SVM - Gatos Silver Is Running Out Of Lives (Rating Downgrade)

Summary

• In October, the company released an updated mineral reserve estimate, and the reserve cut wasn’t as bad as expected.
• The NPV attributable to Gatos Silver was $263.9 million at $22 per ounce of silver and Cerro Los Gatos had record production in Q4.
• However, I think that the positive news has already been fully priced in as the market valuation of the company has surpassed $300 million.
• In my view, Los Gatos is starting to look overvalued, and this could be a good time for investors to trim or exit positions.

Introduction

I’ve written three articles on SA about Mexico-focused silver miner Gatos Silver (GATO). The latest of them was in September and in it I said that I expected the new life of mine (LOM) plan to act as a significant catalyst for the share price. Well, the updated life of mine plan was released in October, and I think it was decent. However, the market valuation of Gatos Silver has almost doubled since my previous article and the company is starting to look expensive. In my view, this could be a good time for investors to trim or exit positions and I’m reducing my rating to neutral. Let’s review.

Overview of the recent developments

In case you haven't read any of my previous articles about Gatos Silver, here's a quick description of the business. The company’s main asset is a 70% stake in a joint venture company with Dowa Metals & Mining that holds the Cerro Los Gatos polymetallic in northwestern Mexico in the heart of the country’s silver belt. This mine started operations in 2019 and was projected to have a post-tax net present value [NPV] of $653.2 million using a 5% discount rate (based on silver, zinc, and lead prices of $18.99 per ounce, $1.09 per pound, and $0.87 per pound over the life of mine, respectively). Unfortunately for investors, Gatos Silver revealed in January 2022 that there were mistakes in the technical report and that the metals content of the mineral reserve could slump by 30% to 50%. My theory was that the reduction would affect mainly the zinc reserves of Cerro Los Gatos which meant that Gatos Silver was oversold. Well, I was mostly wrong . While the updated mineral reserve estimate affected zinc reserves the most, silver and lead content was also cut significantly. Fortunately for investors, the decrease in the reserves was much closer to 30% than 50% and this meant that the net present value of the mine remained positive.

According to the updated LOM plan, Cerro Los Gatos has a NPV of $316 million as of July 1 using a 5% discount rate (based on silver, zinc, and lead prices of $20 per ounce, $1.20 per pound, and $0.90 per pound over the LOM, respectively). With silver trading near $22 per ounce as of the time of writing, this figure jumps to $438 million.

Reserves are expected to deplete in Q1 2028, and Cerro Los Gatos is forecast to produce an average of 7.4 million ounces of silver per year at all-in sustaining costs (AISC) of just $7.04 per ounce. In my view, the AISC are surprisingly low, especially in the second half of the LOM. I’m skeptical that this AISC reduction will be easy to achieve.

The average silver equivalent production, in turn, is forecast to stand at 13.2 million ounces per year while the annual cash flows are expected to be $79 million on average at $22 per ounce of silver. Overall, I think that Cerro Los Gatos still looks like a good mine and the NPV attributable to Gatos Silver’s 70% stake is $263.9 million.

Turning our attention to the recent production results, the company improved its 2022 guidance in October due to strong operating performance and then managed to surpass it. In Q4, silver production was a record of 2.9 million ounces , which is 26% higher than a year earlier. Silver production for the full year came in at a record of 10.3 million ounces, well above the high end of the guidance range of 9.35 million to 9.65 million ounces. Zinc and gold production was near the high end of the 2022 guidance, while lead output was near the guidance midpoint.

The record silver output in Q4 enabled Gatos Silver to boost its cash balance by about $2 million during the quarter to $17 million as of December. Also, the outstanding balance on the company's credit facility decreased by $4 million during the quarter to $9 million. The JV company held another $35 million in cash at the end of 2022, putting the attributable cash balance of Gatos Silver at over $40 million. Unfortunately, we don’t have more details about the financial performance of the company or its balance sheet as Gatos Silver still hasn’t released its 2022 financial report. It appointed an independent auditor in November and the results are expected to be released before the end of Q1 2023.

Looking at what to expect in the future, I think that the reserves and NPV of Cerro Los Gatos could increase significantly in the second half of 2023. The company is currently drilling high grade areas of inferred resources which are located adjacent to planned mine development and I think this could extend the mine life beyond 2030.

Los Gatos is also targeting a 3-4 year LOM extension from the South-East Deeps zone and initial the recent drill results have been encouraging, with highlights including 7.2 meters at 191 g/t silver, 2.93% zinc, 2.38% lead and 0.68 g/t gold and 3 at 771 g/t silver. Mineralization in the South-East Deeps zone has now been intersected 415 meters below the bottom of the 2022 mineral reserve.

Investor takeaway

The past few months have been eventful for Los Gatos and the news is largely positive. The reserve cut wasn’t as bad as expected, production is at record levels, and the NPV attributable to the company is $263.9 million at $22 per ounce of silver. However, I think that the positive news has already been fully priced in as the market valuation of the company stands at $310.4 million as of the time of writing. This means that Los Gatos is valued at above 1x NPV at the moment, which is unusual for the mining sector. Sure, the reserves and the NPV could increase when Los Gatos releases an updated mineral reserve estimate in the second half of 2022, but the company seems overvalued right now and I think there are better investment opportunities in the silver mining sector. My top pick at the moment is Silvercorp Metals (NYSE: SVM ).

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