Fresnillo, the world's largest silver producer and Mexico's leading gold miner, presents a captivating narrative of operational resilience, disciplined capital allocation, and a robust pipeline of growth projects. However, a closer look reveals a potential financial risk that has largely gone unnoticed by analysts: the strengthening Mexican Peso.

While Fresnillo emphasizes its success in navigating inflationary pressures and maintaining a strong balance sheet, the company's dependence on the Mexican Peso creates a precarious situation. The "super peso," as termed by Fresnillo's CFO, Mario Arreguín, has significantly revalued against the US dollar, with the average exchange rate dropping from 20.28 pesos per dollar in 2022 to 18.21 in the first half of 2023. This revaluation, driven by the substantial interest rate differential between Mexico and the US, has dealt a significant blow to Fresnillo's financial performance.

Arreguín acknowledges the adverse impact of the peso's strength, estimating a negative effect of $45 million in the first half of 2023 alone. Furthermore, he highlights that the second half of 2023 will likely see an even greater impact, with the peso continuing its upward trajectory, reaching a rate of 16.7 pesos per dollar. This "super peso" phenomenon, while potentially temporary, has already eaten into Fresnillo's gross profit, masked only by higher production volumes and favorable gold inventory adjustments.

The core issue lies in the structure of Fresnillo's cost base. A significant 40% to 45% of the company's production costs are denominated and paid in pesos. This inherent exposure to peso fluctuations leaves Fresnillo vulnerable to exchange rate volatility, particularly when the peso strengthens against the US dollar, the currency in which its revenues are largely denominated.

Impact of Peso Revaluation on Production Costs

The following table, derived from Fresnillo's Q2 2023 earnings call transcript, illustrates the breakdown of factors affecting adjusted production costs, highlighting the significant negative impact of the peso's revaluation.

The potential consequences of a sustained "super peso" are profound. While Arreguín suggests the peso's strength may revert in the medium to long term, the uncertainty surrounding its future trajectory creates a substantial risk for investors. If the peso remains strong, Fresnillo's profitability could be significantly eroded, impacting its ability to generate free cash flow and fund its ambitious growth projects.

Furthermore, the company's strategy of offsetting rising costs through operational efficiencies may prove insufficient to counter the impact of a sustained "super peso." While commendable, Fresnillo's cost-cutting initiatives, expected to yield savings of $40 million to $50 million in 2023, pale in comparison to the potential losses from an enduringly strong peso.

Hypothetical Impact of Sustained "Super Peso"

Based on the provided hypothesis and Fresnillo's estimates:

If the peso remains at 16.7 pesos per dollar for the remainder of 2023, Fresnillo could experience an additional negative impact of $22.5 million on adjusted production costs in the second half of the year.

If the peso were to remain at this strengthened level in 2024, Fresnillo's total adjusted production costs could increase by approximately $90 million.

These figures, while hypothetical, underscore the potential for a significant financial burden if the "super peso" persists. This situation could potentially offset gains from operational efficiency improvements and jeopardize Fresnillo's future profitability and growth prospects.

Fresnillo's story serves as a cautionary tale for investors, highlighting the hidden risks associated with currency exposure. While the company showcases its operational resilience and growth prospects, the "super peso" presents a significant financial challenge that cannot be ignored. The potential for a ticking time bomb lurking beneath the surface of Fresnillo's seemingly strong financial performance is real, and investors would be wise to proceed with caution.

"Fun Fact: Mexico is the world's leading silver producer, and Fresnillo plays a major role in this dominance. The company's namesake mine, Fresnillo, is one of the oldest and most productive silver mines globally, having been in operation for over 450 years!"