Analysis of Management Results

ceo report on 2016 results

Sales, Earnings and Gross Margins

Sales were practically unchanged from 2015. Consolidated sales increased by only 1% for the year. While the 19% depreciation of the Mexican peso relative to the US dollar helped to increase the peso amount of revenues from the sale of products which we sell in dollars, the decline in our dollar sales prices was greater than the peso devaluation, so we have yet to emerge from the deflationary process that got underway in 2015. The weakness of industrial activity in Brazil adversely affected our sales because industrial activity is the main driver of our business in Brazil. In Mexico, illiquidity in the oil and gas sector has reduced the payment capacity of participants in that industry. For that reason we have prioritized risk reduction and protecting working capital in that sector, something that has lowered our sales to oil and gas companies. It is important to mention that oil and gas constituted our main market, along with mining, up until 2016. Unfortunately, these sectors have seen a major reduction in activity, and, as a result, in their need for inputs.

Gross profit decreased by 3%, falling from Ps 1.11 billion pesos in 2015 to Ps 1.08 billion, primarily due to the negative effects on the sales margin in Brazil.
Our gross margin narrowed 70 basis points (bp) to 17.5% primarily due to the effect of the Brazilian currency revaluation. Our gross margin in Brazil fell 250bp in 2016. Over the course of the year the Brazilian real revalued 19% in relation to the US dollar from 4.04 reais at the beginning of the year to 3.26 at the end of December 2016. This revaluation’s adversely pressured our gross margin in Brazil as inventories that were purchased at higher exchange rates had to be sold at lower exchange rates. Should t the Brazilian exchange rate remain at current levels, we would expect our Brazil gross margin to gradually recover to its historical highs.

2015		2016
18.2%	Gross margin	17.5%

Operating income and EBITDA

Operating income decreased 48% in 2016, falling from Ps 223 million in 2015 to Ps 116 million. Operating margin was 1.9%, which was 180 basis points lower than in 2015. The weak performance of Brazil, which recorded an operating loss for 2016, was the main cause of the decline in our consolidated operating income. Operating income was off by 48% for the full year. EBITDA decreased 27% compared to 2015 while EBITDA margin fell 160 basis points to 4.0%.
Operating expenses (excluding depreciation) increased 8% compared to 2015. Expenses as a percentage of sales increased from 12.6% in 2015 to 13.5% in 2016. The main impact was generated by inflation in Brazil as a considerable part of expenses in the Brazilian economy are indexed and, as a result, are driven higher by inflation. Similarly, the 45% year on year revaluation of the real against the peso, which took the Mexican currency from 4.36 to 6.33 pesos per real, raised by the same percent expenses in Brazil when we convert our results to pesos. Unfortunately, sales in Brazil have undergone a contraction, thereby accentuating the effect of both of these variables on expenses as a percentage of sales.

During 2016 we incurred Ps 32 million in extraordinary / non-recurring expenses. Excluding these expenses, the percentage of expenses to sales would have been 12.9% for the year. The items registered as part of our non-recurring expenses included the following:


Labor fraud backed by the government of Quintana Roo state:	$6mdp
Labor fraud in Monterrey, Nuevo Leon:	$4mdp
Layoffs in Mexico:	$6mdp
Layoffs in Brazil:	$2mdp
Due diligence for contemplating possible acquisitions:	$6mdp

2015		2016
12.6%	Expenses / Sales	13.5%

Financial expense
and net income

Net interest expense decreased 18% year on year during 2016. Bank debt at the end of 2016 totaled Ps 873 million, 7% lower than in 2015. Interest expense will be greater during 2017 as interest rates have risen in Mexico. To be more specific, between December 2015 and the end of 1Q17, Banco de México raised its reference lending rate by 325 bp.

Pochteca registered a Ps 6 million net loss after having posted a Ps 34 million net profit in 2015. The 48% decline in operating income was the main factor underpinning the net loss for the year. The negative impact of the drop in operating income offset the benefits of reduced expenses and foreign exchange losses in 2016 (the latter was 47% less than the Ps 94 million forex loss of 2015).

Net debt and leverage metrics

Net debt at the end of 2016 totaled Ps 728 million, 31% or Ps 174 million greater than at the end of 2015. The revaluation of the Brazilian real relative to the Mexican peso was responsible for part of the increase in our net debt, which we report in pesos.
- During 2016, Coremal’s net debt increased 7% in reais, rising from 46.8 million to 49.9 million.
- The peso/real exchange rate depreciated 45% during that same period from 4.36 to 6.33 pesos per real.
- As a result of that movement, Coremal’s net debt increased 55% in pesos climbing from Ps 204 million to PS 316 million.
- In addition, during 2016 we amortized bank debt in Mexico for Ps 140 million.

Net Debt to EBITDA increased to 2.9 times in 2016 from 1.6 times at the end of 2015.

The most recent level is above our internal policy of not surpassing 2 times and is the result of EBITDA being weaker than we had anticipated as well as an increase in Coremal debt as expressed in pesos in response to the revaluation of the Brazilian currency. We are confident that the combination of the reduction in expenses achieved through corporate restructuring, the gradual recovery in Brazil, and the absence of the non recurring expenses incurred in 2016 will allow EBITDA to recover to levels better than those of 2015, and that this metric will return to our target range levels.

In 2016 interest coverage (EBITDA / interest) was 2.6 times. This indicator is below the 2015 level of 3.0 times.

We will remain focused on cash flow generation by means of a strict management of working capital, as well as the cost and expense controls necessary for strengthening EBITDA.

	2016	2015
Gross debt (Ps million)	873	290
Net debt (Ps million)	728	554
Net debt / EBITDA 12 M	2.9x	1.6x
Interest coverage	2.6x	3.0x
Outstanding shares	130,522,049	130,522,049

Corporate restructuring

G4-34

During 2016 we modified the company’s corporate structure to lower its operating expenses and more efficiently align the commercial area with that of operations.

We made the following management changes:

1. Francisco Martínez, who was Director of Sales and Branches and who has been at Pochteca for more than 10 years, was appointed Operations Director.

2. Eugenio Floresgómez, formerly Director of the Chemicals Division and who has more than six years’ experience in the company, took over the position of Director of Sales and Branches.

3. Carlos Cepeda, who has been with Pochteca for seven years, became Director of Product Segments (excluding Paper and Lubricants) a newly created position. He was previously Director of the Food Chemicals Division.

4. Silvio Zapata, who was Director of Lubricants for Latin America, assumed the responsibility for the entire Lubricants division, including Mexico and Latin America, which were merged. He has worked at the Company for six years.

5. We merged the IT and the Business Intelligence departments. Ricardo Orozco, who has been with Pochteca for four years, was appointed Director of IT & Business Intelligence.