Noting that the price of gold to silver sits at a ten-year high of about 80-to-one, PI Financial’s precious metals and mining analyst Chris Thompson picks three established mining stocks to benefit most from a ‘devil’s metal’ price recovery. (He also picks a ‘sleeper’ for those eternal optimists bent on ferreting out ridiculously under-priced penny mining stocks.)
In a precious metals mining sector that remains starved of new discoveries and development opportunities, we see companies driven by technically strong and proven management teams with experience in making discoveries and delivering real value through the drill bit as engines of value creation.
In recognition of the volatile nature of the metals market and the underlying effect that varying metal prices and operating costs have on equity valuations, it’s important to gauge how sensitive our valuation parameters are to swings in metal prices and operating costs.
We note silver’s history of extreme price volatility, which periodically reminds us of the wrath that the ‘devil’s metal’, or ‘gold’s ugly sister’, silver, can inflict on silver stocks.
We feel that a volatile marketplace, such as silver’s, presents opportunities for operators and investors alike. For risk-tolerant investors, it offers clear points of entry and exit as the market recalibrates to sharp swings (up or down) in the silver price.
For operators that can ride out weak market conditions by operating high-margin assets led by good quality management teams (our coverage focus), we believe that periods of metal price weakness offer growth opportunities through mergers and acquisitions.
We also note that the gold and silver price ratio currently sits at about 80-to-one, which is close to a 10-year high. Silver has rarely been this undervalued relative to gold. When the gold/silver ratio last traded at similar levels (between November 2008 to May 2009 and March 2016 to July 2016), it snapped back to the mid-60s, when silver jumped from about US$9.75 per ounce to roughly US$13.30 per ounce (a 35 per cent increase) in 2008-09. In 2016, it moved from about US$15.25 per ounce to around US$20 per ounce (a 30 per cent increase).
As such, a 30 per cent jump in the silver price isn’t unrealistic. A US$5-per-ounce increase in the silver price would represent a doubling in the operating margin of most of the industry’s primary silver producers, including three profiled in this report—Pan American Silver Corp. (TSX—PAAS; NASDAQ—PAAS), Fortuna Silver Mines Inc. (TSX—FVI; NYSE—FSM), and Endeavour Silver Corp. (TSX—EDR; NYSE—EXK).
Valuations of the companies profiled here are derived assuming flat prices for the following: US$1,350 per ounce of gold, US$18.50 per ounce of silver, US$3 per pound of copper, US$1 per pound of lead and US$1.45 per pound of zinc.
Base metals also add to value
2018 is a transitional year for silver-focused producers PAAS and FVI. We are mindful of our potentially conservative base metal production estimates for both. Base metal production has historically benefited both companies.
Both PAAS and FVI offer attractive medium-term production growth potential (especially FVI). We note that both PAAS and FVI offer near-term net asset value (NAV) growth potential (FVI at 3.6 per cent; PAAS at 1.3 per cent) and attractive near- and medium-term FCF/EV (free cash flow-to-enterprise value) yields, specifically PAAS (near-term) and FVI (medium-term).
While EDR offers an attractive near-term production (and cash-flow) growth profile, we are mindful of the need for development capital expenditures (most likely from debt) and the short high-cost mine lives of its operating base (which weighs down on FCF/EV). We see the development of Terronera in Mexico as EDR’s medium to longer-term production growth driver.
We are initiating coverage on Pan American Silver with a ‘buy’ rating as well, along with a $26-per share target price. The company offers a significant North and South American domiciled diversified precious and base metals production base, and is the world’s second-largest primary silver producer (behind Mexican producer Fresnillo PLC). Based on the value of estimated 2018 production, we categorize PAAS as a diversified metals producer, with silver as the company’s largest revenue contributor.
Key reasons to own PAAS include: Operational, re-development and exploration capabilities in Mexico, Peru, Bolivia and Argentina; an ability to generate meaningful free cash flow at base case price scenarios for gold and silver (mentioned above); one of the strongest balance sheets in the junior precious metals sector (with US$228 million in cash and US$411 million in working capital); a nominal dividend yielding about one per cent; and leverage to silver, gold and base metal prices. As such, we see PAAS as a popular way for precious metals investors to gain exposure to the upside offered by silver which has lagged gold in price.
Like PAAS, Fortuna Silver also offers an attractive North American and South American domiciled diversified production base for both precious and base metals. FVI has a proven track record of growing production organically through discovery and development and ranks as one of the world’s fastest growing junior precious metals producers with operations in Mexico, Peru and a development stage project in Argentina.
Key reasons to own Fortuna Silver include: Operational, development and exploration capabilities in Mexico, Peru and Argentina; fully-funded production growth with 17.5 million ounces of silver equivalent in 2018; 21.5 million ounces in 2019 and 28.1 million ounces in 2020.
We also like its low-cost production with all-in sustaining costs (AISC) in 2018 of US$10.90 per ounce for silver equivalent—plus one of the strongest balance sheets in the junior precious metals sector. The company has around US$213 million in cash, a US$41-million credit line with a US$120-million revolving facility, and US$80 million that is undrawn. Our last key reason to own FVI stock is to possess leverage to silver, gold and base metal prices.
Meanwhile, Endeavour Silver also offers a Mexican-domiciled and diversified precious metals production base. Based on value of production we currently categorize EDR as a primary silver producer with 58 per cent silver and 42 per cent gold production estimated for 2018. EDR offers aggressive near- and medium-term production growth potential. Current estimated production of about 10 million ounces of silver equivalent per year from three operations, as well as development upside offered by two other projects, all of which are in Mexico. This production projection has exemplified EDR’s proven track record of growing production organically through discovery and development.
EDR’s operating expertise over the last four years is reflected by success in development (Bolanitos) and reducing operating costs (El Cubo), facilitated by operational adjustments in pursuit of improving efficiencies.
While we note the unfortunate timing of EDR’s acquisition of El Cubo (in Jul 2012) at high silver and gold prices of around US$27 per ounce and US$1,590 per ounce – with these prices significantly higher than current spot price (US$1,314.50 and US$16.53 as of May 10) – we note the company’s success in redeveloping and optimizing the mine/plant and lowering operating costs.
We also note the relatively short reserve supported mine lives of EDR’s three main mines (Guanacevi, Bolanitos, El Cubo), which is typical of many high-grade, narrow-width, underground Mexican silver mines in operation today. This (and the high cost nature of the mines), provides EDR shareholders with unrivalled leverage to discovery and development success, as well as gold and silver price appreciation.
Enabled by successes in redevelopment, operation and exploration, we see EDR as a leveraged, growth orientated junior- to mid-tier silver (and gold) producer. While EDR screens poorly on potential to deliver near-term NAV growth (an element that we focus on as a valuation benchmark), we see potential for near-term production and cash flow growth, yielding free-cash-flow generation over the longer-term.
Our key reasons to own EDR include: Operational, development and exploration capabilities in Mexico; production growth of 10.3 million ounces of silver equivalent in 2018 and around 15 million ounces in 2022 (driven by the development of the Terronera mine).
The company also has a healthy balance sheet (with US$39 million in cash no debt); as well as leverage to silver and gold prices. We note that because 2018 and 2019 rank as capital-expenditure intensive years for EDR (building Terronera), we see EDR generating no free cash flow (at the base case price scenario mentioned above) until Terronera starts production (expected in 2020).
But it is K92 Mining Inc. (TSXV—KNT) which we believe offers the highest growth profile (based on percentage) for near- and medium-term production, cash flow and NAV. Of the companies profiled in this report, KNT is the best positioned to benefit from ‘needle moving’ and NAV-growing exploration upside. While this comes with risk, significant down-side exposure is limited, in our opinion. We are initiating coverage on K92 Mining Inc. with a ‘buy’ recommendation and a $2-per share target price.
K92 Mining Inc. offers an attractive and growing South East Asian (Papua New Guinea) domiciled precious and base metals production base underpinned by significant exploration/development upside.
KNT sources all of its production from one operation, its flagship Kainantu mine. While we see KNT’s near-term production potential as small (about 45,000 ounces of gold equivalent per year estimated in 2018), we view KNT’s land package as highly prospective for new discoveries. Recent drill results reflect this and underpin potential for significant exploration/development upside.
While KNT experienced delays in achieving commercial production in 2017, we see recent exploration success reflected by the discovery of new high-grade mineralization (Kora North deposit) as a potential game changer for KNT. We also see Kainantu’s potential to generate positive near-term cash flow growth as catalyzing investor interest in KNT.
On March 1, KNT updated its resource for the Kora North deposit. The company says the deposit comprises a measured resource of 33,200 tonnes at 10.3 grams of gold per tonne of ore (g/t), along with 31g/t of silver.
The deposit also comprises indicated resources of 103,500 tonnes at 12.7 g/t of gold and 27 g/t of silver.
Vancouver-based Chris Thompson is precious metals analyst and head of mining research at PI Financial.
This is an edited version of an article that was originally published for subscribers in the May 25, 2018, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.
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