Monday, July 25, 2016

Fresnillo plc - Overvalued In The Short - Term

Fresnillo plc is the largest world’s silver producer. Most recently the company’s shares benefited from the current bull market in silver and since the beginning of 2016 they appreciated by 155%. 

In my opinion, it is quite a significant increase, especially when it is realized that Fresnillo is a giant miner. With its market capitalization of $17.6 billion, the company ranks among such heavyweights as Barrick ($23.9 billion), Newmont ($21.3 billion) or Goldcorp ($14.9 billion). Of these giants only Barrick appreciated more than Fresnillo – since the beginning of 2016 this company increased 169% in its market cap.

Is that outstanding share price increase justified? In my opinion, it is not. I like Fresnillo – the company is well – managed, profitable even during down-turns and has a few very interesting projects under development / construction. What is more – Fresnillo accounts for a large part of my model precious metals stocks portfolio (together with B2 Gold, Richmont Mines, Fortuna Silver and Newmarket Gold). So what is the problem?

Investment thesis

Well, in my opinion, in the short-term Fresnillo shares are currently overvalued against its peers. Additionally, Fresnillo's 1H 2016 results should be a kind of a negative surprise. Therefore, my investment thesis is:

“Do not buy these shares now”

1H 2016 results – my forecast

On July 20, 2016 the company announced its 1H 2016 production results:

As the table shows, the company increased its production substantially. Paradoxically, the lowest increase was in the silver segment. I say “paradoxically” because Fresnillo is perceived as a silver producer. 

However, it is no longer a case. In 2015 the company sold gold for $827 million while silver sales were just $617 million. What is more, even putting the San Julian mine on line (it will be a silver producing operation) should not change the company’s profile – gold is going to be the main metal delivered by Fresnillo.

Metals produced by the company were sold at the following gross prices (it is my estimate – the company did not disclose these prices):

And here is the first problem. As the table shows, apart from gold, all metals were sold at lower prices than in 1H 2015.

Another thing – Fresnillo sells mainly metal concentrates, which means that it is paid only for the so-called payable amounts of metals. What is more, the company has to pay smelting and refining charges to process its concentrates at smelters' facilities. Unfortunately, Fresnillo does not disclose the payable amounts of metals sold. However, I have calculated the average ratios between metals produced and sold over the years so, assuming that all metals produced in 1H 2016 were sold (here I may be wrong – such a reasoning is a little bit simplified), Fresnillo should have sold the following amounts of metals:

…and the company should have reported the following revenues:

Well, for the time being all things look nice – the total 1H 2016 revenue should be higher by 13.5% than that reported in 1H 2015.

Now, problems. Fresnillo did not disclose its costs of production. However, looking at the amount of ore processed, grades and recovery ratios reported at each mine, I assume that to produce one ounce of silver equivalent the company had to spend the same amount of money as in 2015 - $13.64 per ounce.

Note that this figure includes also treatment and refining charges.

If I am right, Fresnillo spent $803.2 million to produce its metals in 1H 2016 ($13.64 x 21.18 million ounces of silver sold divided by 36% (silver share in total revenue). So, due to higher amount of metals sold, in 1H 2016 Fresnillo incurred higher costs of production than in 1H 2015 ($665.1 million).

The table below presents the final forecast:

Note that the line “Silverstream and forex impact” contains the effects of the silverstream contract (signed in 2007 with Penoles) and a number of commodity (yes, Fresnillo is using hedging strategies to hedge itself against lower gold prices) and forex hedges. Due to these instruments, in 1H 2015 the company reported a negative result. According to the last production report, in 1H 2016 the losses should be even higher ($35.0 million against $13.8 million).  


As the table shows, 1H 2016 results should be weaker than those reported in 1H 2015. I think it may be a negative surprise for many investors. The mass mentality is that we are currently in a bull market phase in gold / silver and mining companies should report much better results than in the past. And they are generally right but…not so fast. In the case of Fresnillo, 1H 2016 was rather a disappointment but I am sure that the company is going to deliver much better results in the not so distant future.

So, in the short - term Fresnillo's shares are overvalued but in the long – term they still present a great buying opportunity.

Last but not least, if I am right, at today’s share prices the company is trading at 33.3 of its EV / EBITDA ratio. Really elevated valuation...

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