Apex Silver Forced Into Fire Sale Of San Cristobal

Apex Silver Mines (SIL-x) has been forced to sell its 65% stake in the massive San Cristobal zinc and silver mine to its minority partner, Japan-based Sumitomo Corp. (SSUMY-o) for US$22.5 million.

While the amount seems shockingly low for an in-production world-class silver-zinc-lead deposit, Apex found itself with little leverage at the bargaining table.

“Projected cash flows from operations in twelve months time would be insufficient to fund the US$386 million in operating costs. That’s why the decision was taken,” says Pablo Castanos, Apex’s head of investor relations.

Enter Sumitomo. The massive corporation will take a full interest in the money-losing project in hopes that metal prices will correct in the coming years, as it gets a handle on operational costs.

Its costs for acquiring the project today, however, are far greater than just the US$22.5 million going to Apex and the mine’s projected losses for the coming year.

Sumitomo must also absorb all of the liabilities associated with the mine. San Cristobal is currently held by Minera San Cristobal (MSC) –owned 65% by Apex and 35% by Sumitomo.

Loans associated with MSC amount to roughly US$225 million and Sumitomo will also take over a hedge book that was bleeding cash from MSC.

That Apex — a company that waited patiently through the downturn of the late 1990s for metal prices to recoup before pushing ahead with construction — could find itself in such a dire and unenviable position may seem unbelievable.

But Les Childress, an analyst with Seattle, Wash.-based CIR Equity Research says the writing was on the wall some four years ago.

Childress covered Apex when he was with the securities firm Dutton Associates, and he says he refused to give the company a rating back then because of certain red flags.

“I could see huge issues,” Childress says. “Whether they could complete it on time; the indigenous people around the mine, would they support it. . . and then there were huge cost overruns and the quality of the mine itself, in terms of the ore, was questionable, too.”

Specifically, he says that despite the way Apex was packaging the project, he considered it primarily a zinc mine — something that is far less attractive to prospective investors.

Apex’s Castanos however, says problems with the mine were due to factors larger than Apex management or the ore in the ground.

“When you have an increase in costs, there is always a lag when they drop,” he says. “But the same thing doesn’t happen with mineral prices. Mineral prices move very fast, so where with costs you have a lag of three to six months, the price you’re selling your metal for can just drop almost overnight.”

The convergence of sticky high costs and fast-falling metal prices wiped out margins and left the company US$380 million short.

One of the key metrics on the cost side, according to Castanos, was that of oil. This summer’s spike to US$140 a barrel not only hit the project hard in terms of fuel costs — which are considerable for a large, open-pit project — but also on freight and products like spare parts, the prices of which are affected by higher oil prices.

“The whole issue started before oil prices spiked,” Childress insists. “They’re a long way from the port, they had to build a railway, an electrical system, there’s a lack of water there and then there was a new government coming into place,” he says referring to socialist President Evo Morales who came into power at the end of 2005.

“There was a sense of unease about how it would work out for Apex,” he says of his impressions at the time construction got under way.

And while Morales didn’t nationalize the project as some pundits feared he would, he did introduce a new tax structure that Castanos concedes was, and is, prohibitive.

While the previous tax structure called for a 25% corporate tax rate, with royalties on production subtracted from that amount, the new system separated the two taxes so both were payable in full. In addition, it raised the corporate tax to 37% and put the royalties on a sliding scale from 1-5%, depending on the price of metals.

“The new taxes had a significant impact, but it was not the main reason (for the financial dilemma),” Castanos says. He explains that the corporate income taxes were not even due until the end of January and so hadn’t yet hurt the company’s bottom line.

So just how wounded is Apex’s bottom line at present?

Its income statement for the third quarter shows a pretax loss of US$507 million for the quarter. As alarming as that figure is, it is matched by a number on the balance sheet, which puts its current liabilities (debts and obligations to be paid within a year) at a staggering US$847 million.

While a US$650-million write-down on the mine is partly to blame for the number — the impairment came as a result of falling metal prices and lower than expected cash flows–Apex was also hurt by its hedge book, which cost it US$156 million in the first three quarters of this year.

The ugly sum came as a result of especially tough conditions imposed on Apex by Barclays Bank and BNP Paribas in return for a US$225-million loan.

While hedge books are usually derided by investors because they can require a company to sell its production at a lower than market rate, Apex’s hedge was doubly detrimental as it not only required the company to sell for less when prices were high, but also required it to pay any difference between the market price and the hedged price.

The structure meant Apex was actually penalized on the portion of metals hedged when metal prices were climbing.

For example: zinc was hedged at US48 per lb., so Apex had to pay the banks the difference when prices rose above that level.

Childress says while such conditions are unusual, they aren’t unheard of.

Regardless, with almost all of its lead production hedged, roughly 45% of zinc production hedged and 25% of silver hedged, the bill skyrocketed.

And while falling metal prices would have provided some relief for the fourth quarter on the hedge book — Apex estimates that its hedge book would cost it US$53 million over the next 12 months — such lower prices are, at the same time, wiping out the margins on its unhedged production.

And as if that weren’t enough bad news, Castanos says metal recoveries were well below what was anticipated at the feasibility stage.

Apex had expected 89% recovery for zinc, 87% for lead and 79% for silver, but in the third quarter it managed just 81% for zinc, 76% for lead and 67% for silver. And those numbers were an improvement from earlier quarters. In the first quarter, for instance, lead recoveries came in at just 65%.

Castanos says metallurgical specialists are at the site working to get recoveries up to their preproduction targets.

And just to top off the company’s grief, Apex is bound by a debt covenant to meet certain production throughput targets for 90 consecutive days by the end of this year.

With less than 60 days left in the calendar year, it is clear that Apex won’t meet the threshold.

Other covenants required Apex to have US$72 million in a cash reserve account — it doesn’t — and to meet certain liquidity ratio targets.

“The liquidity ratios are impossible for us to comply with,” Castanos says.

What next?

The current offer from Sumitomo calls for Apex to stay on as manager of the mine for at least a year for a fee that hasn’t been determined. Apex says it will not be paid less than US$6 million and the sum will be sufficient to cover its costs.

It will need all of the cash flow it can get, because while Sumitomo will take over the liabilities associated with MSC, it will not take over those connected to Apex alone.

And that is no minor detail. Apex has roughly US$290 million worth of outstanding convertible bonds — one group has a coupon of 4% while the other’s is 2%.

Bondholders, no doubt, are fretting because if the deal is consummated, Apex will be left without the key asset that would have nourished bondholders in the event of a default.

In lieu of San Cristobal, Apex will re-evaluate its exploration portfolio — it has early-stage projects in Argentina, Peru, Mexico, Chile and Australia, none of which have resources compliant with National Instrument 43-101 — to try and re-fortify its asset column.

A requirement of Sumitomo’s attached to the deal, will buy Apex some time to do just that. But while the requirement will offer some protection, it also speaks to how far the company has fallen in a relatively short time.

Sumitomo’s offer is conditional on Apex agreeing to file for chapter 11 bankruptcy. Chapter 11 is a voluntary bankruptcy filing that protects a company from creditors while it restructures.

San Cristobal lies on Bolivia’s Alto Plano, roughly 100 km from the town of Uyuni. The deposit hosts proven and probable openpittable reserves of 450 million oz. silver, 8 billion lbs. zinc and 3 billion lbs. lead contained in 231 million tonnes of ore.