2023-08-23 07:44:55 ET
Summary
- Gatos Silver owns a 70% stake in the LGJV, which operates the CLG mine in Mexico's Los Gatos District.
- The LGJV recorded a 2% YoY increase in revenues and a 7% YoY decrease in cost of sales in Q2 2023.
- Gatos Silver has a strong balance sheet, with a debt-free status and sufficient liquidity to support exploration initiatives.
Thesis
Gatos Silver ( GATO ) is engaged in the exploration, development, and operation of silver mining assets located in Mexico. The company owns a 70% stake in the LGJV (read: Los Gatos Joint Venture) with Dowa Metals and Mining (or Dowa) owning the remaining 30%. The LGJV operates through the following modes:
- running the production and exploration operations at the CLG (Cerro Los Gatos) mine located in the LGD (read: Los Gatos District).
- exploring other high-value prospecting targets within the LGD.
Besides GATO's investment in the LGD, the company also owns 100% of the Santa Valeria property (also in Mexico). A greater portion of GATO's operational focus is on the LGD assets (primarily the CLG mine).
Hence, our analysis will also be centered around a detailed discussion of multiple aspects relating to GATO's investment in the LGD (through LGJV). For that purpose, we will discuss GATO's recently released Q2 2023 results and also analyze how the stock could perform in a rising silver price environment. We will conclude our analysis with a discussion of the risks relevant to GATO's operating environment. Let's get into the details.
Q2 2023 Review - Results and Expectations
GATO has recently released financial and operating results for Q2 2023. Since GATO's core stake is in the CLG mine operated by the LGJV, it's appropriate to discuss the Q2 performance of the LGJV. In terms of financial performance and position, the JV recorded revenues of $58.3 MM during Q2 2023 witnessing a marginal 2% YoY increase (Q2 2022:$57.2 MM). LGJV also managed to decrease the cost of sales by 7% YoY, from $27.8 MM in Q2 2022 to $25.8 MM during Q2 2023. Interestingly, the YoY reduction in the cost of sales comes despite a 26% YoY increase in mill production (or ~54,000 tons of ore milled).
In my view, it's encouraging to note that LGJV has improved in terms of both revenue and cost performance, YoY.
To quote the CEO of GATO on this occasion (emphasis added by the author),
The LGJV continues to generate robust cash flows and perform in line with our expectations, and we remain on track to achieve 2023 guidance at CLG. We are in a strong financial position with GATO now debt free and with a strong cash balance . We are progressing well with our planned update to the CLG's mineral resource and reserve estimate which we expect to announce later this quarter, including a new life of mine plan.
Let's analyze the key elements highlighted in the above statement of the CEO:
1) Cash flows: LGJV's quarterly cash flows from operations have significantly dwarfed its quarterly capital expenditure, enabling the company to generate significant free cash flows each quarter. During Q2 2023, LGJV generated positive FCFs to the tune of $19.7 MM which marginally exceeded the FCF generated during Q2 2022 (~$19.5 MM). Significant FCF generation has enabled LGJV to maintain handsome cash distributions to its partners (GATO and Dowa). Look at the charts below.
Robust Cash Flows - Source: GATO Earnings Presentation - Q2 2023
In my view, LGJV's robust cash flow profile would help ensure the execution of the company's long-term exploration strategy in the LGD (more on this later) .
2) Guidance: Look at the following table which compares H1 2023 performance with the FY 2023 guidance.
Here are the key takeaways from the date in Table-1:
- In terms of production, we can anticipate a YoY decline during 2023. Nonetheless, 2023 annual production may well be on the higher side of the guidance range. Given spot silver is generally performing better this year compared with 2022, I believe the impact of lower YoY silver production during 2023 will be largely offset by higher YoY silver prices. Check the chart below.
1-Year Silver Price Chart - Source: Kitco
- In terms of cost performance, the by-product AISC during H1 2023 was less than the average value for 2022, and well within the 2023 guidance range. This goes in line with GATO's goal to achieve low-cost production at the CLG mine. In my view, improved YoY silver prices during 2023 combined with lower YoY AISC will help improve the profitability of the LGJV operations, going forward.
- In terms of CAPEX, the company has already incurred >50% of the planned annual drilling development CAPEX which would help the company to issue the updated R&R (reserves and resources) during H2 2023.
3) Strong Balance Sheet: As of June 30, 2023, GATO's balance sheet was $381.3 MM; flat with ~$383.5 MM as of December 31, 2022. Approximately 93% of the June 30th balance sheet comprised the 'investment in affiliate' (70% interest in LGJV) to the tune of $354 MM, with the remaining ~$27 MM comprising of current assets (including cash and equivalents worth $9.1 MM). Notably, the June 30th balance sheet included accounts payable worth ~$26 MM implying that GATO maintained a 'current ratio' of more >1x as of June 30, 2023.
Subsequent to Q2, GATO fully repaid the outstanding RCF to the tune of ~$9 MM. By July 31, 2023, GATO received ~$35 MM from LGJV in the form of distribution to partners. With this, GATO's liquidity position was substantially strengthened; comprising ~$36 MM in cash, and $50 MM in RCF (maturing in December 2025) with an accordion to avail an additional $25 MM.
Notably, the balance sheet is now debt free, has a very small number of outstanding share count which is also <10% of the authorized number of shares (~69.3 million fully diluted shares against 700 million authorized shares), and is equipped with sufficient liquidity to support GATO's exploration initiatives in the future.
Growth Catalysts
1) Silver Prices: Approximately 0.2% of VanEck Junior Gold Miners ETF's ( GDXJ ) holdings comprise GATO. However, we cannot use GDXJ's price returns as a benchmark to assess GATO's price performance since a major chunk of the revenues of CLG are based on silver metal sales (and not gold sales). Perhaps a more appropriate benchmark is iShares Silver Trust ETF ( SLV ) because it mimics the trend in silver prices. The chart below compares GATO's 1-year price performance with that of SLV and reveals that in times of a silver rally, GATO has outperformed the benchmark ETF by a huge margin (check the area covered by the purple lines).
To quantify the impact (correlation factor) of a change in silver prices (represented by SLV's price returns chart below) on the share price of GATO, we can assume that a ~30% increase in silver prices from February 2023 to April 2023 led to a significant increase of ~85% in the price of GATO. The reverse also holds true; a ~20% decline in silver prices led to a massive decline of ~70% in the price of GATO. The above numbers indicate that GATO is highly reactive to volatility in silver prices. In my view, the upcoming FOMC (Federal Open Market Committee) meeting scheduled to be held in September 2023 will keep a check on the most recent bullish momentum in silver prices because analysts expect the Fed to announce another rate hike in its September meeting. Nonetheless, over the long term (say, 5-8 years), the expectations of a massive silver demand hike following attempts by countries to convert to a "net-zero" economy will help uplift silver prices.
2) Exploration Timeline: Another fundamental aspect that amplifies GATO's near-to-medium-term growth potential is the results of exploration activities at LGJV's mining assets located in the Los Gatos District. These include the CLG mine, and other promising orebodies (such as the Esther zone, etc.) in the LGD with prospects of addition to the mineral resource, and extension of mine life. For clarity, let's check the different exploration and resource definition targets in GATO's exploration timeline:
- Based on the existing reserves, CLG's mine life extends till 2028. LGJV is targeting an extension to the mine life by converting some of the higher-grade inferred resources to M&I (Measured and Indicated) resources. 3 underground drilling rigs are allocated for the purpose and GATO expects that LGJV will be in a position to announce an updated resource/reserve statement for the CLG in Q3 2023. This will be a significant positive development as it will extend the mine life from 2028 to 2030.
- Moreover, LGJV also plans to extend the mine life from 2030 onward by targeting the South East Deeps zone. The existing drill program will better define the Inferred resource in this zone (targeted Q3 2023). The resource model will be further updated through conversion drilling (targeted H2 2024). Favorable results of these exploration activities will help extend CLG's mine life by another 3-4 years.
- Out of the 5 drills assigned in the promising SE Deeps zone at CLG, one has been moved to the district satellite deposits. LGJV plans to begin exploration in the district deposits from 2025 onward which will continue for at least the next 10 years.
SE Deep Extension - Source: GATO Earnings Presentation - Q2 2023
As mentioned above, LGJV's exploration timeline stretches well beyond 10 years and provides for significant near-to-long-term milestones regarding resource expansion and mine life extension. Successful execution of these milestones will have a notable impact on GATO's share price as they are indicative of the continuation of FCF-positive, and low-cost mining in the long run.
Investor Takeaway
Our analysis demonstrates GATO's financial and operational strength in terms of rising YoY revenues, improving costs, a debt-free balance sheet studded with adequate liquidity, positive FCFs that can grow over time, and a near-to-long-term exploration schedule to add to the mineral resources/reserves as well as life of the CLG mine operated by GATO's 70%-owned affiliate LGJV. However, it makes sense to reiterate the following risk factors (excerpt taken from Annual Report 2022 ) that may significantly impact the investment thesis in the future:
- Mineral reserve and mineral resource calculations at the CLG and at other deposits in the LGD are only estimates and actual production results and future estimates may vary significantly from the current estimates.
- The Mexican federal government recently promulgated significant amendments to laws affecting the mining industry; while it is difficult to ascertain if and when the amendments will be fully implemented, and there is some lack of clarity in their drafting including their intended retroactive effect, the amendments could have a material adverse effect on the mining industry, and the LGJV’s and our Mexican businesses, particularly in respect of any new concessions, new mining permits, and new operations.
In the absence of the materialization of the above risks, I think GATO is capable of providing suitable share price growth in the medium-to-long term.
For further details see:
Gatos Silver: The Odds Are In Its Favor