Arcadia Economics hosted a podcast with Fortuna Silver Mines (NYSE:FSM) CEO, Jorge Ganoza, to go over the Company’s Q2 earnings report and discuss the remarkable effort by management to contain costs and build value that is yet to be recognized by the stock market:
The following analysis of Fortuna Silver was featured in the last issue of the Mining Stock Journal. I believe Fortuna offers the stability and growth of mid-cap gold and silver producer as well as the upside optionality of a junior development stock with its Seguela and Boussoura assets. You can learn more about my news letter here: Mining Stock Journal information
Fortuna Silver (FSM, FVI.TO) – Fortuna released its Q2 results Wednesday evening. At first blush, the numbers looked disappointing, which apparently was the market’s view because the stock is down over 8% from Wednesday’s close. However, after going through the numbers thoroughly and attending the earnings conference call, FSM’s management did a great job managing the operations through a quarter in which the cost of mining was substantially higher than Q2 2021 and the average price of silver was lower YoY by approximately 16%.
Sales rose 39% YoY but cost of sales rose 63%, in part because of increasing production at Lindero and in part because of the inclusion of Yaramoko. Sales at San Jose declined 23% (lower output and grade per guidance). Gold production more than doubled YoY while silver production fell 13% – again this is in-line with the Company’s guidance at the start of 2022.
Mine operating income declined 33%. Most of this is attributable to the lower cost of silver. However, consistent with guidance, production and head grade at San Jose declined YoY. Operating income declined 71%. Again, 40-50% of this decline is attributable to the drop in the price of silver. But SG&A was also a factor, rising 62% YoY. Of the $14 million incurred in Q2, $1.5 million is non-recurring and related to the Roxgold acquisition. I had a brief conversation with the CFO, Luis Ganoza, who said he expects SG&A to be about $12mm per quarter going forward.
Now for the good news. First, the Company’s mine operating costs have remained in-line with the guidance that it provided at the beginning of 2022. This is a remarkable feat given the considerable price inflation experienced by the industry, particularly with respect to diesel fuel, cyanide and mine explosives. The expenses connected to the development of Seguela continue to remain on target with the cost budget released last September.
$4 million (22%) of the variance in operating income is attributable to a non-cash write-down of low grade ore stockpile at Yaramoko. Many companies would overlook making this adjustment to manage GAAP earnings but it’s a non-cash event. Furthermore, assuming the price of gold rises going forward, that write-down will be more than reversed because the ore can still be profitably processed. If the price of gold continues to rise, the size of the non-cash write-down will be more than offset by real cash income.
Cash provided by operations (from the statement of cash flows) was $47 million, up 61% from Q1 2021. Free cash flow derived from the statement of cash flows, was $6.4 million. For this I added back the $3 million used for share buybacks. This compares with negative $23.2 million (-$23.2mm) free cash flow in Q2 2021. Despite the capex involved with building Seguela plus tweaking production at Lindero, FSM is generating free cash flow. Furthermore, there’s still progress being made with lowering the overall costs at Lindero.
Seguela is 66% complete, with the first gold pour expected in mid-2023. Using the mid-point of FSM’s full-year production guidance, the Company is tracking to produce roughly 340,000 ozs of Au-Eq in 2022. This does not include zinc and lead production. When Seguela is fully ramped-up, FSM will be producing between 420-450k ozs of gold-equivalent, not including lead and zinc.
In my view, the stock market is substantively undervaluing FSM. To begin with, most companies producing in the range of 400k-500k ozs of gold per year are valued, minimally, north of $1 billion. At the extreme end of the range is Alamos, which has a $4 billion market cap on 460k-500k ozs of gold expected in 2023. Interestingly, the average grade of the resource at Alamos is similar to that of FSM. I’m not saying FSM deserves the same market cap as $AGI, but either AGI’s market cap is far too high or FSM’s market cap is far too low.
With most of the variance in operating income attributable to a lower price for silver, a one-time non-cash write-down of low grade ore stockpile at Yaramoko – that likely will be recovered in cash in the future – and $1.5 million of non-recurring SG&A, if you believe that the price of silver and gold – especially silver – is headed higher over the next 12 months, the sell-off in FSM post-earnings is a gift.
FSM has demonstrated that it can manage its operations efficiently in an environment of rising costs and falling precious metals prices. When the price of gold and silver move higher, FSM will experience growth in its income and cash flow generation that is not even remotely priced into its current stock price. On top of this, the market is not giving any credit to the huge resource upside and grade potential that is being demonstrated currently with the drill program at Sequela or to the considerable “optionality” upside potential with Boussoura. In a bullish environment for the sector, I would expect FSM to more than double from the current level (12-18 months).