In an earlier article, we discussed one of the most important metrics to analyze the silver industry, the actual cost of mining an ounce of silver, which can help an investor figure out whether it is time to buy SLV and/or the silver miners. In that analysis, we used the FY2012 financials to calculate the combined results of publicly traded silver companies and come up with a true all-in industry average cost of production to mine each ounce of silver.
In this analysis we will calculate the real costs of production of Fortuna Silver Mines (FSM), which is new to our all-in costs list. FSM is a junior silver miner with two producing mines in Mexico and Peru, and the company is led by CEO Jorge A. Ganoza.
Calculating the True Mining Cost of Silver - Our Methodology
In the previously mentioned article, we gave a thorough overview of the current way mining companies report their costs of production and why it is inaccurate and significantly underestimates total costs. Then we presented a more accurate methodology for investors to use to calculate the true costs of mining gold or silver. Please refer to that article for the details explaining this methodology, and I would encourage all precious metals investors to understand this concept.
Calculating the True Mining Cost of Silver - Our Methodology
In the previously mentioned article, we gave a thorough overview of the current way mining companies report their costs of production and why it is inaccurate and significantly underestimates total costs. Then we presented a more accurate methodology for investors to use to calculate the true costs of mining gold or silver. Please refer to that article for the details explaining this methodology, which is an important concept for all precious metals investors to understand.
Explanation of Our Metrics
Cost Per Silver-Equivalent Ounce - is the costs incurred for every payable silver-equivalent ounce. It is Revenues minus Net Income, which will give an investor total costs. We use payable silver and not produced silver, because payable silver is the silver that the miner actually keeps and is more reflective of their production. Miners also use payable silver and not produced silver when calculating their cash costs, so this is pretty standard.
We then add Derivative Gains (or minus Derivative Losses), which will give investors total costs without the effects of derivatives. Finally, we add Foreign Exchange Gains (or minus Foreign Exchange Losses) to remove the effects of foreign exchange on the company's costs.
Cost Per Silver-Equivalent Ounce Excluding Write-downs - is the above-mentioned "Cost per silver-equivalent ounce" minus Property/Investment Write-downs and Asset Sales. This provides investors with a metric that removes exceptional gains or losses due to write-downs and asset sales.
Cost Per Silver-Equivalent Ounce Excluding Write-downs and Adding Smelting and Refining Costs - is the above-mentioned "Cost per silver-equivalent ounce excluding write-downs" adding in smelting, refining and all other necessary pre-revenue costs. This is a new metric that we are now introducing to our true all-in cost series because it will more accurately measure all-in costs and allow comparisons between miners.
Most investors are unaware that many miners will remove smelting, refining, and other costs before reporting their total revenues figures and these pre-revenue costs are not reported in the income statement. The result of this is that it skews all-in costs higher for miners that refine themselves or include the costs in their income statement, while inaccurately showing lower costs for miners that remove it before reporting revenues.
A simple test can be done on any miner to see if there are any pre-revenue costs that are not reported in the income statement. Simply take payable production and multiply it by average realized sales price and this should come relatively close to the total revenues figure. If it gives you a number much higher than reported revenues then there are pre-revenue costs that are not being reported.
This line should alleviate these issues and allow comparisons on a fair basis.
Tax Calculations - Since we are removing Derivative Gains/Losses, Foreign Exchange Gains/Losses, and Write-downs we have to estimate the approximate tax benefit loss based on this removal - otherwise we would be removing a gain/loss but not removing the associated benefit/loss associated with the taxes related to that gain. We use a 30% base tax rate for these calculations, but investors can use whatever tax rate they feel most comfortable with.
For example, if a company reports a $100 million dollar write-down, we will remove $100 million from its total costs (removing the effect of the write-down) and then add $30 million to costs (30% * $100 million) to represent the estimated tax benefit that the company gained from this write-down. You must do this if you want to remove any item from the income statement, otherwise you will be using taxes based on a removed income statement item.
Real Costs of Production for FSM - Q2FY13
Let us now use this methodology to take a look at FSM's results and come up with their average cost figures. When applying the methodology for the most recent quarter and FY2012, we standardized the equivalent ounce conversion to use the average LBMA price for Q2FY13. This results in a silver-to-gold ratio of 61.2:1, a lead-to-silver ratio of 24.8:1, and a zinc-to-silver ratio of 27.8:1, and a copper-to-silver ratio of 7.1:1. Investors should remember that our conversions change with metal prices and this will influence the total equivalent ounces produced for past quarters - which will make current-to-past quarter comparisons much more relevant.
Observations for Investors
True Cost Figures - FSM's true all-in cost figures for Q2FY13 was $20.38 per silver-equivalent ounce, which was an improvement when compared to Q1FY13 costs ($22.32) but was a little higher than the average costs of $19.86 experienced during FY2012. Investors should note that taxes for Q2FY13 were -$4.1 million dollars (i.e. a tax benefit) while previous quarters had significantly higher taxes, so the all-in costs experienced in Q2FY13 were significantly affected by these factors. With a normalized tax rate we would expect FSM's Q2FY13 costs to be in the $22 - $24 range.
Compared to other primary silver producers we have analyzed, FSM's Q2FY13 costs were fairly good and compare to competitors such as Pan-American Silver (PAAS) (costs over $25), Endeavour Silver (EXK) (costs over $25), Hecla Mining (HL) (costs over $22), Great Panther Silver (GPL) (costs over $25), Alexco Silver (AXU) (costs over $30), Coeur D'Alene Mines (CDE) (costs just over $30), Silver Standard Resources (SSRI) (costs over $25), and cost leader First Majestic (AG) (costs under $20). FSM's costs were below most of these competitors and were clearly in the lower tier of primary silver producers.
Corporate Liquidity - Liquidity is very important for investors to monitor in this current silver environment, especially for producers that have higher true all-in costs and negative earnings. As of Q2FY13, FSM reported around $43.7 million in cash and cash equivalents, $4.7 million in short-term investments, and had no outstanding debt. Since their all-in costs are fairly low, FSM has a very strong cash position and it does not seem there are any liquidity concerns with the company.
One Thing to Note for Investors
There has been a bit of controversy over the company's Mexican operations over the murder of an anti-mining activist, which the company denies. We have no position on this particular issue but if it is found that the company was involved obviously this would be detrimental to its Mexican operations. More importantly, we would never want to be involved with any company that engages in violent operations to further its own economic interests. But we also want to remember the important concept that people and companies are innocent until proven guilty. At this point we are not sure about the details of this investigation, but it is definitely worth noting.
Conclusion for Investors
Fortuna Silver Mines is in the upper-tier primary silver producers with low true all-in costs of production, and the company has successfully contained the rise in costs that have plagued the mining sector. In addition, their liquidity is very strong with a debt-free balance sheet so there are no cash concerns about FSM. There are some political developments in Mexico that investors should monitor on both a specific company basis (the murder case) and on a general basis (rising mining taxes in Mexico). But in terms of low-cost producers FSM ranks very good in true all-in costs and investors looking for a low-cost primary silver producer may want to consider FSM.