Market Overreacts to Silver Producers Setback

Adrian Day Adrian Day of Global Analyst delves into what the denial of the renewal of a mining permit in Mexico means for Fortuna Silver.

Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE) (US$3.87) fell sharply at the end of the week, down 26% in two days
after reporting that a Mexican agency had denied its application for a renewal of its mining permit at San Jose. This took the stock to its lowest level since May of last year.

All mines in Mexico receive permits for a number of years––San Jose’s permit had been for 10 years––at which point they have to reapply for an extension. In the past, this has been more-or-less routine, provided there have been no serious environmental or safety issues, but since the new president came in at the end of 2018, there has been a decidedly anti-mining attitude throughout much of the Mexican government.

Fortuna has experienced several issues recently at San Jose, including a local blockade, and a government dispute over a royalty. The company said it had moved to settle the disputed royalty claim, which covers part of the mine site, for $9.6 million. This settles all past claims (the relevant agency claimed $30 million), and Fortuna agreed to a 3% royalty moving forward. Part of the reason for Fortuna to settle was to show cooperation and goodwill in the country.

Anti-mining agency has another agenda

SEMARNAT, the environmental agency that denied the permit, is the same agency that rejected Almaden’s mine permit and is headed by an anti-mining activist.

However, given everything about the mine’s operations, it was certainly unexpected, and it is unusual for a company that has been operating a mine without any significant environment or safety problem not to have their permit renewed. Fortuna’s CEO Jorge Ganoza called the action “unprecedented.” A Mexican court has granted a temporary injunction for Fortuna to continue to mine. The company preemptively applied for the injunction after the deadline for the mine renewal passed without hearing anything from the agency. Fortuna is now seeking a permanent injunction.

As with the Almaden permit denial, the company is perplexed as to the reasons for the denial. Certainly the stated reasons (including, for example, the company’s failure to supply certain documents) do not appear valid. There is no obvious failing that they have to remedy.

Lack of communication from agency shows bad faith

Other than immediately after filing the renewal application, the company said it had not heard from SEMARNAT at all, until receiving the letter of denial. Local reports indicate that this decision was entirely that of SEMARNAT’s Secretary Albores González, a known anti-mining activist with friends among anti-mining activists in the region, who has repeatedly stated publicly that he is against the presence of Fortuna and wants the mine to close. He has not answered any requests from Fortuna for a meeting for over a year, and continues to be non-responsive.

Fortuna is now working on several fronts to get the decision overturned. This includes answering the agency’s stated reasons for denial, including providing proof that they complied with information requests and seeking a meeting with SEMARNAT (to which there has been no response so far); gaining support from both the state governor and the town mayor, both of whom have been publicly supportive as well as trying to arrange a meeting with the agency; and going to court. In addition, workers at the mine as well as local town people who depend on the mine for business have organized protests. CEO Ganoza said there had been “remarkable support from the local authorities…could not have asked for more support.”

Failure would be important but not a death blow

The court may extend the injunction in coming days, but a permanent solution may take longer. I would think the odds favor Fortuna prevailing but it is by no means a certainty. And operating under a court injunction against a hostile governing agency is not a satisfactory long-term solution. It would certainly be a serious blow if the mine were closed. In the latest quarter it had sales of $43 million out of total company sales of $162 million (and that is down from $65 million a year ago).

On the other hand, the mines it acquired from Roxgold are ramping up, currently accounting for $49 million in sales (more than San Jose), and virtually 50% of the company’s operating income. Certainly one of the reasons the company acquired Roxgold was because of ongoing problems in Mexico and to diversify geographically.

In sum: it is certainly a possibility that the permit is denied and that would be a serious financial blow, but increasingly offset by other income. This issue reflects poorly on Mexico rather than on Fortuna, and if the decision is not overturned and soon, and mining at San Jose were suspended, it would affect all ongoing foreign investment in the sector in the country.

Credit line would be affected as well

Beyond any loss of revenue from the mine, the dispute could affect the company’s line of credit, on which it has currently drawn $120 million. If they do not receive a renewal of the permit or a permanent injunction by January 23rd, there would be a technical default and the line would be reduced to $100 million Fortuna is currently negotiating with the banks to amend or extend this requirement. Fortuna is well capitalized, with $135 million in cash and equivalents. A default would be not be a death blow, but would be serious, however.

Production and earnings up in otherwise strong quarter

Fortuna’s quarterly results were, naturally, completely overshadowed by the permit denial in Mexico. But the results were positive, with record sales. It is operating at a margin of 46%, with adjusted net income of $22.5 million, and strong free cash flow.

Not surprisingly after several quarters of issues, it achieved record gold production at Lindero, in Argentina, which is now performing at 80% of design parameters. The quarter also saw first results from West Africa. Precious metals accounted for 88% of revenue, with silver just over 22% of total revenue.

Fortuna stock lost over $400 million in value in the last two days, but the NAV of San Jose is only $206 million (according to analysts) and with the stock trading at 0.8 x NAV, the stock decline has been vastly exaggerated, even including any additional loss for reputation.

Fortuna definitely should not be sold, given the ramp up in Argentina as well as strong cash flow from West Africa, and the valuation compares very favorably with its peers. (First Majestic trades at 2.6 x NAV; Coeur at 2.3 and so on). The value here is compelling.

Follow the leader

However, a protracted dispute will cause ongoing negative headlines, and would consume time and energy of top management. The San Jose news stopped an incipient stock recovery, and we should not expect a quick bounce back and certainly the road back to $6 and $7 will be a longer one. The stock needs clarity to move ahead. Again, however, the value is strong; this represents a very good level at which to accumulate. CEO Gonzaga said now that the blackout period was over, he would be back in the market. Investors with some patience should follow him.

Originally published on Nov. 14, 2021.

Adrian Day, London-born and a graduate of the London School of Economics, is editor of Adrian Day’s Global Analyst. His latest book is “Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks.”

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