Originally published in TDV in September 2019
Fortuna Silver Mines (FSM, TSX:FVI) is one of the junior producers we hold in our TDV Long-Term
Stock Portfolio. We didn’t include it in our silver share portfolio because the company has up until now at least been transitioning increasingly into a gold producer with the start up of its gold mine in Argentina.
Presently the company owns and operates the Caylloma mine in Peru and the San Jose mine in Mexico.
In the most recent quarter, FSM reported net income of US$10.3 million (Q2 2018: $11.2 million) and operating cash flow of US$24 million (Q2 2018: $21.9 million) on production of 2.39 million silver ounces and 13,204 gold ounces (Q2 2018: 2.32 million silver ounces and 14,422 gold ounces).
Both mines have a 5-year mine life based just on reserves, and the company has always managed to convert enough resources into reserves in the past, an indication that they have a long life ahead.
In 2016, Fortuna acquired 100% control of the Lindero gold project in Argentina, then at the Feasibility stage.
Since then, it has optimised the Feasibility, made a construction decision, and proceeded to actually build the mine with minimal shareholder dilution - a rare feat in what has been a brutal bear market for gold miners.
It is no exaggeration to say that this is one management team that ranks among the best in this business!
As of Q2, Lindero’s construction was 57% complete, with mine production slated to start by August.
When, Suddenly!
The construction of the crushing and leach pad facilities was progressing according to schedule, and over 70% of the initial capex had been spent. All good. But then the politics in Argentina took an unexpected turn for the worst. Argentina has a presidential election coming up next month, and the incumbent candidate Mauricio Macri has been trounced in the primaries. When he was elected back in 2015, he was hailed by investors for being more market oriented. Argentina’s government was then technically in default on its international debt.
Not only did he clean that up by settling with the creditors, he removed capital controls and liberalised the economy. His actions improved Argentina's image on the global front, making it a hot market for foreign investors. So hot, in fact, that a country that had been in default on its debt for over 15 years, and spent much of the last century tottering from one economic/currency crisis to another, issued 100 year bonds!
Chart: USD/ARS exchange rate
As you can guess, things didn't pan out the way investors expected.
Argentina's currency is in freefall, and its central bank, the primary culprit, has imposed capital controls.
Institutions are now required to obtain authorization from the central bank to purchase foreign currency or distribute dividends abroad while exporters have to repatriate their foreign currency earnings within 5 days.
According to Bloomberg,
"The re-imposition of currency controls will be an embarrassment for President Mauricio Macri, who came to office over three years ago pledging to free up the economy after years of state intervention... Now, faced with an electoral defeat in October, Macri has given up trying to restore investor confidence and has instead resorted to the policies he had criticized his predecessors for imposing. As well as pushing back maturities on local short-term debt on Aug. 28, Argentina also said it will ask holders of $50 billion of longer-term debt to accept a “voluntary reprofiling.” It also plans to renegotiate payments on $44 bln it has borrowed from the International Monetary Fund."
In other words, Argentina is technically in default again, and absent some sort of IMF/US Treasury bail-out, the Argentine peso is headed towards its inevitable doom, taking foreign investors' capital with it.
The Politics Ahead
Fortuna's Argentinian subsidiary (Mansfield Minera S.A.) is the direct owner of the Lindero mine, and will be subject to the new rules. 98% of construction capital had already been committed by June, so there would be no cost benefit from the depreciating peso. And unless Macri comes up with a plan, and soon, capital controls will merely be the first step. The political game to leverage the crisis will follow as the economy collapses.
The signs are already there. According to one Spanish newspaper, rival candidate Fernández has added open hostility to foreign capital as part of his campaign agenda:
"On tour in Madrid, the candidate of the Frente de Todos Alberto Fernández said today that it made no sense to have oil if international companies take it, suggesting that a future government of him would not be friendly with foreign investors. "It makes no sense to have oil if to extract it you have to let the multinationals come and take it away," he said after a speech in the Spanish parliament, according to Reuters."
There is a very real chance that Fernández will get elected.
He received 47% of the vote in the primaries, with Macri getting only 32%. To win outright, a candidate must get at least 45% of the vote, or 40% while leading an opponent by at least 10 percentage points. If the primaries are any indication, it is highly likely Fernández will win. The voting happens on October 27.
Argentina has a history of nationalizing foreign-owned assets. The resource industry is easy pickings - once a mine is built, you can't move it. In a worst case scenario, even if Lindero becomes a profitable producer, its earnings are stuck within Argentina in a depreciating peso, eventually becoming worthless, or the mine gets nationalized outright. The risk is that Fortuna's entire investment in Lindero becomes worthless.
That’s not to say the worst case scenario will play out, or that the current regime will lose the election.
Impact on the Company
If they do happen the company could write off its entire $177 million value (or part of it) carried on its balance sheet at the moment, reducing its total assets to $646 million, and its equity to $440 million in the worst case.
But that would still leave it with an industry normal debt/equity ratio and a below average market multiple of book value. In our net asset valuation we assumed production through to 2025 at current operations and a 10% annualized cost escalation to arrive at a hard value of US $3.59 per share at $20 silver and about $5.31 at $25 silver for all of the company’s assets. It is currently trading at the low end of that range, so you could say the shares are priced for $20 silver. This is a conservative valuation not just because we are more bullish on silver prices but also in the sense that it ignores the company’s inferred resource base and its ability to convert those resources into reserves, and also that at peak cycle, most miners tend to trade at twice their NAV5’s.
Excluding Lindero’s $253 million NAV, our NAV valuation for Fortuna drops to a range between $2 and $4 per share. However, just based on its two operating mines, and assuming silver prices of $17 this year, $22 in 2020, and $25 in 2021, and with no large development projects on the horizon to eat up cash flow, we are forecasting operating cash flows of roughly $92.2 million, $130.6 million, and $150.4 million respectively for the years 2019, 2020, and 2021. On a per share basis that works out to around 58 cents per share (USD), 82 cents, and 94 cents. The shares are therefore trading at forward price to cash flow ratios of less than 5 times next year’s and the year after’s cash flow estimates. But that also assumes relatively conservative silver prices.
Recall we are looking for silver to hit $25 a lot sooner given our fair market value at $27 (see the silver share report issued August 5th). The valuation is not excessive but there is room for the shares to drop if our fears come alive in Argentina. Moreover, on the operations front, mine production at Lindero was supposed to begin in August. Nine days into September there has been no update from the company, perhaps an indicator that something has gone wrong. Could it be the effect of the capital controls? Is there major trouble brewing that we investors haven't been alerted to? To top it off, there was a fatality at its San Jose mine in Mexico on August 19th and the company has yet to provide details on how it happened. Is San Jose production going to be affected? The lack of updates from the company is unsettling. So we felt that we should alert you to it.
How to Hedge This Risk
Even without growth from Lindero, Fortuna’s valuation isn’t that bad. That alone makes it a compelling long-term hold. As we have said, however, it has a strong management team. We believe regardless of what happens in Argentina, even if it is bad, this group will direct the company towards new wealth somewhere as the bull market in precious metals picks up momentum. However, there is the possibility of a near-term correction, as long as there is election uncertainty. Hence, we recommend a hedge strategy as follows:
>> Buy FSM 18 October 2019 $4 Put at 65 cents (US) or better.
Using Friday's close of $3.69, the put is in-the-money by 31 cents, which means you pay 34 cents in premium to insure each share of Fortuna in your long-term holding. That’s a worst case cost of around 10% from here.