2023-06-21 15:43:29 ET
Summary
- The Silver Miners Index has underperformed silver with an 8% year-to-date decline, following two double-digit annual declines in 2021 and 2022.
- Rising costs and shrinking margins, along with increased uncertainty and continued cost pressures, have led to the underperformance of the Silver Miners Index.
- I continue to see gold producers as far better investments due to their more conservative metals price assumptions, superior capital discipline, superior jurisdictional profiles, and more attractive valuations.
While investors in the precious metals sector have had to grit their teeth as they've watched the Gold Miners Index ( GDX ) retreat into negative territory for the year after a brief double-digit percentage gain, it's the Silver Miners Index ( SIL ) that has been the real disappointment. Not only has the index underperformed silver ( SLV ) with an 8% year-to-date decline, but this has followed two double-digit annual declines of 20% and 23% in 2021 and 2022, respectively vs. a mere 8% drop in the price of silver. Some investors might chalk this underperformance relative to silver up to manipulation or poor sentiment sector-wide. And while the latter point regarding negative sentiment is certainly valid, an argument can be made that the negative sentiment towards the sector is more than justified. In this update, we'll look at why we've seen such severe underperformance for the Silver Miners Index with a ~15% quarter-to-date decline and dig into why valuations for most names still aren't attractive unless we see much higher silver prices.
Rising Costs & Shrinking Margins
Just over two months ago, there was a stampede of hurrahs from the silver bulls camp, with the price of silver hanging out above $25.00/oz, making investors confident that the "multi-baggers" that they'd been promised by some analysts were finally going to come to fruition. Unfortunately, when the chants are the loudest is often exactly the time to pull some chips off the table (which is why I was taking profits on several positions into strength), and since the April highs we've seen a double-digit decline in the silver price and a 21% decline in the Silver Miners Index. At first glance, this might seem unjustified and many have argued that the sell-off is detached from fundamentals. However, we've seen a sharp rise in costs for the basket of silver producers I track since 2019 because of inflationary pressures (labor, power, fuel, cyanide, steel, etc.) and declining grades, and the silver price has not come close to keeping up to provide an offset from a margin standpoint.
Silver Miners - Annual All-in Sustaining Costs (2019-2022) & Q1 2023 Costs (Company Filings, Author's Chart)
Coeur Mining's ( CDE ) costs are on an adjusted costs applicable to sales basis, with all-in costs being much higher than what's reflected on the chart.
As shown in the chart above, not only have all-in sustaining costs [AISC] for silver miners trended materially higher from 2019 to 2022 on balance, many of these producers have been working with razor-thin margins in the period, and continue to have little breathing room vs. the current silver price of $23.00/oz. And with all-in sustaining costs for this basket of producers increasing from ~$12.50/oz in FY2019 to ~$16.60/oz in FY2022 with a further increase to ~$17.00/oz AISC likely in FY2023, the rally in the silver price from ~$17.50/oz in Q4 2019 to ~$21.30 in Q4 2022 has made little difference from a margin standpoint, with AISC margins actually down slightly in the period. Plus, as those that follow all-in sustaining costs know, they don't provide an accurate portrayal of actual costs, with some producers reporting all-in costs above $25.00/oz if we include growth capital, share-based compensation and interest expense.
Endeavour Silver - AISC vs. AIC Q1 2023 (Company Filings, Author's Chart)
One example is highlighted above, with Endeavour Silver ( EXK ) reporting all-in sustaining costs of $20.16/oz in Q1 2023, but all-in costs of $29.98/oz in the period. Another example where all-in sustaining costs are somewhat misleading to determine profitability is Guanajuato Silver ( OTCQX:GSVRF ) which reported all-in sustaining costs of $21.83/oz in Q1 2023 that might suggest it's generating free cash flow at a ~$23.00/oz silver price. However, this isn't the case at all, as the below financial statements show, with the company reporting an operating loss of ~$7.2 million in the period and a net loss of ~$8.7 million in the period. So, while many investors might argue that a sustained move above $25.00/oz will fix all of the problems for the high-cost producers, this isn't the case at all, with minimal free cash flow generation for these higher-cost producers even at a $28.00-$30.00/oz silver price based on their current operations.
Guanajuato Silver - Q1 2023 Financials (Company Filings, Author's Chart)
To summarize, while many make the argument that the Silver Miners Index ((SIL)) is flat from where it traded in 2019 when the silver price was 20% lower at ~$19.00/oz, this is an irrelevant argument. In fact, we've actually seen slight outperformance for the SIL vs. where it should trade based on where margins are sitting, with margins down slightly in the period due to the impact of inflationary pressures felt sector-wide plus a combination of declining reserve grades. Of course, many will debate that silver can only go higher from these levels and it's only a matter of time before margins expand. And while this may be true, that is required at this point to stave off further margin compression, and with rising commodity prices we often see rising costs, so silver prices will need to increase at a pace above that of inflation, not simply creep higher at the pace they have since 2019.
Never-ending Share Dilution
If the above argument that we've seen no margin expansion was the only issue with the Silver Miners Index (which is made up of a basket of roughly 20 silver miners in the exploration, development and production stage and a couple of royalty/streaming companies), then this wouldn't be the end of the world, and a higher silver price above $25.00/oz could quickly fix this profitability issue. However, the shrinking margins and mineral reserves for most producers is not the only issue. In fact, the much larger issue are the per share metrics tied to most of these companies, with a consistent decline in silver-equivalent production and mineral reserves per share. And while many investors in the sector are aware of the moderate share dilution that comes with mining stocks given that this is a depleting business, many aren't aware of the magnitude of this share dilution, which is highlighted in the chart below.
Silver Miners - Weighted Average Annual Shares & Current Share Count (Company Filings, Author's Chart)
As shown in the chart above, the share counts for silver producers have consistently risen over the past few years, which is inexcusable for most names in a period where the silver price has rallied over 30%. And while some names that are new producers like SilverCrest ( SILV ) can get a pass here, other names like Guanajuato Silver, Coeur Mining, First Majestic Silver ( AG ) and Americas Gold & Silver ( USAS ) have a terrible track record of share dilution, resulting in their reserves per share and production per share declining materially, as discussed in a previous update on Coeur Mining. And as I've highlighted in past updates, if a producer is not growing production and reserves per share or at least holding the line, one should simply own the precious metal vs. the producer as their exposure to that commodity is consistently declining each year.
Coeur Mining - Declining Reserves Per Share (Company Filings, Author's Chart & FY2024 Estimates)
Much of the production per share and reserve per share declines have been attributed to failed ventures such as Silvertip, Relief Canyon and Jerritt Canyon which were major disappointments for Coeur, Americas G&S and First Majestic Silver, respectively. However, we've also seen material share dilution from capex blowouts like at Coeur's Rochester Expansion and while capex blowouts may hurt other producers like Newmont ( NEM ) that reported higher construction costs at its Tanami Expansion and Ahafo North, these companies have the margins and balance sheet to absorb these higher costs without turning around and persistently selling their own stock at depressed levels or divesting assets altogether like Coeur Mining did with Crown and Sterling.
So, with ~66% average share dilution for this basket of silver producers since 2019 alone even in a rising silver price environment, one needs to recognize 95% of silver miners are not investments, and they're hot potatoes at best. This means that while owning them for a trade at the right valuation if they fall to depressed levels might make sense, owning them simply because one is bullish on silver without taking into account the valuation is a recipe for disaster. This means that the only way to make money consistently with the silver miners is to wait for the right price and focus on quality, and the latter shouldn't be hard as there's so little quality in the sector. Unfortunately, most investors get caught up in silver squeeze hypes and herd mentality during parabolic rallies in the metal and throw caution to the wind and are then dragged out at the lows like we've seen in First Majestic as the stock has sunk 70% from when I warned against owning the stock in 2021.
First Majestic Silver Update, February 2021 (Seeking Alpha Premium)
Increased Uncertainty & Continued Cost Pressures
Finally, adding insult to injury, nearly half of the silver producers in the Silver Miners Index have exposure to Mexico, a mining jurisdiction that continues to slide down the ranks from an investment attractiveness standpoint. Fortunately, the Gold Miners Index is not subject to the same issues with much greater geographical diversity, with the top-5 producing nations for gold comprising three Tier-1 ranked mining jurisdictions: Australia, Canada, and the United States. This is not the case for silver production, with the three largest silver-producing nations being Mexico, China, and Peru, with Mexico making up ~25% of total silver production and nearly double the #2 silver-producing country, China.
Given the high weighting to these countries, it's no surprise that most of the companies within the Silver Miners Index will be focused within these less attractive jurisdictions regarding exploration, development, and production. The evidence of declining perceptions around Mexico as a mining jurisdiction is highlighted in the Fraser Mining Institute's Annual Survey of Mining Companies, where we have seen Mexico's investment attractiveness score fall from 73.9 to 60.2 from 2018 to 2022, and this was before the recent mining reforms and a new mining law passed in late April, as well as demands for much higher profit-sharing at Newmont's Penasquito Mine in Zacatecas, Mexico. Hence, I would argue that Mexico's investment attractiveness is likely to decline further, which certainly doesn't help regarding investment dollars moving into silver developers and producers in Mexico.
Mexico - Investment Attractiveness Score (Fraser Mining Institute Annual Survey of Mining Companies 2022)
Some investors will argue that this isn't a big deal, that producers are not affected, and most will continue to operate without issues despite these mining reforms. And while this may be true, perceptions about a jurisdiction are quite important, given that this could impede producer decisions to invest in new projects within the country or impact potential M&A. This negative change in perceptions is also a negative development from an investment standpoint because some investors realize the sector is challenging enough already and don't want to deal with the added risk of mining laws that make permitting slower, more challenging, or take a bite out of miners' profits. So, regardless of whether operations are affected, I see these recent developments as negative for SIL and especially silver developers in Mexico, which may have otherwise been takeover targets at depressed valuations but might be passed over in the current environment because of the added uncertainty.
Mining executives at Fortuna Silver ( FSM ) and Endeavour Silver had the following to say in their Q1 2023 Conference Calls:
"In early May as well, the Mexican Government approved the new mining reform, which we view as negative for investment in the country, unfortunately. For starters, mineral exploration in open ground becomes an activity reserve for the government and existing mineral concessions and mine operations will be subject to many questionable articles in the law, which provides for higher costs and uncertainties to investment. We expect there will be many constitutional appeals filed with the Supreme Court of Justice in Mexico against the new law coming from mining companies and other interest groups."
- Fortuna Silver CEO, Jorge Ganoza
"Lastly, I want to touch on the recent development of the new Mexican mining laws. Of course, this has been a topic with a lot of uncertainty and unfortunately moved swiftly through the Mexican government. From an operating standpoint, our expectation is the new law will increase compliance requirements, specifically around water use and reclamation activities, but don't expect a disruption of our operations or construction activities. There is still uncertainty of the details, but unfortunately, these new laws could discourage future investment into Mexico's exploration sector."
- Endeavour Silver CEO, Dan Dickson
Finally, there are a few other negative developments that have arisen in the past quarter that will affect the profitability of many miners in the Silver Miners Index and have created added uncertainty regarding future profits. The first is the recent strength in the Mexican Peso vs. the US Dollar ( UUP ) which will put pressure on labor costs for Mexican producers, with several companies having between 50%-100% of their operating exposure to Mexico within the SIL. As shown in the chart below, the USD/MXN exchange rate is down over 5% sequentially since Q1 2023, which will partially offset any improvement in the silver price on a quarter-over-quarter basis with labor being the largest expense for most miners.
The second negative development is the near waterfall decline in zinc prices since the start of the year, which may not seem relevant on the surface, but several silver producers have polymetallic mines and rely on by-product credits to reduce their operating costs. And while the price of zinc was a tailwind for mines like Lucky Friday, Greens Creek, Cosala, Topia, Galena, and several other operations in H1-2022, these assets are coming up against tough year-over-year comparisons from H1-2022 that benefited costs and offset some of the impact of inflationary pressures with much less help from a by-product credit basis in the upcoming Q2 2023 results. So, especially for polymetallic mines in Mexico like Guanajuato Silver's Topia Mine, I would expect this to be another tough quarter from a margin standpoint with a stronger Mexican Peso, reduced by-product credits, and continued inflationary pressures called out by some Mexican producers like Endeavour Silver.
Last but not least, from a bigger picture standpoint in Mexico, Newmont has temporarily halted operations at Penasquito (Zacatecas State in Mexico) with the National Union of Mine & Metal Workers of the Mexican Republic notifying the company of a strike action, with demands for a 100% increase in the uncapped profit sharing benefit in the Collective Bargaining agreement (10% ---> 20%). Elsewhere, at the San Jose Mine in Oaxaca, Mexico, an illegal blockade was reported with similar demands with Fortuna Silver noting that a group of workers didn't agree with the estimated amount the company was distributing as part of the worker's profit sharing entitlement. While these are just two operations, this creates added uncertainty regarding demands for further wage increases at other mines in Mexico, and as addressed previously, over 70% of the index constituents have some exposure to Mexico, with nearly ~25% of the index constituents having 100% exposure to Mexico.
Summary
Some investors might believe that the selling pressure in silver miners is unwarranted, I would strongly disagree. This is because we've had multiple negative developments occur over the past six months that affect/could affect profitability for silver producers (a stronger Peso and weaker base metals prices), and developments that affect perceptions surrounding their jurisdictions for explorers, developers, and producers based out of Mexico. So, while the index may be due for an oversold bounce after what's been a sharp 21% correction in less than two months, I continue to see the Silver Miners Index as a low-quality way to get exposure to silver or gold given that there are arguably only two to three names in the sector that are investable of over twenty total holdings, with several that are complete avoids due to low-quality assets, razor-thin margins and/or consistent share dilution.
So, what's the best course of action?
As highlighted in previous updates, I continue to see gold producers as far better run on balance than silver producers, with more conservative metals price assumptions to dictate their mine plans, more capital discipline, and more diversification and superior jurisdictional profiles on balance. Despite these superior attributes, many gold producers trade at much lower P/NAV multiples and cash flow multiples, and while some premiums might be justified for silver producers, there's absolutely no way to justify paying over 2.0x P/NAV for low-quality miners with razor-thin margins and 100% exposure to Mexico, like First Majestic Silver, when one can buy names like Newmont with better margins at half the P/NAV multiple and barely ~7.0x forward cash flow.
To summarize, if I was looking for exposure to silver through a producer and with limited exposure to Mexico, I see Pan American Silver ( PAAS ) as the most attractive name currently. This is because it boasts a near double-digit FY2024 free cash flow yield, an attractive dividend yield (~2.70%), and a strong pipeline (MARA, La Arena Sulphides, Escobal, La Colorada Skarn) which sets the company up for production growth per share and potential balance sheet improvements if it looks to divest any assets and optimize its portfolio. This doesn't mean that the stock must trade higher immediately and it's certainly working against negative short-term momentum, but I see this weakness as unlikely to last as investors recognize the quality of the Yamana portfolio it acquired and the cash flow this business is capable of generating with high-margin assets like Jacobina and El Penon.
For further details see:
Silver Miners Index: Another Quarter Of Underperformance