts are adjusted on an annual basis, and all other terms of the labor contracts are renegotiated every two years. In addition, collective bargaining agreements are typically negotiated on a facility-by-facility basis for our Mexican facilities. Any failure to reach an agreement on new labor contracts or to negotiate these labor contracts could result in strikes, boycotts or other labor disruptions. These potential labor disruptions could have a material and adverse effect on our business. Labor disruptions or significant negotiated wage increases could reduce our sales or increase our costs, which could in turn have a material adverse effect on our results of operations.

 

Operations at our Lackawanna, New York, facility depend on our continuing right to use certain property and assets of an adjoining facility and the termination of any such rights would interrupt our operations and have a material adverse effect on our results of operations and financial condition.

 

The operations of our Lackawanna facility depend upon certain arrangements and understandings relating to, among other things, our use of industrial water, compressed air, sanitary sewer and electrical power. These service and utility arrangements, initially entered into with the Mittal Steel Company N.V. and its affiliates (“Mittal Steel”), were effective through April 30, 2009, at which time Mittal Steel transferred its Lackawanna plant to Tecumseh Redevelopment, Inc. (“Tecumseh”). In December 2010, Tecumseh transferred a portion of the former Mittal Steel facility to Great Lakes Industrial Development, LLC (“GLID”). Upon the transfer to GLID, we entered into a written agreement with GLID regarding the provision of compressed air to our facility. This lease assures that compressed air will be provided to our facility during the lease term (initially two years with automatic one year renewals until terminated by either party) and grants us an option to purchase the equipment at various times and at stated prices, thereby providing us some flexibility while we consider the installation of our own compressed air system at our facility. The water pump that services our plant is located on property still owned by Mittal Steel and is maintained by Mittal Steel, which also continues to furnish industrial water to us on a month-to-month basis. The electric system which services the compressed air equipment, as well as the electric system which services the GLID property, has been re-routed through our electric meter located at a substation on the adjacent GLID property. We continue to pursue a written agreement with GLID covering our use of the electric substation and related equipment on the GLID property, as well as the sanitary sewer lift station on the GLID property that serves our facility, and a truck entrance and security monitoring equipment located on the GLID property. All of these rights are essential to the use and operation of our Lackawanna facility. It is our understanding that GLID has sold or is in the process of selling a portion of its property to an unrelated third party. In the event of a termination of any of our rights, either due to a failure to negotiate a satisfactory outcome with Mittal Steel, GLID or any third party to which it sells all or part of its facility, or for any other reason, we could be required to cease all or substantially all of our operations at the Lackawanna facility. Because we produce certain types of products in our Lackawanna facility that we do not produce in our other facilities, an interruption of production at our Lackawanna facility would result in a substantial loss of revenue and could damage our relationships with customers.

 

Our sales in the United States are concentrated and could be significantly reduced if one of our major customers reduced its purchases of our products or was unable to fulfill its financial obligations to us.

 

Our sales in the United States are concentrated among a relatively small number of customers. Any of our major customers can stop purchasing our products or significantly reduce their purchases at any time. During 2018, 2017, 2016, 2015 and 2014, sales to our ten largest customers in the United States accounted for approximately 68.4%, 68.7%, 62.1%, 56.8% and 51.4% of our consolidated revenues in the United States, respectively, and approximately 17.7%, 20%, 18.1%, 21.5% and 23.6% of our total consolidated revenues, respectively. A disruption in sales to one or more of our largest customers would adversely affect our cash flow and results of operations.

 

We cannot assure you that we will be able to maintain our current level of sales to our largest customers or that we will be able to sell our products to other customers on terms that are favorable to us or at all. The loss of, or substantial decrease in the amount

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of purchases by, or a write-off of any significant receivables from, any of our major customers would materially and adversely affect our business, results of operations, liquidity and financial condition.

 

Unanticipated problems with our manufacturing equipment and facilities could have an adverse impact on our business.

 

Our capacity to manufacture steel products depends on the suitable operation of our manufacturing equipment, including blast furnaces, electric arc furnaces, continuous casters, reheating furnaces and rolling mills. Breakdowns requiring significant time and/or resources to repair, as well as the occurrence of unexpected adverse events, such as fires, explosions or adverse meteorological conditions, could cause production interruptions that could adversely affect our results of operations.

 

We have not obtained insurance against all risks, and do not maintain insurance covering losses resulting from catastrophes or business interruptions. In the event we are not able to quickly and cost-effectively remedy problems creating any significant interruption of our manufacturing capabilities, our operations could be adversely affected. In addition, in the event any of our plants were destroyed or significantly damaged or its production capabilities otherwise significantly decreased, we would likely suffer significant losses, and capital investments necessary to repair any destroyed or damaged facilities or machinery would adversely affect our profitability, liquidity and financial condition.

 

If we are unable to obtain or maintain quality and environmental management certifications for our facilities, we may lose existing customers and fail to attract new customers.

 

Most of our automotive parts customers in Mexico and the United States require that we have ISO 9001, TS 16949 and ISO 14001 certifications. All of the Mexican and U.S. facilities that sell to automotive parts customers are currently certified, as required. If the foregoing certifications are canceled, approvals are withdrawn or necessary additional standards are not obtained in a timely fashion, our ability to continue to serve our targeted market, retain our customers or attract new customers may be impaired. For example, our failure to maintain these certifications could cause customers to refuse shipments, which could materially and adversely affect our revenues and results of operations. We cannot assure you that we will be able to maintain these required certifications.

 

In the SBQ market, all participants must satisfy quality audits and obtain certifications in order to obtain the status of “approved supplier.” The automotive industry has put these stringent conditions in place for the production of auto parts to assure vehicle quality and safety. We currently are an approved supplier for our automotive parts customers. Maintaining these certifications is key to preserving our market share, because they can be a barrier to entry in the SBQ market, and we cannot assure you that we will be able to do so.

 

Failure to comply with environmental laws and regulations may result in fines, penalties or other significant liabilities or prevent us from operating our facilities.

 

Our operations are subject to a broad range of environmental laws and regulations governing our impact on air, water, soil and groundwater and exposure to hazardous substances. The costs of complying with and the imposition of liabilities pursuant to, environmental laws and regulation can be significant. Despite our efforts to comply with environmental laws and regulations, environmental incidents or events that negatively affect the operations of our facilities may occur. In addition, we cannot assure you that we will at all times operate in compliance with environmental laws and regulations. If we fail to comply with these laws and regulations, we may be assessed fines or penalties, be required to make large expenditures to comply with such laws and regulations, or be forced to shut down non-compliant operations and face lawsuits by third parties. In addition, environmental laws and regulations are becoming increasingly stringent and it is possible that future laws and regulations may require us to undertake material environmental compliance expenditures and require modifications in our operations. Furthermore, we need to maintain existing and obtain future environmental permits in order to operate our facilities. The failure to obtain necessary permits or consents or the loss of any permits could result in significant fines or penalties or prevent us from operating our facilities. We may also be subject, from time to time, to legal proceedings brought by private parties or governmental agencies with respect to environmental matters, including matters involving alleged property damage or personal injury that could result in significant liability. Certain of our facilities in the United States have been the subject of administrative action by federal, state and local environmental authorities. See Item 8. “Financial Information—Legal Proceedings.”

 

Greenhouse gas policies and regulations, particularly any binding restriction on emissions of greenhouse gases such as carbon dioxide, could negatively impact our steelmaking operations.

 

Our steel making operations in the United States and in Mexico use electric arc furnaces where carbon dioxide generation is primarily linked to energy use. In the United States, the Environmental Protection Agency has issued rules imposing inventory and reporting obligations to which some of our facilities are subject, and has also issued rules that will affect preconstruction permits for our facilities where increases in greenhouse gas pollutants are contemplated. The U.S. Congress has debated various measures for

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regulating greenhouse gas emission (such as carbon dioxide) and may enact them in the future. Such laws and regulations may also result in higher costs for coking coal, natural gas and electricity generated by carbon-based systems (such as coal-fired electric generating facilities). Such future laws and regulations, whether in the form of a cap-and-trade emissions permit system, a carbon tax or other regulatory regime may have a negative effect on our operations. Climate change policy is evolving at regional, national and international levels, and political and economic events may significantly affect the scope and timing of climate change measures that are ultimately put in place. As signatories to the United Nations Framework Convention on Climate Change (the “UNFCCC”), Mexico and the U.S. became subject to the Paris Agreement to fight climate change, which was approved at the 21th session of the UNFCCC conference in 2015. However, in June 2017, U.S. President Trump stated that the United States would withdraw from the Paris Agreement, but may enter into a future international agreement related to greenhouse gas emissions. In August 2017, the U.S. State Department officially informed the United Nations of the intent of the United States to withdraw from the Paris Agreement. The United States’ adherence to the four-year exit process is uncertain and/or the terms on which the United States may reenter the Paris Agreement or a separately negotiated agreement are unclear at this time. As a result, some of our facilities may ultimately be subject to future regional, provincial and/or federal climate change regulations to manage greenhouse emissions. More stringent greenhouse gas policies and regulations could adversely affect our business and results of operations.

 

If we are required to remediate contamination at our facilities we may incur significant liabilities.

 

Certain of our U.S. facilities are currently engaged in the investigation and/or remediation of environmental contamination. Most of these investigations relate to legacy activities by prior owners. We may in the future be subject to similar investigations or required to undertake similar remediation measures at other facilities. We recognize a liability for environmental remediation when it becomes probable that such remediation will be required and the amount can be reasonably estimated. As estimated costs to remediate change, or when new liabilities become probable, we adjust the record liabilities accordingly. However, due to the numerous variables associated with the judgments and assumptions that are part of these estimates and changes in governmental regulations and environmental technologies over time, we cannot assure you that our environmental reserves will be adequate to cover such liabilities or that our environmental expenditures will not differ significantly from our estimates or materially increase in the future. Failure to comply with any legal obligations requiring remediation of contamination could result in liabilities, imposition of cleanup liens and fines, and we could incur large expenditures to bring our facilities into compliance. See Item 8. “Financial Information—Legal Proceedings.”

 

We could incur losses due to product liability claims and may be unable to maintain product liability insurance on acceptable terms, if at all.

 

We could experience losses from defects or alleged defects in our steel products that subject us to claims for monetary damages. For example, many of our products are used in automobiles and light trucks and it is possible that a defect in one of these vehicles would result in product liability claims against us. In accordance with normal commercial sales, some of our products include implied warranties that they are free from defects, are suitable for their intended purposes and meet certain agreed upon manufacturing specifications. We cannot assure you that future product liability claims will not be brought against us, that we will not incur liability in excess of our insurance coverage, or that we will be able to maintain product liability insurance with adequate coverage levels and on acceptable terms, if at all.

 

Our controlling shareholder, Industrias CH, S.A.B. DE C.V., (Industrias CH) is able to exert significant influence on our business and policies and its interests may differ from those of other shareholders.

 

As of April 29, 2019, Industrias CH, which the chairman of our board of directors, Rufino Vigil González, controls, owned approximately 84% of our shares. Industrias CH nominated and elected all of the current members of our board of directors, and Industrias CH is in a position to exercise substantial influence and control over our business and policies, including the timing and payment of dividends. The interests of Industrias CH may differ significantly from those of other shareholders. Furthermore, as a result of the significant equity position of Industrias CH, there is currently limited liquidity in our series B shares and the ADSs.

 

Mr. Sergio Vigil González is the chief executive officer of Industrias CH and he also functions in a senior management role for the Company, although he holds no formal title at the Company. In this function, Mr. Vigil directs business strategies for the Company, negotiates potential acquisitions and directs intercompany loans, among other things. Our board of directors is aware of Mr. Vigil’s role at the Company and he has been formally authorized by our board of directors as a signatory of the Company. Mr. Vigil is the brother of our controlling shareholder and chairman of the board of directors, Rufino Vigil González. 

We have had a number of related party transactions with our affiliates.

 

Historically, we have engaged in a number and variety of transactions with our affiliates, including entities that Industrias CH owns or controls. While we believe that these transactions were made on terms that were not less favorable to us than those obtainable on an arm’s length basis, there was no independent determination of that fact. We expect that in the future we will continue to enter into transactions with our affiliates, and some of these transactions may be significant. See Item 7.B “Related Party Transactions.”

 

We depend on our senior management and their unique knowledge of our business and of the SBQ industry, and we may not be able to replace key executives if they leave.

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We depend on the performance of our executive officers and key employees. Our senior management has significant experience in the steel industry, and the loss of any member of senior management or our inability to attract and retain additional senior management could materially and adversely affect our business, results of operations, prospects and financial condition. We believe that the SBQ steel market is a niche market where specific industry experience is key to success. We depend on the knowledge of our business and the SBQ industry of our senior management team, including Luis Garcia Limon, our chief executive officer. In addition, we attribute much of the success of our growth strategy to our ability to retain most of the key senior management personnel of the companies and businesses that we have acquired. Competition for qualified personnel is significant, and we may not be able to find replacements with sufficient knowledge of, and experience in, the SBQ industry for our existing senior management or any of these individuals if their services are no longer available. Our business could be adversely affected if we cannot attract or retain senior management or other necessary personnel.

 

Our tax liability may increase if the tax laws and regulations in countries in which we operate change or become subject to adverse interpretations.

 

Taxes payable by companies in the countries in which we operate are substantial and include income tax, value-added tax, excise duties, profit taxes, payroll related taxes, property taxes and other taxes. Tax laws and regulations in some of these countries may be subject to change, varying interpretation and inconsistent enforcement. Ineffective tax collection systems and continuing budget requirements may increase the likelihood of the imposition of onerous taxes and penalties which could have a material adverse effect on our financial condition and results of operations. In addition to the usual tax burden imposed on taxpayers, these conditions create uncertainty as to the tax implications of various business decisions. This uncertainty could expose us to significant fines and penalties and to enforcement measures despite our best efforts at compliance, and could result in a greater than expected tax burden. In addition, many of the jurisdictions in which we operate, including Mexico, have adopted transfer pricing legislation. If tax authorities impose significant additional tax liabilities as a result of transfer pricing adjustments, it could have a material adverse effect on our financial condition and results of operations. It is possible that tax authorities in the countries in which we operate will introduce additional tax raising measures. The introduction of any such provisions may affect our overall tax efficiency and may result in significant additional taxes becoming payable. Any such additional tax exposure could have a material adverse effect on our financial condition and results of operations.

 

If we are unable to protect our information systems against data corruption, cyber-based attacks or network security breaches, our operations could be disrupted.

 

We are increasingly dependent on information technology networks and systems, including over the Internet, to process, transmit and store electronic information. In particular, we depend on our information technology infrastructure for digital marketing activities and electronic communications among us and our clients, suppliers and also among our subsidiaries and facilities. Security breaches or infrastructure flaws can create system disruptions, shutdowns or unauthorized disclosure of confidential information. If we are unable to prevent such breaches or flaws, our operations could be disrupted, or we may suffer financial damage or loss because of lost or misappropriated information.

 

Cyber threats are rapidly evolving and those threats and the means for obtaining access to information in digital and other storage media are becoming increasingly sophisticated. Cyber threats and cyber-attackers can be sponsored by countries or sophisticated criminal organizations or be the work of single “hackers” or small groups of “hackers.”

 

Insider or employee cyber and security threats are increasingly a concern for all companies, including ours. Nevertheless, as cyber threats evolve, change and become more difficult to detect and successfully defend against, one or more cyber-attacks might defeat our or a third-party service provider's security measures in the future and obtain the personal information of customers or employees. Employee error or other irregularities may also result in a defeat of security measures and a breach of information systems. Moreover, hardware, software or applications we use may have inherent defects of design, manufacture or operations or could be inadvertently or intentionally implemented or used in a manner that could compromise information security. A security breach and loss of information may not be discovered for a significant period of time after it occurs. While we have no knowledge of a material security breach to date, any compromise of data security could result in a violation of applicable privacy and other laws or standards, the loss of valuable business data, or a disruption of our business. A security breach involving the misappropriation, loss or other unauthorized disclosure of sensitive or confidential information could give rise to unwanted media attention, materially damage to our customer relationships and reputation, and result in fines, fees, or liabilities, which may not be covered by our insurance policies.

 

Risks Related to Global Economic Conditions

 

Global economic conditions, such as the latest financial crisis and economic recession that occurred during 2008 and 2009, may significantly impact our business.

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The financial crisis that began in the United States in 2008 led to a global recession in which overall economic activity decreased across the world generally and in North America in particular. The corresponding reduction in demand across the economy in general and in the automotive, construction and manufacturing sectors in particular has reduced demand for steel products in North America and globally. These economic conditions significantly impacted our business and results of operations. Although demand, production levels and prices in certain segments and markets have recovered and stabilized to a certain degree, the extent, timing and duration of the recovery and potential return to pre-crisis levels remains uncertain. If global macroeconomic conditions deteriorate, however, the outlook for steel producers would be adversely affected. It is difficult to predict the duration or severity of a new global economic downturn, or to what extent it will affect us. An unsustainable recovery and persistently weak economic conditions in our key markets could depress demand for our products and adversely affect our business and results of operations. We sell our products to the automotive and construction-related industries, both of which reported substantially lower customer demand during and after the latest global recession. As a result, our operating levels declined compared to pre-recession levels. While some of our end-product markets, such as the automotive industry, experienced recoveries during 2013, 2014 and 2015, in 2016 we experienced a reduction in our sales, and in 2017 there was a slight increase in sales to the automotive industry compared to 2016, in 2018 we experienced a slight decrease in our sales to the automotive industry compared to 2017. In addition to slackening demand by end consumers, we believe that some of our customers continue to experience and may experience in the future difficulty in obtaining credit or maintaining their ability to qualify for trade credit insurance, resulting in a further reduction in purchases and an increase in our credit risk exposure. Moreover, if a new global economic downturn occurs, we may face increased risk of insolvency and other credit related issues of our customers and suppliers, as we faced with our customers and suppliers particularly in industries that were hard hit by the latest recession, such as automotive, construction and appliance. Also, there is the possibility that our suppliers may face similar risks. A decrease in available credit may increase the risk of our customers defaulting on their payment obligations to us and may cause some of our suppliers to be delayed in filling or to be unable to fill our needs. The impact of global economic conditions on these industries may have a significant effect on our results of operations.

 

Additionally, if global economic conditions deteriorate, we may be required to undertake asset impairments, as we have been required to undertake in the past.

 

Because a significant portion of our sales are to the automotive industry, a decrease in automotive manufacturing could reduce our cash flows and adversely affect our results of operations.

 

Direct sales of our products to automotive assemblers and manufacturers accounted for approximately 65% of our net sales of SBQ in 2018. Demand for our products is affected by, among other things, the relative strength or weakness of the North American automotive industry. A reduction in vehicles manufactured in North America, the principal market for Republic’s SBQ steel products, would have an adverse effect on our results of operations. We also sell to independent forgers, components suppliers and steel service centers, all of which sell to the automotive market as well as other markets. Developments affecting the North American automotive industry may adversely affect us.

 

Our customers in the automotive industry continually seek to obtain price reductions from us, which may adversely affect our results of operations.

 

A challenge that we and other suppliers of intermediary products used in the manufacture of automobiles face is continued price reduction pressure from our customers in the automobile manufacturing business. Downward pricing pressure has been a characteristic of the automotive industry in recent years and it is migrating to all our vehicular markets. Virtually all automobile manufacturers have aggressive price reduction initiatives that they impose upon their suppliers, and such actions are expected to continue in the future. In the face of lower prices to customers, we must continue to reduce our operating costs in order to maintain profitability. We have taken and continue to take steps to reduce our operating costs to offset customer price reductions; however, price reductions are adversely affecting our profit margins and are expected to do so in the future. If we are unable to offset customer price reductions through improved operating efficiencies, new manufacturing processes, sourcing alternatives, technology enhancements and other cost reduction initiatives, or if we are unable to avoid price reductions from our customers, our results of operations could be adversely affected.

 

Sales may fall as a result of fluctuations in industry inventory levels.

 

Inventory levels of steel products held by companies that purchase our products can vary significantly from period to period. These fluctuations can temporarily affect the demand for our products, as customers draw from existing inventory during periods of low investment in construction and the other industry sectors that purchase our products and accumulate inventory during periods of high investment and, as a result, these companies may not purchase additional steel products or maintain their current purchasing volume. Accordingly, we may not be able to increase or maintain our current levels of sales volumes or prices.

 

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Risks Related to Mexico

 

Adverse economic conditions in Mexico may adversely affect our financial performance.

 

A substantial portion of our operations are conducted in Mexico and our business is affected by the performance of the Mexican economy. The latest global credit crisis and the economic recession has had significant adverse consequences on the Mexican economy, which in 2009 contracted by 6.5%, in 2010 grew by 5.5%, in 2011 and 2012 grew by 3.9%, in 2013 grew by 1.1%, in 2014 grew by 2.3%, in 2015 grew 2.5%, in 2016 grew by 2.9% in 2017 grew by 2% and in 2018 grew by 2% (according to preliminary figures of the Instituto Nacional de Estadística y Geografía (INEGI)), in terms of gross domestic production. Moreover, in the past, Mexico has experienced prolonged periods of economic crises, caused by internal and external factors over which we have no control. Those periods have been characterized by exchange rate instability, high inflation, high domestic interest rates, changes in oil prices, economic contraction, a reduction of international capital flows, balance of payment deficits, a reduction of liquidity in the banking sector and high unemployment rates. Decreases in the growth rate of the Mexican economy, or periods of negative growth, or increases in inflation may result in lower demand for our products. The Mexican government recently cut spending in response to a downward trend in international crude oil prices, and it may further cut spending in the future. These cuts could adversely affect the Mexican economy and, consequently, our business, financial condition, operating results and prospects. We cannot assure you that economic conditions in Mexico will not worsen, or that those conditions will not have an adverse effect on our financial performance.

 

Political, social and other developments in Mexico could adversely affect our business.

 

Political, social and other developments in Mexico may adversely affect our business. Social unrest, such as strikes, suspension of labor, demonstrations, acts of violence and terrorism in the Mexican states in which we operate could disrupt our financial performance. Additionally, the Mexican government has exercised, and continues to exercise, significant influence over the economy. Accordingly, Mexican federal governmental actions and policies concerning the economy, the regulatory framework, the social or political context, and state-owned and stated controlled entities or industries could have a significant impact on private sector companies and on market conditions, prices and returns of Mexican securities. In the past, governmental actions have involved, among other measures, increases in interest rates, changes in tax policies, price controls, currency devaluations, capital controls and limits on imports.

 

Presidential and federal congressional elections in Mexico were held on July 1, 2018. Mr. Andrés Manuel López Obrador, a member of the Movimiento Regeneración Nacional (National Regeneration Movement, or Morena), was elected President of Mexico and took office on December 1, 2018, replacing Mr. Enrique Peña Nieto, a member of the Partido Revolucionario Institucional (Institutional Revolutionary Party, or PRI). The new President’s term will expire on September 30, 2024. The newly-elected members of the Mexican Congress took office on September 1, 2018. The uncertainty regarding the direction of policymaking with the new government could significantly change Mexico’s political and economic situation, which consequently could affect our operations. As of the date of this annual report, the National Regeneration Movement holds an absolute majority in the Chamber of Deputies and controls 19 of 32 Mexican state congresses. This should facilitate the passing of legislation, including potential changes to the Mexican Constitution, which may increase political uncertainty. We cannot provide any assurances that political developments in Mexico, over which we have no control, will not have an adverse effect on our business, financial condition or results from operations. We cannot assure you that the current political situation or future developments in Mexico, over which we have no control, will not have an adverse effect on our business, financial condition or results of operations. Further, we cannot assure you that any new government policies will not adversely affect our business, financial condition and results of operations.

 

The Mexican government has exercised, and continues to exercise, significant influence over the Mexican economy.

 

The Mexican federal government has exercised, and continues to exercise, significant influence over the Mexican economy. Accordingly, Mexican federal governmental actions and policies concerning the economy, state-owned enterprises and state controlled, funded or influenced financial institutions could have a significant impact on private sector entities in general and on us in particular, and on market conditions, prices and returns on securities of Mexican companies. The Mexican federal government occasionally makes significant changes in policies and regulations, and may do so again in the future. Actions to control inflation and other regulations and policies have involved, among other measures, increases in interest rates, changes in tax policies, price controls, currency devaluations, capital controls and limits on imports. Tax legislation in Mexico is subject to continuous change and we cannot assure you whether the Mexican government may maintain existing political, social, economic or other policies, or whether changes may have a material adverse effect on our financial performance.

 

Violence in Mexico may adversely impact the Mexican economy and have a negative effect on our financial performance.

 

Mexican drug related violence and other organized crime have escalated significantly since 2006, when the Mexican federal government began increasing the use of the army and police to fight drug trafficking. Drug cartels have carried out attacks largely directed at competing drug cartels and law enforcement agents, however they also target companies and their employees, including companies’ industrial properties, including through extortion, theft from trucks or industrial sites, kidnapping and other forms of crime and violence. This increase in violence and criminal activity has led to increased costs for companies in the form of stolen products

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and added security and insurance. Corruption and links between criminal organizations and authorities also create conditions that affect our business operations, as well as extortion and other acts of intimidation, which may have the effect of limiting the level of action taken by federal and local governments in response to such criminal activity. We cannot assure you that the levels of violent crime in Mexico, over which we have no control, will not have an adverse effect on the country’s economy and, as a result, on our financial performance.

 

Depreciation of the Mexican peso relative to the U.S. dollar could adversely affect our financial performance.

 

The peso historically has been subject to significant depreciation against the U.S. dollar. Depreciation of the Mexican peso relative to the U.S. dollar decreases a portion of our revenues in U.S. dollar terms, as well as increases the cost of a portion of the raw materials we require for production and any debt obligations denominated in U.S. dollars, and thereby may negatively affect our results of operations. The Mexican Central Bank may from time to time participate in the foreign exchange market to minimize volatility and support an orderly market. The Mexican Central Bank and the Mexican government have also promoted market-based mechanisms for stabilizing foreign exchange rates and providing liquidity to the exchange market, such as using over-the-counter derivatives contracts and publicly-traded futures contracts on the Chicago Mercantile Exchange. However, the Peso is currently subject to significant fluctuations against the U.S. dollar and may be subject to such fluctuations in the future. Since the second half of 2008, the value of the Mexican peso relative to the U.S. dollar has fluctuated significantly. According to the U.S. Federal Reserve Board, during this period the exchange rate registered a low of Ps. 9.91 to U.S.$1.00 on August 5, 2008, and a high of Ps. 21.89 to U.S.$1.00 on January 19, 2017. In 2018 the exchange rate registered a low of Ps. 17.97 to U.S.$1.00 and a high of Ps. 20.67 to U.S.$1.00.

 

A severe depreciation of the Mexican peso may also result in disruption of the international foreign exchange markets and may limit our ability to transfer and to convert Mexican pesos into U.S. dollars and other currencies. While the Mexican government does not currently restrict, and since 1982 has not restricted the right or ability of Mexican or foreign persons or entities to convert Mexican pesos into U.S. dollars or to transfer other currencies out of Mexico, the Mexican government could impose restrictive exchange rate policies in the future.

 

Currency fluctuations or restrictions on transfer of funds outside Mexico may have an adverse effect on our financial performance, and could adversely affect the U.S. dollar value of the price of our Series B shares and the ADSs.

 

On December 17, 2015, a day after the U.S. Federal Reserve increased the target range for the federal funds rate in the United States by 25 basis points, the Mexican Central Bank increased the reference rate from 3.00% to 3.25% in an effort to counteract a sharp depreciation of the Mexican peso that could affect Mexico’s expected rate of inflation. On February 17, 2016, the Mexican Central Bank further increased the reference rate from 3.25% to 3.75%, and has been increasing the reference rate regularly since then, to 8.25% as of March 26, 2019. We cannot assure you that, as a result of future increases by U.S. Federal Reserve of the target range for the federal funds rate in the United States, the Mexican economy or the value of securities issued by Mexican companies will not be affected, including as a result of any precipitous unwinding of investments in emerging markets, depreciations and increased volatility in the value of their currency and higher interest rates.

 

High inflation rates in Mexico may affect demand for our products and result in cost increases.

 

Mexico has historically experienced high annual rates of inflation. The annual rate of inflation, as measured by changes in the Mexican national consumer price index (Índice Nacional de Precios al Consumidor) published by the INEGI was 4.1% for 2014, 2.1% for 2015, 3.4% for 2016, 6.8% for 2017 and 4.8% for 2018. High inflation rates could adversely affect our business and results of operations by reducing consumer purchasing power, thereby adversely affecting demand for our products, increasing certain costs beyond levels that we could pass on to consumers, and by decreasing the benefit to us of revenues earned if the inflation rate exceeds the growth in our pricing levels.

 

Developments in other countries could adversely affect the Mexican economy, our financial performance and the price of our shares.

 

The Mexican economy and the market value of Mexican companies may be, to varying degrees, affected by economic and market conditions globally, in other emerging market countries and major trading partners, in particular the United States. Although economic conditions in other countries may differ significantly from economic conditions in Mexico, investors’ reactions to adverse developments in other countries may have an adverse effect on the market value of securities of Mexican issuers or of Mexican assets. In recent years, for example, prices of both Mexican debt securities and equity securities decreased substantially as a result of developments in Russia, Asia, Europe and Brazil. Also, credit issues in the United States have in the past resulted in significant fluctuations in global financial markets, including Mexico.

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In addition, in recent years economic conditions in Mexico have become increasingly correlated with economic conditions in the United States as a result of the North American Free Trade Agreement, or NAFTA, increased economic activity between the two countries, and the remittance of funds from Mexican immigrants working in the United States to Mexican residents. However, Donald Trump’s victory in the U.S. presidential election in November 2016 has created uncertainty regarding the future of NAFTA and trade between the U.S. and Mexico. On January 20, 2017, Donald Trump became president of the U.S. President Trump and the Trump administration have made comments suggesting that he intends to re-negotiate the free trade agreements that the U.S. is party to, including NAFTA, and to implement high import taxes. On March 1, 2018, President Trump announced a 25% tariff on all steel products and a 10% tariff on all aluminum products imported into the United States for an indefinite amount of time under Section 232 of the Trade Expansion Act. In addition, leaders from the United States, Canada and Mexico also commenced discussions regarding NAFTA on January 23, 2018 in Montreal, Canada. In November 2018, the United States, Mexico and Canada signed the United States-Mexico-Canada Agreement, or USMCA, which is designed to replace NAFTA. The USMCA remains subject to approval and ratification by the legislatures in each of the three countries. If the United States fails to ratify the USMCA and withdraws from NAFTA, or if the United States withdraws from or makes material changes to other international trade agreements to which it is a party, trade barriers and other costs associated with trade between the United States and Mexico may increase, which could have a material adverse effect on our business, financial condition and results of operations.

 

Moreover, the debt crisis in the European Union, changes in Chinese exchange rate policy, continuing concerns regarding the slowdown of the Chinese economy, recent terrorist attacks and recent sharp declines in the price of crude oil, may also affect the global and Mexican economies. We cannot assure you that events in other emerging market countries, in the United States or elsewhere will not adversely affect our financial performance.

 

We could be adversely affected by violations of the Mexican Federal Anticorruption Law in Public Contracting, the U.S. Foreign Corrupt Practices Act and similar worldwide anti-bribery laws.

 

The Mexican Federal Anticorruption Law (Ley Federal de Anticorrupción en Contrataciones Públicas), the U.S. Foreign Corrupt Practices Act and similar worldwide anti-bribery laws generally prohibit companies and their intermediaries from making improper payments to government officials and other persons for the purpose of obtaining or retaining business. There can be no assurance that our internal control policies and procedures will protect us from reckless or criminal acts committed by our employees or agents. Violations of these laws, or allegations of such violations, could disrupt our business and could have an adverse effect on our business, financial condition and results of operations.

 

Our financial statements are prepared in accordance with IFRS and therefore are not directly comparable to financial statements of other companies prepared under U.S. GAAP or other accounting principles.

 

All Mexican companies listed on the Mexican Stock Exchange must prepare their financial statements in accordance with IFRS which differs in certain significant respects from U.S. GAAP. Items on the financial statements of a company prepared in accordance with IFRS may not reflect its financial position or results of operations in the way they would be reflected had such financial statements been prepared in accordance with U.S. GAAP. Accordingly, Mexican financial statements and reported earnings are likely to differ from those of companies in other countries in this and other respects.

 

Mexico has different corporate disclosure and accounting standards than those in the United States and other countries.

 

A principal objective of the securities laws of the United States, Mexico and other countries is to promote full and fair disclosure of all material corporate information, including accounting information. However, there may be different or less publicly available information about issuers of securities in Mexico than is regularly made available by public companies in countries with more highly developed capital markets, including the United States. The disclosure standards imposed by the Mexican Stock Exchange may be different than those imposed by securities exchanges in other countries or regions such as the United States. As a foreign private issuer, we are not subject to U.S. proxy rules and are exempt from certain reports under the U.S. Securities Exchange Act of 1934, as we are not required to file annual, quarterly and current reports and financial statements with the SEC as frequently or as promptly as U.S. domestic reporting companies whose securities are registered under the Exchange Act. These exemptions and leniencies will reduce the frequency and scope of information and protections available to you in comparison to those applicable to a U.S. domestic reporting company.

 

Risks Related to Brazil

 

Brazilian political and economic conditions, and the Brazilian government’s economic and other policies, may negatively affect demand for our products.

 

The Brazilian economy has been characterized by frequent and occasionally extensive intervention by the Brazilian government and unstable economic cycles. The Brazilian government has often changed monetary, taxation, credit, tariff and other policies to influence the course of Brazil’s economy. The Brazilian government’s actions to control inflation and implement other policies have at times involved wage and price controls, blocking access to bank accounts, imposing capital controls and limiting imports into Brazil.

 

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Our results of operations and financial condition may be adversely affected by factors such as:

 

  fluctuations in exchange rates;

 

  exchange control policies;

 

  interest rates;

 

  inflation;

 

  tax policies;

 

  expansion or contraction of the Brazilian economy, as measured by rates of growth in GDP;

 

  liquidity of domestic capital and lending markets; and

 

  other political, diplomatic, social and economic developments in or affecting Brazil.

 

Brazilian markets have been experiencing heightened volatility due to the uncertainties derived from the ongoing Lava Jato investigation, which is being conducted by the Office of the Brazilian Federal Prosecutor, and its impact on the Brazilian economy and political environment. Members of the Brazilian federal government and of the legislative branch, as well as senior officers of the state-owned oil company Petróleo Brasileiro S.A. – Petrobras, have faced allegations of political corruption. These government officials and senior officers allegedly accepted bribes by means of kickbacks on contracts granted by Petrobras to several infrastructure, oil and gas and construction companies. As a result of the Lava Jato investigation, a number of senior politicians, including congressman and officers of the major state-owned companies in Brazil resigned or have been arrested.

 

The potential outcome of these investigations and proceedings is uncertain, but they have adversely affected and we expect that they will continue to adversely affect the Brazilian markets. We cannot predict whether the allegations or proceedings will lead to further political and economic instability or whether new allegations against government officials or other companies in Brazil will arise in the future. In addition, we can neither predict the outcome of any such allegations and proceedings nor their effect on the Brazilian economy.

 

Amidst this background of political uncertainty, in August 2016, the Brazilian Senate approved the removal from office of Brazil’s then-President, Dilma Rousseff, following a legal and administrative impeachment process for infringement of budgetary laws. Michel Temer, the former Vice-President, who assumed the presidency of Brazil following Rousseff’s ouster, is also under investigation on corruption allegations. In addition, the former President, Luiz Inacio Lula da Silva, began serving a 12-year prison sentence on corruption and money laundering charges in April 2018 yet had led for a while the polls as a top contender to win the 2018 presidential election. On October 28, 2018, Jair Bolsonaro, a former member of the military and three-decade congressman, was elected the president of Brazil and took office on January 1, 2019. During his presidential campaign, Bolsonaro was reported to favor the privatization of state-owned companies, economic liberalization, and social security and tax reforms. However, there is no guarantee that Bolsonaro will be successful in executing his campaign promises or passing certain favored reforms fully or at all, particularly when confronting a fractured congress. In February 2019, the Brazilian federal government presented to the Congress a bill proposing a large and comprehensive change of Brazil’s public social security system. If some or all of these public expenses are maintained and the required reforms are not passed, Brazil will continue to run a budget deficit for 2019 and the years going forward. We cannot predict the effects of this budget deficit on the Brazilian economy. We cannot predict which policies the Brazilian federal government may adopt or change or the effect that any such policies might have on our business and on the Brazilian economy. Any such new policies or changes to current policies may have a material adverse impact on our business, results of operations, financial condition and prospects. In addition, his current minister of the economy, Paulo Guedes, proposed during the presidential campaign the revocation of income tax exemption over payment of dividends, which, if enacted, would increase the tax expenses associated with any dividend or distribution by Brazilian companies, which could impact our capacity to receive, from our subsidiaries, future cash dividends or distributions net of taxes. Moreover, Bolsonaro was generally a polarizing figure during his campaign for presidency, particularly in relation to certain of his behavioral views, and we cannot predict the ways in which a divided electorate may continue to impact his presidency and ability to implement policies and reforms, all of which could have a negative impact on our business

 

In addition, the Brazilian steel sector is facing a severe crisis. According to the Brazilian Steel Institute, steel consumption fell by 14% in the first nine months of 2015. We believe this crisis is largely due to a sharp decrease in durable goods manufacturing, particularly motor vehicle production, which is depressing steel consumption and offsetting the positive impact of construction activity associated with the summer 2016 Olympic Games held in Rio de Janeiro. The crisis in the Brazilian steel sector could have a material and adverse effect on our Brazilian business segment.

 

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Brazil has experienced extremely high rates of inflation in the past and has therefore implemented monetary policies that have resulted in one of the highest interest rates in the world. According to the National Extended Consumer Price Index (Índice Nacional de Preços ao Consumidor Amplo), published by the IBGE, the Brazilian price inflation rates were 6.2% in 2014, 11.3% in 2015, 6.6% in 2016, 2.95% in 2017 and 3.43% in 2018.  

 

However, the Brazilian real currency (“BRL”) remains very sensitive to political developments. For example, it depreciated by -9% against the U.S. dollar the day after the Temer scandal surfaced. Although the disinflation process is expected to continue over the next months, allowing for further rate cuts, short-term risks should be closely monitored such as (i) the impact on prices of the approval of fiscal consolidation measures, (ii) the uncertain external environment and its impact on the currency and (iii) shocks on food prices stemming to a large extent from unfavorable weather conditions.

 

There have been significant fluctuations in the exchange rate between the Brazilian currency and the U.S. dollar and other currencies. For example, the Brazilian real depreciated 19.7% and 53.2% against the U.S. dollar in 2001 and 2002, respectively and appreciated 18.0%, 8.0%, 12.3%, 8.5% and 17.0% against the U.S. dollar in 2003, 2004, 2005, 2006 and 2007, respectively. In 2008, the Brazilian real depreciated again approximately 31.9% against the U.S. dollar. In 2009, the Brazilian real appreciated 25.3% against the U.S. dollar, while in December 31, 2010 the Brazilian real to U.S. dollar exchange rate was R$1.6662, according to the Brazilian Central Bank. In 2011, the Brazilian real depreciated by 13.6% against the U.S. dollar, from R$1.6510 in the beginning of the period to R$1.8758 by the end of the period, and in 2012 the Brazilian real went from R$1.8683 in the beginning of the year to R$2.0435 by the end of the period, amounting to a 9.4% depreciation against the U.S. dollar. In 2013, the Brazilian real went from R$2.0415 in the beginning of the year to R$2.3426 by the end of the period. In 2014, the Brazilian real went from R$2.3975 in the beginning of the year to R$2.6652 by the end of the period, corresponding to a 10.8% depreciation against the U.S. dollar.

 

However, during 2015, due to the poor economic conditions in Brazil, including as a result of political instability, the Brazilian real has devalued at a rate that is much higher than in previous years. On September 24, 2015, the Brazilian real fell to the lowest level since the introduction of the currency, at R$4.1949 per U.S.$1.00. In 2015, the Brazilian real depreciated 45%, reaching R$3.9048 per U.S.$1.00 on December 31, 2015. Conversely, in 2016, the Brazilian real went from R$4.0387 per U.S.$1.00 at the beginning of the year to R$3.2591 per U.S.$1.00 on December 31, 2016, corresponding to a 19.3% appreciation against the U.S. dollar. In 2017, the Brazilian real went from R$3.2591 per U.S.$1.00 at the beginning of the year to R$3.3080 per U.S.$1.00 on December 31, 2017, corresponding to a depreciation of 1.5% against the U.S. dollar. In 2018, the Brazilian real went from R$3.3080 per U.S.$1.00 at the beginning of the year to R$3.8748 per U.S.$1.00 on December 31, 2018, corresponding to a depreciation of 17.1% against the U.S. dollar. There can be no assurance that the Brazilian real will not depreciate or appreciate further against the U.S. dollar.

Furthermore, the Brazilian economy has experienced a sharp downturn in recent years due, in part, to the interventionist economic and monetary policies of the Brazilian government and the global drop in commodity prices. The current Brazilian federal government is expected to propose the general terms of a fiscal reform to stimulate the economy and reduce the forecasted budget deficit for 2019, but it is uncertain whether the Brazilian government will be able to gather the required support in the Brazilian Congress to pass additional specific reforms. As of the date of this annual report, many of the proposed public expenses in Brazil’s budget have been maintained and it is not clear whether other expenses will be reduced or entirely eliminated. If some or all of these public expenses are maintained, Brazil will continue to run a budget deficit for 2019 and the years going forward. We cannot predict the effects of this budget deficit on the Brazilian economy. We cannot predict which policies the Brazilian federal government may adopt or change or the effect that any such policies might have on our business and on the Brazilian economy. Any such new policies or changes to current policies may have a material adverse impact on our business, results of operations, financial condition and prospects.

Uncertainty as to whether the Brazilian government will implement changes in policy or regulations affecting these or other factors in the future may contribute to economic uncertainty in Brazil and to heightened volatility in the Brazilian securities markets.

 

 

Item 4. Information on the Company

 

A. History and Development of the Company

 

Overview

 

We are a diversified manufacturer, processor and distributor of SBQ steel and structural steel products with production and commercial operations in the United States, Mexico and Brazil. We believe that in 2014, 2015, 2016, 2017 and 2018 we were an important producer of SBQ products in both the United States and Mexico, in each case in terms of shipped volume. We also believe

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that in 2014, 2015, 2016, 2017 and 2018 we were an important producer of structural and light structural steel products in Mexico in terms of shipped volume.

 

Our SBQ products are used across a broad range of highly engineered end-user applications, including axles, hubs and crankshafts for automobiles and light trucks, machine tools and off-highway equipment. Our structural steel products are mainly used in the non-residential construction market and other construction applications.

 

We focus on the Mexican and U.S. specialty steel markets by providing high value added products and services from our strategically located plants. The quality of our products and services, together with cost benefits generated by our facility locations, has allowed us to develop long standing relationships with many of our SBQ clients, which include Mexico and U.S.-based automotive and industrial equipment manufacturers and their suppliers. In addition, our facilities located in the North West and Central parts of Mexico allow us to serve the structural steel and construction markets in those regions and South West California with an advantage in the cost of freight over competitors which do not have production facilities in such regions.

 

Our legal name is Grupo Simec, S.A.B. de C.V. and our commercial name for advertising and publicity purposes is Simec. We are a sociedad anónima bursátil de capital variable, organized under the laws of Mexico. We are domiciled in the city of Guadalajara, Jalisco, and our principal administrative office is located at Calzada Lázaro Cárdenas 601, Guadalajara, Jalisco, Mexico 44440. Our telephone number is +52-33-3770-6700.

 

 

Our History

 

Our steel operations commenced in 1969 when a group of families from Guadalajara, Jalisco, formed Compañía Siderúrgica de Guadalajara, S.A. de C.V. (“CSG”), a mini-mill steel company. In 1980, Grupo Sidek, S.A. de C.V. (“Sidek”), our former parent company, was incorporated and became the holding company of CSG. In 1990, Sidek consolidated its steel and aluminum operations into a separate subsidiary, Grupo Simec, S.A. de C.V., a Mexican corporation with limited liability, organized under the laws of Mexico.

 

In March 2001, Sidek consummated the sale of its entire approximate 62% controlling interest in our company to Industrias CH. In June 2001, Industrias CH increased its interest in us to 82.5% by acquiring additional shares from certain of our bank creditors that had converted approximately Ps. 1,185 million (U.S.$95.4 million) of our debt (U.S.$90.2 million of principal and U.S.$5.2 million of interest) into our common shares. Industrias CH subsequently increased its equity position in us through various conversions of debt to equity and capital contributions, to an 84% interest.

 

In August 2004, we acquired the property, plant and equipment and the inventories, and assumed liabilities associated with the seniority premiums of employees, of the Mexican steel-making facilities of Industrias Ferricas del Norte S.A. (Corporacion Sidenor of Spain, or “Grupo Sidenor”) located in Apizaco, Tlaxcala and Cholula, Puebla. We refer to this acquisition as the “Atlax Acquisition.” Our total net investment in this transaction was approximately Ps. 1,589 million (U.S.$122 million) (excluding value added tax of approximately Ps. 208 million (U.S.$16 million) paid in 2004 and recouped from the Mexican government in 2005), funded with cash from operations, and a Ps. 247 million (U.S.$19 million) capital contribution from Industrias CH.

 

In July 2005, we and Industrias CH acquired 100% of the capital stock of Republic, a U.S. producer of SBQ steel. We acquired 50.2% of Republic’s stock through our majority owned subsidiary, SimRep, and Industrias CH purchased the remaining 49.8% through SimRep. We financed our portion of the Ps. 2,795 million (U.S.$245 million) purchase price principally through a loan we received from Industrias CH that we have repaid in full.

 

On October 9, 2006 we sold our share ownership in Administradora de Cartera de Occidente, S.A. de C.V. (“ACOSA”). ACOSA engaged in the recovery of non-performing loans acquired pursuant to a public bidding process conducted by the Instituto de Protección al Ahorro Bancario in Mexico.

 

On November 24, 2007 we purchased 99.95% of the shares of three subsidiaries of Grupo TMM S.A de C.V. These three subsidiaries were TMM América, S.A. de C.V., TMM Continental, S.A. de C.V. and Mutimodal Doméstica, S.A. de C.V. Following the purchase, these companies have engaged in marketing steel. In February 2008, the names of these three companies were changed to CSG Comercial, S.A. de C.V., Comercializadora de Productos de Acero de Tlaxcala, S.A. de C.V. and Siderúrgica de Baja California, S.A. de C.V.

 

In 2007, the board of directors of CSG decided to spin-off CSG. CSG conveyed 87.4% of its stockholders equity to Tenedora CSG, S.A. de C.V, as the spun-off company. This corporate restructuring did not have a material effect on our consolidated financial statements.

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On May 30, 2008, we acquired all the capital stock of Aceros DM and certain affiliated companies (“Grupo San”) for a total cost of approximately Ps. 8,730 million (U.S.$844 million at the exchange rate at that time). Grupo San is a long products steel mini-mill and the second-largest corrugated rebar producer in Mexico. Grupo San’s operations are based in San Luis Potosí, Mexico. Its plants have a production capacity of 700 thousand tons of finished products annually.

 

On July 29, 2008, the company acquired 100% of the shares of Aroproc, S. A. de C. V., Del-Ucral, S. A. de C. V., Qwer, S. A. de C. V. and Transporte Integral Doméstico, S.A. de C.V., subsidiaries of Grupo TMM, S. A. de C. V., to convert them into the operating manager of the steel plants located in Mexico. On July 30 2008, these companies were renamed to Promotora de Aceros San Luis, S.A. de C.V., Comercializadora Aceros DM, S.A. de C.V., Comercializadora Msan, S.A. de C.V. and Productos Siderúrgicos de Tlaxcala, S.A. de C.V. respectively.

 

On December 26, 2008, the company acquired 99.95% of the shares of Northarc Express, S.A. de C.V., a subsidiary corporation of Grupo TMM, S.A. de C.V., to convert this company into the operating manager of iron and steel plants located in Mexico. On January 6, 2009, this company changed its name to Simec International 2, S.A. de C.V.

 

On February 5, 2009, Simec International 2, S.A. de C.V. divested assets and liabilities to three new wholly owned Mexican subsidiaries. As a consequence of such reorganization, Simec International 3, S.A. de C.V. operated the Tlaxcala and Puebla facilities, Simec International 4, S.A. de C.V. and Simec International 5, S.A. de C.V jointly operated the San Luis de Potosí facilities, and Simec International 2, S.A. de C.V. operated the Guadalajara and Mexicali facilities.

 

In 2009 we incorporated two new wholly owned subsidiaries. Simec Acero, S.A. de C.V. distributes all Grupo Simec products in Mexico and Simec USA, Corp. is responsible for all export sales of our Mexican companies.

 

On May 12, 2009, we incorporated Pacific Steel Projects, Inc., a wholly owned subsidiary organized under the laws of the State of California whose purpose is to develop technology improvement projects for our Mexican facilities.

 

On August 10, 2009, Simec International, S.A. de C.V. divested assets and liabilities to four new wholly owned Mexican subsidiaries named Siminsa A, S.A. de C.V., Siminsa B, S.A. de C.V., Siminsa C, S.A. de C.V. and Siminsa D, S.A. de C.V. After the divesture, Siminsa A was merged into Simec International 2, Siminsa B was merged into Simec International 3, Siminsa C was merged into Simec International 4 and Siminsa D was merged into Simec International 5.

 

On November 10, 2009, Simec International 2, Simec International 3, Simec International 4 and Simec International 5 divested assets and liabilities to Simec Steel, Inc., a new wholly owned subsidiary organized under the laws of the State of California whose purpose is to provide financing to the Mexican companies of the group and to seek new investment opportunities.

 

On May 31, 2010 Arrendadora Simec, S.A. de C.V. divested assets, liabilities and equity to our subsidiary Corporacion ASL, S. A. de C.V. which assumed the operation of Arrendadora Simec, S.A. de C.V.

 

On June 28, 2010, our subsidiary Simec International 6, S.A. de C.V., whose purpose is to produce steel, was constituted. Simec International 6, S.A. de C.V. begun operations in November of 2010.

 

On June 30, 2010, Simec International, S.A. de C.V., divested assets and equity to our subsidiary Simec International 7, S.A. de C.V. Among the assets transferred the shares of Aceros DM were included.

 

On September 3, 2010 we formed a Brazilian entity denominated GV do Brazil Indústria e Comércio de Aço Ltda. On august 5, 2011 we acquired 1,300,000 square meters of land on Pindamonhangaba, São Paulo State, Brazil, and paid Ps. 121.1 million (U.S.$8 million) for the construction of a new steel facility. In November 2015, our steel plant in Brazil started operations. This facility has a production capacity of 450,000 tons of finished goods of rebar and wire, and 800 employees. We have already established contact with major local suppliers of raw materials. The next step is to attract the special steels market for the automotive and electro-welded wire derivatives products.

 

On October 21, 2010 in the Extraordinary Shareholders Meeting of Arrendadora Simec S.A. de C.V. the dissolution of the company was approved.

 

On November 2, 2010, we acquired 100% of the shares of Lipa Capital, LLC. The total cost of this acquisition was of Ps. 187 million (U.S.$15.2 million at the exchange rate at that time). On December 9, 2010, Lipa Capital, LLC merged to Simec International 6, S. A. de C. V.

 

On February 3, 2011, we, through two of our wholly owned subsidiaries (Solon Wire Processing LLC, and the newly formed Republic Memphis LLC), acquired certain plants, machinery and equipment from BCS Industries LLC and affiliates (“Bluff City

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Steel”), which was our customer and vendor. For these assets we paid Ps. 30.6 million (U.S.$2.5 million) in cash and forgave approximately Ps. 73.5 million (U.S.$6 million due) by Bluff City Steel to us.

 

On May 2, 2011 in an Extraordinary Shareholders Meetings of Acero Transportes S.A. de C.V. and Acero Transportes San S.A. de C.V. (subsidiaries of Grupo San), their merger was authorized, whereby Acero Transportes S.A. de C.V. was merged into Acero Transportes San S.A. de C.V.

 

On May 20 and October 3, 2011 in Extraordinary Shareholders Meetings, Simec International 2, S.A. de C.V., Simec International 3 S.A. de C.V., Simec International 4 S.A. de C.V. and Simec International 5 S.A. de C.V., changed their address, nationality and tax authority to report to the State of California, USA, transforming them into incorporated companies in accordance with the laws and regulations of the State of California, USA.

 

On May 31, 2011 we sold our shares in Arrendadora del Norte de Matamoros S.A. de C.V. to Perfiles Comerciales Sigosa, S.A. de C.V. (subsidiary of ICH) for Ps. 42.5 thousand, paid in cash.

 

On September 1, 2011, the merger of Procesadora Industrial San S.A. de C.V. into Malla San S.A. de C.V. (subsidiaries of Grupo San) was authorized in their respective Extraordinary Shareholders Meetings.

 

On November 2011, Republic Steel, Inc. (a subsidiary of SimRep Corporation) entered into an agreement with an unrelated third-party “purchaser” for the factoring of specific accounts receivable in order to reduce the amount of working capital required to fund accounts receivable. The agreement was amended on October 26, 2016, so that any party can terminate the agreement after giving seven days’ notice. On the sale date, the purchaser advances funds equivalent to 80% of the value of receivables. The maximum amount of outstanding advances related to the assigned receivables is U.S.$30 million (Ps. 620 million). Proceeds on the transfer reflect the face value of the account minus a discount. The remaining amount between the receivable balance and the advance is held in reserve by the purchaser. Payment of the funds held in reserve, minus a discount fee are made by the purchaser within four days of receipt of payment on collection of funds related to each assigned receivable. The discount fee, which generally ranges from 1% if paid within 30 days (of the advance date) to 3.75% if paid within 90 days, is recorded as a charge to interest expense in the Consolidated Statements of Comprehensive Income. The purchaser shall have no recourse against Republic Steel, Inc. if payments are not received due to insolvency of an account debtor within 120 days of the invoice date. However, while the facility calls for the sale, assignment, transfer and conveyance of all rights, title and interests in the selected accounts receivable, the purchaser may put and charge-back any receivable not paid to the purchaser within 90 days of purchase for any reason besides insolvency of the account debtor. As collateral for the repayment of advances for receivables sold, the purchaser has a priority security interest in all accounts receivable of Republic Steel, Inc. Republic Steel, Inc. sold a face amount of Ps. 454.1 million (U.S.$23.1 million) and Ps. 501.3 million (U.S.$25.4 million) of accounts receivable to purchasers during the years ended December 31, 2018 and 2017, respectively. Discount fees incurred pursuant to this agreement were approximately Ps. 9.5 million (U.S.$0.5 million) and Ps. 9.5 million (U.S.$0.5 million) for the years ended December 31, 2018 and 2017, respectively. Of the face amount of accounts receivable sold to purchasers, Ps. 53.1 million (U.S.$2.7 million) and Ps. 37.5 million (U.S.$1.9 million) had not been collected by the purchaser at December 31, 2018 and 2017, respectively, and therefore, such amount at December 31, 2018, is subject to possible charge-back to us.

 

On December 30, 2011 Simec International 7, S.A. de C.V. sold to Corporación ASL S.A. de C.V. all of its shares in Corporación Aceros DM, S.A de C.V., comprising of a total of 627,305,446 shares (99.9% of the common stock) for a value of Ps. 3,200 million, comprised of a down payment of Ps. 63 million and the remaining of Ps. 3,137 million due on April 30, 2012. This transaction generated a tax loss of Ps. 7,860 million which amount under the Mexican Income Tax Law (Ley de Impuesto Sobre la Renta), may be deducted against future gains related to dispositions of securities. On January 30, 2012 Simec International 7, S.A. de C.V. filed a demand challenging the current law, which limits the deduction of this net loss related to shares sales. On September 24, 2013, the second district judge denied the shelter and protection of the federal courts against the company pursuant to Article 32, Section XVII of the Mexican Income Tax Law, arguing that constitutional guaranties were not violated. Dissatisfied with the decision, the company filed an application for review of such judgment with the Mexican Supreme Court of Justice. The Supreme Court resolved that the constitutionality of Article 32, Section XVII of the Mexican Income Tax Law was not violated arguing that the Income Tax Law does not violate the guaranties of tax fairness and proportionality under Article 31, section IV of the Mexican Constitution. As a result, tax losses of the company may only be applied against future gains related to dispositions of securities or capital gains.

 

On August 1, 2012 in their respective extraordinary shareholders meetings of Abastecedora Siderúrgica, S.A. de C.V. and Aceros DM, S.A. de C.V. (subsidiaries of Grupo San) the merger of both companies was authorized, whereby Abastecedora Siderúrgica, S.A. de C.V. was merged into Aceros DM, S.A. de C.V.

 

On October 8, 2012 in their respective extraordinary shareholders meetings of Simec Steel, Inc., Simec International 2, Inc., Simec International 3, Inc. and Simec International 4, Inc., the merger of four subsidiaries was authorized, whereby Simec International 2, Inc., Simec International 3, Inc., Simec International 4, Inc. were merged into Simec Steel, Inc.

 

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On October 30, 2012, we and our subsidiary Corporacion ASL, S.A. de C.V. purchased shares of a company called Orge S.A. de C.V. (Orge) for Ps. 27 million, on that same date, Corporacion ASL, S.A. de C.V. made a capital increase of Ps. 67 million, which proceeds were used for the payment of an outstanding liability of Orge. The shares acquired correspond to one Class “I,” series “B” share, which represents 0.01% of the shares of such class, and 53,564,127 Class “II,” series “L” shares, which represent 100% of the shares of such class. These shares are without par value and shares of Class “II” are restricted and confer limited voting rights and no power to appoint the management of the company, however the Board of Directors is comprised exclusively of officers and shareholders of us, therefore, from that date on, we consolidate the financial statements of Orge. Orge was incorporated on July 19, 2012 through a split. Before we acquired the shares, Orge had a loss on the sale of certain securities that will carry a tax loss of Ps. 1,700 million. Orge is engaged in the production of steel and began operating in October 2012.

 

On December 18, 2012 in an extraordinary shareholders meeting of Simec International 6, S.A. de C.V., the split of this company was approved and two new wholly owned Mexican subsidiaries were incorporated, under the names Simec International 8, S.A. de C.V. and Siminsa E, S.A. de C.V.

 

In May 2013, Malla San, S.A. de C.V., operator of the plant which produces mesh and wire derivatives in San Luis Potosi, split into two new entities, Malla San 1 S.A. de C.V. and Malla San 2 S.A. de C.V., and therefore ceased to exist.

 

On August 8, 2013, we and our subsidiary Simec International, S.A. de C.V. purchased shares of a company called Seehafen Operadora Maritima, S.A.P.I. de C.V. (Seehafen) for Ps. 44 million. The shares acquired correspond to (i) 500 ordinary, nominative

Class “I” shares, representative of the fixed portion of the capital stock of Seehafen, which represents 50% of the shares of such class and (ii) 99,000 nominative Class “II” shares, representative of the variable portion of the capital stock of Seehafen, which represents 100 % of the shares of such class. These shares are without par value and Class “II” shares confer no voting rights. The transactions described above were approved in an extraordinary shareholders meeting of Seehafen celebrated on the same date, which also approved its change of name to Simec International 9, S.A.P.I. de C.V. (Simec 9), the modification of its corporate purpose and the appointment of members to its Board of Directors, comprised exclusively of officers and shareholders of us, therefore, from that date on, we consolidate the financial statements of Simec 9. Seehafen was incorporated on August 3, 2012 through a split.

 

On November 20, 2013, the merger of Simec USA, Corporation and Simec International 5, Inc. was authorized in their respective extraordinary shareholders meetings, whereby the first entity subsisted and the second ceased to exist.

 

On November 30, 2013 and December 2, 2013, the merger of Compañía Siderúrgica del Pacífico, S.A. de C.V., Comercializadora Msan S.A. de C.V., Comercializadora de Productos de Acero de Tlaxcala, S.A. de C.V., Productos Siderúrgicos de Tlaxcala, S.A. de C.V., Comercializadora Simec, S.A. de C.V., Siminsa E, S.A. de C.V., and Siderúrgica de Baja California, S.A. de C.V. was authorized in their respective extraordinary shareholders meetings, whereby the first entity subsisted and the others ceased to exist.

 

On January 16, 2015, we entered into a cooperation agreement with the government of the State of Tlaxcala, Mexico, to build a new steel facility, which will have a production capacity of 600,000 tons of bar quality steel (SBQ). In October and December 2015, we acquired land adjacent to our existing plant in Tlaxcala, which will increase the extension by 100 hectares. On October 20, 2015, we entered into an agreement with Danieli & Officine Meccaniche for the construction (excluding civil engineering) of the plant and the provision of all required equipment. The total budget for the project will be approximately U.S.$600 million (Ps. 12,398 million), which will be financed with our own resources. We started steelmaking operations in July 2018.

 

On January 20, 2015, we incorporated a new wholly-owned subsidiary named Aceros Especiales Simec Tlaxcala, S.A. de C.V., in which Grupo Simec, S.A.B. de C.V. holds 49,999 class “I” shares and Simec International, S.A. de C.V. holds one class “I” share.

 

On January 20, 2015, we incorporated a new wholly-owned subsidiary named Recursos Humanos de la Industria Siderúrgica de Tlaxcala, S.A. de C.V., in which Grupo Simec, S.A.B. de C.V. holds 49,999 class “I” shares and Simec International, S.A. de C.V. holds one class “I” share.

 

On March 21, 2015, we and our subsidiary Simec International, S.A. de C.V. purchased 2,500 class “I1”, ordinary, nominative and without par value shares of a company called RRLC, S.A.P.I. de C.V. (RRLC), representing the fixed portion of its capital stock, which represented 50% of the shares of such class, and 46,103 class “II”, non-voting, nominative, without par value shares of RRLC, representing the variable portion of its capital stock, which represented 100% of the shares of that class, in the aggregate amount of Ps. 18.6 million. RRLC was incorporated as a result of a spin-off of another company on December 11, 2014.

 

29 

 

On October 30, 2015, our subsidiaries Simec International 7, S.A. de C.V. and Simec International, S.A. de C.V., acquired 25,000 class “I”, ordinary, nominative and without par value shares in a company called Grupo Chant, S.A.P.I. de C.V. (Chant), representing the fixed portion of its capital stock, which represented 50% of the shares of such class, and 1,000,000 class “II”, non-voting, nominative and without par value shares of Chant, representing the variable portion of its capital stock, which represented 100% of the shares of that class, in the aggregate amount of Ps. 167 million. Chant was incorporated as a result of a spin-off of another company on June 12, 2015.

 

On January 13, 2016, we incorporated a new wholly-owned subsidiary named GSIM de Occidente, S.A. de C.V., in which Grupo Simec, S.A.B. de C.V. holds 49,999 class “I” shares and Simec International, S.A. de C.V. holds one class “I” share.

 

On January 13, 2016, we incorporated a new wholly-owned subsidiary named Fundiciones de Acero Estructural, S.A. de C.V., in which Grupo Simec, S.A.B. de C.V. holds 49,999 class “I” shares and Simec International, S.A. de C.V. holds one class “I” share.

 

In August 2016 Republic Steel sold to a third party, at a price of U.S.$350,000 (Ps. 7 million), the assets of the Memphis, Tennessee plant, which had been idled.

 

On December 5, 2017, Grupo Simec, S.A.B. de C.V. and Simec International 7, S.A. de C.V. (a subsidiary), acquired 2,000 Class "I" ordinary shares, nominative and without nominal value in a company called Señales del Norte S.A. de C.V., representing the

fixed portion of its capital stock, which represented 100% of the shares of that class and 3,908,782 class "II" shares, without voting rights, nominative, and without nominal value, which represented 100% of the variable portion of the share capital, in the aggregate amount of Ps. 122.7 million pesos, so that as of that date Señales del Norte SA de CV is consolidated in our financial statements. On March 13, 2018 we changed its name to "Siderúrgicos Noroeste S.A. de C.V. "

 

On May 1, 2018, Grupo Simec, S.A.B de C.V. entered into a contract with Arcelor Mittal Brasil, S.A. for the acquisition of the steel products plants of Cariacica, in Espíritu Santo, and the transfer of the lease contract for the plant in Itauna, in Minas Gerais, both in Brazil. The production capacity of the Cariacica plant is 600,000 tons of liquid steel per year and 450,000 tons of rolled steel products per year and the production capacity of the Itauna plant is 100,000 tons of rolled steel products per year.

 

Principal Capital Expenditures

 

We continually seek to improve our operating efficiency and increase sales of our products through capital investments in new equipment and technology. These capital expenditures are financed primarily with funds that we segregate monthly from the results of operations generated by each facility.

 

We currently estimate capital expenditures for the year 2019 will be approximately Ps. 702.4 million (U.S.$35.7 million), Ps. 345.6 million (U.S.$17.6 million) of estimated capital expenditures in our Republic facilities and Ps. 356.8 million (U.S.$18.1 million) consisting of capital expenditures in our facilities in Mexico. Nevertheless, this estimate is subject to certain uncertainties and actual capital expenditures in 2019 may differ significantly from such estimate.

 

In 2018, we spent Ps. 433.2 million (U.S.$22.1 million) on capital investments for Republic’s facilities, including Ps. 91.4 million (U.S.$4.7 million) at the Lorain, Ohio facility, Ps. 107.6 million (U.S.$5.5 million) at the Lackawanna, New York facility, Ps. 187 million (U.S.$9.5 million) at the Canton, Ohio facility, Ps. 35.3 million (U.S.1.8 million) at the Solon, Ohio facility, and Ps. 11.9 million (U.S.$0.6 million) at the Massillon, Ohio facility. We spent Ps. 1,552.5 million (U.S.$78.9 million) on capital improvements at our facilities in Mexico, including Ps. 1,262.6 million (U.S.$64.2 million) at the Apizaco facility, Ps. 15.9 million (U.S.$0.8 million) at the Mexicali facility, Ps. 168.9 million (U.S.$8.6 million) at the Guadalajara facility, and Ps. 105.1 million (U.S.$5.3 million) at the San Luis facilities. We also spent Ps. 8.7 million (U.S.$0.4 million) in our steel facility on Pindamonhangaba, Sao Paulo State, Brazil.

 

In 2017, we spent Ps. 622.8 million (U.S.$31.6 million) on capital investments for Republic’s facilities, including Ps. 8.1 million (U.S.$0.4 million) at the Lorain, Ohio, facility, Ps. 54.8 million (U.S.$2.8 million) at the Lackawanna, New York, facility, Ps. 546.5 million (U.S.$27.7 million) at the Canton, Ohio, facility, Ps. 8.7 million (U.S.0.4 million) at the Solon, Ohio ,facility, and Ps. 4.7 million (U.S.$0.2 million) at the Massillon, Ohio, facility. We spent Ps. 2,394.5 million (U.S.$121.3 million) on capital improvements at our facilities in Mexico, including Ps. 1,525 million (U.S.$77.3 million) at the Apizaco facility, Ps. 3.5 million (U.S.$0.2 million) at the Mexicali facility, Ps. 106.8 million (U.S.$5.4 million) at the Guadalajara facility, and Ps. 759.2 million (U.S.$38.4 million) at the San Luis facilities. We also spent Ps. 22.2 million (U.S.$1.1 million) in our steel facility on Pindamonhangaba, Sao Paulo State, Brazil.

 

30 

 

In 2016, we spent Ps. 816.6 million (U.S.$37.1 million) on capital investments for Republic’s facilities, including Ps. 691.6 million (U.S.$31.4 million) at the Lorain, Ohio, facility, Ps. 2.8 million (U.S.$0.1 million) at the Lackawanna, New York, facility, Ps. 105.3 million (U.S.$4.8 million) at the Canton, Ohio, facility, Ps. 15 million (U.S.0.7 million) at the Solon, Ohio, facility, and Ps. 1.9 million (U.S.$0.1 million) at the Gary, Indiana, facility. We spent Ps. 2,169.3 million (U.S.$135.6 million) on capital improvements at our facilities in Mexico, including Ps. 2,006.1 million (U.S.$125.4 million) at the Apizaco facility, Ps. 1.2 million (U.S.$0.1 million) at the Mexicali facility, Ps. 26.4 million (U.S.$1.6 million) at the Guadalajara facility, and Ps. 135.6 million (U.S.$8.5 million) at the San Luis facilities. We also spent Ps. 114.3 million (U.S.$7.1 million) in our steel facility on Pindamonhangaba, Sao Paulo State, Brazil.

 

 

  B. Business Overview

 

In the United States, Mexico and Brazil, we own and operate 15 state-of-the-art steel making, processing and/or finishing facilities with a combined annual crude steel installed production capacity of 5.3 million tons and a combined annual installed rolling capacity of 4.5 million tons. We own both mini-mill and integrated steel making facilities, which give us the flexibility to optimize our production and reduce production costs based on the relative prices of raw materials (e.g., scrap for mini-mills and iron ore for blast furnace).

 

We currently own and operate:

 

  a mini-mill in Guadalajara, Jalisco;

 

  a mini-mill in Mexicali, Baja California Norte;

 

  two mini-mills in Apizaco, Tlaxcala;

 

  a cold finishing facility in Cholula, Puebla;

 

  two mini-mills in San Luis Potosí, San Luis Potosí, Mexico;

 

  a mini mill in Canton, Ohio, an integrated facility in Lorain, Ohio and value-added rolling and finishing facilities in Lorain and Massillon, Ohio; Lackawanna, New York and Solon, Ohio, all of which we own through our majority-owned subsidiary, Republic, and

 

  a mini-mill and rebar and wire rod rolling mill in Pindamonhangaba, São Paulo (Brazil), a mini-mill in Cariacica, Espirito Santo (Brazil) and we lease and operate rolling and finishing facilities in Itauna, Minas Gerais (Brazil).

 

In 2018, we had net sales of Ps. 35.7 billion, gross profit of Ps. 5.1 billion and net income of Ps. 3.3 billion. In 2018, approximately 26% of our consolidated sales were in our segment in the United States, approximately 57% were in our segment in Mexico and approximately 17% were in our segment in Brazil.

 

Business Strategy

 

We seek to further consolidate our position as a leading producer, processor and distributor of SBQ steel in North America and structural steel in Mexico. We also seek to expand our presence in the steel industry by identifying and pursuing growth opportunities and value enhancing initiatives. Our strategy includes:

 

Improving our cost structure.

 

We are continually working to reduce our operating cost and non-operating expenses and plan to continue to do so by reducing overhead expenses and operating costs through sharing best practices among our operating facilities and maintaining a conservative capital structure.

 

Focusing on high margin and value-added products.

 

We prioritize the production of high margin steel products over volume and utilization levels. We plan to continue to base our production decisions on achieving relatively high margins.

 

 

31 

 

Building on our strong customer relationships.

 

We intend to strengthen our long-standing customer relationships by maintaining strong customer service and proactively responding to changing customer needs.

 

Pursuing strategic growth opportunities.

 

We have successfully grown our business by acquiring, integrating and improving under-performing operations. In addition, we intend to continue to pursue acquisition opportunities that will allow for disciplined growth of our business and value creation for our shareholders. We also intend to pursue organic growth by reinvesting the cash generated by our operating activities to expand the capacity and increase the efficiency of our existing facilities.

 

Our Products

 

We produce a wide range of value-added SBQ steel, long steel and medium-sized structural steel products. In our Mexican facilities, we produce I-beams, channels, structural and commercial angles, hot rolled bars (round, square and hexagonals), flat bars, rebars, cold finished bars and wire rods. In our U.S. facilities, we produce hot rolled bars, cold finished bars, semi-finished tube rounds and other semi-finished trade products. In our Brazil facilities, we produce rebars, I-beams, channels, structrual and commercial angles. The following is a description of these products and their main uses:

 

  I-beams. I-beams, also known as standard beams, are “I” form steel structural sections with two equal parallel sides joined together by the center with a transversal section, forming 90º angles. We produce I-beams in our Mexican and Brazil facilities and they are mainly used by the industrial construction sector as structure supports.

 

  Channels. Channels, also known as U-Beams because of their “U” form, are steel structural sections with two equal parallel sides joined together by its ends with a transversal section, forming 90º angles. We produce channels in our Mexican and Brazil facilities and they are mainly used by industrial construction sector as structure supports and for stocking systems.

 

  Angles. Angles are two equal sided sections joined by their ends with a 90º angle, in an “L” form. We produce angles in our Mexican and Brazil facilities and they are used mainly by the construction and furniture industries as joist structures and framing systems.

 

  Hot rolled bars. Hot rolled bars are round, square and hexagonal steel bars that can be made of special or commodity steel. The construction, auto part and furniture industries mainly use the round and square bars. The hexagonal bars are made of special steel and are mainly used by the hand tool industry. We produce the steel sections in our Mexican and U.S. facilities.

 

  Flat bars. Flat bars are rectangular steel sections that can be made of special or commodity steel. We produce flat bars at our Mexican facilities. The auto part industry mainly uses special steel as springs, and the construction industry uses the commodity steel flat bars as supports.

 

  Rebar. Rebar is reinforced, corrugated round steel bars with sections from 0.375 to 1.5 inches in diameter, and we produced rebar in our Mexican facilities and in our Brazil facilities. Rebar is only used by the construction industry to reinforce concrete. Rebar is considered a commodity product due to its general acceptance by most consumers of industry standard specifications.

 

  Cold-finished bars. Cold-finished bars are round and hexagonal SBQ steel bars transformed through a diameter reduction process. This process consists of (1) reducing the cross sectional area of a bar by drawing the material through a die without any pre-heating or (2) turning or “peeling” the surface of the bar. The process changes the mechanical properties of the steel, and the finished product is accurate to size, free from scale with a bright surface finish. We produce these bars in our Mexican and U.S. facilities, primarily to supply the auto part industry.

 

 

32 

 

 

The following table sets forth, for the periods indicated, our sales volume for basic steel products.

 

Steel Product Sales Volume

 

 

Years ended December 31,

 

2014

2015

2016

2017

2018

  (thousands of tons)
I-Beams 71.7 83.2 81.7 76.6 72.5
Channels 62.7 63.3 65.8 54.3 48.7
Angles(1) 164.3 182.3 182.5 155.9 156.7
Hot-rolled bars (round, square and hexagonal rods) 823.2 666.9 600.4 560.0 564.9
Flat bar 94.5 183.1 129.7 150.0 168.7
Rebar 567.4 577.8 774.6 854.9 924.2
Cold finished bars 207.5 126.3 163.2 149.4 151.9
Other semi-finished trade products(2) 130.8 89.4 10.7 8.4 14.0
Electro-Welded wire mesh 17.7 21.7 22.3 18.7 18.5
Wire rod 12.2 3.8 24.8 34.9 48.7
Electro-Welded wire mesh panel 19.9 22.8 28.1 24.9 22.1
Other

25.1

5.3

1.1

3.2

0.9

Total steel sales

2,197.0

2,025.9

2,084.9

2,091.2

2,191.8

 

 

  (1) Includes structural angles and commercial angles.

 

  (2) Includes billets and blooms (wide section square and round bars).

 

Sales and Distribution

 

We sell and distribute our steel products throughout North America. We also export steel products from Mexico to Central and South America and Europe. In 2018, approximately 32% of our steel product sales in tons represented SBQ steel products, of which we sold 65% to the auto part industry, 21% to service centers, 1% for hand tools and the remaining 13% to other industries.

 

In 2018, direct sales in tons to the automotive industry decreased by 4% compared to 2017. In 2017, direct sales in tons to the automotive industry increased by 6% compared to 2016. In 2016, direct sales in tons to the automotive industry decreased by 23% compared to 2015. In 2015, direct sales in tons to the automotive industry increased by 18% compared to 2014. In 2014, direct sales in tons to the automotive industry increased by 44% compared to 2013. In 2014, 2015, 2016, 2017 and 2018 sales in tons to the energy sector accounted for 10%, 0.01%, 0.1%, 0.5% and 0.4%, respectively, of our sales of SBQ steel products.

 

The following table sets forth, for the periods indicated, our Mexico, U.S., Canada and Brazil product sales as a percentage of our total product sales in tons.

 

Steel Product Sales By Region

 

 

Mexico 

United States, Canada, Brazil and Other Countries 

 

Years ended December 31, 

 

2014 

2015

2016 

2017 

2018 

2014 

2015 

2016 

2017

2018

I-Beams 99% 98% 97% 98% 94%   1%   2%   3%   2%   6%
Channels 44% 54% 62% 55% 56% 56% 46% 38% 45% 44%
Angles 75% 82% 84% 83% 67% 25% 18% 16% 17% 33%
Hot-rolled bars (round, square and hexagonal rods) 33% 36% 42% 39% 32% 67% 64% 58% 61% 68%
Flat bar 99% 92% 95% 96% 68%   1%   8%   5%    4% 32%
Rebar 100% 99% 75% 63% 67%   1%  25% 37% 33%
Cold drawn finished bars 54% 66% 73% 73% 77%   46% 34%   27%  27%  23% 
Other semi-finished trade products 100% 100% 100%  100%  100% 
Electro-Welded wire mesh 100% 100% 100% 100% 100%
Wire rod 100% 100% 96% 100% 100%   4%
Electro-Welded wire mesh panel 100% 100% 100% 100% 100%
Other

3% 

12% 

76% 

— 

75% 

97% 

88% 

24% 

100% 

25% 

Total (weighted average)

60% 

67% 

68% 

63% 

60% 

40% 

33% 

32% 

37% 

40% 

                       

 

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During 2018, approximately 17.6% of our sales by volume came from the U.S. segment, with almost 100% of such sales representing SBQ product and 19.7% of our sales by volume came from the Brazil segment. The Mexican segment represents approximately 62.7% of our sales by volume, with SBQ products representing approximately 23% of such sales and the remainder representing commercial steel products.

 

Approximately 75% of our sales in the United States and Canadian markets came from contractual long-term agreements that establish minimum quantities and prices, which are adjustable based on fluctuations of prices of key production materials. The remainder of our sales in the United States and Canadian markets were spot sales either directly to end customers through our sales force or through independent distributors. We sell to customers in the United States and Canadian markets through a staff of professional sales representatives and sales technicians located in the major manufacturing centers of the Midwest, Great Lakes and Southeast regions of the United States.

 

We sell to the Mexican market through a group of approximately 100 independent distributors, who also carry other steel companies’ product lines, and through our wholly-owned distribution center in Guadalajara. Our sales force and distribution center are an important source of information concerning customer needs and market developments. By working through our distributors, we believe that we have established and can maintain market leadership with small-and mid-market end-users throughout Mexico. We believe that our domestic customers are highly service-conscious.

 

We distribute our exports outside North America primarily through independent distributors who also carry other product lines.

 

During 2018 and 2017, we received orders for our products in our Mexican facilities on average approximately two weeks before producing those products. We generally filled orders for our U.S. and Canadian SBQ steel products within one to 12 weeks of the order depending on the product, customer needs and other production requirements. Customer orders are generally cancelable without penalty prior to finishing size rolling and depending on customers’ changing production schedules. Accordingly, we do not believe that backlog is a significant factor in our business. A substantial portion of our production is ordered by our customers prior to production. We cannot assure you that significant levels of preproduction sales orders will continue.

 

In our Republic plants, we have long term relationships with most of our major customers, in some cases for 10 to 20 years or longer. Our major direct and indirect customers include: leading automotive and industrial equipment manufacturers General Motors Corporation, Ford Motor Company, Chrysler LLC, Honda of America Mfg, Inc. and Nissan North America, Inc.; first tier suppliers to automotive and industrial equipment manufacturers such as American Axle & Manufacturing Holdings, Inc. and Nexteer, NSK and NTN Driveshafts, Inc.; service centers which include AM Castle & Co., Earle M. Jorgensen Co., and Eaton Steel Bar Company.

 

Our U.S. facilities are strategically located to serve the majority of consumers of SBQ products in the United States. Our U.S. facilities ship products between their mills and finished products to customers by rail and truck. Customer needs and location, determine the type of transportation used for deliveries. The proximity of our rolling mills and cold finishing plants to our U.S. customers allows us to provide competitive rail and truck freight rates and flexible deliveries in order to satisfy just-in-time and other customer manufacturing requirements. We believe that the ability to meet the product delivery requirements of our customers in a timely and flexible fashion is a key to attracting and retaining customers as more SBQ product consumers reduce their in-plant raw material inventory. We optimize freight costs by using our significantly greater scale of operations to maintain favorable transportation arrangements, continuing to combine orders in shipments whenever possible and “backhauling” scrap and other raw materials.

 

Our plant in Brazil began production in June 2015 with 30,000 tons produced and 4,000 tons shipped in 2015, all of which correspond to rebar. Our main objective is to sell our products through independent distributors, targeting the construction market by providing quality service, a key factor in attracting and retaining customers.

 

Notwithstanding, our sales policy in Brazil has been well accepted by our customers and, even in the midst of a global crisis, our sales have begun to increase steadily, opening us a place in the steel market in Brazil.

 

Our major customers in 2018 include: Marson Com, Udiaco Comercio and Ind. ACOS Sao Carlos Come, Comercial Litoranea, RDG Acos do Brasil, Fertel Comercial Ltda, JR Comercio de Cimento e Concreto Ltda., Lorenfer Ind. and Com. From prod. Metalurgicos Ltda.

 

In order to grow our position in the Brazilian market, we acquired a plant from ArcelorMittal Brazil and leased a rolling mill plant in May 2018. We expect an increase in sales which will consolidate our position in the Brazilian market as a result of these acquisitions.

 

34 

 

 

Competition

 

Competition in the steel industry is significant. Competition in the steel industry exerts a downward pressure on prices, and, due to high start-up costs, the economics of operating a steel mill on a continuous basis may encourage mill operators to establish and maintain high levels of output even in times of low demand, which further decreases prices and profit margins. The recent trend of consolidation in the global steel industry may further increase competitive pressures on independent producers of our size, particularly if large steel producers formed through consolidations, which have access to greater resources than us, adopt predatory pricing strategies that decrease prices and profit margins. If we are unable to remain competitive with these producers, our profitability and market share would likely be materially and adversely affected.

 

A number of our competitors in the United States, Mexico and Brazil have undertaken modernization and expansion plans, including the installation of production facilities and manufacturing capacity for certain products that compete with our products. As these producers become more efficient, we will face increased competition from them and may experience a loss of market share. In each of Mexico, Brazil and the United States we also face competition from international steel producers. Increased international competition, especially when combined with excess production capacity, would likely force us to lower our prices or to offer increased services at a higher cost to us, which could materially reduce our profit margins.

 

Mexico

 

We compete in the Mexican domestic market and in its export markets for non-flat steel products primarily on the basis of price and product quality. In addition, we compete in the domestic market based upon our responsiveness to customer delivery requirements. The flexibility of our production facilities allows us to respond quickly to the demand for our products. We also believe that the geographic locations of our various facilities throughout Mexico and variety of products help us to maintain our competitive market position in Mexico and in the southwestern United States. We believe that our Mexicali mini-mill, one of the closest mini-mills to the southern California market, is competitive in terms of production and transportation costs in northwestern Mexico and southern California.

 

We believe that our competitors’ closest plants to the southern California market are: Nucor, Corporation, located in Plymouth, Utah; Commercial Metals Company, located in Meza, Arizona; Thyssenkrupp Steel North America, Inc., located in Santa Fe Springs, California; Deacero, S.A. de C.V. (“Deacero”), located in Saltillo, Coahuila, México and Gerdau Corsa, S.A.P.I. de C.V. (“Gerdau Corsa”), located in Tijuana, Baja California, Mexico. We believe that we have an advantage over certain competitors due to the labor cost in our Mexican operations.

 

In 2018, we sold approximately 173,764 tons of I-beams, channels and angles at least three inches in width which represented approximately 7.9% of our total finished product sales for the year. In 2017, we sold approximately 179,483 tons of I-beams, channels and angles at least three inches in width which represented approximately 8.6% of our total finished product sales for the year. We believe that the domestic competitors in the Mexican market for structural steel are Gerdau Corsa, Deacero, and Siderúrgica del Golfo, S.A. de C.V. (a wholly-owned subsidiary of Industrias CH). We estimate that our share of Mexican production of structural steel was 16.8% in 2018 and 20.6% in 2017, according to information provided by the Cámara Nacional de la Industria del Hierro y del Acero (CANACERO).

 

In 2018, we sold approximately 834,489 tons of hot rolled and cold finished steel bars and 859,427 tons in 2017. Our other major product lines are rebar and light structural steel (angles less than three inches in width and flat bar), for which our share of domestic production was 15.3% and 19.7%, respectively, in 2018 and 14% and 21%, respectively, in 2017. Rebar and light structural steel together accounted for approximately 1,080,012 tons, or 49%, of our total production of finished steel products in Mexico, the United States and Brazil in 2018. Rebar and light structural steel together accounted for approximately 963,802 tons, or 46%, of our total production of finished steel products in Mexico, the United States and Brazil in 2017. We compete in the Mexican market with a number of producers of these products, including Deacero, Talleres y Aceros, S.A., Grupo Acerero, S.A. de C.V., Nucor Corporation, ArcelorMittal Lazaro Cardenas, S.A. de C.V., Ternium Mexico, S.A. de C.V. and Gerdau Corsa.

 

We believe that we have been able to maintain our domestic market share and profitable pricing levels in Mexico in part because the central Mexico sites of the Guadalajara, Apizaco, Cholula and San Luis facilities afford us cost advantages relative to certain U.S. producers when shipping to customers in central and southern Mexico, and our flexible production facility has given us the ability to ship specialty products in relatively small quantities with short lead times. The Mexicali mini-mill has helped to increase sales in northwestern Mexico and the southwestern United States because its proximity to these areas reduces our freight costs.

 

United States

 

In the United States, we compete primarily with both domestic SBQ steel producers and importers. Our U.S. domestic competition for hot-rolled engineered bar products is both large U.S. domestic steelmakers and specialized mini-mills. Non-U.S. competition may impact segments of the SBQ market, particularly where certifications are not required, and during periods when the U.S. dollar is strong compared with foreign currencies.

 

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The principal areas of competition in our markets are product quality and range, delivery reliability, service and price. Special chemistry and precise processing requirements characterize SBQ steel products. Maintaining high standards of product quality, while keeping production costs low, is essential to our ability to compete in our markets. The ability of a manufacturer to respond quickly to customer orders currently is, and is expected to remain, important as customers continue to reduce their in-plant raw material inventory.

 

We believe our principal competitors in the United States market, depending on the product, include Nucor, Corporation, Niagara LaSalle, Corporation, Charter Steel, Inc., Steel Dynamics, Inc., The TimkenSteel Corporation and Gerdau.

 

Brazil

 

Our main competitors in the Brazilian market are Aperam, ArcelorMittal Brazil, CSN, Gerdau, Sinobras, Thyssenkrupp CSA; Usiminas, VSB tubes, V & M do Brasil and Villares Metals.

 

The Brazilian steel industry is comprised of 14 private companies, controlled by 11 business groups and operating 30 mills in 10 Brazilian states, making Brazil the 8th largest producer in the world.

 

The privatization of steel companies, finalized in 1993, brought a significant flow of capital into the sector, with diverse shareholder composition. Thus, many steel companies came to be part of industrial and/or financial groups, with their interests in steelmaking unfolding into related activities, aiming to improved economies of scale and competitiveness.

 

Plants in Sao Paulo: 

  Gerdau Aços Especiais (Usina Pindamonhangaba)

 

  Gerdau Aços Especiais (Usina Mogi das Cruzes)

 

  ArcelorMittal Aços Longos (Piracicaba)

 

  Usiminas (Cubatão)

 

  Gerdau Aços Longos (Usina São Paulo)

 

  Gerdau Aços Longos (Usina Araçariguama)

 

  Villares Metals

 

  Simec Aços Barra (Usina Pindamonhangaba) (property of Grupo Simec)

 

In 2017 there was a merger between Votorantim Aço and ArcelorMittal Brazil. The Brazilian unit of ArcelorMittal has concluded the takeover of rival Votorantim Siderurgia SA in the second quarter of 2018 to become the country’s largest long steel producer, with a capacity in Brazil of up to 6 million tons per year.

 

Certifications

 

ISO is a worldwide federation of national standards bodies which have united to develop internationally accepted standards so that customers and manufacturers have a system in place to provide a product of known quality and standards. The standards set by ISO cover every aspect of quality from management responsibility to service and delivery. We believe that adhering to the stringent ISO procedures not only creates efficiency in manufacturing operations, but also positions us to meet the strict standards that our customers require. We are engaged in a total quality program designed to improve customer service, overall personnel qualifications and team work. The facilities at Apizaco and Cholula have received ISO/TS 16949:2009 certification from International Quality Certifications the current certification is effective until August 31, 2021

 

 As of April 15, 2019, all of Republic Steel’s plants are certified to ISO9001:2015 and IATF16949:2016. In the case of our plants in Canton, Ohio, Lackawanna, New York, and Massillon, Ohio, all are certified to IATF16949, effective until February 2021. The plant in Solon, Ohio, is certified to ISO 9001:2015, and the current certification is effective until January 2021. The ISO/TS

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16949:2009 standard, developed by the International Automotive Task Force, is the result of the harmonization of the supplier quality requirements of vehicle manufacturers worldwide and provides for a single quality management system of continuous improvement, defect prevention and reduction of variation and waste in the supply chain. It places greater emphasis on management’s commitment to quality and customer focus. ISO 9001 is a set of international quality control standards for management and practices.

 

Through these certifications, Republic’s Environmental, Health & Safety Management System is structured upon training, communication, employee participation, document control, objective and target setting, and management’s periodic reviews to implement our commitments to environmental protection and providing a safe and clean workplace.

 

Raw Materials

 

Prices for raw materials necessary for production of our steel products have fluctuated significantly in the past and significant increases in raw material prices could adversely affect our profit margins. During periods when prices for scrap metal, iron ore, ferroalloys, coaking coal and other raw materials have increased, our industry has historically sought to maintain profit margins by passing along increased raw materials costs to customers by means of price increases. For example, prices of scrap metal increased approximately 7% in 2014, decreased approximately 16% in 2015, increased approximately 2% in 2016, increased approximately 30.8% in 2017, and increased approximately 19.4% in 2018 and prices of ferroalloys increased approximately 16% in 2014, decreased approximately 9% in 2015, decreased approximately 13% in 2016, increased approximately 22% in 2017 and increased approximately 9.7% in 2018. We may not be able to pass along these and other cost increases in the future and, therefore, our profitability may be materially and adversely affected. Even when we can successfully increase our prices, interim reductions in profit margins frequently occur due to a time lag between the increase in raw material prices and the market acceptance of higher selling prices for finished steel products. We cannot assure you that our customers will agree to pay increased prices for our steel products that compensate us for increases in our raw material costs.

 

We purchase our raw material requirements either in the open market or from certain key suppliers. We cannot assure you that we will be able to continue to find suppliers of these raw materials in the open market, that the prices of these materials will not increase or that the quality will remain the same. In addition, if any of our key suppliers fails to deliver or we fail to renew our supply contracts, we could face limited access to some raw materials, or higher costs and delays resulting from the need to obtain our raw materials requirements from other suppliers.

 

In 2018, our cost of sales in Mexico, as a percentage of sales in Mexico, was 77%, compared to our U.S. operations where our cost of sales, as a percentage of sales in the United States, was 101%, as a percentage of sales in Brazil, was 94% and our consolidated cost of sales, as a percentage of consolidated sales, was 86%. The higher cost of sales of Republic facilities is mainly a result of higher labor costs prevailing in our U.S. operations, and the higher costs of the raw materials that our U.S. operations use in the production of SBQ steel.

 

Scrap metal, electricity, ferroalloys, electrodes and refractory products are the principal materials that we use to manufacture our steel products.

 

Scrap metal. Scrap metal is among the most important components for our steel production and accounted for approximately 56% of our consolidated manufacturing conversion cost in 2018 (64% of the manufacturing conversion cost in our Mexico operations, 40% of the manufacturing conversion cost in our U.S. operations and 61% in our Brazil operations), compared to 59% of our consolidated manufacturing conversion cost in 2017 (64% of the manufacturing conversion cost in our Mexico operations, 47% of the manufacturing conversion cost in our U.S. operations and 60% in our Brazil operations). Scrap metal is principally generated from automobile, industrial, naval and railroad industries. The market for scrap metal is influenced by availability, freight costs, speculation by scrap brokers and other conditions largely beyond our control. Fluctuations in scrap costs directly influence the cost of sales of finished goods.

 

We purchase raw scrap from dealers in Mexico and the San Diego area, and we process the raw scrap into refined scrap metal at our Guadalajara, San Luis, Mexicali and Apizaco facilities. We meet our refined scrap metal requirements through: (i) our wholly-owned scrap processing facilities, which in the aggregate provided us with approximately 21% and 19.1% of our refined scrap tonnage in 2018 and 2017, respectively, and (ii) purchases from third party scrap processors in Mexico and the southwestern United States, which, in the aggregate, provided us with approximately 74.9% and 4.1%, respectively, in 2018 and approximately 72.2% and 8.7%, respectively, in 2017 of our refined scrap metal requirements. We are a large scrap collector in the Mexicali, Tijuana and Hermosillo regions, and, by primarily dealing directly with small Mexican scrap collectors, we believe we have been able to purchase scrap at prices lower than those in the international and Mexican markets. We purchase scrap on the open market through a number of brokers or directly from scrap dealers for our U.S. facilities. We purchase scrap on the open market through a number of brokers or directly from scrap dealers for our Brazil facilities. We do not depend on any single scrap supplier to meet our scrap requirements.

 

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Ferroalloys, Electrodes and Refractory Products. In our Mexican operations, ferroalloys, electrodes and refractory products collectively accounted for approximately 16% of our manufacturing conversion cost in 2018, compared to 13% in 2017, in our U.S. and Canadian facilities accounted for 17% of our manufacturing conversion cost in 2018, compared to 16% in 2017 and in our Brazil facilities accounted for approximately 14% of our manufacturing conversion cost in 2018 compared to 13% in 2017.

 

Ferroalloys are essential for the production of steel and are added to the steel during manufacturing process to reduce undesirable elements and to enhance its hardness, durability and resistance to friction and abrasion. For our Mexican operations, we buy most of our manganese ferroalloys from Compañía Minera Autlán, S.A., Elmet, S.A. de C.V., Autlán Metal Services, S.A. de C.V., Marco Metales de Mexico, S. de R.L. de C.V., Possehl México, S.A. de C.V. and Distribuidora de Aleaciones y Metales, S.A. de C.V. Our U.S. facilities purchase most of their ferroalloys from Affival, Duferco Steel, Globe Met., Gottlieb, Kennecott, Rusian Ferro, Traxys, Vale Americas, Minerais U.S. LLC and Glencore LTD. Our Brazil facilities purchase most of their ferroalloys from Multiligas Eireli., Comercial Cometa Industria y Comercio Ltda., Fertiligas Industria e Comércio Ltda., Cia. de Ferroligas de Bahia Ferbasa, Bozel Brasi, S.A., Fertileg Ferro Liga Ltda, Granhas Ligas Ltda., Cia. De Ferro Ligas da Bahia Ferbasa and Cia. Brasileira de Matalurgia e Mineracao.

 

For our Mexican operations, we obtain electrodes used to melt raw materials (scrap metal) from Dura Carbon Singapore Private Limited, Sinosteel Jilin Carbon Co. Ltd., Starex Inc., Cimm Carbon Group, Heg Limited and Graphite Cova GmbH. Our U.S. facilities purchase most of their electrodes from SGL Carbon, Showa Denko Carbon, SK Carbon and E. J. Bognar Inc. Our Brazil facilities purchase most of their electrodes from Starex, Inc., Ray Group Limited, Cimm Carbon Group, Dura Carbon Singapore Private Limited, Jilin Carbon Co. Ltd., Baystar, Daliane and Graftech Comercial de Mexico, S.A.

 

Refractory products include firebricks, which line and insulate furnaces, ladles and other transfer vessels. We purchase our refractory products for our Mexican operations from Vesuvius de México, S.A. de C.V., Magnesita Refractories México, S.A. de C.V., Magna Refractarios México, S.A. de C.V. and Refratechnik Steel GmbH. Our U.S. facilities purchase most of their refractory products from RHI Inc, Vesuvius USA, Corp., Nock & Son Co.-Minteq, Magna Refractories Inc., Refractory Materials Intl., Altus Refractories, LLC, Thermatex Sales Corp., Harbison-Walker Refractories Company and Magnesita Refractories Co. Our Brazil facilities purchase most of their refractory products from Magnesitas Navarrasm S.A., Vesivius, Samboba and Magnesita Refractaries Mexico S.A. de C.V.

 

Electricity. In 2018 and 2017 electricity accounted for approximately 9% and 9% respectively, of our consolidated manufacturing conversion cost. Electricity accounted for 9% in 2018 of our manufacturing conversion cost and 9% in 2017 in our Mexico facilities and is supplied by the Comisión Federal de Electricidad (CFE). It accounted for 8% in 2018 and 8% in 2017 of the manufacturing conversion cost in our U.S. operations and is supplied by American Electric Power Company, Nipsco Industries, Inc., New York Power and Ohio Edison. It accounted for 9% in 2018 and 15% in 2017 of the manufacturing conversion cost in our Brazil operations and is supplied by Ecom Energia Ltda. and Comercializadora de Energiaeletrica Ltda. We, like most high volume users of electricity in Mexico, pay special rates to CFE for electricity. Energy prices in Mexico have historically been very volatile and subject to dramatic price increases in short periods of time. In the late 1990s, the CFE began to charge for electricity usage based on the time of use during the day and the season (summer or winter). As a result, we have modified our production schedule in order to reduce electricity costs by limiting production during periods when peak rates are in effect. We cannot assure that any future cost increases will not have a material adverse effect on our business.

 

Natural Gas. Natural gas (including “combustoleo” fuel oil which is an oil derivative that is less refined than gasoline and diesel fuel oil that can be used instead of gasoline in our Mexicali plant) consisted of approximately 3% of our consolidated manufacturing conversion cost (2% of the manufacturing conversion cost of our Mexican operations, 3% of the manufacturing conversion cost of our U.S. operations and 3% of our Brazil operations) in 2018 and approximately 3% of our consolidated manufacturing conversion cost (2% of the manufacturing conversion cost of our Mexican operations, 3% of the manufacturing conversion cost of our U.S. operations and 3% of our Brazil operations) in 2017. In previous years we have entered into natural gas cash-flow exchange contracts or swaps where we receive a floating price and pay a fixed price to hedge our risk of from fluctuations in natural gas prices. Fluctuations in natural gas prices from volume consumed are recognized as part of our operating costs. As applicable, we recognized the fair value of instruments either as liabilities or assets. We periodically evaluated the changes in the cash flows of derivative instruments to analyze if the swaps are highly effective for mitigating the exposure to natural gas price fluctuations. At December 31, 2018 and 2017 we did not have natural gas cash-flow exchange contracts or swaps. For the derivatives that qualified for hedge accounting, their fair value was adjusted through the stockholders’ equity under the caption fair value of derivative financial instruments until such time as the related item in the derivative hedges is recognized as income.

 

We do not enter into contracts for speculation purposes.

 

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Regulation

 

U.S. Operations

 

Our U. S. operations are subject to U.S. federal, state and local environmental laws and administrative regulations concerning, among other things the management of hazardous materials and the discharge of pollutants to the atmosphere and to surface waters. Our U.S. operations have been the subject of administrative action by federal, state (or provincial) and local environmental authorities. The resolution of any of these claims may result in significant liabilities. See Item 3.D. “Risk Factors—Risk Factors Related to our Business—In the event of environmental violations at our facilities we may incur significant liabilities” and Item 8. “Financial Information—Legal Proceedings.”

 

Environmental Matters

 

We are subject to a broad range of environmental laws and regulations, including those governing the following:

 

  discharges to the air, water and soil;

 

  the handling and disposal of solid and hazardous wastes;

 

  the release of petroleum products, hazardous substances, hazardous wastes, or toxic substances to the environment; and

 

  the investigation and remediation of contaminated soil, sediment and groundwater.

 

We monitor our compliance with these laws and regulations through our environmental management system, and believe that we currently are in substantial compliance with them, although we cannot assure you that we will at all times operate in compliance with all such laws and regulations. If we fail to comply with these laws and regulations, we may be assessed fines or penalties or be subject to injunctive relief which could have a material adverse effect on us.

 

Future changes in the applicable environmental laws and regulations, or changes in the regulating agencies’ approach to enforcement or interpretation of their regulations, could cause us to make additional capital expenditures beyond what we currently anticipate.

 

Our Lorain, Ohio plant (which is not currently in operation) and our Canton, Ohio facility are subject to the Maximum Achievable Control Technology (“MACT”) standard for Electric Arc Furnaces as an “area source.” Revisions of this standard are under development and, when promulgated, may impose additional restrictions on our Lorain and Canton operations including those relating to mercury emissions and control.

 

Our steelmaking operations in the United States and in Mexico use electric arc furnaces where carbon dioxide generation is primarily linked to energy use. In the United States, the federal environmental agency has issued rules imposing inventory and reporting obligations to which some of our facilities are subject, and has also issued rules that will affect preconstruction permits for our facilities where increases in greenhouse gas pollutants are contemplated. The U.S. Congress has debated various measures for regulating greenhouse gas emission (such as carbon dioxide) and may enact them in the future. Such laws and regulations may also result in higher costs for coking coal, natural gas and electricity generated by carbon-based systems (such as coal-fired electric generating facilities). Such future laws and regulations, whether in the form of cap-and-trade emissions permit system, a carbon tax or other regulatory regime may have a negative effect on our operations. Climate change policy is evolving at regional, national and international levels, and political and economic events may significantly affect the scope and timing of climate change measures that are ultimately put in place. As signatories to the UNFCCC, Mexico and the U.S. became subject to the Paris Agreement to fight climate change, which was taken by the parties at the 21th session of the UNFCCC conference of the Parties in 2015. However, in June 2017, U.S. President Trump stated that the United States would withdraw from the Paris Agreement, but may enter into a future international agreement related to greenhouse gas emissions. In August 2017, the U.S. State Department officially informed the United Nations of the intent of the United States to withdraw from the Paris Agreement. The United States’ adherence to the exit process is uncertain and/or the terms on which the United States may reenter the Paris Agreement or a separately negotiated

agreement are unclear at this time. As a result, some of our significant facilities may ultimately be subject to future regional, provincial and/or federal climate change regulations to manage greenhouse emissions. More stringent greenhouse policies and regulations could adversely affect our business and results of operations.

 

Various federal, state (or provincial) and local laws, regulations and ordinances govern the removal, encapsulation or disturbance of asbestos-containing materials (“ACMs”). These laws, regulations and ordinances may impose liability for the release of ACMs and may permit third parties to seek recovery from owners or operators of facilities at which ACMs were or are located for

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personal injury associated with exposure to ACMs. We are aware of the presence of ACMs at our facilities but we currently believe that such materials are being managed in accordance with applicable law.

 

In the United States, the federal environmental protection agency is developing a new rule that is expected, among other things, to impose a timeline for the phasing out of polychlorinated biphenyl (“PCB”) -containing fluid in equipment that we currently use at many of our U.S. facilities. A preliminary notice regarding this future regulation was published in 2016 for comments, and a formal proposed rule is expected within the next two years. If the rule is enacted as proposed, it will require our facilities to reduce the levels of PCBs in our equipment to less than 50 ppm within 5 years following its adoption, which will in turn require us to incur cost for the removal and disposal of PCB containing oils, sampling and possible replacement of equipment in the event PCB levels cannot be reduced to acceptable levels.

 

Also in the United States, more stringent standards for particulate matter were promulgated in 2012. As these new more stringent standards were implemented through the different state programs, we experienced higher costs associated with any preconstruction permitting of new or modified sources at our U.S. facilities in 2014 and subsequent years. These costs were related to extensive dispersion modeling and/or pre-construction monitoring not previously required.

 

Mexican Operations

 

We are subject to Mexican federal, state and municipal laws, administrative regulations and Mexican Official Rules (Normas Oficiales Mexicanas) relating to a variety of environmental matters, anti-trust matters, trade regulations, and tax and employee matters.

 

Among other matters, Mexican tax returns are open for review generally for a period of five years, and, according to Mexican tax law, the purchaser of a business may become jointly and severally liable for unpaid tax liabilities of the business prior to its acquisition, which may have an impact on the liabilities and contingencies derived from any such acquisitions. Although we believe that we are in compliance with all material Mexican federal, state and municipal laws, administrative regulations and Mexican Official Rules, we cannot assure you that the interpretation of the Mexican authorities of the laws and regulations affecting our business or the enforcement thereof will not change in a manner that could increase our costs of doing business or could have a material adverse effect on our business, results of operations, financial condition or prospects.

 

Environmental Matters

 

We are subject to various Mexican federal, state and municipal laws, administrative regulations and Mexican Official Rules (Normas Oficiales Mexicanas) relating to the protection of human health, the environment and natural resources.

 

The major federal environmental laws applicable to our operations, among others, are: (i) the General Law of Ecological Balance and Environmental Protection (Ley General del Equilibrio Ecológico y la Protección al Ambiente or “LGEEPA”) and its regulations, which are administered and overseen by the Ministry of the Environment and Natural Resources (Secretaría de Medio Ambiente y Recursos Naturales or “SEMARNAT”) and enforced by the Ministry’s enforcement branch, the Federal Attorney’s Office for the Protection of the Environment (Procuraduría Federal de Protección al Ambiente or PROFEPA”); (ii) the General Law for the Prevention and Integral Management of Waste (Ley General para la Prevención y Gestión Integral de los Residuos or the “Law on Wastes”), which is also administered by SEMARNAT and enforced by PROFEPA; (iii) the National Waters Law (Ley de Aguas Nacionales) and its regulations, which are administered and enforced by the National Waters Commission (Comisión Nacional de Agua), also a branch of SEMARNAT; and (iv) the Federal Law on Environmental Responsibility (Ley Federal de Responsabilidad Ambiental), which is also administered by SEMARNAT and enforced by PROFEPA.

 

In addition to the foregoing, Mexican Official Rules, which are technical standards issued by applicable regulatory authorities pursuant to the General Normalization Law (Ley General de Metrología y Normalización) and to other laws that include the environmental laws described above, establish standards relating to air emissions, waste water discharges, the generation, handling and disposal of hazardous wastes and noise control, among others. Mexican Official Rules regarding soil contamination and waste management were enacted in order to protect these potential contingencies. Although not enforceable, the internal administrative criteria on soil contamination established by PROFEPA is widely used as guidance in cases where soil remediation, restoration or clean-up is required.

 

LGEEPA sets forth the legal framework applicable to the generation and handling of hazardous wastes and materials, the release of contaminants into the air, soil and water, as well as the environmental impact assessment of the construction, development and operation of different projects, sites, facilities and industrial plants similar to the ones owned and/or operated by us and our subsidiaries. In addition to LGEEPA, the Law on Wastes regulates the generation, handling, transportation, storage and final disposal of hazardous waste.

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LGEEPA also mandates that companies that contaminate soil be responsible for the clean-up. Furthermore, the Law on Wastes provides that owners and lessors of real property with soil contamination are jointly and severally liable for the remediation of such contaminated sites, irrespective of any recourse or other actions such owners and lessors may have against the contaminating party, and aside from the criminal or administrative liability to which the contaminating party may be subject. The Law on Wastes also restricts the transfer of contaminated sites.

 

PROFEPA can bring administrative, civil and criminal proceedings against companies that violate environmental laws, regulations and Mexican Official Rules, and has the power to impose a variety of sanctions. These sanctions may include, among others, monetary fines, revocation of authorizations, concessions, licenses, permits or registries, administrative arrests, seizure of contaminating equipment, and in certain cases, temporary or permanent closure of facilities.

 

Additionally, as part of its inspection authority, PROFEPA is entitled to periodically visit the facilities of companies whose activities are regulated by Mexican environmental legislation, and verify compliance. Similar rights are granted to state environmental authorities pursuant to applicable state environmental laws.

 

Companies in Mexico are required to obtain proper authorizations, concessions, licenses, permits and registries from competent environmental authorities for the performance of activities that may have an impact on the environment or may constitute a source of contamination. Such companies in Mexico are also required to comply with a variety of reporting obligations that include, among others, providing PROFEPA and SEMARNAT with periodic reports regarding compliance with various environmental laws. Among other permits, the operations and related activities of the steel industry are subject to the prior obtainment of an environmental impact authorization granted by SEMARNAT.

 

We believe that we have obtained all the necessary authorizations, concessions, general operating licenses, permits and registries from the applicable environmental authorities to duly operate our facilities, plants and sites, and sell our products and that we are in material compliance with applicable environmental legislation. We, through our subsidiaries, have made significant capital investments to assure our production and operation facilities comply with requirements of federal, state and municipal law and administrative regulation, and to remain in compliance with our current authorizations, concessions, licenses, permits and registries.

 

We cannot assure you that in the future, we and our subsidiaries will not be subject to stricter Mexican federal, state or municipal environmental laws and administrative regulations, or more stringent interpretation or enforcement of existing laws and administrative regulations. Mexican environmental laws and administrative regulations have become increasingly stringent over the last decade, and this trend is likely to continue, influenced recently by the North American Agreement on Environmental Cooperation entered into by Mexico, the United States and Canada in connection with the NAFTA or the USMCA. Further, we cannot assure you that we will not be required to devote significant expenditures to environmental matters, including remediation-related matters. In this regard, any obligation to remedy environmental damages caused by us or any contaminated sites owned or leased by us could require significant unplanned capital expenditures and be materially adverse to our financial condition and results of operations.

 

Water

 

In Mexico, the National Waters Law regulates water resources. In addition, the Mexican Official Rules govern the quality of water. A concession granted by the National Waters Commission is required for the use and exploitation of national waters. Some of our facilities in Mexico have a renewable concession to use and exploit underground waters from wells in order to meet the water requirements of our production processes. We pay the National Waters Commission duties per cubic meter of water extracted under our concessions. We believe we are in substantial compliance with all the requirements imposed by each of the concessions we have obtained.

 

Pursuant to the National Waters Law, companies that discharge waste into national water bodies must comply with certain requirements, including maximum permissible contamination or pollution levels. Periodic reports on water quality must be provided by dischargers to applicable authorities. Liability may result from the contamination of underground waters or recipient water bodies. We believe that we are in substantial compliance with all water and waste water legislation applicable to us.

 

Antitrust Matters

 

We are also subject to the Mexican Antitrust Law (Ley Federal de Competencia Económica), which regulates monopolies and monopolistic practices in Mexico and requires Mexican government approval of certain mergers, acquisitions and joint ventures. We believe that we are currently in material compliance with the Mexican Antitrust Law. However, due to our growth strategy of acquiring new businesses and assets and because we are a large manufacturer with a significant share of the markets in Mexico with respect to certain of our products, we may be subject to greater regulatory scrutiny in the future.

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Measurements Law

 

Mexico’s Ministry of Economy (Secretaría de Economía), through the General Rules Department (Dirección General de Normas or “DGN”), promulgates regulations regarding many products that we manufacture. Specifically, pursuant to the Measurements Law (Ley Federal sobre Metrología y Normalización), the DGN issues specifications on the quality and safety standards for our product lines. We believe that all of our products are in material compliance with all applicable DGN regulations.

 

Trade Regulation Matters

 

We have experienced significant competition from imports into Mexico in the past as a result of excess worldwide steel production capacity, particularly in periods of economic slowdown, and as a consequence of the Peso’s appreciation, making imports cheaper and more competitive in peso terms. In 2003, imports declined as international market conditions improved and the peso weakened. Recently, the Mexican government, at the request of CANACERO, has taken several measures to prevent unfair trade practices such as dumping the steel import market. The overall climate for imports in Mexico is influenced by the free trade agreements that Mexico has entered into with other countries, as well as the level of tariffs and anti-dumping duties (some of which are described below).

 

We have benefited from the free trade agreements that Mexico has entered into. Specifically, we have directly benefited from our ability to export finished steel products directly to export markets and compete with similar products manufactured in those markets. We have also indirectly benefited from increased demand from our domestic customers who similarly manufacture their products to foreign markets under free trade agreements. Nevertheless, we cannot assure you that the trade agreements affecting our business or the enforcement thereof will not change in a manner that could have a material adverse effect on our business, results of operations, financial condition or prospects.

 

North American Free Trade Agreement. NAFTA became effective on January 1, 1994. NAFTA provided for the progressive elimination over a period of ten years of the 10% duties formerly in effect on most steel products imported into Mexico from the United States and Canada, including those that compete with our main product lines. Currently there is a 25% duty for steel products being exported to the United States. Leaders from the United States, Canada and Mexico also commenced discussions regarding NAFTA on January 23, 2018 in Montreal, Canada. In November 2018, the United States, Mexico and Canada signed the United States-Mexico-Canada Agreement, or USMCA, which is designed to replace NAFTA. The USMCA remains subject to approval and ratification by the legislatures in each of the three countries. See “Item 3.D. Risk Factors—Risks Related to Mexico—Developments in other countries could adversely affect the Mexican economy, our financial performance and the price of our shares.”

 

Mexican-European Community Free Trade Agreement. The Mexican-European Free Trade Agreement, or “MEFTA,” became effective on July 1, 2000, and taxes applying to a large quantity of imported goods were eliminated or reduced. The goal of this trade agreement is to establish a bilateral and preferential, progressive and reciprocal framework to encourage the development of trade in goods and services, taking into account the sensitivity of certain products and services sectors, and in accordance with relevant rules of the World Trade Organization (WTO). The Joint Council is responsible for deciding the arrangements and timetable for the liberalization of duties and non-duty barriers to trade in goods, in accordance with the relevant WTO rules. This agreement was modified in 2018.

 

Mexico-Japan Economic Association (the “Association”). On January 1, 2004, Japan and the other members of the G-7, agreed to reduce the steel tariffs to zero percent, so Mexico has benefited from this rate since such date. However, Mexico is sensitive to the steel exports coming from Japan, so the Association was negotiated in the following terms: (i) the specialized steel that is not produced in Mexico, and that is used to produce vehicles, spare parts, electronics, machinery and heavy equipment, was released from any tariffs, as from the effective date of the Association, (ii) the steel products coming from Japan currently have a zero percent rate, (iii) the products to be imported from the under the programs established by the Association, will pay the tariffs pursuant to the fixed tariffs established in such Sector Programs, so the electronic and vehicles industries will be exempted as of the effective date of the Association.

 

Other Trade Agreements. In the last several years, Mexico has signed other free trade agreements with Israel (2000), Iceland, Norway, Liechtenstein and Switzerland (2001), and with the following Latin American countries: Chile (1992 and amended in 1999); Venezuela and Colombia (1995); Costa Rica (1995); Bolivia (1995); Nicaragua (1998); Honduras, El Salvador and Guatemala (2001); and Uruguay (2003). We do not anticipate any significant increase in competition in the Mexican steel market as a result of these trade agreements due to their minimal steel production or, in the case of Venezuela and Chile, minimal share of the Mexican market. Venezuela stepped off the free trade agreement with Mexico and Columbia.

 

Transpacific Partnership Trade Agreement (TPP). On February 4, 2016, Mexico, along with Australia, Brunei, Canada, Chile, United States, Japan, Malaysia, New Zealand, Peru, Singapore and Vietnam, signed the TPP, in the City of Auckland, New Zealand. This treaty will grant Mexican products access to six markets (Australia, Brunei, Malaysia, New Zealand, Singapore and Vietnam) with approximately 155 million of potential consumers, which were not covered by any other trade agreement. The TPP is supposed to

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become effective two years after its signature, provided all 12 participating countries ratify the agreement, or when at least six countries representing at least 85% of the gross domestic product of the TPP ratify the agreement.

 

The TPP will eliminate or reduces tariff and non-tariff barriers across substantially all trade in goods and services and covers the full spectrum of trade, including goods and services trade and investment, so as to create new opportunities and benefits for the businesses, workers, and consumers of the countries members.

 

The TPP will facilitate the development of production and supply chains, and seamless trade, enhancing efficiency and supporting the goal of creating and supporting jobs, raising living standards, enhancing conservation efforts, and facilitating cross-border integration, as well as opening domestic markets.

 

The TPP will promote innovation, productivity, and competitiveness by addressing new issues, including the development of the digital economy, and the role of state-owned enterprises in the global economy.

 

The TPP includes new elements that seek to ensure that economies at all levels of development and businesses of all sizes can benefit from trade. It includes commitments to help small- and medium-sized businesses understand the Agreement, take advantage of its opportunities, and bring their unique challenges to the attention of the TPP governments. It also includes specific commitments on development and trade capacity building, to ensure that all Parties are able to meet the commitments in the Agreement and take full advantage of its benefits.

 

The TPP is intended as a platform for regional economic integration and designed to include additional economies across the Asia-Pacific region.

 

The President of the United States, Donald Trump, signed an executive order on January 2017 withdrawing the United States from the TPP.

 

On January 23, 2018, the 11 remaining countries participating in the TPP reached an agreement in Tokyo, Japan. Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam, member countries of the TPP, signed the agreement on March 8, 2018 in Santiago de Chile. The countries that have ratified the TPP are Mexico, Canada, Australia, Japan, New Zealand and Singapore. It is expected that in 2019, Peru, Chile, Brunei, Malaysia and Vietnam will join when their governments ratify the agreement.

 

Dumping and Countervailing Duties. We are or have been a party to, or have been affected by, numerous steel dumping and countervailing duty claims. Many of these claims have been brought by Mexican steel producers against international steel companies, while others have been brought against Mexican steel companies. In certain instances, such cases have resulted in duties being imposed on certain imported steel products and, in a few instances, duties have been imposed on Mexican steel exports. In the aggregate, these duties have not had a material impact on our results of operations.

 

On September 11, 2013, the United States International Trade Commission (USITC) started an official anti-dumping investigation against rebar exports from Mexico and Turkey promoted by Nucor, Gerdau, Commercial Metals, and Cascade Steel Byer.

 

  On September 25, 2013, the USITC determined that there was sufficient evidence of “injury” therefore, on October 2, 2013, the Department of Commerce (DOC) started the antidumping investigation.

 

  On November 21, 2013, DeAcero was named a “Mandatory Respondent” of the questionnaires and on February 12, 2014, we were named the second “Mandatory Respondent” thereby replacing Grupo Acerero, S.A. de C.V. which is not participating in the process.

 

  On April 21, 2014, preliminary “dumping” quotas were published: 66.7 % to Grupo Acerero, S.A. de C.V., 10.66 % to us and 20.59% to other Mexican exporters (including DeAcero).

 

  On October 14, 2014, the United States International Trade Commission (USITC) determined that a U.S. industry is materially injured by reason of imports of steel concrete reinforcing bar from Mexico that are sold in the United States at less than fair value and from Turkey that are subsidized by the government of Turkey. As a result of the USITC’s affirmative determinations, the U.S. Department of Commerce will issue an antidumping duty order on imports of this product from Mexico and a countervailing duty order on imports of this product from Turkey. The U.S. government imposed tariffs of 66.7% against imports for rebar from Deacero and us and tariffs of 20.58% for rebar from all other imports from producers in Mexico. On November 16, 2015, we filed a request for review with the U.S. Department of Commerce against the imposed tariffs. On December 6, 2016, the US Department of Commerce issued a preliminary

 

43 

 

  resolution in which it determined that the tariff is 0%.

 

  On June 8, 2017, the US Department of Commerce issued a final resolution in which it determined that the tariff should become 0%, although this is currently under review by U.S. authorities.

 

On August 14, 2013, the Ministry of Industry and Tourism of Colombia (MIT) started an official safeguard investigation against imports of commercial angles and plates originating from countries that are members of the World Trade Organization (WTO) at the request of DIACO-GERDAU and SIDOC, seeking the imposition of a countervailing duty of 35%.

 

  We were the only Mexican producer that responded to the questionnaire in October 10, 2013.

 

  On April 2, 2014, the MIT announced at a press conference that they would not impose safeguard measures to rebar nor to profiles of steel angles, square bars / slabs / plates. Only wire was subject to safeguard measures with an antidumping duty of 21.29%.

 

  On May 1, 2019, the Peruvian Commission on Dumping, Subsidies and Elimination of Commercial Customs (INDECOPI ) resolved not to impose duties on Mexican and Brazilian rebar imports.

 

Brazil operations

 

We produce according to the technical specifications of the Brazilian standard ABNT NBR 7480:2007 for steel bars and wires designed for the reinforcement for concrete structures. Our products are also registered with the Brazilian National Institute of Metrology, Quality and Technology (INMETRO), in accordance with Resolution CONMETRO No. 05, dated May 6, 2008, and comply with conformity assessment regulations, including Ordinance No. 73, dated March 17, 2010, and with compulsory product certification regulations.

 

We have received environmental permits from the Sao Paulo State, for which hydrological studies and feasibility of groundwater have been conducted, such permits include a license granted by the Ministry of Environment of Sao Paulo and an operations license granted by the Ministry of Environment CETESBE Sao Paulo State Comnahia.

 

  C. Organizational Structure

 

The chart below sets forth a summary of our corporate structure.

 

 

  

 

 

  (1) Includes the following subsidiaries: Compañía Siderúrgica del Pacífico, S.A. de C.V. (99.99%); Coordinadora de Servicios Siderúrgicos de Calidad, S.A. de C.V.

44 

 

  (100%); Industrias del Acero y del Alambre, S.A. de C.V. (99.99%); Procesadora Mexicali, S.A. de C.V. (99.99%); Servicios Simec, S.A. de C.V. (100%); Sistemas de Transporte de Baja California, S.A. de C.V. (100%); Operadora de Metales, S.A. de C.V. (100%); Operadora de Servicios Siderúrgicos de Tlaxcala, S.A. de C.V. (100%); Administradora de Servicios Siderúrgicos de Tlaxcala, S.A. de C.V. (100%); Operadora de Servicios de la Industria Siderúrgica ICH, S.A. de C.V. (100%); Arrendadora Simec S.A. de C.V. (100%); CSG Comercial, S.A. de C.V. (99.95%); Compañía Siderúrgica de Guadalajara S.A. de C.V. (99.99%); Simec Acero, S.A. de C.V. (100%); Undershaft Investment N. V., (100%); Simec USA Corp. (100%); Pacific Steel Projects Inc. (100%); Simec Steel Inc. (100%); Simec International, S. A. de C. V.(100%); Corporativos G&DL, S.A. de C.V. (100%); Simec International 7, S. A. de C. V., (99.99%), Simec International 9, S.A.P.I. de C.V., (100.00%); Corporación ASL, S.A. de C.V. (99.99%); Siderúrgica del Occidente y Pacífico, S.A. de C.V. (100%); GS steel B.V. (100%) (liquidated in 2018), Recursos Humanos de la Industria Siderúrgica de Tlaxcala, S.A. de C.V. (100%), Siderúrgicos Noroeste, S.A. de C.V. and Fundiciones de Acero Estructrual, S.A. de C.V. (100%).

 

  (2) Our principal Mexican facilities consist of steel-making facilities in Guadalajara, Jalisco; Mexicali, Baja California; Apizaco, Tlaxcala, and San Luis Potosí; and cold finishing facilities in Cholula, Puebla. These facilities were operated by Simec International 6, S.A. de C.V. until October 31, 2012 (began operations in November 2010). Since November 1, 2012 these facilities were operated by Orge, S.A. de C.V. (incorporated in October, 2012). These facilities were operated by RRLC, S.A.P.I. de C.V. (95.10%) (incorporated in 2015) and Grupo Chant, S.A.P.I. de C.V. (97.61%) (incorporated in 2015), since April, 2015 and October 2015, respectively. These facilities were operated by GSIM de Occidente, S.A. de C.V. (incorporated in 2016) and Aceros Especiales Simec Tlaxcala, S.A. de C.V. (incorporated in 2015), since March 2016 and July 2016, respectively.

 

  (3) The remaining 49.8% of SimRep is owned by our controlling shareholder, Industrias CH.

 

  (4) SimRep, Co. owns 100% of Republic Steel, Inc. Our principal U.S. facilities consist of a steel-making facility in Canton, Ohio; a steel- making and hot-rolling facility in Lorain, Ohio; a hot-rolling facility in Lackawanna, New York; and cold finishing facilities in Massillon, Ohio and Solon, Ohio; all, of which are owned directly by Republic.

 

  (5) Grupo San facilities are conformed by Corporacion Aceros DM, S.A. de C.V. (100%) and Subsidiaries, Aceros DM, S.A. de C.V. (99.99%) Acero Transportes SAN, S.A. de C.V. (99.99%), Aceros San Luis, S.A. de C.V. (99.99%), Malla San 1, S.A. de C.V. (99.98%), Malla San 2, S.A. de C.V. (99.98%) and Alambres Trefilados de San Luis Potosí, S.A. de C.V. (99.99%).

 

(6)Our Brazil facilities are conformed by GV do Brasil Industria e Comercio de Aço LTDA., Companhia Siderúrgica do Espirito Santo, S.A. and the plant in Itauna, Minas Gerais, that is leased to a third party.

The following table identifies each of our significant operating subsidiaries, including its country of incorporation and our percentage ownership thereof at December 31, 2018:

 

Name of Subsidiary

Country of Incorporation

Ownership
Interest (%)

Simec International, S.A. de C.V. Mexico 100.00%
Undershaft Investments, N.V. Curaçao 100.00%
Pacific Steel, Inc. United States 100.00%
SimRep Corporation and subsidiaries (Republic) United States 50.22%
Compañía Siderúrgica del Pacífico, S.A. de C.V. Mexico 99.99%
Coordinadora de Servicios Siderúrgicos de Calidad, S.A. de C.V. Mexico 100.00%
Industrias del Acero y del Alambre, S.A. de C.V. Mexico 99.99%
Procesadora Mexicali, S.A. de C.V. Mexico 99.99%
Servicios Simec, S.A. de C.V. Mexico 100.00%
Sistemas de Transporte de Baja California, S.A. de C.V. Mexico 100.00%
Operadora de Metales, S.A. de C.V. Mexico 100.00%
Operadora de Servicios Siderúrgicos de Tlaxcala, S.A. de C.V. Mexico 100.00%
Administradora de Servicios Siderúrgicos de Tlaxcala, S.A. de C.V. Mexico 100.00%
Operadora de Servicios de la Industria Siderúrgica ICH, S.A. de C.V. Mexico 100.00%
Arrendadora Simec S.A. de C.V. Mexico 100.00%
Compañía Siderúrgica de Guadalajara S.A. de C.V. Mexico 99.99%
CSG Comercial, S.A. de C.V Mexico 99.95%
Corporación Aceros DM, S.A. de C.V. and subsidiaries Mexico 100.00%
Corporación ASL, S.A. de C.V. Mexico 99.99%
Simec International 6, S. A. de C. V. Mexico 100.00%
Simec International 7, S. A. de C. V. Mexico 99.99%
Simec International 9, S.A.P.I. de C. V. Mexico 100.00%
Simec Acero, S. A. de C. V. Mexico 100.00%
Simec USA, Corp. United States 100.00%
Pacific Steel Projects, Inc. United States 100.00%
Simec Steel, Inc. United States 100.00%
Corporativos G&DL, S.A. de C.V. Mexico 100.00%
GV do Brasil Industria e Comercio de Aço LTDA. Brazil 100.00%
Orge, S.A. de C.V. Mexico 99.99%
Siderúrgica del Occidente y Pacífico, S.A. de C.V. Mexico 100.00%
GS Steel BV (liquidated in 2018) Netherlands 100.00%
RRLC S.A.P.I. de C.V. Mexico 95.10%
Grupo Chant S.A.P.I. de C.V. Mexico 97.61%

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Aceros Especiales Simec Tlaxcala, S.A. de C.V. Mexico 100.00%
Recursos Humanos de la Industría Siderúrgica de Tlaxcala, S.A. de C.V. Mexico 100.00%
GSIM de Occidente, S.A. de C.V. Mexico 100.00%
Fundiciones de Acero Estructural, S.A. de C.V. Mexico 100.00%
Siderúrgicos Noroeste, S.A. de C.V. Mexico 100.00%
Companhia Siderúrgica do Espirito Santo, S.A. Brazil 100.00%

 

  D. Property, Plants and Equipment

 

Our Operations and Production Facilities

 

We conduct our operations at 15 facilities throughout America. At December 31, 2018, our crude steel production capacity was 5.3 million tons, of which 1.2 million tons were based on an integrated blast furnace technology, and 4.1 million were based on electric arc furnace, or mini-mill, technology. Our Mexican facilities have 2.3 million tons of crude steel production capacity, operating six mini-mill facilities. Our U.S. operations have 2.1 million tons of crude steel production capacity and our Brazil operations have 0.9 million tons of crude steel production capacity. In addition, we have 4.5 million tons of rolling and finishing capacity, of which 2.1 million are located in Mexico, 1.7 million are located in the United States and Canada and 0.7 million are located in Brazil.

 

We operate nine mini-mills, six in Mexico, one in the United States and two in Brazil. The Mexican mini-mills are located in Guadalajara, Jalisco; two in Apizaco, Tlaxcala; Mexicali, Baja California; as well as two in San Luis Potosí. Our mini-mill in the United States is located in Canton, Ohio. Our mini-mills in Brazil are located in Pindamonhangaba, São Paulo and Cariacica, Espírito Santo. We also own an integrated blast furnace and an electric arc furnace in Lorain, Ohio and a rolling mill in Lackawanna, New York. Processing mills are located in Massillon, Ohio and Solon, Ohio.

 

Because we own both mini-mill and integrated blast furnace production facilities, we can allocate production between each type of facility based on efficiency and cost. In addition, as long as our facilities are not operating at full capacity, we can allocate production based on the relative cost of basic inputs (iron ore, coaking coal, scrap metal and electricity) to the facility where production costs would be the lowest. Our production facilities are designed to permit the rapid changeover from one product to another. This flexibility permits us to efficiently produce small volume orders to meet customer needs and to produce varying quantities of standard product. Production runs, or campaigns, occur on four to eight weeks cycles, minimizing customer waiting time for both standard and specialized products.

 

We can use scrap metal or iron ore to produce our finished steel products. We produce liquid steel using an electric arc furnace, alloying elements and carbon are added, and then is transported to continuous casters for solidification. The continuous casters produce long, square strands of steel that are cut into billet and transferred to the rolling mills for further processing or, in some cases, sold to other steel producers. In the rolling mills, the billet is reheated in a walking beam furnace with preheating burners, passed through a rolling mill for size reduction and conformed into final sections and sizes. The shapes are then cut into a variety of lengths. Our facility in Canton, Ohio is capable of producing billets and blooms.

 

Our mini-mill plants use an electric arc furnace to melt ferrous scrap and other metallic components, which are then cast into long, square bars called billets in a continuous casting process, all of which occurs in a melt shop. The billet is then transferred to a rolling mill, reheated and rolled into finished product. In contrast, an integrated steel mill heats iron pellets and other primary materials in a blast furnace to first produce pig iron, that must be refined in a basic oxygen furnace to liquid steel, and then cast to billet and finished product. Mini-mill plants typically produce certain steel products more efficiently because of the lower energy requirements resulting from their smaller size and because of their use of ferrous scrap. Mini-mills are designed to provide shorter production runs with relatively fast product changeover times. Integrated steel mills are more efficient in producing longer runs and are able to produce certain steel products that a mini-mill cannot.

 

The production levels and capacity utilization rates for our melt shops and rolling mills for the periods indicated are presented below.

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Production Volume and Capacity Utilization

 

    Years ended December 31,
    2014   2015   2016   2017   2018
    (tons in thousands)
Melt shops                    
Steel billet production   2,483.7   2,318.0   2,219.6   2,288.0   2,359.0
Annual installed capacity(1)   4,207.9   4,552.9   4,552.9   4,596.9   5,257.9
Effective capacity utilization   59.0%   50.9%   48.8%   49.8%   44.9%
Rolling mills                    
Total production   2,286.3   2,206.4   2,211.4   2,171.6   2,306.7
Annual installed capacity(1)   3,829.6   4,279.6   4,131.8   4,000.0   4,480.0
Effective capacity utilization   59.7%   51.6%   53.5%   54.3%   51.5%

 

 

  (1) Annual installed capacity is determined based on the assumption that billet of various specified diameters, width and length is produced at the melt shops or that a specified mix of rolled products are produced in the rolling mills on a continuous basis throughout the year except for periods during which operations are discontinued for routine maintenance, repairs and improvements. Amounts presented represent annual installed capacity as of December 31 for each year.

 

Mexican Operations and Facilities

 

The following table presents production by product at each of our Mexican facilities as a percentage of total production at that facility for 2018.

 

Mexican Production per Facility by Product
Location

 

Product

Guadalajara

Mexicali

Apizaco/
Cholula

San Luis

Total

  Production (%)
I Beams 24.4% 0.6% 0% 0% 5.0%
Channels 9.2% 7.7% 0% 0% 3.2%
Angles 29.0% 12.4% 0% 0% 8.8%
Hot rolled bars (round, square and hexagonal rods) 17.2% 5.2% 36.0% 1.4% 13.8%
Rebar 12.0% 71.8% 0.4% 82.0% 45.6%
Flat bars 8.2% 2.3% 27.0% 0% 8.5%
Cold finished bars 0% 0% 36.6% 0% 8.6%
Electro-Welded wire mesh 0% 0% 0% 3.5% 1.4%
Wire rod 0% 0% 0% 9.0% 3.5%
Electro-Welded wire mesh panel 0% 0% 0% 4.1% 1.6%
Other

0%

0%

0%

0%

0%

Total 100.0% 100.0% 100.0% 100.0% 100.0%

 

Guadalajara. Our Guadalajara mini-mill facility is located in central western Mexico in the state of Jalisco which is Mexico’s second largest city. Our Guadalajara facilities and equipment include one improved electric arc furnace utilizing water-cooled sidewalls and roof, one four-strand continuous caster, five reheating furnaces and three rolling mills. The Guadalajara mini-mill has an annual installed capacity of 370,000 tons of billet and an annual installed capacity of finished product of 480,000 tons. In 2018, the Guadalajara mini-mill produced 234,827 tons of steel billet and 312,513 tons of finished product, operating at 63% capacity for billet production and 65% capacity for finished product production. The Guadalajara rolling facilities process billet production from our Mexicali and Apizaco mills. Our Guadalajara facility is 336 miles from Mexico City. Our Guadalajara facility mainly produces structurals, SBQ steel, light structurals and rebars.

 

Guadalajara Mini-Mill 

 

 

Years ended December 31,

 

2014

2015

2016

2017

2018

Steel sales (thousands of tons) 335 369 375 340 307
Average finished product price per ton Ps.  10,410 Ps.  9,726 Ps. 10,779 Ps. 12,000 Ps. 13,896
Average scrap cost per ton 4,934 4,539 4,691 5,695 7,071

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Average manufacturing conversion cost per ton of finished product(1) 2,613 2,399 2,452 2,789 3,252
Average manufacturing conversion cost per ton of billet(1) 1,586 1,489 1,588 1,927 2,674

 

 

  (1) Manufacturing conversion cost is defined as all production costs excluding the cost of scrap and related yield loss.

 

 

Mexicali. In 1993, we began operations at our mini-mill located in Mexicali, Baja California. The mini-mill is strategically located approximately 22 miles south of the California border and approximately 220 miles from Los Angeles.

 

Our Mexicali facilities and equipment include one electric arc furnace utilizing water-cooled sidewalls and roof, one four-strand continuous caster, one walking beam reheating furnace, one SACK rolling mill, a Linde oxygen plant and a water treatment plant. This facility has an annual installed capacity of 430,000 tons of steel billet and an annual installed capacity of finished product of 250,000 tons. Excess billet produced at the Mexicali facility is used primarily by the Guadalajara facility. This allows us to increase the utilization of the Guadalajara facility’s finishing capacity, which exceeds its production capacity. In 2018, the Mexicali mini-mill produced approximately 271,221 tons of billet, of which the Guadalajara mini-mill used 77,308 tons. In 2018, the Mexicali mini-mill produced 199,119 tons of finished products. In 2018 we operated the Mexicali mini-mill at 63% capacity for billet production and at 80% capacity for finished product production. Our facility is strategically located and has access to key markets in Mexico and the United States, stable public sources of scrap, electricity, a highly skilled workforce and other raw materials. The Mexicali mini-mill also is situated near major highways and a railroad linking the Mexicali and Guadalajara mini-mills, allowing for coordinated production at the two facilities. Our Mexicali facility mainly produces structurals, light structurals and rebar. In 2018, 72% of the products produced at the Mexicali mini-mill were rebar, 12% were angles, 5% were hot rolled bars (round, square and hexagonal rods) and the remaining 11% were channels and flat bar.

 

Mexicali Mini-Mill

 

 

Years ended December 31,

 

2014

2015

2016

2017

2018

Steel sales (thousands of tons) 206 220 216 193 208
Average finished product price per ton Ps.  9,170 Ps.  9,405 Ps. 9,935 Ps. 10,720 Ps. 13,538
Average scrap cost per ton 4,348 3,981 3,942 4,544 6,302
Average manufacturing conversion cost per ton of finished product(1) 2,659 2,414 2,277 2,878 3,290
Average manufacturing conversion cost per ton of billet(1) 1,752 1,608 1,541 2,013 2,249

 

 

  (1) Manufacturing conversion cost is defined as all production costs excluding the cost of scrap and related yield loss.

 

Apizaco mini-mills (mini-mill 1 and mini-mill 2) and Cholula facility. We have operated Apizaco mini-mill 1 and Cholula facility since August 1, 2004 and Apizaco mini-mill 2 since July, 2018. Mini-mill 1 and 2 are located in central Mexico in Apizaco, Tlaxcala. Our Apizaco facilities and equipment include two EBT Danieli electric arc furnace utilizing water-cooled sidewalls and roof, three ladle stations (two Danieli and the other Daido), two Daido degasification station, two Danieli four-strand continuous caster, three walking beam reheating furnaces and three rolling mills (two Danieli and the other Pomini). Mini-mill 1 has an annual installed capacity of 510,000 tons of steel billet and an annual installed capacity of finished product of 492,000 tons. In 2018, mini-mill 1 produced 357,477 tons of steel billet. In 2018, mini-mill 1 produced 348,248 tons of finished products. In 2018, we operated mini-mill 1 at 70% capacity for billet production and at 71% capacity for finished product production. Mini-mill 2 has an installed capacity of 305,000 tons of steel billet (for the period of July 2018 to December 2018) and an installed capacity of finished product of 280,000 tons (for the period of July 2018 to December 2018). In 2018, mini-mill 2 produced 43,849 tons of steel billet. In 2018, mini-mill 2 produced 27,198 tons of finished products. In 2018, we operated mini-mill 2 at 14% capacity for billet production and at 10% capacity for finished product production. Our Apizaco mini-mills are 1,112 miles from Mexicali and less than 124 miles from Mexico City. Our Apizaco facilities mainly produce SBQ steel, light structurals and rebar. Our Cholula facility is approximately 25 miles from our Apizaco facilities, which allows the integrated operations of the Apizaco mini-mills and Cholula facility. Our Cholula facilities and equipment include cold drawing and turning machines for peeling bars. This facility has an annual installed capacity of finished product of 120,000 tons. In 2018, the Cholula facility produced 107,794 tons of finished products, at 90% capacity. Our Cholula facility mainly produces cold finished SBQ steel.

 

In 2018, our plants in Apizaco and Cholula produced 401,326 tons of billet and 375,446 tons of finished product, operating at 49% of its billet capacity and 49% capacity for finished product.

 

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In 2018, 36% of the products we produced at the Apizaco and Cholula facilities were hot rolled bars (round, square and hexagonals), 27% were flat merchant bar and 37% were cold finished products.

 

Apizaco Mini-Mill and Cholula Facility 

 

 

Years ended December 31,

 

 

2014

2015

2016

2017

2018

Steel sales (thousands of tons) 361 339 350 331 321
Average finished product price per ton Ps.  12,047 Ps.  12,366 Ps. 12,763 Ps. 15,426 Ps. 17,935
Average scrap cost per ton 4,800 4,111 4,376 5,725 6,383
Average manufacturing conversion cost per ton of finished product(1) 3,400 3,455 3,321 4,524 5,604
Average manufacturing conversion cost per ton of billet(1) 2,154 2,195 2,168 2,796 3,767

 

 

  (1) Manufacturing conversion cost is defined as all production costs excluding the cost of scrap and related yield loss.

 

 

San Luis Operations and Facilities. We have operated our San Luis facilities since we acquired them on May 30, 2008. The facilities are located in central Mexico in the city of San Luis Potosí, in the state of San Luis Potosí. Our San Luis facilities and equipment include four electric arc furnaces, three continuous casters, three reheating furnaces, two rebar rolling mills and one wire rod rolling mill. As of December 31, 2018, these facilities had an annual installed capacity of 660,000 tons of billet and 610,000 tons of finished product. In 2018, the San Luis facilities produced 549,844 tons of steel billet. In 2018, the San Luis facilities produced 530,029 tons of finished product, operating at 83% capacity for billet production and 87% capacity for finished product production. Our San Luis facilities mainly produce rebar, light structurals and wire rod. In 2018, 82% of the products produced at the San Luis facilities were rebar, 17% were electro-welded wire mesh, wire rod and electro-welded wire mesh panel, and the remaining 1% were other light structurals.

 

The following table sets forth, for the periods indicated selected operating data for our San Luis facilities. 

 

 

 

Years ended December 31,

 

 

2014

2015

2016

2017

2018

           
Steel sales (thousands of tons) 517 524 554 540 538
Average finished product price per ton Ps.  9,269 Ps.  9,786 Ps. 10,301 Ps. 10,870 Ps. 14,255
Average scrap cost per ton 4,936 4,462 4,628 5,859 6,822
Average manufacturing conversion cost per ton of finished product(1) 2,268 2,060 2,032 2,414 3,094
Average manufacturing conversion cost per ton of billet(1) 1,764 1,584 1,571 1,857 2,481
 
  (1) Manufacturing conversion cost is defined as all production costs excluding the cost of scrap and related yield loss.

 

U.S. Operations and Facilities

 

We have operated our Republic facilities (in Ohio and New York) since we acquired them from the shareholders of PAV Republic, Inc. on July 22, 2005. As of December 31, 2018, these facilities had an annual installed capacity of 2,083,000 tons of billet and 1,660,000 tons of finished product. In 2018, Republic facilities produced 414,847 tons of steel billet. For the same period, Republic facilities produced 360,253 tons of hot-rolled bars. Republic facilities produced 32,296 tons of cold finish bars. In 2018, Republic facilities produced 36,288 tons of wire products.

 

The following table sets forth, for the periods indicated selected operating data for our Republic facilities.

 

 

Years ended December 31,

 

2014

2015

2016

2017

2018

Steel sales (thousands of tons) 778 570 397 387 385
Average finished product price per ton Ps.  15,823 Ps.  16,611 Ps. 23,526 Ps. 21,630 Ps. 24,016
Average scrap cost per ton 5,354 3,899 3,939 6,114 7,026

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Average manufacturing conversion cost per ton of finished product(1) 6,417 7,042 6,621 6,790 10,555
Average manufacturing conversion cost per ton of billet(1) 4,665 4,481 4,661 4,915 6,842
 

 

  (1) Manufacturing conversion cost is defined as all production costs excluding the cost of scrap and related yield loss.

 

Lorain, Ohio. The Lorain facility operates an integrated steel mill, it has a blast furnace, two 220-ton basic oxygen furnaces, a 150-ton electric arc furnace, two ladle metallurgy facilities, a vacuum degasser, a five-strand continuous bloom caster, a six-strand billet caster, a billet rolling mill and two bar rolling mills.

 

Our Lorain facility had, at December 31, 2018, an annual installed capacity of 952,000 tons of steel billet and 816,000 tons of finished product. This facility did not produce any steel billets or finished steel bars in 2018 as it has been idled since 2016.

 

Canton, Ohio. Our Canton facility mainly produces SBQ steel and includes two 200-ton top charge electric arc furnaces, a 5-strand bloom/billet caster, two ladle metallurgical furnaces, two vacuum degassers and two slag rakes. This facility also includes a combination Caster rolling facility that continuously casts blooms in a 4-strand caster, heats the blooms to rolling temperature in a walking beam furnace, then rolls billets through an 8-stand rolling mill in an inline operation. We installed and commissioned the electric arc furnace, the bloom/billet caster, ladle metallurgical furnace and vacuum degasser in 2005. Other Canton equipment includes a Mecana billet inspection line, four stationary billet grinders, a saw line and a quality verification line (or “QVL line”).

 

Canton produces blooms and billets for the three rolling mills in Republic facilities and for trade customers. We use the QVL inspection line to inspect finished bar produced in Lackawanna. As of December 2018, the Canton facility had annual installed capacity of 1,131,000 tons of steel billet. In 2018, this facility produced 414,847 tons of blooms, billets and other semi-finished trade product and was operated at 37% capacity of steel billet.

 

Lackawanna, New York. Our Lackawanna facility mainly produces SBQ steel and includes a three-zone walking beam billet reheat furnace, a recently upgraded 16 conventional stand mill with a 5 stand sizing mill and two saw lines capable of producing rounds, squares, and hexagons in both cut length and coils. This facility produces hot rolled bar sizes that range from 0.562” to 3.250” with coil weights up to 6,000 lb. Our Lackawanna facility’s finishing equipment includes a QVL inspection line and three saw lines. We sell a portion of the hot rolled bars produced at our Lackawanna facility to trade customers, and we also ship a portion of the finished bars to our cold finishing operations for further processing. As of December 31, 2018, the Lackawanna facility had annual installed capacity of 653,000 tons of hot rolled bars. In 2018, this facility produced 360,253 tons of hot rolled bars and was operated at 55% capacity of finished product.

 

Massillon, Ohio. Our Massillon facility mainly produces SBQ steel and contains a cold finishing facility which includes the machinery and equipment to clean, draw, turn, chamfer, anneal, grind, straighten and saw bars. Our Massillon facility had, at December 31, 2018, an annual installed capacity of 125,000 tons of finished product. During 2018, the Massillon facility was operated at 26% capacity of finished product and produced 32,296 tons of cold finished bars.

 

Solon, Ohio. Our Solon facility, acquired in February, 2011, mainly produce Cold Heading Quality (CHQ) wire products and have wire drawing and finishing facilities that include the machinery and equipment to clean and coat, draw, and anneal wire. As of December 31, 2018, the Solon facility had installed capacities of 65,000, for wire products. During 2018, the Solon facility produced and shipped 36,288 tons of wire products and was operated at 56% capacity of finished product.

 

Hamilton, Ontario, Canada. Our Hamilton facility was shut down permanently during 2018. All machinery and equipment will eventually be relocated to our other facilities on a structured basis. It is anticipated that the relocation work will be completed by the end of 2019..

 

Brazil.

 

We have three plants in Brazil: a mini-mill and rebar and wire-rod rolling mill in Pindamonhangaba, São Paulo, a mini-mill in Cariacica, Espirito Santo and rolling and finishing facilities in in Itauna, Minas Gerais, that is leased to a third party. Our plant located in Pindamonhangaba, State of Sao Paulo, is 87 miles from the city of Sao Paulo, and is 218 miles from Rio de Janeiro. Our Pindamonhangaba facility and equipment include an electric arc furnace and a rebar and wire rod rolling mill. Our facility in Pindamonhangaba began operations in July 2015 and currently produces rebar, while the plants in Cariacica and Itauna began operations in May 2018, and include an electric arc furnace and two rebar and wire rod rolling mills. As of December 31, 2018, our plant in Pindamonhangaba had installed capacity to produce 500,000 tons of “billet” and 420,000 tons of finished product per year capacity. In 2018 our plant in Pindamonhangaba produced 261,826 tons of “billet” and 279,306 tons of finished product, operating at 52% of its capacity for “billet” and 67% capacity for finished product. Our plant in Cariacica had installed capacity to produce 400,000 tons of “billet” and 232,000 tons of finished product (for the period of May 2018 to December 2018). In 2018, our plant in Cariacica produced 225,116 tons of

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“billet” and 133,070 tons of finished product, operating at 56% of its capacity for “billet” and 57% capacity for finished product (for the period between May 2018 and December 2018). The leased plant in Itauna had installed capacity to produce 56,000 tons of finished product (for the period of May 2018 to December 2018). In 2018, our plant in Itauna produced 48,413 tons of finished product, operating at 86% capacity for finished product (for the period between May 2018 and December 2018).

 

In 2018, our plants in Brazil produced 486,942 tons of billet and 460,789 tons of finished product, operating at 54% of its billet capacity and 65% capacity for finished product.

 

The following table sets forth, for the period indicated, selected operating data for our Brazil facilities.

 

Years ended December 31,

 
 

2015

2016

2017

2018

Steel sales (thousands of tons) 4 193 300 433
Average finished product price per ton Ps.  7,500 Ps. 9,399 Ps. 10,680 Ps. 13,681
Average scrap cost per ton 2,322 3,679 4,846 6,553
Average manufacturing conversion cost per ton of finished product(1) 2,481 2,551 3,181 4,240
Average manufacturing conversion cost per ton of billet(1) 1,103 1,703 2,403 2,957
           
 

 

  (1) Manufacturing conversion cost is defined as all production costs excluding the cost of scrap and related yield loss.

 

The following table shows the products that we produce, the equipment that we use and the volume that we produce in each of our separate production facilities:

 

Production per Facility by Product, Equipment and Volume

Location

Product (%)

Equipment

2018 Annual
Production Volume
(tons)

Finished Product
Annual Installed
Capacity (tons)

Guadalajara I Beams (25%); Channels (9%); Angles (29%); Rebar (12%);Hot rolled bars (17%); Flat bars (8%) electric arc furnace with continuous caster rolling mill and bar processing lines 312,513 480,000
         
Mexicali Angles (12%); Rebar (72%); Channels (8%); Hot rolled bars (5%) Other (3%) electric arc furnace with continuous caster and rolling mills 199,119 250,000
         
Apizaco and Cholula SBQ (100%) electric arc furnace with vacuum tank degasser, continuous caster, rolling mills, cold drawn and bar turning equipment 375,446 772,000(3)
         
San Luis Potosí Rebar (82%); Wire rod (9%); Electro-Welded wire mesh (4%); Electro-Welded wire mesh panel (4%); Bars (1%) electric arc furnaces, whit continuous casters, rolling mill and wire rod rolling mill 530,029 610,000
         
Lorain(1) SBQ (100%) electric arc furnace, blast furnace, vacuum tank degasser, continuous caster, and rolling mills            0 816,000
         

 

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Canton(2) SBQ (100%) electric arc furnace, vacuum tank degasser and continuous caster Our billet and bloom for internal consumption Our billet and bloom for internal consumption
         
Lackawanna SBQ (100%) rolling mill and wire rod rolling mill 360,253 653,000
         
Massillon SBQ (100%) cold drawn, bar turning and heat treating equipment 32,296 125,000
         
Solon SBQ (100%) equipment to clean and coat, draw, and anneal wire 36,288 65,000
         
Brazil Rebar (69%); Angles (8%); Bars (9%); Flat bars (12%); Other (2%); electric arc furnace, with continuous caster with rolling mills and wire rod rolling mill 460,789 708,000(4)

 

 
  (1) Production capacity is for rolling only.
  (2) Production capacity is for billets only.
  (3) Includes the production capacity of our mini-mill 2 from July to December 2018 (280,000 tons), from the date on which it started operations.
  (4) Includes the production capacity of our mini-mill in Cariacica (232,000 tons) and our leased rolling mill in Itauna (56,000 tons) from May to December 2018, from the date on which the Cariacica Mill was acquired.

 

Item 4A. Unresolved Staff Comments

 

In the months of December 2017 and February and March 2018, the Company received written comments from the staff of the U.S. Securities and Exchange Commission (the “SEC”) regarding the Company's annual report on Form 20-F for the year ended December 31, 2016. In such comments, the staff requested further information regarding the nature and the accounting treatment of certain related party loans. The SEC continues to request that the Company voluntarily produce certain documents related to such related party loans and the Company has been and continues to cooperate with the SEC on this matter. See “Item 8. Financial Information-A. Consolidated Statements and Other Financial Information-Legal Proceedings.”

 

Item 5. Operating and Financial Review and Prospects

 

The following discussion is derived from our audited consolidated financial statements, which are presented elsewhere in this annual report. This discussion does not include all of the information included in our financial statements. You should read our financial statements to gain a better understanding of our business and our historical results of operations. All of the statements in this Item 5.A are subject to and qualified by the information set forth under the “Cautionary Statement Regarding Forward Looking Statements.”

 

Adoption of International Financial Reporting Standards (IFRS)

 

The Mexican National Banking and Securities Commission (CNBV) has established the requirement that listed companies must disclose their financial information to the public, through the Mexican Stock Exchange (BMV) or the Bolsa Institucional de Valores, S.A. de C.V. (BIVA) (operating since July 25, 2018), and therefore, beginning in 2012, we prepare our financial information in accordance with IFRS, as issued by the IASB. IFRS differs in certain significant respects from U.S. GAAP. Accordingly, Mexican financial statements and reported earnings are likely to differ from those of companies in other countries in this and other respects.

 

 

A. Operating Results

 

Overview

 

We are producers of SBQ and structural steel products. Accordingly, our net sales and profitability are highly dependent on market conditions in the steel industry which is greatly influenced by general economic conditions in North America and globally. The sharp reduction in economic activity and consumer demand in general, and in the automotive, construction and manufacturing industries in particular, in North America starting in the fourth quarter of 2008 has had a significant negative impact on the demand and price levels for all steel products, including SBQ and structural steel products. These economic conditions have had an impact on all parts of our operations since the fourth quarter of 2008. Demand, production levels and prices in certain segments and markets

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have recovered and stabilized to a certain degree, although the extent, timing and duration of the recovery and potential return to pre-crisis levels remains uncertain. Our net revenue from sales increased in 2014, compared to 2013, increased by 42% in the automotive sector, decreased 13% in the independent distributor sector, decreased 34% in the hand tools sector, decreased 61% in the mining sector and increased 29% in other industries. The total increase in net revenue from sales of SBQ products in 2014, compared to 2013, was 18%. Our net revenue from sales decreased in 2015, compared to 2014, increased by 20% in the automotive sector, decreased 43% in the independent distributor sector, increased 204% in the hand tools sector, decreased 52% in the mining sector and decreased 48% in other industries. The total decrease in net revenue from sales of SBQ products in 2015, compared to 2014, was 16%. Our net revenue from sales decreased in 2016, compared to 2015, decreased by 18% in the automotive sector, increased 9% in the independent distributor sector, decreased 72% in the hand tools sector, decreased 42% in the mining sector and decreased 10% in other industries. The total decrease in net revenue from sales of SBQ products in 2016, compared to 2015, was 13%. In 2017, the total increase in net revenue from sales of SBQ products compared to 2016 was 13%. In 2018, the total increase in net revenue from sales of SBQ products compared to 2017 was 10%.

 

As a result of the significant competition in the steel industry and the commodity-like nature of some of our products, we have limited pricing power over many of our products. The North American and global steel markets influence finished steel product prices. Nevertheless, many of our products are SBQ products for which competition is limited, and, therefore, these products tend to generate somewhat higher margins compared with our more commercial steel products. We attempt to adjust the mix of our product output toward higher margin products to the extent that we are able to do so, and we also adjust our overall product levels based on the product demand.

 

We focus on controlling our cost of sales as well as our selling, general and administrative expenses. Our cost of sales largely consist of the costs of acquiring the raw materials necessary to manufacture steel, primarily scrap metal and ferroalloys. Market supply and demand generally determine scrap prices, and, as a result, we have limited ability to influence their cost or the costs of other raw materials, including energy costs; however, in 2014, 2015, 2016, 2017 and 2018 we did not purchase iron ore pellets or coaking coal since our Lorain, Ohio blast furnace facility, which is our only facility that utilizes these materials, was idled during these periods. There is a correlation between the prices of scrap and iron ore and finished product prices, although the degree and timing of this correlation varies from time to time, so we may not always be able to fully pass along scrap and other raw material price increases to our customers. Therefore, our ability to decrease our cost of sales as a percentage of net sales is largely dependent on increasing our productivity. Our ability to control selling, general and administrative expenses, which do not correlate to net sales as closely as cost of sales do, is a key element of our profitability. Although our revenues and costs fluctuate from quarter to quarter, we do not experience large fluctuations due to seasonality.

 

Production costs at our U.S. facilities are higher by approximately 69% than those in our facilities in Mexico principally due to the higher cost of labor and the higher cost of ferroalloys used to manufacture SBQ steel, which is the only steel product that we produce in the United States.

 

The negative operating trends in our USA segment are primarily driven by under-utilized production capacity that severely impacts cost. The automotive sector is stable and continues to provide good demand for our products.

 

Our U.S. subsidiaries have entered into sale agreements with customers and, in order to comply with the terms thereof, any existing orders pursuant to those agreements need to be fulfilled even if the price of raw material increases with time. As the existing sale agreements expire, we will evaluate new agreements which would result in a production of profitable products.

 

Typically, about 75% of our business uses a fixed base price that is negotiated annually, plus monthly scrap and alloy surcharges. The remaining 25% is transaction business, where we can adjust the base pricing as required. Scrap metal and commodity prices stabilized somewhat midway through 2016, and in 2017 and 2018 the prices of scrap and other inputs increased significantly. Financial resources will continue to be made available as our U.S. segment tackles the cost curve and restores the business to profitability.

 

 

Sales Volume, Price and Cost Data, 2014 - 2018

 

  Year ended December 31,
  2014 2015 2016 2017 2018
Shipments (thousands of tons) 2,197 2,026 2,085 2,091 2,192
Guadalajara and Mexicali 540 589 591 533 515
Apizaco and Cholula 362 339 350 331 321
San Luis facilities 517 524 554 540 538
Republic facilities 778 570 397 387 385
Brazil 4 193 300 433
           
                         

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Net sales (Ps. millions) 26,829 24,476 27,516 28,700 35,678
Guadalajara and Mexicali 5,366 5,658 6,188 6,149 7,082
Apizaco and Cholula 4,361 4,192 4,467 5,106 5,757
San Luis facilities 4,792 5,128 5,707 5,870 7,669
Republic facilities 12,310 9,468 9,340 8,371 9,246
Brazil 30 1,814 3,204 5,924
           
Cost of sales (Ps. millions) 25,492 23,097 22,776 23,994 30,563
Guadalajara and Mexicali 4,740 3,955 5,364 4,703 5,710
Apizaco and Cholula 3,115 2,764 3,635 3,607 3,948
San Luis facilities 4,221 4,529 4,726 5,030 6,058
Republic facilities 13,416 11,829 7,332 7,814 9,294
Brazil 20 1,719 2,840 5,553
           
Average price per ton (Ps.) 12,212 12,081 13,197 13,725 16,276
Guadalajara and Mexicali 9,937 9,606 10,470 11,537 13,751
Apizaco and Cholula 12,047 12,366 12,763 15,426 17,935
San Luis facilities 9,269 9,786 10,301 10,870 14,255
Republic facilities 15,823 16,611 23,526 21,630 24,016
Brazil 7,500 9,399 10,680 13,681
           
Average cost per ton (Ps.) 11,603 11,400 10,924 11,475 13,943
Guadalajara and Mexicali 8,778 6,715 9,076 8,824 11,087
Apizaco and Cholula 8,605 8,153 10,386 10,897 12,299
San Luis facilities 8,164 8,643 8,531 9,315 11,260
Republic facilities 17,244 20,753 18,469 20,191 24,140
Brazil 5,000 8,907 9,467 12,824
                         

 

 

Our results are affected by general global trends in the steel industry and by the economic conditions in the countries in which we operate and in other steel producing countries. Our results are also affected by the specific performance of the automotive, non-residential construction, industrial equipment, tooling equipment and other related industries. Our profitability is also impacted by events that affect the price and availability of raw materials and energy inputs needed for our operations. The factors and trends discussed below also affect our results and profitability.

 

Our primary source of revenue is the sale of SBQ steel and structural steel products.

 

In August 2004, we completed the Atlax Acquisition (Tlaxcala and Cholula facilities). In July 2005, we and our controlling shareholder, Industrias CH, completed the acquisition of Republic. We believe that these acquisitions allowed us to become the leading producer of SBQ steel in North America and the leading producer of structural and light structural steel in Mexico, in each case in terms of sales volume. We expect the sale of SBQ steel, structural steel and other steel products to continue to be our primary source of revenue. The markets for our products are highly competitive and highly dependent on developments in global markets for those products. The main competitive factors are price, product quality and customer relationships and service.

 

Our results are affected by economic activity, steel consumption and end-market demand for steel products.

 

Our results of operations depend largely on macroeconomic conditions in North America. Historically, there has been a strong correlation between the annual rate of steel consumption and the annual change in gross domestic products (“GDP”) in the Mexican and U.S. markets.

 

We sell our steel products to the automotive, construction, manufacturing and other related industries. These industries are generally cyclical, and their demand for steel is impacted by the stage of their industry market cycles and the country’s economic performance. Mexico’s GDP increased 2.1% in 2018 (according to preliminary figures of the INEGI) and increased 2% in 2017. The U.S. GDP increased 2.9% in 2018 (according to preliminary figures of the U.S. Department of Commerce) and 2.2% in 2017. Deterioration in economic conditions in the countries in which we operate is likely to adversely affect our results of operation.

 

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Our results are affected by international steel prices and trends in the global steel industry.

 

Steel prices are generally set by reference to world steel prices, which are determined by global supply and demand trends. As a result of general excess capacity in the industry, the world steel industry was previously subject to substantial downward pricing pressure, which negatively impacted the results of steel companies in the second half of 2000 and all of 2001. International steel prices generally improved beginning in 2003, driven by a strong increase in global demand fostered by economic growth in Asia and an economic recovery in the United States, combined with increased rationalization of production capacity in the United States and elsewhere. Average steel prices continued to improve from 2003 to 2008 due to strong end-market demand fundamentals for a number of key steel-consuming industries, continued strong steel demand in China, India and other developing economies, relatively high raw material and energy costs and reductions in U.S. production from some of the industry’s largest producers.

 

This period of high prices for steel encouraged reactivation of investment in production capacity, and consequently an increase in the supply of steel products that contributed to a decline in steel prices. As the 2008 financial crisis worsened in late 2008 and early 2009, global demand for steel fell while new steel production capacity was coming into the market, and as a result steel prices fell worldwide. In 2009 the average steel price decreased approximately 22% compared to 2008. Our average steel price increased approximately 4% in 2017 compared to 2016. Our average steel price increased approximately 18.6% in 2018 compared to 2017.

 

In recent years, there has been a trend toward consolidation of the steel industry. For example, Aceralia, Arbed and Usinor merged in February 2002 to create Arcelor, and LNM Holdings and Ispat International merged in October 2004 to create Mittal Steel, which subsequently acquired International Steel Group. In 2006, Arcelor completed the acquisition of Dofasco in Canada, and Mittal Steel announced the acquisition of Arcelor, forming the largest steel company in the world. In addition, a number of other steel acquisition transactions have been announced, including the acquisition of Oregon Steel by Evraz and the acquisition of Corus by Tata Steel. Consolidation has enabled steel companies to lower their production costs and allowed for more stringent supply-side discipline, including through selective capacity closures or idling, as the ones observed recently in the United States by Mittal Steel, U.S. Steel and others. Consolidation may result in increased competition and could adversely affect our results.

 

Our results are affected by competition from imports.

 

Our ability to sell our products is influenced, to a certain degree, by global trade for steel products, particularly trends in imports of steel products into the Mexican and U.S. markets. During 2005, the Mexican government, at the request of CANACERO, implemented several measures to prevent unfair trade practices such as dumping in the steel import market. These measures include initiating anti-dumping and countervailing duty proceedings, temporarily increasing import tariffs for countries with which Mexico does not have free trade agreements. As a result, the competitive price pressure from dumping declined, contributing to a general upward trend in domestic Mexican steel prices. In 2006 and 2007, imports to Mexico increased as market conditions improved, and in 2008, imports to Mexico continued to increase, notwithstanding the worsening of international market conditions. In 2009, however, imports to Mexico decreased as domestic and global market conditions worsened. In 2010, 2011 and 2012, imports to Mexico increased as market conditions improved. In 2013, imports to Mexico decreased as domestic and global market conditions worsened. In 2014, imports to Mexico increased slightly. In 2015, imports to Mexico increased 10% compared to 2014 according to information of CANACERO. In 2016, imports to Mexico increased 1.6% compared to 2015 according to information of CANACERO. In 2017, imports to Mexico in tons increased 6.8% compared to 2016 according to information of CANACERO. In 2018, imports to Mexico in tons increased 4.5% compared to 2017 according to information of CANACERO.

 

Steel imports to the United States accounted for an estimated 23% of the domestic U.S. steel market in 2018 and an estimated 27% in 2017. Foreign producers typically have lower labor costs, and in some cases are owned, controlled or subsidized by their governments, allowing production and pricing decisions to be influenced by political and economic policy considerations as well as prevailing market conditions. Increases in future levels of imported steel in the United States could reduce future market prices and demand levels for steel in the United States. To this extent, the U.S. Department of Commerce and the U.S. International Trade Commission are currently conducting five year “sunset” reviews of existing trade relief in several different steel products. Imports represent less of a threat to SBQ producers like us in the United States than to commodity steel producers because of the high quality requirements and standard required by buyers of SBQ steel products.

 

Our results are affected by the cost of raw materials and energy.

 

We purchase substantial quantities of raw materials, including scrap metal, and ferroalloys for use in the production of our steel products. The availability and price of these inputs vary according to general market and economic conditions and thus are influenced by industry cycles. As a result of the 2008 financial crisis that continues to affect the international markets, the prices of these inputs have remained highly volatile. For example, prices of scrap metal increased approximately 7% in 2014, decreased approximately 16% in 2015, increased approximately 2% in 2016, increased approximately 31% in 2017 and increased

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19.4% in 2018; and prices of ferroalloys increased approximately 16% in 2014 and decreased approximately 9% and 13% in 2015 and 2016, respectively, in 2017 increased approximately 22% and increased approximately 9.6% in 2018. As with other raw materials, iron ore and coaking coal prices fluctuate significantly. However, in 2014, 2015, 2016, 2017 and 2018 we did not purchase coaking coal or pellets since our Lorain, Ohio blast furnace facility was idle during this period.

 

In addition to raw materials, electricity and natural gas are both relevant components of our cost structure. We purchase electricity and natural gas at prevailing market prices in Mexico and the United States. These prices are impacted by general demand and supply for energy in the United States and Mexico as economic activity fueled energy demand and the supply and price of oil was impacted by geopolitical events. While natural gas and electricity prices in the United States and Mexico decreased in response to the financial crisis, they have remained highly volatile. Prices for electricity increased approximately 7% in 2014, decreased approximately 12% in 2015, increased approximately 1.5% in 2016, increased approximately 22% in 2017 and increased approximately 14% in 2018; and prices for natural gas increased approximately 25% in 2014, decreased approximately 23% in 2015, increased approximately 8% in 2016, increased approximately 22% in 2017 and increased approximately 28% in 2018.

 

If inflation rates in Mexico rise significantly, our costs may increase and the demand for our services may decrease.

 

Mexico has historically experienced high annual rates of inflation. The annual rate of inflation, as measured by changes in the Mexican national consumer price index (Índice Nacional de Precios al Consumidor) published by the INEGI was 4.1% for 2014, 2.1% for 2015, 3.4% for 2016, 6.8% for 2017 and 4.8% for 2018. High inflation rates could adversely affect our business and results

of operations by increasing certain costs, such as the labor costs of our Mexican facilities, beyond levels that we could pass on to our customers and reducing consumer purchasing power, thereby adversely affecting demand for our products.

 

Depreciation of the Mexican peso relative to the U.S. dollar, as well as the reinstatement of exchange controls and restrictions, could adversely affect our financial performance.

 

Depreciation of the Mexican peso relative to the U.S. dollar may negatively affect our results of operations. Since the second half of 2008, the value of the Mexican peso relative to the U.S. dollar has fluctuated significantly. According to the Mexican Central Bank (Banco de Mexico), during the period from 2008 to 2019, the exchange rate registered a low of Ps. 9.92 per U.S.$1.00 at August 6, 2008, and a high of Ps. 20.84 per U.S.$1.00 at January 13, 2017. The appreciation of the Mexican peso relative to the U.S. dollar in 2018 was 0.4%. The exchange rate at December 31, 2018 was 19.6566 compared to 19.7354 at December 31, 2017. At July 30, 2019 the exchange rate was Ps. 19.0900 per U.S.$1.00.

 

A severe depreciation of the Mexican peso may also result in disruption of the international foreign exchange markets and may limit our ability to convert Mexican pesos into U.S. dollars and other currencies. While the Mexican government does not currently restrict, and has not recently restricted the right or ability of Mexican or foreign persons or entities to convert Mexican pesos into U.S. dollars or to transfer other currencies out of Mexico, it has done so in the past and could reinstate exchange controls and restrictions in the future. Currency fluctuations or restrictions on the transfer of foreign currency outside of Mexico may have an adverse effect on our financial performance.

 

Segment Information

 

We are required to disclose segment information in accordance with IFRS 8 “Operating Segments”: Information which establishes standards for reporting information about operating segments in annual financial statements and requires reporting of selected information about operating segments in interim financial reports issued to shareholders. Operating segments are components of a company about which separate financial information is available that is regularly evaluated by the chief operating decision maker(s) in deciding how to allocate resources and assess performance. The statement also establishes standards for related disclosures about a company’s products and services, geographical areas and major customers.

 

We conduct business in three principal business segments which are organized on a geographical basis:

 

  our Mexican segment represents the results of our operations in Mexico, including our plants in Mexicali, Guadalajara, Tlaxcala and San Luis Potosí;

 

  our U.S. segment represents the results of our operations of Republic, including its five plants, located in the United States; and

 

  our Brazil segment represents the results of our operations in three plants located in Brazil, one of which started operations in June 2015 and two of which started to consolidate operations in May 2018 .

 

The following information shows other results by segment.

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    For the year ended December 31, 2018  
    Mexico   United States   Brazil   Operations between Segments   Total  
    (in thousands of pesos)  
Net sales   20,507,794   9,246,444   5,924,015     35,678,253  
Cost of sales   15,715,761   9,294,352   5,553,202     30,563,315  
Gross profit (loss)   4,792,033   (47,908)   370,813   —    5,114,938  
Administrative expenses   592,218   267,905   219,889   —    1,080,012  
Other (income) expense, net   (11,367)   (3,685)       (15,052)  
Interest income   307,279   5,542       312,821  
Interest expense   52,226   (99,985)   (103,141)   134,389   (16,511)  
Exchange (loss) gain, net   445,289   7,522   (602,747)   3,040   (146,896)  
Income (loss) before income tax   5,015,976   (399,049)   (554,964)   137,429   4,199,392  
Income tax   905,482   7,145   (160,165)     752,462  
Net income (loss)   4,110,494   (406,194)   (394,799)   137,429   3,446,930  

 

 

 

Other Data   Mexico   United States   Brazil   Operations between Segments   Total  
Depreciation and amortization   587,407   268,635   256,376     1,112,418  
Total assets   40,617,874   10,181,967   6,733,362   (8,679,380)   48,853,823  
Total liabilities   8,458,465   10,815,692   2,750,043   (8,679,380)   13,344,820  
Additions of property, plant and equipment, net   1,552,587   433,154   8,724     1,994,465  

 

 

    For the year ended December 31, 2017  
    Mexico   United States   Brazil   Operations between Segments   Total  
    (in thousands of pesos)  
Net sales   17,125,369   8,370,999   3,204,082     28,700,450  
Cost of sales   13,340,648   7,814,180   2,839,698     23,994,526  
Gross profit (loss)   3,784,721   556,819   364,384   —    4,705,924  
Administrative expenses   753,676   257,001   228,266   —    1,238,943  
Other (income) expense, net   98,915   (105,849)       (6,934)  
Interest income   252,074   217       252,291  
Interest expense   (7,459)   (50,962)   (65,186)   69,203   (54,404)  
Exchange (loss) gain, net   (1,291,909)   (26,256)   1,861   661,942   (654,362)  
Income (loss) before income tax   1,884,836   328,666   72,793   731,145   3,017,440  
Income tax   786,902   322,444   13,463     1,122,809  
Net income (loss)   1,097,934   6,222   59,330   731,145   1,894,631  

 

 

 

Other Data   Mexico   United States   Brazil   Operations between Segments   Total  
Depreciation and amortization   677,665   538,699   249,395     1,465,759  
Total assets   32,878,143   10,548,895   5,356,860   (2,807,367)   45,976,531  
Total liabilities   1,134,438   10,760,999   2,570,925   (2,807,367)   11,658,995  
Additions of property, plant and equipment, net   2,394,541   622,785   22,175     3,039,501  

 

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    For the year ended December 31, 2016  
    Mexico   United States   Brazil   Operations between Segments   Total  
    (in thousands of pesos)  
Net sales   16,361,808   9,339,527   1,814,230     27,515,565  
Cost of sales   13,724,880   7,332,094   1,718,619     22,775,593  
Gross profit (loss)   2,636,928   2,007,433   95,611       4,739,972  
Administrative expenses   901,849   298,967   76,671       1,277,487  
Other (income) expense, net   40,134   (1,481,573)     1,477,637   36,198  
Interest income   139,886   147       140,033  
Interest expense   (15,053)   (45,120)   (50,980)   70,983   (40,170)  
Exchange gain (loss), net   2,343,393   42,727   765,684   (1,376,820)   1,774,984  
Income (loss) before income tax   4,163,171   3,187,793   733,644   (2,783,474)   5,301,134  
Income tax   678,020   256,089   2,285     936,394  
Net income (loss)   3,485,151   2,931,704   731,359   (2,783,474)   4,364,740  

 

Other Data   Mexico   United States   Brazil   Operations between Segments   Total  
Depreciation and amortization   620,354   551,650   257,377     1,429,381  
Total assets   33,364,827   9,684,303   5,293,891   (6,463,293)   41,879,728  
Total liabilities   4,370,124   9,893,536   2,325,325   (7,940,930)   8,648,055  
Additions of property, plant and equipment, net   2,169,375   816,586   114,298     3,100,259  

 

    

 

 

 

Our net sales by product during 2016, 2017 and 2018 were as follows:

 

SALES BY PRODUCT

(in thousands of pesos)

 

  2016 2017 2018
Light structural 1,467,727 1,557,567 1,654,720
Structurals 2,321,771 2,232,979 2,441,079
Bars 1,122,116 1,065,731 1,575,291
Rebar 7,449,278 8,931,862 12,363,530
Flat bar 1,090,841 1,552,578 2,271,347
Hot rolled bars 7,729,167 8,594,130 9,549,286
Cold drawn bars 3,207,924 3,370,150 3,779,385
Other 3,126,741 1,395,453 2,043,615
Total 27,515,565 28,700,450 35,678,253

 

Our net sales by country or region during 2016, 2017 and 2018 are as follows:

 

SALES BY COUNTRY OR REGION

(in thousands of pesos)

 

  2016 2017 2018
Mexico 16,077,884 16,712,874 20,421,529
USA 9,198,561 8,333,259 8,975,585
Brazil 1,828,279 3,214,117 5,932,297
Canada 350,673 370,803 267,606
Latin America 34,932 30,173 60,578

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Other (Europe and Asia) 25,236 39,224 20,658
Total 27,515,565 28,700,450 35,678,253

 

Consolidated Statements of Comprehensive Income

Comparison of Years Ended December 31, 2017 and 2018

 

Net Sales

 

Net sales increased 24%, to Ps. 35,678 million in 2018 compared to Ps. 28,700 million in 2017. This increase resulted primarily from a 19% increase in the average price per ton of steel products and an increase of 101,000 tons in shipments of finished steel products. Total sales outside of Mexico increased 27%, to Ps. 15,257 million in 2018 compared to Ps. 11,987 million in 2017. Total sales in Mexico increased 22%, from Ps. 16,713 million in 2017 to Ps. 20,421 million in 2018.

 

Shipments of finished steel products increased 4.8%, to 2.192 million tons in 2018, compared to 2.091 million tons in 2017. Total sales volume outside of Mexico of finished steel products increased 14.8% to 0.853 million tons in 2018, compared to 0.743 million tons in 2017, while total Mexican sales decreased 0.7%, from 1.348 million tons in 2017, compared to 1.339 million tons in 2018. The average price of steel products increased 18.6% in 2018 compared to 2017.

 

Cost of Sales

 

Our cost of sales increased 27%, from Ps. 23,994 million in 2017 to Ps. 30,563 million in 2018, which increase is mainly attributable to a 21.5% increase in the average cost per ton of steel products sold. Cost of sales as a percentage of net sales was 86% in 2018 and 84% in 2017. We experienced higher cost of sales at our Republic facilities, mainly as a result of (i) higher labor costs corresponding to our U.S. operations, and (ii) the higher cost of raw materials, which our U.S. operations use in the production of SBQ steel. Hourly wages at our Mexican operations were approximately U.S.$1.9 (Ps. 36) per hour in 2018 and U.S.$ 1.6 (Ps. 31) per hour in 2017, compared to U.S.$55.3 (Ps.1,087) and U.S.$ 56.4 (Ps. 1,113) per hour for 2018 and 2017, respectively, at our U.S. operations. Although raw material costs are similar in the United States and Mexico, our U.S. operations produce higher value-added SBQ steel, which requires more expensive raw materials such as chromium, nickel, molybdenum and other alloys. Our Mexican operations require these alloys to a lesser extent, because they produce commodity steel as well as SBQ steel.

 

Gross Profit

 

Our gross profit was Ps. 5,115 million in 2018 compared to a Ps. 4,706 million gross profit in 2017. This increase in gross profit is attributable mainly to an increase of 101,000 tons of finished steel products shipped, a 18.6% increase in the average price of steel products sold, and a 21.5% increase in the average cost per ton of steel products sold. As a percentage of net sales, our gross profit was 14% in 2018 and our gross profit was 16% in 2017.

 

Administrative Expenses

 

Our administrative expenses (including depreciation and amortization) decreased 13%, to Ps. 1,080 million in 2018, compared to Ps. 1,239 million in 2017. The variation of Ps. 159 million corresponds to the decrease of Ps. 162 million in the Mexican segment, the increase of Ps. 11 million in the United States segment and a decrease of Ps. 8 million in the Brazil segment. In 2018 and 2017, our general and administrative expenses included Ps. 10 million of amortization of the tangible and intangible assets registered principally in connection with the acquisition of Republic and Ps. 125 million, of amortization of the tangible and intangible assets registered principally in connection with the acquisition of Grupo San, respectively.

 

Administrative expenses as a percentage of net sales were 3% in 2018 and 4% in 2017. Depreciation and amortization expense were Ps. 157 million in 2018 compared to Ps. 285 million in 2017.

 

Other (Income) Expense, Net

 

We recorded other income, net, of Ps. 15 million in 2018, reflecting (i) income of Ps. 10 million related to the sale of scrap, (ii) expense of Ps. 9 million in land remediation at Pacific Steel, (iii) income of Ps. 6 million for recovery of insurance companies and (iv) income related to other financial operations of Ps. 8 million.

 

We recorded other income, net, of Ps. 7 million in 2017, reflecting (i) income of Ps. 10 million related to the sale of scrap, (ii) expense of Ps. 7 million in land remediation at Pacific Steel and (iii) income related to other financial operations of Ps. 4 million.

 

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Interest Income

We recorded an interest income of Ps. 313 million in 2018 compared to Ps. 252 million in 2017. This increase is attributable mainly to higher interest rates in the U.S. and Mexico.

 

Interest Expense

 

We recorded an interest expense of Ps. 17 million in 2018 compared to Ps. 54 million in 2017. This decrease is attributable mainly to the lesser use of financial services.

 

Foreign Exchange Loss (Gain)

 

We recorded a foreign exchange loss of Ps. 147 million in 2018 compared to a foreign exchange loss of Ps. 654 million in 2017; this foreign exchange loss reflected the 0.4% appreciation of the peso against the dollar in 2018, compared to the 4.5% appreciation of the peso against the dollar in 2017.

 

Income Tax

 

In 2018 we recorded an income tax provision of Ps. 752 million, which included an income tax provision of Ps. 511 million and an income tax provision for deferred income taxes of Ps. 241 million. In 2017 we recorded an income tax provision of Ps. 1,123 million, which included an income tax provision of Ps. 45 million and an income tax provision for deferred income taxes of Ps. 1,078 million.

 

Our effective income tax rates for 2018 and 2017 were 16.9% and 38.9%, respectively. According to the Income Tax Law in Mexico, the tax rate for the year 2018 and years thereafter is 30%. We have implemented the practice of recognizing the benefit derived from the amortization of tax losses for the period in which such losses are actually amortized. In 2018 and 2017, we amortized tax losses which generated a benefit on income tax of approximately Ps. 1,238 million and Ps. 115 million, respectively. These effects caused our effective tax rates during 2018 to be lower than the statutory tax rate.

  

Net Income (Loss)

 

We recorded net income of Ps. 3,447 million in 2018, compared to net income of Ps. 1,895 million in 2017. The increase in net income for the year 2018 compared to 2017 is mainly as a result of (i) an increase of 101,000 tons of finished steel products shipped, a 18.6% increase in the average price of steel products sold, and a 21.5% increase in the average cost per ton of steel products sold, (ii) in the year 2017 we had Ps. 198 million of interest income compared to the year 2018 where we had Ps. 297 million of interest income, net, (iii) the decrease in the foreign exchange loss in 2018 to Ps. 151 million compared to Ps. 654 million in 2018 and (iv) the decrease in the provision of income taxes in 2018 to Ps. 752 million compared to Ps. 1,123 million in 2017.

 

Mexican Segment

Statements of Comprehensive Income

Comparison of Years Ended December 31, 2017 and 2018

 

Net Sales

 

Net sales increased 20%, to Ps. 20,508 million in 2018 compared to Ps. 17,125 million in 2017. This increase resulted principally from a 22% increase in the average price per ton of steel products in 2018 compared to 2017.

 

Shipments of finished steel products decreased 2%, to 1.374 million tons in 2018, compared to 1.404 million tons in 2017.

  

Cost of Sales

 

Our cost of sales increased 18%, from Ps. 13,340 million in 2017 to Ps. 15,716 million in 2018, which increase is mainly attributable to a 20% increase in the average cost per ton of steel products sold. As a percentage of net sales, our cost of sales was 77% in 2018, compared to 78% in 2017.

 

Gross Profit

 

Our gross profit increased 27%, to Ps. 4,792 million in 2018 compared to Ps. 3,785 million in 2017. This increase is attributable mainly to an increase of 22% in the average price of steel products sold. As a percentage of net sales, our gross profit was 23% in 2018, compared to 22% in 2017.

 

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Administrative Expenses

 

Our administrative expenses (including depreciation and amortization) decreased 21%, to Ps. 592 million in 2018, compared to Ps. 754 million in 2017. In 2018 our general and administrative expenses included Ps. 0 million of amortization of the tangible and intangible assets and in 2017 our general and administrative expenses included Ps. 103 million, of amortization of tangible and intangible assets registered principally in connection with the acquisition of Grupo San.

 

Administrative expenses as a percentage of net sales were 3% in 2018 and 4% in 2017. Depreciation and amortization expense were Ps. 129 million in 2018 compared to Ps. 211 million in 2017.

 

Other Expense (Income), Net

 

We recorded other income, net, of Ps. 11 million in 2018, reflecting (i) an income of Ps. 10 million related to the sale of scrap, (ii) income of Ps. 6 million for recovery of insurance companies, (iii) other expense of Ps. 9 million in the land treatment at Pacific Steel and (iv) other income, net, related to other financial operations of Ps. 4 million.

 

We recorded other expense, net, of Ps. 99 million in 2017, reflecting (i) an income of Ps. 10 million related to the sale of scrap, (ii) other expense of Ps. 108 million related to the transportation and other expenses of acquired equipment by the Tlaxcala plant from the Republic plant, (iii) other expense of Ps. 8 million in the land remediation at Pacific Steel and (iv) other income, net, related to other financial operations of Ps. 7 million.

 

Interest Income

 

We recorded an interest income of Ps. 307 million in 2018 compared to Ps. 252 million in 2017. This increase is attributable mainly to higher interest rates in the US and Mexico.

 

 

Interest Expense

 

We recorded an interest income of Ps. 52 million in 2018, corresponding mainly to related party transactions that are eliminated in the consolidated statement of income, compared to Ps. 7 million of interest expense in 2017.

 

Foreign Exchange Gain (Loss)

 

We recorded a foreign exchange gain of Ps. 445 million in 2018 compared to an exchange loss of Ps. 1,292 million in 2017; this foreign exchange reflected the 0.4% appreciation of the peso against the dollar in 2018.

 

Income Tax

 

In 2018, we recorded an income tax provision of Ps. 905 million, which included an income tax provision of Ps. 497 million and an income tax provision for deferred income taxes of Ps. 408 million. In 2017, we recorded an income tax provision of Ps. 787 million, which included an income tax provision of Ps. 131 million and an income tax provision for deferred income taxes of Ps. 656 million.

 

According to the Income Tax Law in Mexico, the tax rate for the year 2018 and years thereafter is 30%.

 

Net Income

 

We recorded net income of Ps. 4,110 million in 2018, compared to net income of Ps. 1,098 million in 2017. This increase is attributable mainly to; (i) an increase of 22% in the average price of steel products sold, and (ii) a foreign exchange gain of Ps. 445 million in 2018 compared to Ps. 1,292 million of foreign exchange loss in 2017.

 

USA Segment

Statements of Comprehensive Income

Comparison of Years Ended December 31, 2017 and 2018

 

Net Sales

 

Net sales increased 10%, to Ps. 9,246 million in 2018 compared to Ps. 8,371 million in 2017. This increase resulted principally from an increase of 11% in the average price of steel products.

 

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Shipments of finished steel products decreased 0.5%, to 385,000 tons in 2018, compared to 387,000 tons in 2017.

 

The average price of steel products in pesos increased 11% in 2018 compared to 2017.

 

Cost of Sales

 

Our cost of sales increased 19%, from Ps. 7,814 million in 2017 to Ps. 9,294 million in 2018, which increase is mainly attributable to an increase of 20%, approximately, in the average cost per ton of steel products sold. Cost of sales as a percentage of net sales was 101% in 2018, compared to 93% in 2017.

 

Gross Profit (Loss)

 

Our gross loss was Ps. 48 million in 2018 compared to a Ps. 557 million gross profit in 2017. As a percentage of net sales, our gross loss was (1%) in 2018 mainly attributable to an increase of 20%, approximately, in the average cost per ton of steel products sold, compared to a 7% gross profit in 2017. The selling steel prices throughout the year also impacted our margin since prices for steel products charged to our customers were gradually lower than our costs of raw material purchases as a result of the time lag between the production and sales cycles.

 

Administrative Expenses

 

Our administrative expenses (including depreciation and amortization) increased 4%, to Ps. 268 million in 2018, compared to Ps. 257 million in 2017.

 

Administrative expenses as a percentage of net sales were 3% in 2018 and 3% in 2017. Depreciation and amortization expense were Ps. 25 million in 2018 compared to Ps. 37 million in 2017.

 

Other Income, Net

 

We recorded other income, net, of Ps. 4 million in 2018, related to other financial operations.

 

We recorded other income, net, of Ps. 106 million in 2017, reflecting (i) other income, net, of Ps. 108 million related to the sale of plant and equipment by Republic to the Tlaxcala plant and (ii) other expense, net, of Ps. 2 million related to other financial operations.

 

Interest Income

 

We recorded an interest income of Ps. 6 million in 2018 compared to Ps. 0 million in 2017.

 

Interest Expense

 

We recorded an interest expense of Ps. 100 million in 2018 compared to Ps. 51 million in 2017.

 

Foreign Exchange Gain (Loss)

 

We recorded a foreign exchange gain of Ps. 8 million in 2018 compared to an exchange loss of Ps. 26 million in 2017.

 

Income Tax

 

In 2018 we recorded an income tax provision of Ps. 7 million for deferred income taxes. In 2017 we recorded an income tax provision of Ps. 322 million for deferred income taxes.

 

Net Income (Loss)

 

We recorded a net loss of Ps. 406 million in 2018, compared to a net income of Ps. 6 million in 2017. Our net loss in 2018 is attributable mainly to an increase of 20% in the average cost of steel products sold, compared to 2017, which impacted our margin since prices for steel products charged to our customers were gradually lower than our costs of raw material purchases as a result of the time lag between the production and sales cycles.

 

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Brazil Segment

Statements of Comprehensive Income

 Comparison of Years Ended December 31, 2017 and 2018

 

Net Sales

 

Net sales increased to Ps. 5,924 million in 2018 compared to Ps. 3,204 million in 2017. This increase resulted principally from an increase of 133,000 tons of shipments of finished steel products and the 28% increase in the average price per ton of steel products.

 

Shipments of finished steel products increased to 433,000 tons in 2018 (including the shipment of the new plants acquired in 2018, which began to consolidate operations in May 2018: Cariacica with 115,000 tons and Itauna with 41,000 tons) compared to 300,000 tons in 2017.

 

Cost of Sales

 

Our cost of sales increased to Ps. 5,553 million in 2018 compared to Ps. 2,840 million in 2017, which increase is mainly attributable to the increase of the shipments of finished steel products of 133,000 tons in 2018 and a 35% increase in the average cost per ton of steel products sold compared to 2017. Cost of sales as a percentage of net sales was 94% in 2018, compared to 89% in 2017.

 

Gross Profit

 

Our gross profit was Ps. 371 million in 2018 compared to Ps. 364 million of gross profit in 2017. The gross profit in the year 2018 remains practically the same as in 2017 due to the fact that the increase by 133,000 tons shipped and the increase in prices of 28% in the tons shipped did not offset the increase of 35% in the average cost of steel products sold. As a percentage of net sales, our gross profit was 6% in 2018, compared to 11% of gross profit in 2017.

 

Administrative Expenses

 

Our administrative expenses (including depreciation and amortization) were Ps. 220 million in 2018 compared to Ps. 228 million in 2017. Operating expenses as a percentage of net sales were 4% in 2018 compared to 7% in 2016.

 

Depreciation and amortization expenses were Ps. 3 million in 2018 compared to Ps. 36 million in 2017.

 

Other Expense, Net

 

We did not record other expense, net, in 2018 or 2017.

 

Interest Expense

 

We recorded an interest expense of Ps. 103 million in 2018 compared to Ps. 65 million in 2017.

 

Foreign Exchange Gain (Loss)

 

We recorded a foreign exchange loss of Ps. 603 million in 2018 compared to an exchange gain of Ps. 2 million in 2017. This foreign exchange loss reflected the 17.1% depreciation of the Brazilian real against the dollar in 2018 compared to 2017.

 

Income Tax

 

In 2018 we recorded an income tax profit provision of Ps. 160 million, which included an income tax provision of Ps. 15 million and an income tax profit provision for deferred income taxes of Ps. 175 million, compared to Ps. 13 million of income tax provision in 2017.

 

Net Income (Loss)

 

We recorded a net loss of Ps. 395 million in 2018 compared to Ps. 59 million of net income in 2017. Our net loss in 2018 is attributable mainly to a foreign exchange loss of Ps. 603 million in 2018 compared to an exchange gain of Ps. 2 million in 2017.

 

 

 

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Consolidated Statements of Comprehensive Income

Comparison of Years Ended December 31, 2016 and 2017

 

Net Sales

 

Net sales increased 4%, to Ps. 28,700 million in 2017 compared to Ps. 27,516 million in 2016. This increase resulted primarily from a 4% increase in the average price per ton of steel products and an increase of 6,000 tons in shipments of finished steel products. Total sales outside of Mexico increased 5%, to Ps. 11,987 million in 2017 compared to Ps. 11,438 million in 2016. Total sales in Mexico increased 4%, from Ps. 16,078 million in 2016 to Ps. 16,713 million in 2017.

 

Shipments of finished steel products increased 0.3%, to 2.091 million tons in 2017, compared to 2.085 million tons in 2016. Total sales volume outside of Mexico of finished steel products increased 17% to 0.743 million tons in 2017, compared to 0.636 million tons in 2016, while total Mexican sales decreased 10%, from 1.495 million tons in 2016, compared to 1.348 million tons in 2017. The average price of steel products increased 4% in 2017 compared to 2016.

 

Cost of Sales

 

Our cost of sales increased 5%, from Ps. 22,776 million in 2016 to Ps. 23,994 million in 2017, which increase is mainly attributable to a 5% increase in the average cost per ton of steel products sold. Cost of sales as a percentage of net sales was 84% in 2017 and 83% in 2016. We experienced higher cost of sales at our Republic facilities, mainly as a result of (i) higher labor costs corresponding to our U.S. operations, and (ii) the higher cost of raw materials, which our U.S. operations use in the production of SBQ steel. Hourly wages at our Mexican operations were approximately U.S.$1.6 (Ps. 31) per hour in 2017 and U.S.$1.4 (Ps. 29) per hour in 2016, compared to U.S.$56.4 (Ps. 1,113) and U.S.$61.3 (Ps. 1,267) per hour for 2017 and 2016, respectively, at our U.S. operations. Although raw material costs are similar in the United States and Mexico, our U.S. operations produce higher value-added SBQ steel, which requires more expensive raw materials such as chromium, nickel, molybdenum and other alloys. Our Mexican operations require these alloys to a lesser extent, because they produce commodity steel as well as SBQ steel.

 

Gross Profit (Loss)

 

Our gross profit was Ps. 4,706 million in 2017 compared to a Ps. 4,740 million gross profit in 2016. This gross profit is attributable mainly to an increase of 6,000 tons of finished steel products shipped, a 4% increase in the average price of steel products sold, and a 5% increase in the average cost per ton of steel products sold. As a percentage of net sales, our gross profit was 16% in 2017 and our gross profit was 17% in 2016.

 

Administrative Expenses

 

Our administrative expenses (including depreciation and amortization) decreased 3%, to Ps. 1,239 million in 2017, compared to Ps. 1,277 million in 2016. The variation of Ps. 38 million corresponds to the decrease of Ps. 148 million in the Mexican segment, the decrease of Ps. 42 million in the United States segment and an increase of Ps. 152 million in the Brazil segment. In 2017 and 2016, our general and administrative expenses included Ps. 125 million and Ps. 258 million, respectively, of amortization of the tangible and intangible assets registered principally in connection with the acquisition of Grupo San.

 

Operating expenses as a percentage of net sales were 4% in 2017 and 5% in 2016. Depreciation and amortization expense were Ps. 285 million in 2017 compared to Ps. 398 million in 2016.

 

Other (Income) Expense, Net

 

We recorded other income, net, of Ps. 7 million in 2017, reflecting (i) income of Ps. 10 million related to the sale of scrap, (ii) expense of Ps. 7 million in land remediation at Pacific Steel and (iii) income related to other financial operations of Ps. 4 million.

 

We recorded other expense, net, of Ps. 36 million in 2016, reflecting (i) income of Ps. 10 million related to the sale of scrap, (ii) expense of Ps. 35 million in the dismantling of machinery and (iii) an expense related to other financial operations of Ps. 11 million.

 

Interest Income

 

We recorded an interest income of Ps. 252 million in 2017 compared to Ps. 140 million in 2016. This decrease is attributable mainly to interest rates negotiated with financial services institutions.

 

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Interest Expense

 

We recorded an interest expense of Ps. 54 million in 2017 compared to Ps. 40 million in 2016. This increase is attributable mainly to the interest rates negotiated with our lenders.

 

Foreign Exchange Loss (Gain)

 

We recorded a foreign exchange loss of Ps. 654 million in 2017 compared to an exchange gain of Ps. 1,775 million in 2016; this foreign exchange gain reflected the 4.5% appreciation of the peso against the dollar in 2017, compared to the 19.2% depreciation of the peso against the dollar and the 17% appreciation of the Brazilian real against the dollar in 2016.

 

Income Tax

 

In 2017 we recorded an income tax provision of Ps. 1,123 million, which included an income tax provision of Ps. 45 million and an income tax provision for deferred income taxes of Ps. 1,078 million. In 2016 we recorded an income tax provision of Ps. 936 million, which included an income tax provision of Ps. 67 million and an income tax provision for deferred income taxes of Ps. 869 million.

 

Our effective income tax rates for 2017 and 2016 were 38.9% and 17.6%, respectively. According to the Income Tax Law in Mexico, the tax rate for the year 2017 and years thereafter is 30%. We have implemented the practice of recognizing the benefit derived from the amortization of tax losses for the period in which such losses are actually amortized. In 2017 and 2016, we amortized tax losses which generated a benefit on income tax of approximately Ps. 115 million and Ps. 1,166 million, respectively. These effects caused our effective tax rates during 2016 to be lower than the statutory tax rate.

 

 

Net Income (Loss)

 

We recorded net income of Ps. 1,895 million in 2017, compared to net income of Ps. 4,365 million in 2016. The decrease in net income for the year 2017 compared to 2016 is mainly as a result of (i) the exchange loss of 654 million in 2017 compared to a foreign exchange gain of 1,775 million in 2016, (ii) in the year 2017 we had Ps. 198 million of interest income net compared to the year 2016 where we had Ps. 140 million of interest income net and (iii) the increase in the provision of income taxes in 2017 of Ps. 1,123 million compared to Ps. 936 million in 2016.

 

Mexican Segment

Statements of Comprehensive Income

Comparison of Years Ended December 31, 2016 and 2017

 

Net Sales

 

Net sales increased 4.7%, to Ps. 17,125 million in 2017 compared to Ps. 16,362 million in 2016. This increase resulted principally from a 11.5% increase in the average price per ton of steel products.

 

Shipments of finished steel products decreased 6%, to 1.404 million tons in 2017, compared to 1.495 million tons in 2016.

 

The average price of steel products increased 11.5% in 2017 compared to 2016.

 

Cost of Sales

 

Our cost of sales decreased 2.8%, from Ps. 13,725 million in 2016 to Ps. 13,340 million in 2017, which decrease is mainly attributable to a decrease of 91,000 tons of shipments of finished steel products. As a percentage of net sales, our cost of sales was 78% in 2017, compared to 84% in 2016.

 

Gross Profit

 

Our gross profit increased 43%, to Ps. 3,785 million in 2017 compared to Ps. 2,637 million in 2016. This increase is attributable mainly to an increase of 11.5% in the average price of steel products sold. As a percentage of net sales, our gross profit was 22% in 2017, compared to 16% in 2016.

 

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Administrative Expenses

 

Our administrative expenses (including depreciation and amortization) decreased 16%, to Ps. 754 million in 2017, compared to Ps. 902 million in 2016. In 2017 and 2016, our general and administrative expenses included Ps. 103 million and Ps. 245 million, respectively, of amortization of tangible and intangible assets registered principally in connection with the acquisition of Grupo San.

 

Administrative expenses as a percentage of net sales were 4% in 2017 and 6% in 2016. Depreciation and amortization expense were Ps. 211 million in 2017 compared to Ps. 338 million in 2016.

 

Other Expense (Income), Net

 

We recorded other expense, net, of Ps. 99 million in 2017, reflecting (i) an income of Ps. 10 million related to the sale of scrap, (ii) other expense of Ps. 108 million related to the transportation and other expenses of acquired equipment by the Tlaxcala plant from the Republic plant, (iii) other expense of Ps. 8 million in the land remediation at Pacific Steel and (iv) other income, net, related to other financial operations of Ps. 7 million.

 

We recorded other expense, net, of Ps. 40 million in 2016, reflecting (i) an income of Ps. 10 million related to the sale of scrap, (ii) other expense of Ps. 35 million related to dismantling machinery and (iii) other expense, net, related to other financial operations of Ps. 15 million.

 

Interest Income

 

We recorded an interest income of Ps. 252 million in 2017 compared to Ps. 140 million in 2016.

 

 

Interest Expense

 

We recorded an interest expense of Ps. 7 million in 2017 compared to Ps. 15 million in 2016. This decrease was principally due to negotiations with our lenders in connection with commissions payable to them.

 

Foreign Exchange Gain (Loss)

 

We recorded a foreign exchange loss of Ps. 1,292 million in 2017 compared to an exchange gain of Ps. 2,343 million in 2016; this foreign exchange reflected the 4.5% appreciation of the peso against the dollar in 2017.

 

Income Tax

 

In 2017, we recorded an income tax provision of Ps. 787 million, which included an income tax provision of Ps. 131 million and an income tax provision for deferred income taxes of Ps. 656 million. In 2016, we recorded an income tax provision of Ps. 678 million, which included an income tax provision of Ps. 17 million and an income tax provision for deferred income taxes of Ps. 661 million.

According to the Income Tax Law in Mexico, the tax rate for the year 2017 and years thereafter is 30%.

 

Net Income

 

We recorded net income of Ps. 1,098 million in 2017, compared to net income of Ps. 3,485 million in 2016. This decrease is attributable mainly to a foreign exchange loss of Ps. 1,292 million in 2017 compared to Ps. 2,343 million of foreign exchange gain in 2016.

 

USA Segment

Statements of Comprehensive Income

Comparison of Years Ended December 31, 2016 and 2017

 

Net Sales

 

Net sales decreased 10%, to Ps. 8,371 million in 2017 compared to Ps. 9,339 million in 2016. This decrease resulted principally from a decrease of 8% in the average price of steel products.

 

Shipments of finished steel products decreased 3%, to 387,000 tons in 2017, compared to 397,000 tons in 2016.

 

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The average price of steel products in pesos decreased 8% in 2017 compared to 2016, derived mainly from the appreciation of the peso against the dollar in 2017.

 

Cost of Sales

 

Our cost of sales increased 7%, from Ps. 7,332 million in 2016 to Ps. 7,814 million in 2017, which increase is mainly attributable to an increase of 9%, approximately, in the prices of raw materials used for the production of finished products. Cost of sales as a percentage of net sales was 93% in 2017, compared to 79% in 2016.

 

Gross Profit (Loss)

 

Our gross profit was Ps. 557 million in 2017 compared to a Ps. 2,007 million gross profit in 2016. As a percentage of net sales, our gross profit was 7% in 2017, compared to a 21% gross profit in 2016. The selling steel prices throughout the year also impacted our margin since prices for steel products charged to our customers were gradually lower than our costs of raw materials as a result of the time lag between the production and sales cycles.

 

Administrative Expenses

 

Our administrative expenses (including depreciation and amortization) decreased 14%, to Ps. 257 million in 2017, compared to Ps. 299 million in 2016.

 

Administrative expenses as a percentage of net sales were 3% in 2017 and 3% in 2016. Depreciation and amortization expense were Ps. 37 million in 2017 compared to Ps. 58 million in 2016.

 

Other Income, Net

 

We recorded other income, net, of Ps. 106 million in 2017, reflecting (i) other income, net, of Ps. 108 million related to the sale of plant and equipment by Republic to the Tlaxcala plant and (ii) other expense, net, of Ps. 2 million related to other financial operations.

 

We recorded other income, net, of Ps. 1,482 million in 2016, reflecting (i) income of Ps. 1,478 million related to the transfer of the total assets of the Gary, Indiana plant in the United States to the current Tlaxcala plant in Mexico, through a turnkey transaction, by which Republic Steel developed the project until the start of the operations in Tlaxcala, Mexico, and (ii) other income, net, of Ps. 4 million related to other financial operations. 

 

Interest Income

 

We recorded an interest income of Ps. 0 million in 2017 compared to Ps. 0 million in 2016.

 

Interest Expense

 

We recorded an interest expense of Ps. 51 million in 2017 compared to Ps. 45 million in 2016.

 

Income Tax

 

In 2017 we recorded an income tax provision of Ps. 322 million for deferred income taxes. In 2016 we recorded an income tax provision of Ps. 256 million for deferred income taxes.

 

Net Income (Loss)

 

We recorded net income of Ps. 6 million in 2017, compared to a net income of Ps. 2,932 million in 2016. The decrease in our net income in 2017 compared to the net income in 2016 is mainly due to (i) the selling steel prices throughout the year, which impacted our margin since prices for steel products charged to our customers were gradually lower than our costs of raw materials as a result of the time lag between the production and sales cycles, and (ii) the fact that in 2017 we had other net income of Ps. 106 million, compared to other net income of Ps. 1,482 million in 2016.

 

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Brazil Segment

Statements of Comprehensive Income

Comparison of Years Ended December 31, 2016 and 2017

 

Net Sales

 

Net sales increased to Ps. 3,204 million in 2017 compared to Ps. 1,814 million in 2016. This increase resulted principally from an increase of 107 thousand tons of shipments of finished steel products and the 13.6% increase in the average price per ton of steel products.

 

Shipments of finished steel products increased to 300,000 tons in 2017, compared to 193,000 tons in 2016.

 

Cost of Sales

 

Our cost of sales increased to Ps. 2,840 million in 2017 compared to Ps. 1,719 million in 2016. which increase is mainly attributable to the increase in shipments of finished products of 107,000 tons in 2017 compared to 2016 and a 6.3% increase in the average cost per ton of steel products sold. Cost of sales as a percentage of net sales was 89% in 2017, compared to 95% in 2016.

 

Gross Profit

 

Our gross profit was Ps. 364 million in 2017 compared to Ps. 95 million of gross profit in 2016. This increase is attributable mainly to an increase of 107,000 tons of shipments of finished steel products and an increase of 13.6% in the average price of steel products sold. As a percentage of net sales, our gross profit was 11% in 2017, compared to 5% of gross profit in 2016.

 

Administrative Expenses

 

Our administrative expenses (including depreciation and amortization) were Ps. 228 million in 2017 compared to Ps. 77 million in 2016. Operating expenses as a percentage of net sales were 7% in 2017 compared to 4% in 2016. This increase is attributable mainly due to the fact that in 2017 we operated at a production capacity of 61% and in 2016 we operated at a production capacity of 45%.

 

Depreciation and amortization expenses were Ps. 36 million in 2017 compared to Ps. 3 million in 2016.

 

Other Expense, Net

 

We did not record other expense, net, in 2017 or 2016.

 

Interest Expense

 

We recorded an interest expense of Ps. 65 million in 2017 compared to Ps. 51 million in 2016.

 

Foreign Exchange Gain (Loss)

 

We recorded a foreign exchange gain of Ps. 2 million in 2017 compared to a foreign exchange gain of Ps. 766 million in 2016. This foreign exchange gain reflected the 17% appreciation of the Brazilian real against the dollar in 2016.

 

Income Tax

 

In 2017 we recorded an income tax provision of Ps. 13 million compared to Ps. 2 million in 2016.

 

Net Income (Loss)

 

We recorded a net income of Ps. 59 million in 2017 compared to Ps. 731 million of net income in 2016. The decrease of our net income in 2017 compared to the net income in 2016 is mainly due to the fact that in 2017 the foreign exchange gain was Ps. 2 million and in 2016 the foreign exchange gain was Ps. 766 million.

 

Consolidated Statements of Comprehensive Income

Comparison of Years Ended December 31, 2015 and 2016

 

Net Sales

 

Net sales increased 12%, to Ps. 27,516 million in 2016 compared to Ps. 24,476 million in 2015. This increase resulted primarily from a 9% increase in the average price per ton of steel products and an increase of 59 thousand tons in shipments of

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finished steel products. Total sales outside of Mexico increased 15%, to Ps. 11,438 million in 2016 compared to Ps. 9,932 million in 2015. Total sales in Mexico increased 11%, from Ps. 14,543 million in 2015 to Ps. 16,078 million in 2016.

 

Shipments of finished steel products increased 3%, to 2.085 million tons in 2016, compared to 2.026 million tons in 2015. Total sales volume outside of Mexico of finished steel products increased 0.6% to 0.636 million tons in 2016, compared to 0.632 million tons in 2015, while total Mexican sales volume decreased 0.2%, from 1.452 million tons in 2015, compared to 1.449 million tons in 2016. The average price of steel products increased 9% in 2016 compared to 2015.

 

Cost of Sales

 

Our cost of sales decreased 1%, from Ps. 23,097 million in 2015 to Ps. 22,776 million in 2016, which decrease is mainly attributable to a 4% decrease in the average cost per ton of steel products sold and the impairment recorded of the coaking coal inventory. Cost of sales as a percentage of net sales was 83% in 2016 and 94% in 2015. We experienced higher cost of sales at our Republic facilities, mainly a result of (i) higher labor costs corresponding to our U.S. operations, and (ii) the higher cost of raw materials, which our U.S. operations use in the production of SBQ steel. Hourly wages at our Mexican operations were approximately U.S.$1.4 (Ps. 29) per hour in 2016 and U.S.$1.7 (Ps. 35) per hour in 2015, compared to U.S.$61.3 (Ps. 1,267) and U.S.$52.5 (Ps. 1,085) per hour for 2016 and 2015, respectively, at our U.S. operations. Although raw material costs are similar in the United States and Mexico, our U.S. operations produce higher value-added SBQ steel, which requires more expensive raw materials such as chromium, nickel, molybdenum and other alloys. Our Mexican operations require these alloys to a lesser extent, because they produce commodity steel as well as SBQ steel.

 

Gross Profit (Loss)

 

Our gross profit was Ps. 4,740 million in 2016 compared to a Ps. 693 million gross loss in 2015. This gross profit is attributable mainly to an increase of 59 thousand tons of finished steel products shipped, a 9% increase in the average price of steel products sold, a 4% decrease in the average cost per ton of steel products sold and in 2015 we registered the impairment of property, plant and equipment of Ps. 2,072 million (U.S. $130.7 million). As a percentage of net sales, our gross profit was 17% in 2016 and our gross loss was 3% in 2015.

 

Administrative Expenses

 

Our administrative expenses (including depreciation and amortization) decreased 19%, to Ps. 1,277 million in 2016, compared to Ps. 1,582 million in 2015. The decrease of Ps. 305 million in 2016 compared to 2015 is attributable principally to the fact that in 2015 we made the following payments, which we did not make in 2016: (i) Ps. 178 million in royalties to Industrias CH for use of their brands, (ii) Ps. 78 million related to fees for legal services and (iii) expenses of Ps. 76 million corresponding to severance payments in Republic, which were made in 2015. In 2016 and 2015, our general and administrative expenses included Ps. 258 million and Ps. 256 million, respectively, of amortization of the tangible and intangible assets registered principally in connection with the acquisition of Grupo San.

 

Operating expenses as a percentage of net sales were 5% in 2016 and 6% in 2015. Depreciation and amortization expense were Ps. 398 million in 2016 compared to Ps. 419 million in 2015.

 

Other (Expense) Income, Net

 

We recorded other expense, net, of Ps. 36 million in 2016, reflecting (i) income of Ps. 10 million related to the sale of scrap, (ii) expense of Ps. 35 million in the dismantling of machinery and (iii) an expense related to other financial operations of Ps. 11 million.

 

We recorded other income, net, of Ps. 173 million in 2015, reflecting (i) income of Ps. 4 million related to the sale of scrap, (ii) income of Ps. 174 million related to proceeds from a settlement with a client and (iii) an expense related to other financial operations of Ps. 5 million.

 

Interest Income

 

We recorded an interest income of Ps. 140 million in 2016 compared to Ps. 34 million in 2015. This increase is attributable mainly to better interest rates negotiated with financial services institutions.

 

Interest Expense

 

We recorded an interest expense of Ps. 40 million in 2016 compared to Ps. 40 million in 2015.

 

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Foreign Exchange Gain (Loss)

 

We recorded a foreign exchange gain of Ps. 1,775 million in 2016 compared to an exchange loss of Ps. 382 million in 2015; this foreign exchange gain reflected the 19.2% depreciation of the peso against the dollar and the 17% appreciation of the Brazilian real against the dollar in 2016, compared to the 47% depreciation of the Brazilian real against the dollar and the 17.7% depreciation of the peso against the dollar in 2015.

 

Income Tax

 

In 2016 we recorded an income tax provision of Ps. 936 million, which included an income tax provision of Ps. 67 million and an income tax provision for deferred income taxes of Ps. 869 million. In 2015 we recorded an income tax provision of Ps. 771 million, which included an income tax provision of Ps. 1,598 million and an income tax benefit for deferred income taxes of Ps. 827 million. The income tax of 2015 includes Ps. 1,333 million that was paid by Simec International 6 S.A. de C.V. and Simec International 8 S.A. de C.V. arising from a review by the tax authority initiated in July 2015 to the fiscal year ended December 31, 2010, due to a difference of opinion on the deduction of losses on disposal of treasury bonds of the United States.

 

Our effective income tax rates for 2016 and 2015 were 17.6% and 22.5%, respectively. According to the Income Tax Law in Mexico, the tax rate for the year 2016 and years thereafter is 30%. We have implemented the practice of recognizing the benefit derived from the amortization of tax losses for the period in which such losses are actually amortized. In 2016 and 2015, we amortized tax losses which generated a benefit on income tax of approximately Ps. 1,166 million and Ps. 39 million, respectively. These effects caused our effective tax rates during 2016 and 2015 to be lower than the statutory tax rate.

 

Net Income (Loss)

 

We recorded net income of Ps. 4,365 million in 2016, compared to net loss of Ps. 3,261 million in 2015. This income is attributable mainly to (i) an increase of 59,000 tons of shipments of finished steel products, (ii) an increase of 9% in the average price of steel products sold, (iii) the 4% decrease in the average cost per ton of steel products sold and (iv) a foreign exchange gain of Ps. 1,775 million in 2016 compared to Ps. 382 million of foreign exchange loss in 2015.

 

Mexican Segment

Statements of Comprehensive Income

Comparison of Years Ended December 31, 2015 and 2016

 

Net Sales

 

Net sales increased 9%, to Ps. 16,362 million in 2016 compared to Ps. 14,978 million in 2015. This increase resulted principally from a 6% increase in the average price per ton of steel products and an increase of 43 thousand tons of shipments of finished steel products.

 

Shipments of finished steel products increased 3%, to 1.495 million tons in 2016, compared to 1.452 million tons in 2015.

 

The average price of steel products increased 6% in 2016 compared to 2015.

 

Cost of Sales

 

Our cost of sales increased 22%, from Ps. 11,248 million in 2015 to Ps. 13,725 million in 2016, which increase is mainly attributable to a 18% increase in the cost of sales of our products sold and the increase of 43 thousand tons of shipments of finished steel products. As a percentage of net sales, our cost of sales was 84% in 2016, compared to 75% in 2015.

 

Gross Profit

 

Our gross profit decreased 29%, to Ps. 2,637 million in 2016 compared to Ps. 3,731 million in 2015. This decrease is attributable mainly to an increase of 18% in the average cost of steel products sold. As a percentage of net sales, our gross profit was 16% in 2016, compared to 25% in 2015.

 

Administrative Expenses

 

Our administrative expenses (including depreciation and amortization) decreased 18%, to Ps. 902 million in 2016, compared to Ps. 1,101 million in 2015. Such decrease is attributable principally to the fact that in 2015 we had an administrative expense of Ps.

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178 million in royalties paid to Industrias CH for use of their brands, which we did not have in 2016. In 2016 and 2015, our general and administrative expenses included Ps. 245 million and Ps. 245 million, respectively, of amortization of the tangible and intangible assets registered principally in connection with the acquisition of Grupo San.

 

Administrative expenses as a percentage of net sales were 6% in 2016 and 7% in 2015. Depreciation and amortization expense were Ps. 338 million in 2016 compared to Ps. 366 million in 2015.

 

Other Expense (Income), Net

 

We recorded other expense, net, of Ps. 40 million in 2016, reflecting (i) an income of Ps. 10 million related to the sale of scrap, (ii) other expense of Ps. 35 million related to the dismantling of machinery and (iii) other expense, net, related to other financial operations of Ps. 15 million.

 

We recorded other income, net, of Ps. 6 million in 2015, reflecting (i) an income of Ps. 4 million related to the sale of scrap and (ii) other income related to other financial operations of Ps. 2 million.

 

Interest Income

 

We recorded an interest income of Ps. 140 million in 2016 compared to Ps. 34 million in 2015. This increase is attributable mainly to better interest rates negotiated with financial services institutions.

 

Interest Expense

 

We recorded an interest expense of Ps. 15 million in 2016 compared to Ps. 10 million in 2015. This increase was principally due to commissions payable to our financial services providers.

 

Foreign Exchange Gain (Loss)

 

We recorded a foreign exchange gain of Ps. 2,343 million in 2016 compared to an exchange gain of Ps. 840 million in 2015; this foreign exchange reflected the 19.2% depreciation of the peso against the dollar in 2016.

 

Income Tax

 

In 2016, we recorded an income tax provision of Ps. 678 million, which included an income tax provision of Ps. 17 million and an income tax provision for deferred income taxes of Ps. 661 million. In 2015 we recorded an income tax provision of Ps. 1,413 million, which included an income tax provision of Ps. 1,598 million and an income tax benefit for deferred income taxes of Ps. 185 million. The income tax of 2015 includes Ps. 1,333 million that was paid by Simec International 6 S.A. de C.V. and Simec International 8 S.A. de C.V. arising from a review by the tax authority initiated in July 2015 to the fiscal year ended December 31, 2010, due to a difference of opinion on the deduction of losses on disposal of treasury bonds of the United States.

 

According to the Income Tax Law in Mexico, the tax rate for the year 2016 and years thereafter is 30%.

 

Net Income

 

We recorded net income of Ps. 3,485 million in 2016, compared to net income of Ps. 2,087 million in 2015. This increase is attributable mainly to (i) an increase of 43,000 tons of shipments of finished steel products, (ii) an increase of 6% in the average price of steel products sold, and (iii) a foreign exchange gain of Ps. 2,343 million in 2016 compared to Ps. 840 million of foreign exchange gain in 2015.

 

USA Segment

Statements of Comprehensive Income

Comparison of Years Ended December 31, 2015 and 2016

 

Net Sales

 

Net sales decreased 1%, to Ps. 9,339 million in 2016 compared to Ps. 9,468 million in 2015. This decrease resulted principally from a decrease of 173 thousand tons of shipments of finished steel products.

 

Shipments of finished steel products decreased 30%, to 397 thousand tons in 2016, compared to 570 thousand tons in 2015.

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The average price of steel products in pesos increased 41% in 2016 compared to 2015.

 

Cost of Sales

 

Our cost of sales decreased 38%, from Ps. 11,829 million in 2015 to Ps. 7,332 million in 2016, which decrease is mainly attributable to a 30% decrease in shipments of finished steel products, a decrease of 11% in the prices of raw materials used for the production of finished products and to the fact that in 2016 Ps. 466 million was charged against the cost of sales as a result of the increase in the value of the coaking coal inventory, compared to Ps. 552 million in 2015. Cost of sales as a percentage of net sales was 79% in 2016, compared to 125% in 2015.

 

Gross Profit (Loss)

 

Our gross profit was Ps. 2,007 million in 2016 compared to a Ps. 4,433 million gross loss in 2015. As a percentage of net sales, our gross profit was 21% in 2016, compared to a 47% gross loss in 2015. The selling steel prices throughout the year also impacted our margin since prices for steel products charged to our customers were gradually lower than our costs of raw materials as a result of the time lag between the production and sales cycles.

 

Administrative Expenses

 

Our administrative expenses (including depreciation and amortization) decreased 35%, to Ps. 299 million in 2016, compared to Ps. 457 million in 2015.

 

Administrative expenses as a percentage of net sales were 4% in 2016 and 5% in 2015. Depreciation and amortization expense were Ps. 58 million in 2016 compared to Ps. 67 million in 2015.

 

Other Income, Net

 

We recorded other income, net, of Ps. 1,482 million in 2016, reflecting (i) income of Ps. 1,478 million related to the transfer of the total assets of the Gary, Indiana plant in the United States to the current Tlaxcala plant in Mexico, through a turnkey transaction, by which Republic Steel developed the project until the start of the operations in Tlaxcala, Mexico, and (ii) other income, net of Ps. 4 million related to other financial operations.

 

We recorded other income, net, of Ps. 184 million in 2015, reflecting (i) income of Ps. 174 million related to proceeds from a settlement with a client and (ii) other income, net of Ps. 10 million related to other financial operations.

 

Interest Income

 

We recorded an interest income of Ps. 0 million in 2016 compared to Ps. 0 million in 2015.

 

Interest Expense

 

We recorded an interest expense of Ps. 45 million in 2016 compared to Ps. 47 million in 2015.

 

Income Tax

 

In 2016 we recorded an income tax provision of Ps. 256 million for deferred income taxes. In 2015 we recorded an income tax benefit of Ps. 642 million for deferred income taxes.

 

Net Income (Loss)

 

We recorded net income of Ps. 2,932 million in 2016, compared to a net loss of Ps. 4,111 million in 2015. Our net income is attributable mainly to (i) the increase of 41% in the average price of steel products sold, (ii) a decrease of 11% in the prices of raw materials used for the production of finished products and (iii) other income, net, of Ps. 1,482 million.

 

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Brazil Segment

Statements of Comprehensive Income

Comparison of Years Ended December 31, 2015 and 2016

 

Our segment in Brazil started operations in late 2015. The information presented for 2016 is not comparable with 2015 because the information presented for 2016 corresponds to a full year of operations, while the information presented for 2015 corresponds only to a few months of operations.

 

Net Sales

 

Net sales increased to Ps. 1,814 million in 2016 compared to Ps. 29 million in 2015. This increase resulted principally from an increase of 189 thousand tons of shipments of finished steel products.

 

Shipments of finished steel products increased to 193 thousand tons in 2016, compared to 4 thousand tons in 2015.

 

Cost of Sales

 

Our cost of sales increased to Ps. 1,719 million compared to Ps. 20 million in 2015. Cost of sales as a percentage of net sales was 95% in 2016, compared to 69% in 2015.

 

Gross Profit

 

Our gross profit was Ps. 95 million in 2016 compared to Ps. 9 million of gross profit in 2015. As a percentage of net sales, our gross profit was 5% in 2016, compared to 31% of gross loss in 2015.

Administrative Expenses

 

Our administrative expenses (including depreciation and amortization) were Ps. 77 million in 2016 compared to Ps. 24 million in 2015. Operating expenses as a percentage of net sales were 4% in 2016 compared to 83% in 2015. Depreciation and amortization expense were Ps. 3 million in 2016 compared to Ps. 1 million in 2015.

 

Other Expense, Net

 

We did not record other expense, net, in 2016. We recorded other expense, net, of Ps. 16 million in 2015, reflecting other expenses related to other financial operations.

 

Interest Expense

 

We recorded an interest expense of Ps. 51 million in 2016 compared to Ps. 25 million in 2015.

 

Foreign Exchange Gain (Loss)

 

We recorded a foreign exchange gain of Ps. 766 million in 2016 compared to an exchange loss of Ps. 497 million in 2015; this foreign exchange gain reflected the 17% appreciation of the Brazilian real against the dollar in 2016 compared to 2015.

 

Income Tax

 

In 2016 we recorded an income tax provision of Ps. 2 million, while in 2015 we did not record any income tax.

 

Net Income (Loss)

 

We recorded a net income of Ps. 731 million in 2016 compared to Ps. 553 million of net loss in 2015.

 

 

Critical Accounting Policies

 

The discussion in this section is based upon our consolidated financial statements, which have been prepared in accordance with IFRS. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at year-end, and the reported amount of revenues and expenses during the year. Management regularly evaluates these estimates, including those related to the carrying value of property, plant and equipment and other non-current assets, inventories and cost of sales, income taxes, foreign currency transactions and exchange differences, liabilities for deferred income taxes, valuation of financial instruments, obligations relating to employee benefits, potential tax deficiencies, environmental obligations, and potential litigation claims and settlements. Management estimates are based on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent

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from other sources. Accordingly, actual results may differ materially from current expectations under different assumptions or conditions.

 

Management believes that the critical accounting policies which require the most significant judgments and estimates used in the preparation of the financial statements relate to deferred income taxes, the impairment of property, plant and equipment, impairment of intangible assets, valuation allowance on accounts receivable and inventories obsolescence. We evaluate the recoverability of operating tax losses (NOL) carry forwards, and only for those who have probability of being recovered is determined a deferred tax asset. The final realization of deferred tax assets depends on the generation of taxable profits in the periods when the temporary differences are deductible. Upon carrying out this evaluation, we considered the expected reversal of deferred tax liabilities, projected taxable profit and planning strategies. Based on the company’s evaluation, it determined the amount of deferred tax assets that is more likely than not to be realized in the future against those taxable profits.

 

We evaluate periodically the adjusted values of our property, plant and equipment and intangible assets to determine whether there is an indication of potential impairment. Impairment exists when the carrying amount of an asset exceeds net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds the fair value. Assets to be disposed of are reported at the lower of the carrying amount or realizable value. Significant judgment is involved in estimating future revenues and cash flows or realizable value, as applicable, of our property, plant and equipment due to the characteristics of those assets. The class of our assets which most require complex determinations based upon assumptions and estimates relates to indefinite lived intangibles including goodwill, due to the current market environment.

 

In June of 2015 Republic Steel temporarily idled the newly constructed electric arc furnace at the Lorain, Ohio, facility in response to the severe economic downturn in the energy exploration sector following the sharp drop in the price of oil which has led to significant market declines and demand for product. As a consequence of this event management determined a triggering event took place to where the long-lived assets at the Lorain facility may not be fully recoverable. Management performed an analysis of the fair value of the Lorain facility with the assistance of an independent valuation firm and determined the net book value exceeded the fair value by approximately U.S.$130.7 million (Ps. 2,701 million) and as such recognized an asset impairment of this amount during the year ended December 31, 2015. The fair value determination at the Lorain facility was based on an independent valuation of the Lorain melt shop assets using the comparable match method of the market approach. The income approach was not considered an appropriate fair value measurement due to the absence of reliable forecast data as the facility was idled indefinitely in early 2016.

 

As of the date of this report, management has no near-term plans to restart the facility. The expectation is that it will be restarted when market conditions improve substantially, particularly in the oil and gas industry. We have property, plant and equipment with a net book value of approximately U.S.$32.7 million (Ps. 643 million) as of December 31, 2018, pertaining to the Lorain, Ohio, facility after recording the impairment charge of U.S.$130.7 million (Ps. 2,701 million) in 2015 (the impairment charge did not impact the cash flows, as it was not a cash expenditure). Management further assessed if there were any impairments at the Company’s other asset groups in accordance with IFRS and determined that as of December 31, 2018, no other asset groups were impaired based on current projections. No further impairment was considered necessary or appropriate.

 

In assessing the recoverability of the goodwill and other intangibles, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. We perform an annual review in the fourth quarter of each year, or more frequently if indicators of potential impairment exist, to determine if the carrying value of recorded goodwill is impaired. The impairment review process compares the fair value of the reporting unit in which goodwill resides to its carrying value. We estimate the reporting unit’s fair value based on a discounted future cash flow approach that requires estimating income from operations. In order to estimate our cash flows used in impairment computations, we considered the following:

 

  our history of earnings;

 

  our history of capital expenditures;

 

  the remaining useful lives of our primary assets;

 

  current and expected market and operating conditions; and

 

  our weighted average cost of capital.

 

Other intangible assets are mainly comprised of trademarks, customer list and non-competition agreements. When impairment indicators exist, or at least annually for indefinite live intangibles, we determine our projected revenue streams over the estimated useful life of the asset. In order to obtain undiscounted and discounted cash flows attributable to each intangible asset, such revenues are adjusted for operating expenses, changes in working capital and other expenditures as applicable, and discounted to net

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present value using the risk adjusted discount rates of return. As of December 31, 2017 and 2018 there was no impairment charge to other intangible assets.

 

As a result of the downturn in the construction industry in Mexico during 2009 and the negative impact the downturn had on our operations mainly at the San Luis facilities, in which goodwill resides we adjusted the key assumptions used in the valuation model. As of December 31, 2017 and 2018, there was no impairment charge related to the San Luis facilities.

 

As of December 31, 2018, the main key assumptions used in the valuation models of the San Luis reporting unit are as follows:

 

  discount rate: 14.5%; and

 

  sales: we estimate an increase in sales volume of approximately 13% in 2019, mainly attributable to the increase in volume due to the start of production of the new industrial wire product line. After 2020, no sales increases in volume terms are considered in the valuation model. For the year 2019 we estimate a decrease in sales prices of 9.6% and for the years after 2020, only an increase in sales prices in line with estimated inflation.

 

If these estimates or their related assumptions for prices and demand change in the future, we may be required to record additional impairment charges for these assets.

 

With respect to valuation allowance on accounts receivable, on a periodic basis management analyzes the recoverability of accounts receivable in order to determine if, due to credit risk or other factors, some receivables may not be collected. If management determines that such a situation exists, the book value of the non-recoverable assets is adjusted and charged to the income statement through an increase in the doubtful accounts allowance. This determination requires substantial judgment by management. As a result, final losses from doubtful accounts could differ significantly from estimated allowances.

 

We apply judgment at each balance sheet date to determine whether the slow moving inventory is impaired. Inventory is impaired when the carrying value is greater than the net realizable value.

 

The reserve for environmental liabilities represent the estimated environmental remediation costs that we believe are going to incur. These estimates are based on currently available data, existing technology, the current laws and regulations and take into account the likely effects of inflation and other economic and social factors. The time in which we could incur these costs cannot be determined reliably at this time due to the absence of deadlines for remediation under the laws and regulations which apply to remediation costs will be made.

 

New Accounting Pronouncements

 

IASB has issued amendments to IFRS, which were enacted but some of which are not yet effective:

  

IFRS to be effective from 2019:

 

  IFRS 16, Leases;
  Amendment to IAS 28, regarding long-term interests in associates and joint ventures;
  Amendment to IAS 3, Business Combinations;
  Amendment to IAS 11, Joint Arrangements;
  Amendment to IAS 12, Income Taxes;
  Amendment to IAS 23, Borrowing Costs;
  Interpretation IFRIC 23, to clarify the recognition of deferred tax assets for unrealized losses related to debt instruments measured at fair value and
   ●  Amendment to IAS 19, Employee Benefits

 

IFRS to be effective from 2020:

 

  Amendment to IAS 3, Business Combinations and
  Amendments to IAS 1, Presentation of Financial Statements and to IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors

 

At the date of issuance of our consolidated financial statements, these new standards have not had any effect on our financial information.

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  B. Liquidity and Capital Resources

 

On December 31, 2018, our total consolidated debt was Ps. 5.936 million (U.S.$302,000) of 8 7/8% medium-term notes (“MTNs”) due 1998 which remained outstanding after we conducted exchange offers for the MTNs in October 1997 and August of 1998. We could not identify the holders of such MTNs at the time of the exchange offers and as a result such MTNs, which matured in 1998, have not been paid and remain outstanding.

 

On September 6, 2006, Industrias CH and its subsidiaries and affiliates made available a line of credit in favor of Republic. Effective January 1, 2009, Industrias CH reduced the interest rate from 5.23% to 0.25% per annum. As of December 31, 2018, the credits to Industrias CH and its subsidiaries and affiliates were liquidated and as of December 31, 2017, Republic had Ps. 985 million (comprised of U.S.$38 million and Ps. 227 million, including interest), respectively, outstanding under this line of credit. See Note 18 to our consolidated financial statements included elsewhere herein.

 

We depend heavily on cash generated from operations as our principal source of liquidity. Other sources of liquidity have included financing made available to us by our parent Industrias CH (primarily in the form of equity or debt, substantially all of which was subsequently converted to equity), primarily for the purpose of repaying third party indebtedness, as well as limited amounts of vendor financing. On February 8, 2007, we completed a public offering of ADSs and series B shares and raised cash proceeds of approximately Ps. 2,421 million (U.S.$214 million). As of December 31, 2013 we had cash and cash equivalents of Ps. 6,985 million, as of December 31, 2014 we had cash and cash equivalents of Ps. 7,003 million, as of December 31, 2015 we had cash and cash equivalents of Ps. 6,224 million, as of December 31, 2016 we had cash and cash equivalents of Ps. 7,536 million, as of December 31, 2017 we had cash and cash equivalents of Ps. 7,204 million and as of December 31, 2018 we had cash and cash equivalents of Ps. 6,987 million. We believe that this amount of cash generated from operations will be sufficient to satisfy our currently anticipated cash requirements, including our currently anticipated capital expenditures.

 

Our principal use of cash has generally been to fund our operating activities, to acquire businesses and to fund our capital expenditure programs. The following is a summary of cash flows for the three years ended December 31, 2016, 2017 and 2018:

 

Principal Cash Flows

 

    Years ended December 31,
    2016   2017   2018
Funds provided by operating activities   5,705   3,184   3,224
Funds used in investing activities   (5,442)   (3,118)   (820)
Funds used in financing activities   898   (374)   (2,641)

 

Our net funds provided by operations were Ps. 3,224 million in 2018 compared to Ps. 3,184 million of net funds provided by operations in 2017. The increase of Ps. 40 million in the net funds provided by operations between 2018 and 2017 originated mainly from the higher net income for the year 2018. Our net funds provided by operations were Ps. 3,184 million in 2017 compared to Ps. 5,705 million of net funds provided by operations in 2016. The decrease of Ps. 2,522 million in the net funds provided by operations between 2017 and 2016 originated mainly from the lower net income for the year 2017.

 

We attribute our net funds used in investing activities primarily to the acquisition of new facilities, property, plant and equipment and other non-current assets. Our net funds used in investing activities were Ps. 820 million in 2018 compared to Ps. 3,118 million in 2017. In 2018 the acquisition of property, plant and equipment was Ps. 1,994, we received payments for loans granted to related parties for Ps. 1,939, we made partial payments for the acquisition of two plants in Brazil for Ps. 639 million, we granted loans to related parties for Ps. 477 and other non-current assets provided for Ps. 351 million. Our net funds used in investing activities were Ps. 3,118 million in 2017 compared to Ps. 5,442 million in 2016 our acquisition of property, plant and equipment was Ps. 3,100 million. We created loans to related parties for Ps. 2,277 million and other non-current assets were used for Ps. 65 million. In addition, in 2017 we also recovered temporary investments of Ps. 339 million.

 

Our net funds used by financing activities in 2018 were Ps. 2,641 million, compared to Ps. 374 million used by financing activities in 2017. In 2018, there was an increase of Ps. 1,640 million in the buy-back of our own shares, we made the payment of our debt with Industrias CH and some of its subsidiaries for Ps. 985 million and we paid interest for Ps. 16 million. Our net funds used by financing activities in 2017 were Ps. 374 million, compared to Ps. 898 million provided by financing activities in 2016. In 2017, there was a decrease of Ps. 279 million in the buy-back of our own shares compared to Ps. 40 million used in loans to related parties and there was an increase of Ps. 938 million in the buy-back of our own shares in 2016.

 

As of December 31, 2018, we have the following commitments for capital expenditures:

 

In January 2013, the Company entered into a 15 year product supply agreement with Air Products and Chemicals, Inc. The agreement required Air Products and Chemicals to construct and install a plant for the production of oxygen, nitrogen and argon gas

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on the premises of the Lorain, Ohio facility. In August of 2016, the Company entered into an agreement with Air Products and Chemicals, Inc. whereby the plant was purchased for U.S.$30 million (Ps. 592 million) and the supply agreement cancelled in its entirety. The purchase price is repayable over 6 years in equal monthly installments of U.S.$0.4 million (Ps. 7.9 million) after an initial payment of U.S.$1.2 million (Ps. 23 million) and carries no interest cost. Obligations are secured by certain physical assets (operating, manufacturing, and storage equipment, buildings and machinery) at the Company’s Canton facility.

 

In December 2017, the Company entered into a contract with the supplier COMERC, LTDA, for an amount of U.S.$5.2 million (Ps. 103 million) for the purchase of 8,000 MWH of energy per month, for its subsidiary GV do Brasil Industria y Comercio of Aço LTDA. The monthly payments expire 6 days after the closing date of the month. The contract ended in February 2019.

 

In January 2018, the Company entered into a contract with the supplier ECOM, LTDA, for an amount of U.S.$ 6.1 million (Ps. 120 million) for the purchase of 10,000 MWH of energy per month, for its subsidiary GV do Brasil Industria e Comercio de Aço LTDA. The monthly payments expire 6 days after the closing date of the month. The contract ended in February 2019.

 

In January 2018, the Company entered into a contract with the supplier ECOM, LTDA, for an amount of U.S.$ 6.3 million (Ps. 124 million) for the purchase of 10,000 MWH of energy per month, for its subsidiary GV do Brasil Industria e Comercio de Aço LTDA. The monthly payments expire 6 days after the closing date of the month. The contract ends in February 2020.

 

On February 22, 2018, a contract was signed with Primental Technologies of Italy, the United States and Mexico for the reconstruction of the rolling mill and the supply of a new reheating furnace for the Mexicali plant, which will increase capacity of finished product manufacturing from 17,500 to 22,500 tons per month. An advance of 20% has already been paid for U.S.$1.67 million (Ps. 33 million) and the placement of the letters of credit is in process. The term of execution of the project is 16 months and a budget of U.S.$23.2 million (Ps. 458 million) is estimated.

 

 

C. Research and Development, Patents and Licenses

 

The San Luis facilities are registered with the Mexican Institute of Industrial Property (“IMPI”) for the trademarks “SAN” and “Aceros San Luis.” The trademark “Grupo Simec” is registered with the IMPI. On October 11, 2017, Simec International 6, S.A. de C.V., concluded the registration of the patent “Fabricación de Aceros de Mecanizado Fácil con Plomo en la Máquina de Colada Continua” (Manufacture of Easy Machining Steels with Lead in Continuous Casting Machine) in the IMPI.

 

D. Trend Information

 

In the first quarter of 2019, net sales increased 8% compared to the fourth quarter of 2018. Sales in tons of finished steel increased 1% in the first quarter of 2019 compared to the fourth quarter of 2018. Prices of finished products sold in the first quarter of 2019 increased approximately 6.9% compared to the fourth quarter of 2018.

 

All of the statements in this “Trend Information” section are subject to and qualified by the information set forth under the “Cautionary Statement Regarding Forward Looking Statements.” See also Item 5.A “Operating and Financial Review and Prospects—Overview of Operating Results.”

 

E. Off-Balance Sheet Arrangements

 

We do not have any material off-balance sheet arrangements.

 

F. Contractual Obligations

 

The table below sets forth our significant short-term and long-term contractual obligations as of December 31, 2018:

 

Maturity 

 
 

Less than 1
year 

1– 3 years 

4– 5 years 

In excess of
5 years 

Total 

(millions of pesos)  
Short-term debt obligations 6 6
Long-term contractual obligations (see paragraph below) 1 1 2
Total 7 1 8
                       

 

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Republic leases certain equipment, office space and computers through operating contracts under non-cancelable operating leases. These lease contracts expire on several different dates by the end of 2020. During 2018 and 2017, the expenses for operating leases were Ps. 13.4 million (U.S.$0.7 million) and Ps. 9.5 million (U.S.$0.5 million), respectively. As of December 31, 2018, total future minimum lease payments under non-cancelable operating leases are Ps. 0.6 million (U.S.$0.03 million) in 2019 and Ps. 0.1 million (U.S.$0.006 million in 2020. At December 31, 2018 there are no additional obligations after 2020.

 

In January 2013, Republic entered into an agreement with EnerNOC which enables Republic to receive payments for reducing the electricity consumption during a dispatch declared by PJM Interconnection as an emergency. The agreement is for 5 years, effective January 31, 2013 and expired on May 31, 2018. Republic recognized income of Ps. 53.9 million (U.S.$2.8 million) and of Ps. 19 million (U.S.$ 1 million) from this agreement in 2018 and in 2017, respectively.

 

In December 2017, the Company entered into a contract with the supplier COMERC, LTDA. for an amount of Ps. 102.6 million (U.S.$ 5.2 million) for the purchase of 8,000 MWH of energy per month, for its subsidiary GV do Brasil Industria y Comercio de Aço LTDA. All monthly payments due 6 days after the closing date of the month. The contract ended in February 2019.

 

In January 2018, the Company entered into a contract with the supplier ECOM, LTDA, for an amount of U.S.$ 6.1 million (Ps. 120 million) for the purchase of 10,000 MWH of energy per month, for its subsidiary GV do Brasil Industria e Comercio de Aço LTDA. The monthly payments expire 6 days after the closing date of the month. The contract ended in February 2019.

 

In January 2018, the Company entered into a contract with the supplier ECOM, LTDA. for an amount of Ps. 124.3 million (U.S.$ 6.3 million) for the purchase of 10,000 MWH of energy per month from its subsidiary GV do Brasil Industria y Comercio de Aço LTDA, beginning the supply in 2019. All payments due monthly six days after the closing date of the month. The contract ends in February 2020.

 

Item 6.       Directors, Senior Management and Employees

 

A. Directors and Senior Management

 

Our Board of Directors

 

Our board of directors is responsible for managing our business. Pursuant to our by-laws, the board of directors shall consist of a maximum of 21 but not less than five members elected at an ordinary general meeting of shareholders. Our board of directors currently consists of five directors, each of whom is elected at the annual shareholders’ meeting for a term of one year with an additional period of thirty days, if a successor has not been appointed. The board of directors may appoint provisional directors until the shareholders’ meeting appoints the new directors. Under the Mexican Securities Market Law and our bylaws, at least 25% of our directors must be independent. Under the law, the determination as to the independence of our directors made by our shareholders’ meeting may be contested by the CNBV. In compliance with our bylaws and applicable Mexican law, our board of directors meets on a quarterly basis and resolutions adopted by a majority of directors at the meeting are valid resolutions.

 

Election of the Board of Directors

 

At each shareholders’ meeting for the election of directors, the holders of shares are entitled pursuant to our by-laws to elect the directors. Each person (or group of persons acting together) holding 10% of our capital stock is entitled to designate one director.

 

The current members of our board of directors were nominated and elected to such position at the 2019 general meeting of shareholders as proposed by Industrias CH. We expect that Industrias CH will be in a position to continue to elect the majority of our directors and to exercise substantial influence and control over our business and policies and to influence us to enter into transactions with Industrias CH and affiliated companies. However, our by-laws provide that at least 25% of our directors must be independent from us and our affiliates, and our board of directors has passed a resolution requiring the approval of at least two independent directors for certain transactions between us and our affiliates which are not our subsidiaries.

 

Under Mexican law, a majority shareholder has no fiduciary duty to minority shareholders but may not act contrary to the interests of the corporation for the majority shareholder’s benefit. Such a majority shareholder is required to abstain from voting on any matter in which it directly or indirectly has a conflict of interest and can be liable for actual and consequential damages if such matter passes as a result of its vote in favor thereof. In addition, the directors of a Mexican corporation owe a duty to act in a manner which, in their independent judgment, is in the best interests of the corporation and all its shareholders.

 

Our board of directors adopted a code of ethics in December 2002.

 

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Authority of the Board of Directors

 

The board of directors is our legal representative. The board of directors must approve, among other matters, the following:

 

  our general strategy;

 

  annual approval of the business plan and the investment budget;

 

  capital investments not considered in the approved annual budget for each fiscal year;

 

  proposals to increase our capital or that of our subsidiaries;

 

  with input from the Audit Committee, on an individual basis: (i) any transactions with related parties, subject to certain limited exceptions, (ii) our management structure and any amendments thereto, and (iii) the election of our chief executive officer, his compensation and removal for justified causes; (iv) our financial statements and those of our subsidiaries, (v) unusual or non- recurrent transactions and any transactions or series of related transactions during any calendar year that involve (a) the acquisition or sale of assets with a value equal to or exceeding 5% of our consolidated assets or (b) the giving of collateral or guarantees or the assumption of liabilities, equal to or exceeding 5% of our consolidated assets, and (vi) contracts with external auditors and the chief executive officer annual report to the shareholders’ meeting;

 

  calling shareholders’ meetings and acting on their resolutions;

 

  any transfer by us of shares in our subsidiaries;

 

  creation of special committees and granting them the power and authority, provided that the committees will not have the authority which by law or under our by-laws is expressly reserved for the board of directors or the shareholders;

 

  determining how to vote the shares that we hold in our subsidiaries; and

 

 

  the exercise of our general powers in order to comply with our corporate purpose.

 

Meetings of the board of directors will be validly convened and held if a majority of our members are present. Resolutions at the meetings will be valid if approved by a majority of the members of the board of directors, unless our by-laws require a higher number. The chairman has a tie-breaking vote. Notwithstanding the board’s authority, our shareholders pursuant to decisions validly taken at a shareholders’ meeting at all times may override the board.

 

Duty of Care and Duty of Loyalty

 

The Mexican Securities Market Law imposes a duty of care and a duty of loyalty on directors. The duty of care requires our directors to act in good faith and in the best interests of the company. In carrying out this duty, our directors are required to obtain the necessary information from the executive officers, the external auditors or any other person to act in the best interests of the company. Our directors are liable for damages and losses caused to us and our subsidiaries as a result of violating their duty of care.

 

The duty of loyalty requires our directors to preserve the confidentiality of information received in connection with the performance of their duties and to abstain from discussing or voting on matters in which they have a conflict of interest. In addition, the duty of loyalty is violated if a shareholder or group of shareholders is knowingly favored or if, without the express approval of the board of directors, a director takes advantage of a corporate opportunity. The duty of loyalty is also violated, among other things, by (i) failing to disclose to the audit and corporate practices committee or the external auditors any irregularities that the director encounters in the performance of his or her duties or (ii) disclosing information that is false or misleading or omitting to record any transaction in our records that could affect our financial statements. Directors are liable for damages and losses caused to us and our subsidiaries for violations of this duty of loyalty. This liability also extends to damages and losses caused as a result of benefits obtained by the director or directors or third parties, as a result of actions of such directors.

 

Our directors may be subject to criminal penalties of up to 12 years’ imprisonment for certain illegal acts involving willful misconduct that result in losses to us. Such acts include the alteration of financial statements and records.

 

Liability actions for damages and losses resulting from the violation of the duty of care or the duty of loyalty may be exercised solely for our benefit and may be brought by us, or by shareholders representing 5% or more of our capital stock, and criminal actions only may be brought by the Mexican Ministry of Finance, after consulting with the CNBV. As a safe harbor for

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directors, the liabilities specified above (including criminal liability) will not be applicable if the director acting in good faith (i) complied with applicable law, (ii) made the decision based upon information provided by our executive officers or third-party experts, the capacity and credibility of which could not be subject to reasonable doubt, (iii) selected the most adequate alternative in good faith or if the negative effects of such decision could not have been foreseeable, and (iv) complied with shareholders’ resolutions provided the resolutions do not violate applicable law.

 

The members of the board are liable to our shareholders only for the loss of net worth suffered as a consequence of disloyal acts carried out in excess of their authority or in violation of our by-laws.

 

In accordance with the Mexican Securities Market Law, supervision of our management is entrusted to our board of directors, which shall act through an audit and corporate practices committee for such purposes, and to our external auditor. The audit and corporate practices committee (together with the board of directors) replaces the statutory auditor (comisario) that previously had been required by the Mexican Corporations Law. See Item 6.C. “— Committees” below.

 

The following table sets forth the names of the members of our board of directors and the year of their initial appointment:

 

Name  

Director Since 

Rufino Vigil González 2001
Raúl Arturo Pérez Trejo 2003
Luis García Limón 2011
Rodolfo García Gómez de Parada 2001
Alfonso Barragán Galindo 2019

 

Biographical Information of our Board of Directors

 

Alfonso Barragán Galindo. Mr. Barragán was born in 1953. He is an independent director for purposes of Mexican law and has been appointed to our board of directors and the Audit Committee in 2019. Mr. Barragán is a labor lawyer and since 1978 has worked at La Comer, a group of self-service stores for which he is the Director of the Legal Department since 2016.

 

Rodolfo García Gómez de Parada. Mr. García was born in 1953. He has been a member of our board of directors since 2001 and is an independent director for purposes of Mexican law. He has been the tax advisor of Industrias CH since 1991 and also serves as member of the board of directors of a group of retail stores since 1990.

 

Luis García Limón. Mr. García was born in 1944. He is currently our chief executive officer and has been a member of our board of directors since 2011. From 1982 to 1990 he was general director of Compañía Siderúrgica de Guadalajara, S.A. de C.V. (“CSG”), from 1978 to 1982 he was Operation Director of CSG, from 1974 to 1978 he was general manager of Moly Cop and Pyesa, and from 1969-1974 he was Engineering Manager of CSG. In addition, from 1967 to 1969 Mr. García was the director of electrical installation of a construction company.

 

Raúl Arturo Pérez Trejo. Mr. Pérez was born in 1959. He has been a member of our board of directors since 2003, and is an independent director for purposes of Mexican law, and is the chairman of our Audit Committee. Mr. Pérez has also served since 1992 as the chief financial officer of a group that produces and sells structural steel racks for warehousing, aluminum and other industrial storage.

 

Rufino Vigil González. Mr. Vigil was born in 1948. He is currently the chairman of our board of directors and has been a member of the board of directors since 2001. Since 1973, Mr. Vigil has been chief executive officer of a steel related products corporation. From 1988 to 1993, Mr. Vigil was a member of the board of directors of a Mexican investment bank and from 1971 to 1973 he was a construction corporation manager.

 

Executive Officers

 

The following table sets forth the names of our executive officers, their current position with us and the year of their initial appointment to that position.

 

Name 

 

Position 

 

Position
Held Since 

Luis García Limón   Chief Executive Officer   1982*
Mario Moreno Cortez   Coordinator of Finance   2012
Juan José Acosta Macías   Chief Operating Officer   2004

__________________

* Represents the date as of which Mr. García Limón first held this office with our predecessor, CSG.

 

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Luis García Limón. Mr. García was born in 1944. He is currently our chief executive officer and has been a member of our board of directors since 2011. From 1982 to 1990 he was general director of CSG, from 1978 to 1982 he was Operation Director of CSG, from 1974 to 1978 he was general manager of Moly Cop and Pyesa, and from 1969-1974 he was Engineering Manager of CSG. In addition, from 1967 to 1969 Mr. García was the director of electrical installation of a construction company.

 

Mario Moreno Cortez. Mr. Moreno was born in 1968. He is currently our coordinator of Finance. From 1998 to 2010 he was the general accountant within the main subsidiaries of Grupo Simec. Previously Mr. Moreno worked in various departments of the financial area within certain of our principal subsidiaries.

 

Juan José Acosta Macías. Mr. Acosta was born in 1960. He is currently our chief operating officer. From 1998 to 2004 he was production manager of CSG, he has been working with us since 1983. Prior to working with us, Mr. Acosta worked for Mexicana de Cobre as a supervisor in 1982.

 

 

Our chief executive officer and executive officers are required, under the Mexican Securities Market Law, to act for our benefit and not that of a shareholder or group of shareholders. Our chief executive is required, principally, to (i) implement the instructions of our shareholders’ meeting and our board of directors, (ii) submit to the board of directors for approval the principal strategies for the business, (iii) submit to the Audit Committee proposals for the systems of internal control, (iv) disclose all material information to the public and (v) maintain adequate accounting and registration systems and mechanisms for internal control. Our chief executive officer and our executive officers will also be subject to liability of the type described above in connection with our directors.

 

Role of Mr. Sergio Vigil González:

Mr. Sergio Vigil González is the chief executive officer of Industrias CH, which together with its wholly-owned subsidiaries, currently hold approximately 84% of our series B shares. Mr. Vigil also functions in a senior management role for the Company, although he holds no formal title at the Company. In this function, Mr. Vigil directs business strategies for the Company, negotiates potential acquisitions and directs intercompany loans, among other things. Our board of directors is aware of Mr. Vigil’s role at the Company and he has been formally authorized by our board of directors as a signatory of the Company. For example, in May 2018, Mr. Sergio Vigil executed contracts on behalf of the Company with respect to the acquisition and lease transfer of two plants in Brazil from Arcelor Mittal Brasil, S.A. Mr. Vigil does not receive any compensation for his role. Mr. Vigil is the brother of our controlling shareholder and chairman of our board of directors, Rufino Vigil González. 

The business address of our directors and executive officers is our principal executive headquarters.

 

  B. Compensation

 

For the years ended December 31, 2018, 2017 and 2016, we paid no fees to our five directors, and the aggregate compensation our executive officers earned was approximately Ps. 90.6 million and Ps. 82.4 million, respectively. We do not provide pension, retirement or similar benefits to our directors in their capacity as directors. Our executive officers are eligible for retirement and severance benefits required by Mexican law on the same terms as all other employees, and we do not separately set aside, accrue or determine the amount of our costs that is attributable to executive officers.

 

  C. Board Practices

 

None of our directors or executive officers are entitled to benefits upon termination under their service contracts with us, except for what is due to them according to the Mexican Federal Labor Law (Ley Federal del Trabajo).

 

Committees

 

Our by-laws provide for an audit and corporate practices committee to assist the board of directors with the management of our business.

 

Audit and Corporate Practices Committee

 

Our audit and corporate practices committee is governed by our bylaws and Mexican law. Our by-laws provide that the audit and corporate practices committee shall be at least three members, all of which must be independent directors. The chairman of the audit and corporate practices committee is elected by our shareholders’ meeting, and the board of directors appoints the remaining members.

 

The audit and corporate practices committee is currently composed of three members. Raúl Arturo Pérez Trejo was appointed as chairman of the audit and corporate practices committee at our annual ordinary shareholders’ meeting held on April 22, 2019, and Alfonso Barragán Galindo and Rodolfo García Gómez de Parada were re-elected as members. Raúl Arturo Pérez Trejo has been ratified as the “audit committee financial expert.”

 

The audit and corporate practices committee is responsible, among others, for (i) supervising our external auditors and analyzing their reports, (ii) analyzing and supervising the preparation of our financial statements, (iii) informing the board of our

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internal controls and their adequacy, (iv) requesting reports of our board of directors and executive officers whenever it deems appropriate, (v) informing the board of any irregularities that it may encounter, (vi) receiving and analyzing recommendations and observations made by the shareholders, members of the board, executive officers, our external auditors or any third party and taking the necessary actions, (vii) calling shareholders’ meetings, (viii) supervising the activities of our chief executive officer, (ix) providing an annual report to the annual shareholders’ meeting, (x) providing opinions to our board of directors, (xi) requesting and obtaining opinions from independent third parties and (xii) assisting the board in the preparation of annual reports and other reporting obligations.

 

The chairman of the audit and corporate practices committee, shall prepare an annual report to the annual shareholders’ meeting with respect to the findings of the audit and corporate practices committee, which shall include (i) the status of the internal controls and internal audits and any deviations and deficiencies thereof, taking into consideration the reports of external auditors and independent experts, (ii) the results of any preventive and corrective measures taken based on results of investigations in respect of non-compliance of operating and accounting policies, (iii) the evaluation of external auditors, (iv) the main results from the review of our financial statements and those of our subsidiaries, (v) the description and effects of changes to accounting policies, (vi) the measures adopted as result of observations of shareholders, directors, executive officers and third parties relating to accounting, internal controls, and internal or external audits; (vii) compliance with shareholders’ and directors’ resolutions; (viii) observations with respect to relevant directors and officers; (ix) the transactions entered into with related parties; and (x) the remuneration paid to directors and officers.

 

Our audit and corporate practices committee met at least quarterly in 2018.

 

  D. Employees

 

As of December 31, 2018, we had 4,685 employees (2,765 were employed at our Mexico facilities, of whom 1,215 were unionized, 965 were employed at Republic facilities, of whom 783 were unionized and 955 were employed at our Brazil plant, of whom 878 were unionized) compared to 3,767 employees as of December 31, 2017 (2,552 were employed at our Mexico facilities, of whom 1,131 were unionized, 892 were employed at Republic facilities, of whom 737 were unionized and 323 were employed at our Brazil plant, of whom 249 were unionized) compared to 3,973 employees as of December 31, 2016, (2,616 were employed at our Mexico facilities, of whom 1,189 were unionized, 1,087 were employed at Republic facilities, of whom 927 were unionized and 270 were employed at our Brazil plant, of whom 198 were unionized).

 

The unionized employees in each of our Mexican facilities are affiliated with different unions. Salaries and benefits of our Mexican unionized employees are determined annually and biannually, respectively, through collective bargaining agreements. Set forth below is the union affiliation of the employees of each of our Mexican facilities and the expiration date of the current collective bargaining agreements.

 

  Guadalajara facilities: Sindicato de Trabajadores en la Industria Siderúrgica y Similares en el Estado de Jalisco. The contract expires on February 18, 2020.

 

  Mexicali facilities: Sindicato de Trabajadores de la Industria Procesadora y Comercialización de Metales de Baja California. The contract expires on January 15, 2020.

 

  Apizaco facilities: Sindicato Nacional de Trabajadores de Productos Metálicos, Similares y Conexos de la República Mexicana. The contract expires on January 15, 2020.

 

  Cholula facilities: Sindicato Industrial “Acción y Fuerza” de Trabajadores Metalúrgicos Fundidores, Mecánicos y Conexos CROM del Estado de Puebla. The contract expires on January 31, 2020.

  

  San Luis facilities: At the Aceros San Luis facility: Sindicato de Empresas adherido a la CTM, the contract expires on January 15, 2020; and at the Aceros DM facility: Sindicato de Trabajadores de la Industria Metal Mecánica, Similares y Conexos del Estado de San Luis Potosí CTM, the contract expires on January 23, 2020.

 

We have had good relations with the unions in our Mexican facilities. The collective bargaining agreements are renegotiated every two years, and wages are adjusted every year.

 

Republic is the only subsidiary of the Group which offers other benefits and pension plans to their employees. Benefit plans to employees with Republic are described below.

 

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Collective Bargaining Agreements

 

As of December 31, 2018, 81% of Republic’s workers are covered by a collective bargaining agreement with the United Steelworkers (USW) that expires on August 15, 2019.  The agreement renews all the provisions, understandings and agreements set forth in the January 1, 2012 Basic Labor Agreement. The extended agreement provides that the Company’s quarterly contributions to fund the Republic Retirement VEBA Benefit Trust (the “Benefit Trust”) be reduced from U.S.$2.6 million (Ps. 51 million) to U.S.$0.25 million (Ps. 5 million) beginning in August 15, 2016 through June 30, 2019. Effective July 1, 2019, the Company’s contribution to the Benefit Trust will change to U.S.$4.00 (Ps. 83) per hour for each hour worked by USW represented employees.

 

For the Mexican operations, approximately 44% of the employees are under collective bargaining agreements, which expire as described above.

 

For the Brazil operations, approximately 92% of the employees are under collective bargaining agreements, with Sindicato dos Metalúrgicos de Pindamonhangaba, Moreira César e Roseira afiliado a CUT, which expires on August 31, 2019 (plant in Pindamonhangaba) and Sindicato dos Trabalhadores nas Industrias Metalúrgicas, Mecânicas, de Material Elétrico e Eletrônico do Estado do Espirito Santo (plant in Cariacica), which expires on September 30, 2019.

 

Defined Contribution Plans

 

Steelworkers Pension Trust

 

Republic participates in the Steelworkers Pension Trust (SPT), a defined benefit multi-employer pension plan. While this plan provides defined benefits as a result of lack of information, the company accounts for the plan as a defined contribution plan. Specifically, the plan does not maintain accounting records for purposes of IFRS presentation and does not provide enough information to allocate amounts between participating employers’.

 

The company obligations to the plan are based upon fixed contribution requirements. The company contributes a fixed dollar amount of U.S.$1.68 (Ps. 33) per hour for each covered employee’s contributory hours, as defined under the plan.

 

Participation in a multi-employer pension plan agreed to under the terms of a collective bargaining agreement differs from a traditional qualified single employer defined benefit pension plan. The SPT shares risks associated with the plan in the following respects:

 

- Contributions to the SPT by the Company may be used to provide benefits to employees of other participating employers;

 

- If a participating employer stops contributing to the SPT, the unfunded obligations of the plan may be borne by the remaining participating employers; and

 

- If Republic chooses to stop participating in the SPT, the Company may be required to pay an amount based on the underfunded status of the plan, referred to as a withdrawal liability.

 

On March 21, 2011, the Board of Trustees of the SPT elected funding relief which has the effect of decreasing the amount of required minimum contributions in near-term years, but will increase the minimum funding requirements during later plan years. As a result of the election of funding relief, the SPT’s zone funding under the Pension Protection Act may be impacted.

 

In addition to the funding relief election, the Board of Trustees also elected a special amortization rule, which allows the SPT to separately amortize investment losses incurred during the SPT’s December 31, 2008 plan year-end over a 29 year period, whereas they were previously required to be amortized over a 15 year period.

 

Republic’s participation in the SPT for the annual periods ended December 31, 2018 and 2017, is outlined in the table below.

 

        Pension
Protection Act
Zone Status(a)
       

Republic Steel Contributions 

(U.S.$ in thousands) 

    Surcharge Imposed(c)      
Pension
Fund
  EIN/ Pension
Plan Number
  2018     2017     FIP/RP Status Pending/ Implemented(b)   2018     2017     2018     2017     Expiration of
Collective Bargaining
Agreement
                                                             
Steelworkers
Pension Trust
  23-6648508/499     Green       Green     No   $ 2,366     $ 2,467       No       No     August 15, 2019

  

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  (a) The zone status is based on information that Republic received from the plan and is certified by the plan’s actuary. Among other factors: plans in the green zone are at least 80% funded, plans in the yellow zone are less than 80% funded, and plans in the red zone are less than 65% funded.

 

  (b) Indicates if a financial improvement plan (FIP) or a rehabilitation plan (RP) is either pending or has been implemented.

 

  (c) Indicates whether there were charges to Republic from the plan.

 

 

Republic has not been listed in the plans’ Forms 5500 as providing more than five percent of the total contributions for any plan years.

 

There have been no significant changes that affect the comparability of 2018 and 2017 contributions.

 

VEBA Benefit Trust

 

Republic is required to make quarterly contributions to the VEBA Benefit Trust as determined by the terms of the USW collective bargaining agreement. The VEBA Benefit Trust is a health and welfare plan for USW retiree healthcare benefits, and is not a “qualified” plan under the regulations of the Employee Retirement Income Security Act of 1974 (ERISA). Under the terms of the extended collective bargaining agreement referred to above, the Benefit Trust contributions have been reduced from U.S.$2.6 million (Ps. 54 million) to U.S.$0.25 million (Ps. 5 million) million per quarter, effective August 16, 2016. For the years ended December 31, 2018 and 2017, the company recorded expenses of Ps. 19.2 million (U.S.$1 million) and Ps. 19 million (U.S.$1 million), respectively, related to the Benefit Trust.

 

Republic recorded combined expenses of Ps. 69.2 million (U.S.$3.6 million) and Ps. 66 million (U.S.$3.5 million) for the years ended December 31, 2018 and 2017, respectively, related to the funding obligations of the Benefit Trust and SPT.

 

401(k) Plans

 

Republic has a defined contribution 401(k) retirement plan that covers substantially all salaried and nonunion hourly employees. This plan is designed to provide retirement benefits through company contributions and voluntary deferrals of employees’ compensation. The company funds contributions to this plan each pay period based upon the participant’s age and service as of January first of each year. The amount of the company’s contribution is equal to the monthly base salary multiplied by the appropriate percentage based on age and years of service. The contribution becomes 100% vested upon completion of three years of vesting service. In addition, employees are permitted to make contributions into a 401(k) retirement plan through payroll deferrals. The company provides a 25.0% matching contribution for the first 5.0% of payroll that an employee elects to contribute. Employees are 100% vested in both their and the Company’s matching 401(k) contributions. For the years ended December 31, 2018 and 2017, the company recorded expense of Ps. 19.2 million (U.S.$1 million) and Ps. 15.1 million (U.S.$0.8 million), respectively, related to this defined contribution retirement plan.

 

Employees who are covered by the USW labor agreement are eligible to participate in the defined contribution 401(k) retirement plan through voluntary deferrals of employees’ compensation. There are no company contributions or employer matching contributions relating to these employees.

 

Profit Sharing Plans and Incentive Compensation Plans

 

The labor agreement includes a profit sharing plan to which Republic is required to contribute 2.5% of its quarterly pre-tax income, as defined in the labor agreement. At the end of each year, the contribution is based upon annual pre-tax income up to U.S.$50.0 million (Ps. 1,033 million) multiplied by 2.5%, U.S.$50.0 million (Ps. 1,033 million) to U,S.$100.0 million (Ps. 2,066 million) multiplied by 3.0%, and above U.S.$100.0 million (Ps. 2,066 million) multiplied by 3.5%, less the previous payouts during the year. An expense of Ps. 1.9 million (U.S. $0.1 million) was recorded during 2018 and no expense was recorded during 2017.

 

Republic has a profit sharing plan for all salaried and nonunion hourly employees. During 2012, the profit sharing plan was based upon achieving target Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) amounts, as these are defined within the plan. During 2018 and 2017, the profit sharing plan was based upon achieving certain inventory and shipment targets. During the years ended December 31, 2018 and 2017, Republic paid Ps. 15.4 million (U.S.$0.8 million) and Ps.17 million (U.S.$0.9 million), respectively, to employees covered by the profit sharing plans.

 

 

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E. Share Ownership

 

Industrias CH and its direct wholly-owned subsidiaries currently hold approximately 84% of our series B shares. At March 31, 2019, Rufino Vigil González, the chairman of our board of directors, owned, directly or indirectly, approximately 67% of the shares of Industrias CH.

 

Item 7.        Major Shareholders and Related Party Transactions

 

A. Major Shareholders

 

As of March 31, 2019, we had 465,766,156 shares of series B common stock outstanding. Based on information available to us, we believe that our officers and directors own no series B shares. Accordingly, on an individual basis, and as a group, our directors and executive officers beneficially owned less than one percent of any class of our shares. None of our directors or officers holds any options to purchase series B shares or preferred shares. Prior to June 2002, our capital stock also included series A shares. On June 5, 2002, we converted all of our series A shares to series B shares on a one-for-one basis.

 

Industrias CH and its direct wholly-owned subsidiaries currently hold approximately 84% of our series B shares. At March 31, 2019, Rufino Vigil González, the chairman of our board of directors, owned, directly or indirectly, approximately 67% of Industrias CH.

 

Our major shareholders do not have voting rights different from the rights of our other shareholders.

 

The following table shows the ownership of our series B shares as of March 31, 2019.

 

Name of Shareholder  

 

Number of shares
owned 

   

% of shares
owned 

             
Industrias CH, S.A.B. de C.V     275,369,337       55.3 %
Tuberías Procarsa, S.A. de C.V. (1)     99,461,866       20.0 %
Vigon Control, S.R.L. de C.V.(2)     31,048,736       6.2 %
Aceros y Laminados Sigosa, S.A. de C.V. (1)     4,377,776       0.9 %
Joist Estructuras S.A. de C.V. (2)     6,188,406       1.2 %
Industrial de Herramientas CH, S.A. de C.V. (2)     2,240,628       0.5 %
Public Investors     47,079,407       9.5 %
Treasury Shares     31,943,058       6.4 %
Total     497,709,214       100 %

 

  (1) A subsidiary of Industrias CH.
  (2) Companies directly or indirectly owned by members of the Vigil family.

 

At March 31, 2019, 465,766,156 series B common shares were held in Mexico by approximately 102 shareholders who were record holders in Mexico and 13 were ADS record holders in the United States. The ADS represent 2,249,058 common shares.

 

B. Related Party Transactions

 

We have engaged from time to time in a number of transactions with certain of our shareholders and companies that are owned or controlled, or are under common control, directly or indirectly, by our controlling shareholder, Industrias CH, S.A.B. de C.V., or its affiliates and/or the Vigil family. These transactions were made on terms that we believe were not less favorable than those obtainable on an arm’s length basis. See Note 18 to our consolidated financial statements included herein for additional information.

 

Loans to Related Parties

 

Our related party transactions include loans made to the following related parties: Perfiles Comerciales Sigosa, S.A. de C.V. (“Sigosa”), Industrias CH, S.A.B. de C.V. (“Industrias CH”), Proyectos Comerciales el Ninzi, S.A. de C.V. (“Ninzi”), Operadora Compañía Mexicana de Tubos S.A de C.V., Compañía Manufacturera de Tubos, S.A. de C.V. and Compañía Laminadora Vista Hermosa, S.A. de C.V.

 

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Sigosa Loan

 

In 2016, we entered into a loan arrangement with Sigosa, a subsidiary of Industrias CH. The purpose of the loan was to provide funding in connection with a strategic joint venture in the seam-welded tube business line between Tuberias Procarsa, S.A. de C.V. (“Procarsa”), a subsidiary of Industrias CH, and Quality Tube, S.A. de C.V. The funding was provided to Procarsa through a series of intercompany loans amongst subsidiaries of Industrias CH. The loan to Sigosa was memorialized under a current account agreement, dated as of November 30, 2016. The current account agreement provided that the term of the loan was indefinite, but could be terminated by either party upon 30 day’s written notice. In addition, the current account agreement provided that amounts advanced under the agreement would bear interest at the Interbank Interest Rate of Equilibrium (TIIE) (Tasa de Interés Interbancaria de Equilibrio) plus 1%, and that interest will accrue and be payable upon the final repayment and termination of the loan.

 

As of December 31, 2016, the total amount advanced under the Sigosa current account agreement was U.S. $32.9 million. In January 2017, the debt was converted into Mexican pesos at the exchange rate of Ps. 21.9076 for $1.00 USD, resulting in an outstanding balance of Ps. 721.4 million. As of December 31, 2017, the outstanding balance was Ps. 806.4 million, consisting of outstanding principal of Ps. 721.4, and accrued interest of Ps. 85.0 million (consisting of accrued interest of Ps. 24.6 million in 2016 and Ps. 60.4 million in 2017). As of December 31, 2018, the outstanding balance of the loan was Ps. 579.0 million, resulting from payments in the amount of Ps. 297.0 million during 2018, plus an adjustment of Ps. 4.0 million related to the conversion from U.S. dollars to pesos, plus accrued interest in 2018 of Ps. 65.6 million. In the event that Sigosa fails to repay the outstanding balance, it will be paid by Industrias CH.

 

Ninzi Loan

 

In August 2016, we entered into a loan arrangement with Proyectos Comerciales el Ninzi, S.A. de C.V., a subsidiary of Controladora VG, S.A. de C.V. (“CVG”) and an affiliate of the Company. CVG is a holding company that is 100% owned by the members of the Vigil family, and is controlled by Mr. Rufino Vigil, chairman of our board of directors. In 2016, we advanced net proceeds of Ps. 1,549.4 million to Ninzi to facilitate the acquisition of companies engaged in the seam-welded tube business line. As of December 31, 2016, the outstanding balance of the loan was Ps. 1,571.0 million, which included Ps. 18.9 million of accrued interest and Ps. 2.8 million of value added tax. As of December 31, 2017, the outstanding balance of the loan was Ps. 1,695.9 million, which included Ps. 124.9 million of accrued interest. As of December 31, 2018, the balance of the outstanding loan was Ps. 376.8 million, as a result of Ps. 1,455.1 million in loan payments made by Ninzi to the Company, offset by accrued interest of Ps. 136.0 million. Interest on this loan is charged at the Interbank Interest Rate of Equilibrium (TIIE) (Tasa de Interés Interbancaria de Equilibrio) plus 1%, and will accrue and become payable upon the final repayment and termination of the loan. While certain negotiations and due diligence of acquisitions were ongoing, Ninzi used the loan proceeds to purchase an aggregate amount of 29,007,216 shares of series B common stock in the Mexican open market. See “Item 16 E. Purchases of Equity Securities by the Issuer and Affiliated Purchasers” herein for further discussion. The value of the shares purchased by Ninzi increased, resulting in an unrealized gain of Ps. 125.3 million. After adding interest and taxes payable, Ninzi paid the Company Ps. 165.1 million in 2018 to provide us with the benefit of the unrealized gain. As of December 31, 2018, Ninzi did not own any series B common shares of the Company. In the event that Ninzi fails to repay the outstanding balance, it will be paid by either CVG or Mr. Rufino Vigil.

 

Other Loans to Related Parties

 

In 2017, we made two loans to Industrias CH. The first loan was for U.S. $21.4 million, and accrues interest at a rate of LIBOR plus 1%. The second loan was for Ps. 89.4 million, and accrues interest at a rate of TIIE plus 1%. Interest will accrue and be paid upon the final repayment and termination of the loans. In 2018, we made two additional loans to Industrias CH. The first loan was for U.S. $25.4 million, and accrues interest at a rate of LIBOR plus 1%. The second loan was for Ps. 186.7 million, and accrues interest at a rate of TIIE plus 1%. Interest will accrue and be paid upon the final repayment and termination of the loans.

 

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In 2018, the Company entered into a loan agreement with Operadora Compañía Mexicana de Tubos S.A de C.V. for U.S. $1.9 million. The principal balance accrued interest at a rate of LIBOR plus 1%. The outstanding principal and accrued interest on this loan was paid in full in May 2019.

 

In 2018, the Company entered into a loan agreement with Compañía Manufacturera de Tubos, S.A. de C.V. for U.S. $2.2 million. The principal balance accrued interest at a rate of LIBOR plus 1%. The outstanding principal and accrued interest on this loan was paid in full in May 2019.

 

In 2018, the Company entered into a loan agreement with Compañía Laminadora Vista Hermosa, S.A. of C.V. for U.S. $9.3 million. The principal balance accrued interest at a rate of LIBOR plus 1%. The outstanding principal and accrued interest on this loan was paid in in full in May 2019.

 

Loans from Related Parties

 

We have also received loans from related parties for the purpose of financing acquisitions, debt redemptions, and bank loan amortization and interest payments. These related party transactions include loans received from the following related parties: Industrias CH, S.A.B. de C.V., Tuberias Procarsa, S.A. de C.V., Procarsa Tube and Pipe Co. and Pytsa Industrial de México, S.A. de C.V. These loans were primarily received in U.S. dollars, in an aggregate amount of approximately U.S. $50.0 million. The term of the loans was indefinite and they all accrued interest at a rate of 0.25% per annum. As of December 31, 2017, the outstanding balances of the loans (translated to pesos) were as follows: Industrias CH, S.A.B. de C.V. in the amount of Ps. 226.8 million, Tuberias Procarsa, S.A. de C.V. in the amount of Ps. 591.8 million, Procarsa Tube and Pipe Co. in the amount of Ps. 59.6 million and Pytsa Industrial de México, S.A. de C.V. in the amount of Ps. 102.6 million. As of December 31, 2018, all outstanding loan balances and accrued interest were paid in full, and we had no outstanding loans from related parties.

 

Purchases and Sales

 

From time to time, we purchase and/or sell steel products, primarily “billet,” to Industrias CH and its affiliates. In 2016, 2017 and 2018 such purchases totaled Ps. 324 million, Ps. 52 million and Ps. 373 million, respectively. In addition, in 2016, 2017 and 2018 we sold Ps. 5 million, Ps. 4 million and Ps. 20 million of steel products to Industrias CH and its affiliates, respectively. We believe that terms of these transactions were not less favorable than terms that would be available on an arms-length basis.

 

As of December 31, 2018, we have accounts receivable corresponding to the following related parties: Industrias CH, S.A.B. de C.V. in the amount of Ps. 648.3. million, Operadora Construalco, S.A. de C.V. in the amount of Ps. 548,000, Operadora Industrial de Herramientas, S.A. de C.V. in the amount of Ps. 912,000, Joist del Golfo, S.A. de C.V. in the amount of Ps. 6.5 million, Compania Laminadora Vista Hermosa, S.A. de C.V. in the amount of Ps. 360,000, Perfiles Comerciales Sigosa, S.A. de C.V. in the amount of Ps. 1.6 million, and other related parties in the amount of Ps. 5.8 million. The account receivable with Industrias CH, S.A.B. de C.V. corresponds to ISR (Impuesto sobre la renta, or income taxes) balances recoverable from certain subsidiaries that until 2013 were consolidated for tax purposes. The other receivable balances correspond to sales of finished products.

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As of December 31, 2018, we have accounts payable corresponding to the purchase of finished products from the following related parties: Aceros y Laminados Sigosa, S.A. de C.V. in the amount of Ps. 1.9 million, Industrias CH in the amount of Ps. 205.9 million, Operadora de Perfiles Sigosa, S.A. de C.V. in the amount of Ps. 112.6 million, Operadora Pytsa Industrial, S.A. de C.V. in the amount of Ps. 5.2 million, Tuberías Procarsa, S.A. de C.V. in the amount of Ps. 1.9 million, Compania Manufacurera de Tubos, S.A. de C.V. in the amount of Ps. 6.2 million, and other related parties in the amount of Ps. 924.000.

 

Service Agreements

 

We have service agreements with Industrias CH and certain of its affiliates, pursuant to which Industrias CH and its affiliates provide administrative, business, financial and legal services to us and our subsidiaries. The term of the service agreements are indefinite. We make payments to Industrias CH on a monthly basis. Under the service agreement, in 2016, 2017 and 2018 we paid Ps. 24 million, Ps. 26 million and Ps. 23 million, respectively, to Industrias CH. In August 2016, we entered into a service agreement with Proyectos Comerciales el Ninzi, S.A. de C.V, pursuant to which we provided due diligence services to Ninzi related to potential acquisitions, at no cost to Ninzi.

 

C. Interests of Experts and Counsel

 

Not applicable.

 

Item 8.       Financial Information

 

A. Consolidated Statements and Other Financial Information

 

See Item 18. “Financial Statements” and “Index to Financial Statements.”

 

Legal Proceedings

 

Mexico

 

On January 19, 2017, we received a letter issued by the General Director of Crimes and Sanctions of the Comisión Nacional Bancaria y de Valores (National Banking and Securities Commission) (the “CNBV”), notifying us that certain actions in connection with the repurchase of our own shares could be contrary to the provisions of the Ley del Mercado de Valores (Securities Market Law) (the “LMV”). In December 2017, the General Direction of Crimes and Sanctions of the CNBV fined the Company with the amount of Ps. 545,000. Grupo Simec appealed for reconsideration before the CNBV itself, which was favorable to Grupo Simec in 2018, and the fine was left without effect.

 

During 2018, the Company and certain of its subsidiaries were subject to audits by the Mexican tax authorities for the years 2013 to 2017, resulting in a demand by such tax authorities of a further payment of approximately Ps. 5,900 million. We are contesting such additional amounts in the Mexican courts, and to the date of this report the payment of these additional amounts has not been enforced.

 

The tax authorities in Mexico have the right to review the previous five years and could determine differences in taxes payable, plus corresponding adjustments, interest and fines.

 

United States and Canada

 

On February 13, 2017, the Securities and Exchange Commission (the “SEC”) notified us that the SEC was conducting an informal, and non-public, inquiry into the Company in connection with our internal controls. After cooperating with the SEC, we settled certain internal controls charges with the SEC on January 29, 2019. We agreed to retain an independent consultant to remediate our material weaknesses and to pay a civil monetary penalty in the amount of US$200,000.

 

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In connection with a sales and use tax audit by the Ohio Department of Taxation covering the period from January 1, 2009 through December 31, 2012, an assessment of U.S.$2.4 million (Ps. 47.4 million) (including interest of $0.4 million, Ps. 7.9 million) was issued against Republic on December 9, 2016. The Company disagrees with the assessment in its entirety and has filed a Petition for Reassessment on January 30, 2017, appealing the assessment with the Ohio Board of Tax Appeals. The Company's position is that the assessment that certain services were taxable is substantively incorrect, and based upon a misinterpretation of the relevant regulations and a misunderstanding of the facts that led the Company to determine that the services qualified for Ohio’s sales and use tax exemption for manufacturers. Due to the nature of this matter and its early stages, the Company is unable to determine the amount of loss, if any, it may sustain.  Accordingly, the Company has not recorded an expense in fiscal 2018 or 2017 recognizing the assessment or any estimated settlement amount.

 

The tax authorities in the United States have the right to review the previous three years and could determine differences in taxes payable, plus corresponding adjustments, surcharges and fines.

 

The tax authorities in Canada have the right to review the previous four years and could determine differences in taxes payable, plus corresponding adjustments, surcharges and fines.

 

Our operations in the United States and Canada have been the subject of various environmental claims, including those described below. The resolution of any claims against us may result in significant liabilities.

 

California Department of Toxic Substances Control, DTSC

 

In September 2002, the Department of Toxic Substances Control (DTSC) inspected Pacific Steel’s (PS) facilities based on an alleged complaint from neighbors due to PS’s excavating to recover scrap metal on its property and on a neighbor’s property, which PS rents from a third party (BNSF Railway). In this same month, DTSC issued an enforcement order of imminent and substantial endangerment determination, which alleges that certain soil piles, soil management and metal recovery operations may cause an imminent and substantial danger to human health and the environment. Consequently, DTSC sanctioned PS for violating the Hazardous Waste Control Laws in the State of California and imposed an obligation to make necessary changes to the location. On July 26, 2004, DTSC filed a Complaint for Civil Penalties and Injunctive Relief against PS in San Diego Superior Court. On July 26, 2004, the court issued a judgment, whereby PS was obligated to pay U.S.$235,000 (Ps. 5 million). This payment was made by PS in 2004 and 2005.

 

On June 6, 2010 the DTSC and the San Diego Department of Environmental Health (DEH) inspected the facilities of PS, in response to a general complaint. On August 10, 2010 DTSC and DEH conducted a second inspection and found seven infractions. The DEH was satisfied with the compliance of PS on those issues. On October 19, 2010 the technical division of the DTSC recommended to the enforcement division of DTSC that it impose significant penalties upon PS as a result of such infractions. As of December 31, 2018, PS is awaiting a final decision from DTSC.

 

The land remediation was suspended at the beginning of 2011 due to the inefficiency of the process, which was verified by several studies. As an alternative, once the necessary permits were obtained from the authorities in Mexico, in November 2011, the Mexicali plant began the process of importing raw soil for final disposal in a secure landfill based in Nuevo León, once the metal content was separated, which metal content is used as raw material in the smelting process.

 

The disposition of a stack estimated at 8,000 tons of material classified RCRA (hazardous for Federal purposes) was also considered for shipment to Mexico. The process began in early 2013, but to date they have not granted permits.

 

Therefore, on April 9, 2015, a letter from the California Attorney General Department of Justice (Attorney General) was received pursuant to which PS was required, in the absence of obtaining permission from the Mexican authorities, to present a program for transporting the pile of contaminated soil classified as RCRA to an authorized confinement in the United States at the latest on April 22, 2015. This letter warned that PS must ship the stack no later than July 9, 2015, or risk DTSC proceeding with a civil lawsuit seeking the maximum amount of fines established by law and corresponding legal redress.

 

On April 21, 2015, PS sent a letter to the Attorney General explaining that the authorities in Mexico had not denied permission to the Company but had simply requested that it present its application in a different format, which had already been presented and reviewed by the authority on April 17, 2015.

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On July 23, 2015, the Attorney General denied the extension requested by PS and demanded the immediate shipment of the RCRA stack to an authorized landfill. PS began transporting the RCRA soil on July, 29, 2015, and completed removal of the RCRA stack by September 12, 2015 with a total of 3,000 metric tons.

 

 On January 5, 2016, the Attorney General and PS filed a "final judgment and order on consent" or Consent Judgment in San Diego Superior Court. The parties negotiated the Consent Judgment, which includes the following terms:

 

  PS must pay US$ 138,000 as a civil penalty for alleged violations of the 2004 Corrective Action Consent Agreement.  PS has made all of the required payments to DTSC as of December 31, 2018.

 

  PS agreed to remove the RCRA stack and send it to an approved landfill. The Judgment indicates that the Company complied with this commitment by October 2, 2015.

 

  After removing the RCRA stack, the Company must take samples of the soil in the area where the stack of land was located. Samples were taken and the results indicate that the soil had pollution levels which, although not equal to those of the RCRA stack, exceed the limits set by the State of California. On April 7, 2016, the Attorney General and DTSC demanded that the Company remove the soil 10 feet across and 2 feet deep on the perimeter of the area where the stack of RCRA land was located and dispose of it in an approved confinement. On August 5, 2016, DTSC informed PS that it did not need to remove the soil in the vicinity of the former RCRA stack that exceeds California hazardous waste standards.  Instead, PS and DTSC entered into a Tolling Agreement on August 10, 2016, which tolls for two years (until August 10, 2018) the statute of limitations for DTSC to challenge PS’s compliance with the Consent Judgment.  This Agreement was extended in August 10, 2018, for an additional period of two years, effective December 2018 and ending August 10, 2020.

 

  PS shall continue to meet the conditions of the final judgment, the corrective measures, and all tasks arising therefrom, which were entered in the same court in 2004. PS is working to develop a “corrective measures study” (CMS) that is intended to develop a plan for determining what remedy will be implemented at the site.  As of December 31, 2018, it is not yet clear what the appropriate remedy will be, when the CMS will be completed, how long remediation will take, and how much it will cost.

 

Environmental Liabilities

 

As is the case with most steel producers in the United States, we could incur significant costs related to environmental compliance activities and remediation stemming from historical waste management practices or other environmental issues at Republic’s facilities. At December 31, 2018 and 2017, we had a reserve to cover probable environmental liabilities totaling Ps. 51.1 million (U.S.$2.6 million) and Ps. 53.3 million (U.S.$2.7 million), respectively. The reserve includes incremental direct costs of remediation efforts and post remediation monitoring costs that are expected to be included after corrective actions are complete. As of December 31, 2018, the current and non-current portions, Ps. 19.7 million (U.S.$1 million) and Ps. 31.5 million (U.S.$1.6 million), respectively, of the environmental reserve are included in other accrued liabilities and accrued environmental liabilities, respectively, in the accompanying consolidated statement of financial position. The company is not otherwise aware of any material environmental remediation liabilities or contingent liabilities relating to environmental matters with respect to the Republic’s facilities for which the establishment of an additional reserve would be necessary at this time. To the extent the company incurs any such additional future costs, these costs will most likely be incurred over a number of years. However, future regulatory action regarding historical waste management practices at the company’s facilities and future changes in applicable laws and regulations may require the company to incur significant costs that may have a material adverse effect on the company’s future financial performance.

 

Brasil

 

On September 5, 2017, Grupo Simec and GV do Brasil were notified of an arbitration procedure brought by SMS Concast before the International Court of Arbitration (ICC), in which the payment of US$1.4 million is requested (Ps.27.6 million), plus additional expenses, for additional costs incurred in the construction and assembly of the steel plant area in Brazil. On November 6, 2017, the Company filed a response, suing SMS Concast for various items that amount to US$5 million (approximately Ps. 98.3 million) approximately. The panel of arbitrators is already constituted and the resolution of the matter is in process.

 

The tax authorities in Brasil have the right to review the previous five years and could determine differences in taxes payable, plus corresponding adjustments, surcharges and fines.

 

 

 

90 

 

B. Significant Changes

 

None

 

 

Item 9.      The Offer and Listing

 

Our series B shares are listed on the Mexican Stock Exchange, and the ADSs are listed on the New York Stock Exchange. On February 20, 2003, we effected a 1 for 20 reverse stock split. On May 30, 2006, we effected a 3 for 1 stock split. To maintain trading prices in the United States, the ADS to share ratio was simultaneously adjusted from one ADS representing one series B share to one ADS representing three Series B shares. The ADSs are evidenced by American depositary receipts, or “ADRs,” issued by The Bank of New York as depositary under a Deposit Agreement, dated as of July 8, 1993, as amended, among us, the depositary and the holders from time to time of ADRs.

 

Share Price Information

 

The following table sets forth for the periods indicated the high and low share prices expressed in historical pesos of our series B shares on the Mexican Stock Exchange, and the high and low sales price expressed in U.S. dollars of the ADSs on the New York Stock Exchange

 

 

   

Mexican Stock Exchange