2023-06-01 10:39:26 ET
Summary
- GATO has underperformed the sector considerably, as the shares are down 35%.
- Until GATO corrects and files its financial statements and gets back in compliance with the exchanges, it adds to the near-term risk.
- There is heightened risk for all mining companies in Mexico (not just GATO) until the government provides more details on the new mining bill.
- There are a number of positive aspects to the GATO story as well.
- I'm buying back at these prices, but not as heavily.
In April 2023, I discussed the outperformance of Gatos Silver ( GATO ) from the September 2022 sector lows, as GATO had increased over 200%, compared to a 52% increase in the HUI (an index of gold mining stocks) and a 45% gain in the Global X Silver Miners ETF ( SIL ).
YCharts.com
As I stated in the article, it was an opportune time to sell at least some shares of GATO, given:
1) The outperformance in the stock.
2) The expected restatement of the just-released quarterly and annual financial results going back to 2021.
3) The fact that while there is exploration potential, we can't value unknowns.
4) And the more fair valuation.
I felt at that point, it was best to reduce exposure and either wait for a pullback or for exploration to confirm the upside potential of the company's CLG mine in Mexico.
We didn't have to wait long.
Since then, GATO has underperformed the sector considerably, as the shares are down 35%, compared to an ~11% drop in the HUI and a ~14% decline in SIL. The entire sector has been under pressure since April, but GATO has been a notable loser during this time.
The shares were around ~$7 when I discussed taking profits a little over a month ago, and they've fallen to ~$4.50 since then. GATO went from overbought to now oversold, making a round trip in the process. It's also retesting its 200-day. This would be a logical low point for the correction. So is this an excellent opportunity to repurchase what was sold near the peak?
StockCharts.com
Before answering that question, let's discuss the company's two main risks.
1) The Continued Uncertainty Regarding The Financial Statements
GATO has failed to file its recent financial statements in a timely manner. As a consequence, both the NYSE and TSX sent a notice to the company in April 2023 as Gatos was not in compliance with all rules and requirements for continued listing at the respective exchanges.
The NYSE gave GATO the standard six months to correct the deficiency; the TSX is more strict, and Gatos Silver has " been granted 120 days to comply with all requirements for continued listing. "
Gatos also stated in the TSX press release that if it: " cannot demonstrate that it meets all TSX requirements set out in Part VII of the TSX Company Manual on or before August 18, 2023, the Company's securities will be delisted 30 days from such date. "
Gatos claims that it's:
"Continuing to work expeditiously to complete the required adjustments and continues to believe that these adjustments are non-cash items that will not affect the Company’s strong cash position."
Again, this issue was already discussed in my previous article, and the NYSE and TSX notices weren't surprising. However, GATO tanked the day the TSX news was announced, so apparently it was shocking to many investors and is having a negative impact on the stock.
Given statements by the company, it seems GATO will be able to eventually file all of its financial statements to get back in compliance with the exchanges, but it adds to the near-term risk until we see fully corrected and audited results.
2) The New Uncertainty Regarding Mexico
In late April 2023, Mexico passed a bill that changes how mining concessions and water rights are determined, including reducing the maximum length of concessions from 50 to 30 years, and it allows authorities to cancel concessions if no work is done on them within two years.
A good portion of this bill is about environmental protection, as it allows for the cancellation of mining concessions in protected natural areas or areas where local communities' water consumption is at risk.
The mining reform bill also implements a 5% profit sharing for local communities, but the question is whether it applies to every mine and community or just mines located in indigenous communities.
Some of the language in the bill is unclear, and many mining companies in the region are still trying to determine what (if any) impact it will have on their operations or projects. Many companies operating in the country have come out since then, stating they are seeking clarification on some parts of the bill.
Fitch Ratings claims :
The law affects new concessions but is still unsettled with regard to current concessions, pending final rules from the respective government secretaries.
The potential impact of this bill might be company and mine/project-specific. For example, an established producer with a strong track record in the country could be far less susceptible than a developer looking to build a large, environmentally unfriendly, open-pit project that has yet to be permitted.
To be conservative, at least until there is more clarity, my base case would be a 5% profit reduction for any current gold/silver producer in Mexico. That's not the worst-case scenario, just to be clear.
I've discussed with subscribers of The Gold Edge what gold and silver companies I would avoid because of this bill, but GATO isn't on that list. At least not yet.
Still, it's a heightened risk for all mining companies in Mexico (not just GATO) until the government provides more details.
The Positives
1) The Updated Life Of Mine Shows Robust Production And Cash Flow
The CLG mine is estimated to produce over seven million ounces of silver per annum on average between 2023 and 2027 at progressively lower AISC that will reach mid to low-single digits, making CLG one of the largest and lowest-cost primary silver mines in the world. At $22 silver, $1.20 per pound zinc, and $0.90 per pound lead, CLG will generate $55 million of free cash flow per year for Gatos.
Gatos Silver
2) The Mine Is Now Outperforming
GATO reported record silver production from the CLG operation in Q3 and Q4 2022, raised silver production estimates for the year, and ended up surpassing those upwardly revised estimates.
The trend continued in Q1 2023, as silver production was 2.43 million ounces for the quarter, which is 31% of the expected Ag production for the year using the mid-point of guidance.
3) Cash Continues To Increase
The cash balance at the corporate and JV levels continue to increase, as GATO ended 2022 with $8 million of net cash, and the JV had a cash balance of $35 million, which subsequently increased to $55.5 million as of February 28, 2023.
4) Exploration Results Are Promising And Highlight The Potential For Significant Mine Life Extension
Resource conversion drilling in the North-West zone intercepted 8.0 meters (estimated 5.7 meters true width) at 596 g/t silver, 9.75% zinc, 2.70% lead, and 0.71 g/t gold in hole NW-501. While drilling the South-East zone returned 4.0 meters (estimated 2.6 meters true width) at 411 g/t silver, 3.75% zinc, 9.29% lead, 0.47 g/t gold, and 1.42% copper in hole SE-491, and hole SE-513 intercepted 9.0 meters (estimated 7.5 meters true width) at 133 g/t silver, 6.64% zinc, 4.91% lead, 2.33 g/t gold, and 0.47% copper. What's compelling about these intercepts is the high grade base metals, especially copper, as those could be used as by-product credits and drive down AISC. In several of the drill intercepts, the value of the copper surpassed lead and in some instances zinc. The mine doesn't produce payable copper in concentrates but Gatos is conducting metallurgical test work to see if a copper separation circuit would be economical. Copper production would add another layer to this story, especially at grades of 1.42%.
Gatos Silver
I also want to highlight holes SE-514 and SE-506, as these are resource expansion holes that targeted an area near (30-50 meters from) the current resource at the SE zone (shown right-center on the diagram). SE-514 intercepted 16.5 meters (estimated 12.3 meters true width) at 271 g/t silver, 3.25% zinc, 4.30% lead, 0.36 g/t gold, and 1.06% copper, while SE-506 hit 5.9 meters (estimated 4.8 meters true width) at 222 g/t silver, 6.90% zinc, 8.75% lead, 0.47 g/t gold, and 0.37% copper. It's the combination of true width + robust AgEq grades + near the current resource at still shallow depths that makes these drill results so special. This near-mine mineralization would require only minimal additional access development, which means it wouldn't cost much capital to bring these ounces into production and it could be done quickly.
Gatos Silver
Gatos plans to release an updated reserve estimate next quarter and is targeting 1-2 years of additional mine life due to high-grade inferred resource conversion, and another 3-4 years of mine life extension from SE Deeps before the end of 2024.
I'm Buying Back At These Prices, But Not As Heavily
My bullish thesis on Gatos' CLG mine hasn't changed since April, and now the valuation is cheap again. If it weren't for the new mining bill and the uncertainty surrounding it, I would be buying back all of what I sold at the recent top.
However, until there is clarity on the mining reforms in Mexico, I believe more caution on GATO is warranted.
Therefore, I'm buying back, but only 25-50% of what I sold, as the position size won't be as "weighty" for the short term as it was before.
Without question, GATO continues to be a high-risk play and is one of the more volatile stocks in the sector, but the updated technical report shows that CLG is still one of the best silver mines in the world, will generate robust free cash flow over the next ~5 years at current metal prices, and the exploration upside is compelling.
I imagine over the coming months, there will be more details on this new bill, and we can better separate those companies that will be impacted the most vs. the least.
I'm not more cautious on GATO because of anything the company disclosed in recent weeks. Rather, I'm hesitant on most mining stocks that have significant exposure to Mexico. In Gatos' case, it has 100% exposure to the region. It's not stopping me from buying, but I'm exercising more caution than before.
I'm also following the technicals closely as I want to see stabilization in the stock. There's important support at $4.00-$4.50, and GATO is now at the top of that range. It needs to hold this level, and it would be justification to sell if it fails to do so.
For further details see:
Gatos Silver: After 35% Plunge, I'm Buying Back Some Shares Sold At The Top (Rating Upgrade)