Solid Costs And Expansion Potential For Fortuna Silver

| About: Fortuna Silver (FSM)
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The closest thing to a safe hiding place that investors in precious metal miners can find today is a company with a clean balance sheet and a competitive cost structure. Fortuna Silver (NYSE:FSM) seems to fit the bill, as the company's cash production costs are on the correct side of industry-wide averages and the company has a net cash position with no particularly demanding capital requirements in the near term.

Even though Fortuna Silver has a better cost position than Pan American Silver (NASDAQ:PAAS) and Coeur Mining (NYSE:CDE), the all-in sustaining cost of more than $20/oz is a little higher than the current spot price of silver. What that suggests to me is that cash flow is likely to get tight if silver prices don't recover, as I am not convinced that the company has the scope to significantly curtail costs from here. I do believe that the stock is trading at an attractive price relative to its NAV, but investors should note that Fortuna's current price would seem to be forecasting silver prices at least 10% lower than today's level.

Two Basically Solid Assets

Fortuna Silver is effectively a two-mine company, with a silver-lead mine in Peru (Caylloma) and a silver-gold mine in Mexico (San Jose). Between them, Fortuna has close to 43 million ounces of silver in proven and probable reserves, which isn't actually that much relative to the company's expectation to hit over 5 million ounces/year in the coming years (more than 7 million on a silver-equivalent basis).

San Jose is the more valuable of the two projects to Fortuna, and the company recently completed a significant mill expansion at San Jose, taking daily production capacity from about 1.2Ktpd to 1.8Ktpd. Significantly, this projected was completed on time and within budget.

Although Caylloma's cash production costs were actually below those of San Jose in the third quarter, the reason I place more value on San Jose has to do in part with the Trinidad North discoveries. Fortuna acquired Trinidad North from Pan American Silver for a total consideration of $10 million and a 2.5% net smelter return interest, it lies just beyond Fortuna's existing proved reserves at San Jose. Drilling results in Trinidad North have been quite encouraging, with grades sometimes double those of Fortuna's current reserve grades and about 25% higher overall. If the results hold up, I believe Trinidad could increase Fortuna's 2P reserves by 50% or more and at attractive economics.

Are The Reserves Too Small?

So how is the company positioned with respect to reserves and future production? Eight years of mine life on the basis of current 2P reserves certainly isn't a lot, and even the addition of Trinidad North may only extended that to 12 years. First, 12 years of mine life would actually be pretty solid by the standards of the silver mining industry - Pan American's reserve base is similar, and most of the productive silver mines in the world today have expected useful lives of eight years or less.

Further exploration and expansion at existing sites should allow Fortuna to convert some of its "measured and indicated" resources into mineable reserves. I would also expect the company to take the cash flow that it will generate over the next six to 10 years and look to reinvest it in new mining opportunities - acquiring existing mines, shovel-ready projects, or exploration acreage.

Attractive Costs Underpin The Value

While less efficient high-cost miners tend to outperform in periods of rising metal prices, low-cost producers are generally the ones who survive the periods of falling prices. Fortuna has an attractive cost structure, as third quarter cash costs came in about $7.50/oz, with all-in costs of about $22.75/oz. Management's expectations for the full year are more in the range of $8.27 and $20.45, respectively, and those cash costs are quite competitive.

Estimates for 2012 industry-wide cash costs range from about $9 to $10/ounce. Pan American Silver is on the high end of the range with cash costs over $12/ounce and Coeur Mining is slightly higher than Fortuna at $9. Fortuna is competitive with leading silver producer BHP Billiton (NYSE:BHP) in the "high single digits", but nobody touches Fresnillo (OTCPK:FNLPF) who can produce silver at a cash cost close to $5 an ounce.

Looking ahead, management believes it can do even better. Management is targeting all-in sustaining cash costs of less than $13/oz for 2014 to 2016. If they can achieve that, silver prices will have to get crushed to make Fortuna's operations a money-losing proposition. I am skeptical that Fortuna will manage to attain that goal. I do believe that the company's expansion into Trinidad North will be good for costs, as well the company's overall increased production of silver and gold (better leveraging existing fixed costs and overhead). I just don't have as much confidence in the cost structure in Peru, nor the overall trend in mine operating costs.

Careful With Cash

Fortuna is in a good position with its balance sheet, as the company is solidly in a net cash position with cash at more than 10% of the company's market cap. With that cash, Fortuna should be able to cover its maintenance/sustenance capex needs for at least two years - and that is excluding the operating cash flow that the company will generate along the way. Silver prices around $20 would make for a tight couple of years in terms operating and free cash flow, and a drop into the teens would make things relatively tight. Even with that, though, the company has access to a credit line and I do not see the coverage of its maintenance needs and expansion into Trinidad North as major threats.

Management isn't looking to just sit on its balance sheet though, and they have acknowledged that they would like to pursue strategic acquisitions in this hemisphere. That may be easier said than done, though, as Pan American has reported evaluated over 50 potential deals recently and rejected them all due to inadequate expected returns.

I do believe that there are, and will be, small miners that have worthwhile silver/gold mine assets but lack the capital to develop them further and there are plenty of silver and gold mining stocks that appear to be trading at discounts to their NAV. The key is price and perception, though, as investors and analysts may not cheer the company "doubling down" on silver and gold as prices are falling (even though that's often the best time to buy from a long-term perspective).

The Bottom Line

I am not going to weigh in on the debate between owning gold and silver outright (or through ETFs) and owning precious metals miners. Each approach has its advantages and its risks. I will say that owning a mining company and not paying attention to its operating qualities and reserves is not a very effective way of gaining exposure to precious metals.

Fortuna does appear to be trading in line with a pretty bearish outlook on silver prices. While the sell-side average target on FVI.TO (the company's Canada-listed shares) works out to US$5.24, I think many sell-side analysts are too optimistic on silver prices, operating costs, and discount rates. Sell-side analysts are also still sticking to the old paradigm where these stocks traded for 1.5x NAV or more.

Where sell-side analysts are, in my opinion, maybe too eager with respect to the company's measured and indicated resources in the valuation, I discount those assets much more steeply (at 15%). I am likewise somewhat less bullish on long-term silver prices and less optimistic that the company will reach its low-to-mid teens guidance on all-in sustaining costs. After all of that, I use a 1.1x multiple to my own NAV estimate ($3.13), which works out to a fair value of about $3.50 today. An EV/EBTIDA model suggests a somewhat higher target ($3.85).

Buying any mining stock today could well be reaching out to catch a falling knife, but that's the risk that goes with this sector. At a nearly 20% discount to NAV and with a cost profile that is on the good side of the industry average, I think Fortuna screens out as a comparatively solid prospect in the silver sector.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.