2023-11-07 11:09:01 ET
Summary
- This analysis reaffirms the Buy rating for Gatos Silver, Inc. stock.
- Gatos Silver has a 70% interest in a silver mining and exploration joint venture operating in Mexico. These mineral activities demonstrate good throughput trends and have realistic growth targets.
- Any improvement in Mexico contributes to the positive market reception of Gatos Silver stock.
- The expected increase in the price of silver and the strong correlation with Gatos Silver's share price, provide great growth opportunities.
This Analysis Reaffirms the Buy rating for Gatos Silver, Inc.
This analysis reaffirms the Buy rating for Gatos Silver, Inc. ( GATO ) ( GATO:CA ) stock.
The previous analysis assumed that further improvement in some key operating metrics and cost initiatives would be positively coupled with higher silver prices to support the share price.
As the company worked toward its operational goals, it achieved a record mill throughput rate in Q2 of 2023 while silver prices remained robust. The merger resulted in an improvement in Q2-2023 EBITDA and strong cash flow generation at the mine site in the first half of 2023.
These were improvements that the market received very positively, as evidenced by the growth opportunities presented by the share price.
GATO did not fall short of expectations; rather the opposite has happened with its shares. After a 17.3% rise in silver prices, GATO shares finished nearly 3.5x higher, benefiting from the stock price's strong positive correlation with the precious metal's price. This also applied to the company's shares, which trade on the Toronto Stock Exchange under the symbol GATO:CA.
By investing in this stock, investors were able to benefit from strong price gains of over 80% during the regional banking crisis in March-April 2023 and also from significant return margins after the Fed's interest rate hike pause in late summer/early fall.
The gains made by retail investors on Gatos Silver confirm that this stock is very well positioned to benefit from the silver rally triggered by certain events such as those mentioned above. These events have strengthened silver's safe-haven properties as investors fear for the value of their assets.
This analysis again suggests a Buy rating: the company should continue to benefit from operational improvements and ongoing cost savings initiatives, while the price of silver is expected to rise sharply in the next forecast scenario.
The Silver Price Outlook: Another Strong Upside Catalyst Is in Sight. This is the Economic Recession
An ounce of silver was trading at $23,113 at the time of writing, but the price is expected to be higher in the future as demand is supported by robust industrial applications, as the metal is a key factor in energy transition projects while the investment in the precious metal helps protect assets against the next expected economic recession.
The worsening economic cycle will create headwinds that could impact the value of the portfolio, but investors will try to offset much of them through the expected increase in the price of silver and silver-backed securities.
In terms of energy transition projects, silver is often used in the construction of solar panels, which will help countries replace a large part of the energy generated by burning fossil fuels with energy from photovoltaic technology. As a benchmark, China will provide a huge boost to the global energy transition through the increasing adoption of silver-made solar panels, with the Asian country appearing to be leading the way. According to the International Energy Agency (IEA), China is investing convincingly and massively in solar energy as the country has tripled its capacity in just two years and is expected to step up its efforts once it manages to find the right solution for its economic recovery, struggling a bit at the moment.
As for silver investments to combat portfolio headwinds, the U.S. economy appears poised to create as many of them as possible to bring out the precious metal's safe-haven properties. If the next economic cycle turns into a recession, there will be many negative tailwinds, and in fact, recent trends in the labor market and consumption appear to support the thesis of economists predicting a recession for the US economy.
With its restrictive stance, the Fed is steering the economy in the desired direction and reducing core inflation from the current 4.1% to the target rate of 2%. The labor market cooled in October as payroll additions and wage growth rates in the non-farm sector slowed and consumption, which has always been largely supported by the robust labor market situation, is now showing signs of weakening.
Consumption, which accounts for nearly 70% of U.S. GDP , is weakening, as shown by some trends in new orders and inventory changes at U.S. goods makers. The latest reading of the US ISM Purchasing Managers Index, which pointed to the 11th consecutive decline in U.S. manufacturing in October, shows U.S. goods manufacturers face a continued slowdown in demand for their products as consumers, burdened by high borrowing costs and increased core inflation, are tightening their belts.
These economists predict an economic recession:
Michael Pearce , Chief US Economist at Oxford Economics, Chryssa Halley , Chief Financial Officer of the US Federal National Mortgage Association (Fannie Mae), and David Rosenberg , Economist at Rosenberg Research. Most recently, former US Treasury Secretary Larry Summers predicted that the next economic cycle would be a recession as early as 2024, and Luke Tilley , Chief Economist at Wilmington Trust, says that the US economy is not recovering but weakening, which will soon be clear to everyone, implicitly indicating an economic recession.
Due to the above factors, silver is expected to trade higher at around $23.71 per ounce before the end of 2023 and then continue to rise to $25.27 per ounce in 12 months.
The Strong Positive Correlation Between Gatos Silver, Inc. and Silver Prices
Retail investors may wish to take a position on the expected increase in the price of silver, not directly in the physical metal, which implies a capital capacity in terms of which retail investors cannot usually compare with large/institutional investors, but through shares of US-listed silver producers.
To that end, they might consider buying shares of Gatos Silver, Inc., as this stock appears to be well-positioned to benefit from rising silver prices. In particular, the stock has the following strengths: promising silver production and margin prospects, supported by cost reduction initiatives and estimates of a rising silver price.
The company's cash flow benefits from the sale of silver equivalent ounces produced from its 70% mineral interest in the Los Gatos Joint Venture, as this joint venture owns the Cerro Los Gatos mine in Chihuahua, Mexico.
Due to the high positive correlation between Gatos Silver's stock price and the price of silver as measured by silver futures (SIN2024) over the past five years, robust silver ounces and cash flow generation are expected to translate into positive stock price performance.
The positive correlation between the two securities, meaning that Gatos Silver shares rise when the price of silver is in an uptrend, is very strong, as the chart above shows. This shows that the gray zone is almost always above zero, with the only exception in spring 2022, when the increase in energy bills disrupted markets and led to greater volatility, and often very close to the upper limit of the correlation coefficient range of -1 to +1.
Perhaps the difference in performance between the two securities, Gatos Silver -25.67% and silver futures -3.3% over the past five years, can be confusing, but retail investors should be aware that the difference in performance has nothing to do with the correlation. The latter represents the relationship between the two assets and indicates that, on average, these two are moving in the same direction. Instead, the difference in the performance of the two securities is affected by comparing only two sets of prices, namely the prices of the two securities five years ago compared to the current prices of both securities. Current prices versus 5-year-ago prices ignore a variety of drivers that have affected securities' performance in the interim.
The result of this multitude of drivers meant that silver futures recovered from past losses much faster than GATO during a newfound bullish sentiment around the metal, with GATO shares down 25.67% while the price of silver fell by just 3.30% over the past 5 years.
Even the very low value of 0.04 for the correlation coefficient in the graph should not confuse retail investors, as this is simply the result of the trend at the time this analysis was written.
To determine whether and to what extent there is a positive or negative correlation between two assets, the benchmark for retail investors is instead the development of the gray area in recent years. And as already explained, for a long time in the last 5 years, the gray area has been well above the zero line.
This analysis also calculated how much, on average, GATO stock price could rise if the price of silver went much higher from here. For this purpose, weekly returns on silver futures are linked to weekly returns on the GATO stock price according to a linear model in which silver futures are the input and GATO is the output. The model was run on the weekly returns of both securities over the past 52 weeks and no further into the past as current markets are likely to look similar to last year as macroeconomic and geopolitical factors will be roughly the same: high-interest rates, increased core inflation and the consequences of the war in Ukraine and Gaza.
The results of the model indicate that the stock price under the GATO symbol, on average, amplifies any positive change in the price of silver by 1.2 times, with a coefficient of determination of about 20%, providing an acceptable approximation of the relationship: the change in the silver price determines 20% of the change in stock price. Very similar results emerge for shares of Gatos Silver on the Toronto Stock Exchange under the symbol ((GATO:CA)).
About Gatos Silver in 2023 (Year-to-Date): The Foundation Continues to Be Laid for Gatos Silver's More Years in the Profitable Silver Market
Amid a favorable silver price environment with prices well above the five-year average of $21,174 per ounce, the Canadian company's interest in the silver explorer and miner in Mexico sees ongoing improvement in several key operating metrics such as tons of mineral processed, and interesting prospects for higher ounces and longer mine life.
Here are the company's year-to-date results from Mexico exploration and mining activities and their impact on Gatos Silver, Inc.'s financial position and business outlook published after the market close on November 6, 2023.
Over the past 9 months, thanks to an incredible improvement in milled mineral to 794,082 tonnes (or up 12% y-o-y to 2,909 tonnes per day), offsetting the lower grade (293 g/t in 9M 2023 vs 361 g/t in 9M 2022) the Cerro Los Gatos mine managed to produce 6.65 million ounces of silver, which was in line with the company's expectations, albeit down 10.5% year-on-year.
The company continues to report significant production volumes of zinc and lead, which are also important to the company's goal of increasing profitability as they also have a bright future in the global fight against climate change through the energy transition. However, silver remains the primary source of cash for Gatos Silver, Inc.
Thus, the company also produced 42.7 million pounds of zinc, 28.7 million pounds of lead and nearly 3,860 ounces of gold. Secondary production was slightly lower in the first 9 months of 2023 due to an expected decline in average metal content compared to the same period in 2022: Zinc -9.3%, lead -16.1%, and gold -3%.
Production in silver equivalent ounces for the first 9 months of 2023 was 10.45 million ounces, down 10.5% year-over-year considering all metals production trends.
EBITDA margin was 50.4% for the first nine months of 2023, compared to an EBITDA margin of 53.8% for the first nine months of 2022, reflecting lower ounces of payable metal. However, through more prudent management of drilling exploration expenses and a greater focus on mining resource growth, the Los Gatos joint venture was able to generate significant free cash flow ($62.6 million in first 9M of 2023 versus $58.1 million in first 9M of 2022) and build a solid foundation for continued operations and the replication over time of the opportunity to profit from silver price cycles with a position in Gatos Silver, Inc. stock.
In fact, the goal of the Los Gatos JV is to extend the mine life by one to two years from conversion to reserves of higher quality inferred resources, as well as the potential for a further extension of the mine life by three to four years through exploration in the depths of the mine from its southeastern zone. Currently, the mine life of the underground multi-metal deposit ends in 2028.
Thanks to investments in improving operational performance and in the optimization of the mine plan, the Los Gatos Joint Venture is now raising the amount of silver ounces to deliver. The company has significantly increased the guidance range for its full-year 2023 silver and silver equivalent production as follows: Silver production is now estimated at 8.8 million to 9.3 million ounces, versus the original forecast of 7.4 million to 8.2 million ounces. Silver equivalent production is now expected to be in the range of 13.8 million to 14.6 million ounces, versus the original forecast of 12.4 million to 13.8 million silver equivalent ounces.
It must also be said that the company controlled by the joint venture would hardly have increased its forecast if it had not received positive inputs from the project aimed at expanding mining activities in Mexico.
These are significant upward revisions which, along with costs projected to trade lower than middle points of respective guidance ranges of $15.50 to $17.50/oz for co-product AISCs and of $15.50 to $17.50/oz for by-product AISCs, will interact favorably with silver's outlook, particularly if silver catalyzes the expected rally on recession fears.
All seems settled as the Los Gatos joint venture continues to return money to its partners, potentially at a faster pace than the $85 million already transferred so far in 2023, with Gatos Silver, Inc. being in a strong position with its 70 percent stake in the joint venture. In October alone, Gatos Silver, Inc. received an additional $24.5 million in cash distributions.
Due to profitable operations (i.e., investments in the joint venture), Gatos Silver's balance sheet has grown from debt-free plus $36 million in available cash and $50 million in revolving credit facilities as of July 31, 2023, to debt-free plus $57.7 million in available cash and $50 million in revolving credit facilities as of October 2023.
The Stock Valuation
Shares of Gatos Silver, Inc. under the GATO symbol, were trading at $4.95 apiece as of this writing, for a market capitalization of $344.43 million.
Given the growth potential, current share prices do not appear expensive: they are near the 200- and 50-day moving averages of $5.01 and $5.05. Thanks to upward pressure from the catalysts described earlier in this analysis, share prices can rise very quickly from these levels, as has already been the case over the last 12 months.
GATO shares have a 52-week price range of $3.32 to $7.49, with a median of $5.405, and are currently well below that median.
As the 14-day relative strength indicator at 49.23 shows, shares have plenty of room to fall under pressure from the Fed's "higher and longer" stance, but this analysis doesn't see much chance of lower prices from here. The Fed's intention to keep rates higher is already reflected in stock prices, as this information has been in the market for weeks.
The shares also look cheap compared to what might be considered a fair valuation, according to estimates from Aswath Damodaran, professor of business administration and stock valuation at New York University's Stern School of Business. Damodaran indicates that non-gold precious metals and minerals stocks should have an EBITDA multiple of not more than 6.97 times to be considered fairly valued in the stock market. Based on Gatos Silver's production and cost expectations, as well as analysts' silver price forecasts, the company can easily achieve a 12-month EBITDA of $130-$135 million in the future, resulting in an EV/EBITDA of 2.5x to 2.7x, which is well below Damodaran's estimate. So far, there is no reason to believe that an EBITDA of $130-135 million - which results from an annualization of the item for the first 9 months - cannot be pursued as a target.
The same considerations are applied to the stock traded on the Toronto Stock Exchange.
Shares of Gatos Silver, Inc. stock under the GATO:CA symbol, are trading at CA$6.86 apiece as of this writing, below the 200- and 50-day simple moving averages of CA$6.77, and CA$6.87, respectively. Shares are also trading below the middle point of CA$ 7.225 in the 52-week range of CA$ 4.45 to CA$ 10. The stock has a market cap of CA$ 470.82 million.
The stock under the symbol GATO:CA has a 14-day Relative Strength Indicator of 50.12.
There is a risk that this stock may not perform as expected, and this could happen if the catalyst for silver's rally fails to materialize. However, this analysis assumes that this risk will decrease as the onset of the economic recession gains momentum.
Moreover, even in the presence of a concrete risk of a soft landing rather than a recession, this will face mitigating effects from the gradual rate cut that the Fed will begin sometime in 2024 and from there go a little faster.
Lower interest rates decrease the opportunity cost of investing in silver rather than interest-bearing securities, contributing to higher silver prices through a strengthening of the demand for investment purposes. However, a gradually lower interest rate will encourage investment in manufacturing activities and growth projects, which also bodes well for the silver industry.
The retail investor must be careful not to increase his position too much as the lower volume of shares trading on the exchanges can make it difficult to quickly reduce the position if necessary.
GATO has an average volume of 390,282 shares traded on the New York Stock Exchange over the past 3 months. GATO:CA has an average volume of 1,485 shares traded on the Toronto Stock Exchange over the past 3 months.
Conclusion
This Gatos Silver, Inc. stock is well positioned to benefit from the expected rally in silver prices, as the company's 70% stake in the Mexican mining and exploration joint venture should benefit from a continued robust cash payout on the prospect of higher silver production, contained costs, and mine life extension.
As the market processes information about this stock, it tends to amplify any change in the price of silver in terms of reflections on Gatos Silver's share price. This, as measured by this analysis, could send this stock soaring if silver were to experience a bull market as a result of its safe haven properties amid the origination of fears of looming economic recession.
For further details see:
Gatos Silver Could Perform Strongly If Silver Rallies