A perfect buying opportunity 500 years in the making

This is by far the oldest part of the Mexican silver giant’s portfolio, though its other operations also have a degree of longevity: its second oldest mine opened in 1992. 

But the recent past is more important: Fresnillo shares sit far below the highs of 2020, and the company itself has had operational and regulatory issues in the past year. However, a potential step-change in silver demand and a peak in capital expenditure mean now is a good time to buy in for the long haul. 

During 2022, the company’s 12-month forward price/earnings (PE) ratio crept up from 13 to 33, as higher costs ate into earnings expectations. That ratio has come down this year, but still sits at a chunky 27. While less than North American giant First Majestic (US:AG) on 33 times, this is still more than triple fellow UK-listed silver miner Hochschild Mining (HOC), which has lots of licensing issues. 

The investor hesitation around Fresnillo has been reasonable. Although its new Juancipio mine was built by the end of 2021, permitting to connect it to the grid took another year. As such, the processing plant has only been operational for six months. Secondly, as per a new law, Fresnillo had to bring its contractors in-house, including specialist operators and their equipment. Though unexpected, chief executive Octavio Alvídrez spun the development and related increase in permanent workers as a route to “greater stability and control over our operations”. 

There are still some labour issues. A worker blockade of the Herradura mine in May, in industrial action not backed by the union, resulted in several days of lost output and a 1 per cent potential hit to total sales for 2023. The impact on profits will be clearer next month when the interim results are out. 

Guidance for this year is 57mn to 64mn ounces of silver and 590,000 to 640,000 oz of gold (or 104mn to 115mn oz on a silver-equivalent basis). This will be an improvement in silver terms, assuming guidance is met, but a significant drop for gold, which also fell last year following a decline in output from Herradura. In the coming years, the challenge will be to reverse 2022’s dip in the Ebitda margin, which fell to 31 per cent, back towards the 40-plus per cent level achieved in 2020 and 2021.

Beyond leaving a high watermark for profits, those boom years allowed for major capital spending without drowning the balance sheet in debt. Across 2022 and 2021, capital spending hit a combined $1.2bn, while exploration projects incurred $300mn in the same two years, with a further $175mn expected for 2023. On balance, this suggests that weaker earnings have disguised good momentum. 

My (other) precious

The number of UK-listed precious metals companies has tumbled in recent years. Following some sector consolidation, and with the Russian producers gone, just a handful of large gold and silver miners remain. Narrow that down further to silver, and Fresnillo looks unique. Hochschild also has significant silver production but is seen very differently by investors, who have been left unnerved by the delay to a critical permit from the Peruvian government.

Given the limited options, the question is why go for silver? Its price largely tracks gold, even if it didn’t follow the yellow metal’s rise to near an all-time high earlier this year. In sterling terms, the price is still strong, however, and thanks to the weaker dollar the price did get close to the 2021 peak of £22 an ounce.

But beyond its speculative price value, the metal has two things going for it that don’t apply to gold. 

The first is industrial demand, including for battery metals, which can serve as a bigger driver of price than investment demand. “Near term, we see strong silver [supply] growth but acknowledge the out years look extremely tight even with flattening demand,” said Bob Brackett, an analyst at Bernstein. “We see 2027 as the turning point to undersupply.” 

Investment drives about a quarter of silver demand, although this proportion spiked in 2020 as people looked for a cheap safe haven. Solar panels and electricals account for a third of demand, while photography also still needs 28mn oz a year from the market, out of total demand of around 1bn oz. The investment bank also sees solar demand climbing from 140mn oz last year to 247mn oz in 2030. 

Then there is silver’s different investment demand profile. Unlike gold, which is highly sought-after by central banks, silver is a favourite of retail investors looking for a cheap store of value. This is more of a US phenomenon than a UK one, however, as the metal attracts VAT on these shores.

Even if tight supply produces a ratcheting effect on demand, investor purchases are difficult to forecast. “Arguably it is a self-reinforcing source of demand,” notes Brackett. “If the market remains tight for silver, it could drive investment interest,” adding that buyers are a “fairly passionate subsector of investors”. 

In terms of correlated economic data – akin to the negative relationship between the gold price and the yield of Treasury inflation-protected securities (Tips) – Brackett said the closest was consumer sentiment in the US. The lower sentiment goes, the higher silver is likely to be. Sentiment did improve in June, although real spending fell for the second consecutive month. 

But Fresnillo is not a leveraged pure play on silver prices, given the metal is usually mined as a by-product. While Fresnillo has three of the world’s top 10 silver-producing mines in San Julian, Fresnillo and Saucito, these are all primary zinc mines according to the Silver Institute. In Fresnillo’s accounting, it is zinc (along with lead) that is the by-product, meaning instead of including sales in revenue, they are deducted from costs. The zinc market is reliant on steel production for pricing, and so China’s weakness this year has knocked the price, narrowing the benefit to costs. 

The upside

With price moves out of its hands, Fresnillo is looking to what it can control: operations. Earlier this year, chair Alejandro Baillères highlighted the expected tie-in and commissioning of the pyrites plant at a Fresnillo mine, alongside the continued ramp-up of the new Juanicipio mine, as key focuses.

Looking further ahead, two pipeline projects could add 300,000 oz a year of gold to its output from around 2027. The Rodeo and Orisyvo mines are still early in the development phase but could – when combined with the usual infill drilling and conversion of resources to reserves – provide the company with a significant source of production growth. 

With current assets alone, there is likely to be an uptick in profits in 2023 and 2024, as per Peel Hunt’s outlook (see chart). The 2024 figure would take the adjusted cash profit margin back up to 48 per cent, down from 56 per cent in 2021. Berenberg analyst Richard Hatch is less optimistic, and expects Ebitda to hit $893mn this year, below consensus of $929mn. 

But even if the upcoming interims prove disappointing, this is a play for the long term. The shares come with risks, including a deteriorating security situation in several of the states where Fresnillo’s operations are based, a dominant majority shareholder, and the inherent vagaries of metals prices.

Then again, the potential for technology to supercharge demand for silver, and prospective shareholders should recognise that the high current multiple is largely a function of outsized spending depressing recent years’ earnings. Judged against the Covid years, profits may look meagre, but zoom out and the prospects look enticing.