Pan American Silver Corp - Waiting for Christmas

As the days get shorter here in northern latitudes, we note that the market optimism of the spring has faded.  The uber-bear of this moment, David Rosenberg, beats a drum for long bonds as the best way (save being short) to survive a continuing depression.  Technical analysts warn of a Hindenburg omen, presaging a stock market crash.

 

However, at this juncture, I find myself in the unusual position of being a relative bull.  Save for a few noteworthy trouble spots (such as certain banks originating real estate loans in the world’s remaining overheated housing markets) the stock market looks to me more poised for a melt-up rather than melt-down.  Three percent long-bond rates should simply not co-exist with 10x earnings multiples on Dow components like Microsoft (NASDAQ: MSFT) and Chevron (NYSE: CVX).  And while end-demand is soft in the developed world, credit expansion may be making up the difference in emerging markets, at least for now.

 

But given the uncertainty, I am partial to companies that can thrive in either a weak or strong economic outcome.  As an example of this class, I offer Pan American Silver Corp (TSX: PAA; NASDAQ: PAAS)  which faces either growing industrial demand for its production in a strengthening global economy or a growing fear-trade demand for silver should we descend again into crisis.  Having flatlined for the past two years against a 40% gain in silver, Pan American is overdue for an upward re-rating.

 

Silver vs. Gold

 

Before addressing the specifics of Pan American, it is worth revisiting the case for silver as the value play in the precious metals universe.  I believe there is still great potential for silver because the price ratio between the two metals (currently about 65:1 in favour of gold) has rarely been as lopsided.  Back in the days of gold and silver money, the value ratio between silver and gold coins was typically about 15:1.  Through the 1970’s gold was typically about 30:1 to silver and touched 15:1 at the peak of the precious metals cycle in 1980.  Even if gold stayed flat through the next round of quantitative easing, a re-rating of silver to its past 60 year average ratio would imply silver in the range of $25 per ounce.

Figure 1: Silver’s Re-Rating Potential

 

 

Catalysts for re-rating of silver vs. gold?  I can think of a few.  One might be a supply shock.  Keep in mind that over 70% of silver production is by-product production from mines whose major focus is base metals or gold.  A weaker market in base metals, for instance, might reduce silver output to a degree even in the face of higher prices. 

 

Another catalyst might be simply be price outperformance of the pearly metal and the resultant effect on speculative activity.  Note that the i-Shares Gold exchange-traded fund (NYSE: GLD) has $48 billion in assets, while its sister silver fund (NYSE: SLV) has only $5 billion in assets.  A price momentum shift in favour of silver that drove even a modest amount of gold-to-silver bullion switching could have enormous effect on the much smaller silver bullion market.  I am aware that the foregoing reasoning is entirely circular.  Having witnessed a few of these fund flow valuation changes, however, all I can say is welcome to the capital markets.

 

Digging into Pan American

 

For the uninitiated, Pan American Silver is a 16 year old company which has seven significant silver mines distributed through the Americas.  Its top mine, the Mexican Alamo Dorado property produced over 5 million ounces of silver in 2009.  Total production in 2009 was 23 million ounces and its resource base, on a broadly defined basis, is over 900 million ounces.  The company has significant production of other associated metals including gold, lead, zinc and copper, which combined amounted to nearly 40% of revenues in the trailing 12 months.

 

Relative to its peers, Pan American stands out for having a clean balance sheet, with no debt and net working capital of over $300 million.  Conservative perhaps, but useful in consideration of the major capital development projects on the company’s plate, most notably the very large Navidad project in Argentina.

 

Management appears sensible, with a focus on long-term economics and value creation.  In highlighting his priorities, Chief Financial Officer Rob Doyle emphasizes return on invested capital over production growth for its own sake.  And despite being surrounded by bullish prognostications on future silver prices (such as my own) his $14 per ounce base case silver price projection demonstrates a relentless commitment to sobriety.

 

Upside surprise for Pan American might be delivered by a couple of different sources.  The first driver is the potential rebound in the prices of base metals.  Chilled by deflation fears, lead and zinc have been beaten back to trough valuation levels and now trade near 20 year lows in relation to silver.  A rebound in these prices to the levels experienced in the middle of the last decade could boost Pan American’s profitability enormously.  It is worth noting than in 2006, base metals accounted for 40% of company revenues compared to 22% this year.

 

Figure 2:  Lead Prices Could Provide a Catalyst

 

 

 

The second driver relates to the potential amendment of the current mining law in Argentina’s Chubut province, where Pan American’s 600 million ounce Navidad project is located.  The project requires open pit mining, which is currently banned in  Chubut.  In view of this, the market is currently ascribing very little value, if any, to Navidad.  If and when the law is amended, Pan American’s silver output could rise significantly.

 

 Risks and Valuation

 

No investment is without risk and a company whose entire operating portfolio is comprised of Latin American mineral deposits is hardly immune from such consideration.  Clearly political risks, taxation and expropriation are potential outcomes in certain countries.  A futher big picture risk would be a general, but not life-threatening deflation that drives silver prices down without threatening the existence of fiat money.

 

More specific to Pan American’s operations, diminishing ore grades, a gentle erosion at the moment, but always a cause of concern could weaken results going forward.  Cost inflation (running at 20% in Mexico and Peru, comprised of approximately 10% currency and 10% operating costs) is also a headwind that offsets much of the benefit of higher silver prices.  However, relative to a silver price rise of 33% over the same period, the cost inflation has only moderated, not eliminated, the leverage to operating earnings that a miner like Pan American has to silver price gains.

 

As for valuation.  I think the best way to value a mining company is to value its mines on a full-extraction discounted cash flow basis, without reference to current period earnings.  However this approach is complex, and requires a lot of detailed mine-level information.

 

Figure 3: Pan-American Silver Stock Price

 

 

 

A reasonable way for an outsider to derive a price target for Pan American Silver might be to think in terms of two relative valuation ratios which can fluctuate in our favour.  Since 2008 PAA has declined 40% relative to the price of silver, a gap which could easily close.  The price of silver itself, were it just to revert to its historical average value ratio against gold of 48:1 would increase 35%.  Applying those two mean-reversions alone could boost Pan American Silver to $44 per share, an increase of about 75% from today’s level.  Layering on an improvement in base metal pricing or perhaps a “Christmas present” in the form of a Navidad mine permit could send Pan American well beyond $50 per share.

 

Overall, Pan American Silver strikes me as a good risk/return opportunity with potential to double over the next three years.  Relative to the other miners I have reviewed of late (Silver Wheaton and Goldcorp) Pan American appears somewhat cheaper and therefore is my preferred pick in this relatively attractive sector.

 

Comments

[Peter Kratoska]

Since silver has been traditionally used in photographic film as well as film for the print industry - how do you see the technological change ie. shift to digital cameras and the print industry's move away from film to direct to plate and digital print as affecting the price of silver.

According to T. Lanzano et al 2006 (quick google search on use of silver in manufacturing) - photographic film as part of the silver cycle in (European) manufacturing was 26%, second only to silver in jewelry and silverware 30%. This is a fairly significant amount when that is no longer used for that purpose should that not drive down the demand and hence the price? Kodak for instance does not see more than 5 years of film left in the print industry, and how many people use film cameras instead of digital.

Just curious for your thoughts on this.
Enjoy your articles in BIV.
Peter

[Peter Kratoska]

Thanks for your response Geoff,

I will take a look at that article.

I'm sure that Investment demand in precious metals always increases following an economic downturn or possibility of war, but I guess a lot depends on continued confidence in the US dollar.

thanks
Peter.