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In my earlier article, I discussed one of the most important metrics to analyze the silver industry, the actual cost of mining an ounce of silver, which can help an investor figure out whether it is time to buy SLV and/or the silver miners. In that analysis, I used the 3Q 2012 financials to calculate the combined results of a number of publicly traded silver companies and came up with the average cost it takes to mine each ounce of silver. Once the 4Q FY12 reports from all gold and silver miners are out, we will be posting the consolidated true production cost calculations for both gold and silver.

In this analysis we will calculate the real costs of production of First Majestic Silver (NYSE:AG), a primary silver miner with producing mines and development projects located in Mexico.

Calculating the True Mining Cost of Silver - Our Methodology

In a previous article about Goldcorp's (NYSE:GG) cost of production, I gave a thorough picture of the current way mining companies report their cost of production and why it is inaccurate and significantly underestimates costs. Then we presented a more accurate methodology for investors to use to calculate the true costs of mining gold or silver. Please refer to that article for the details explaining this methodology, and I would encourage all precious metals investors to understand this important concept. It is important for investors interested in miners or those who focus on gold and silver as a commodity investment, because the true costs of production will show where a possible floor exists for a commodity (the production cost) which is important to silver (SLV investors) and is also an obvious way to differentiate miners.

Real Costs of Production for AG - 4Q 2012 and FY2012

Let us now use this methodology to take a look at AG's results and come up with their average cost figures. When applying our methodology for the most recent quarter and FY2012, we standardized the equivalent ounce conversion to use the average LBMA price for Q4FY12. This results in a gold ratio of 52.7:1, lead ratio of 32.68:1, and iron price per ton of $120, and a zinc ratio of 37:1. We like to be precise, but realistically minor changes in these ratios have little impact on the total average price - investors can use whatever ratios they feel most appropriate represent the by-product conversion.

Important Note: When calculating silver equivalent ounces, our silver equivalent production may differ a little bit from AG's numbers. The reason is that even though we are using the same base numbers, depending on the ratio of conversion it may change the number of total equivalent ounces. We believe our methodology of using the most recent LBMA prices is the most accurate in terms of predicting future silver equivalent production. It also allows investors to compare AG with other silver companies because if they use our methodology then the comparisons will be apples-to-apples, while using individual silver miner calculations may yield much different results since each miner may use a different equivalency calculation.

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Observations for AG Investors based on True Costs of Production

The first thing that investors should note is that the costs to produce an ounce of silver for AG were $18.88 in 2011 and $18.44 in 2012, which is a reduction of about 2% per ounce of production. This is a very good performance for AG and compares well to fellow competitor Pan American Silver (NASDAQ:PAAS) (true production costs around $19.34 for 2012). Management successfully reduced costs while other miners were struggling to keep cost rises low - it is definitely something that investors should appreciate in AG's management.

Even better, costs in the fourth quarter ($17.71 per ounce) were less than the average for 2012, which may be a sign that costs in 2013 can continue this downtrend. This is not always the case, but we would rather see it on the lower end of the annual average price than on the higher end.

In terms of production, it looks like AG is aggressively increasing production. Attributed silver production was 7.9 million ounces for 2012 which was about a 15% rise over 2011 production. Additionally, it looks like management is also increasing byproduct production (lead, iron, and zinc) which is having the effect of lowering total silver costs and increasing equivalent silver production from around 7.5 to 8.8 million equivalent ounces.

So in terms of both production and production costs, AG's report card looks pretty good, but the problem is that Wall Street did not like their earnings report, especially since EPS and net income was down even while production rose. Even with increased production of silver equivalent ounces and tame production costs, AG's net income dropped from $103.6 million to a mere $88.9 million - what happened?

There are a few reasons for this drop in net income, with the first being that the silver price was down in 2012 versus 2011 which obviously dragged down revenues - AG sold significantly more silver and byproduct metals than in 2011 but its revenues were basically flat primarily due to the lower average silver price.

The second reason is not as clear, and at this point most investors will simply attribute it to rising costs. But knowing the true costs of production helps us determine that AG is not spending more per ounce than in FY2011, yet their net income is significantly lower - so something else must be at play here.

We believe that something has to do with the costs that AG realizes for its byproducts. Unfortunately, this is one aspect of AG's financial reports that they need to improve because we have no idea as investors what price AG realized for its byproduct production. All we know is that AG realized an average price of $31.10 for the year per silver ounce and this number includes credits for byproduct production. What this means is that AG did NOT get $31 per ounce of silver, they must have gotten lower than that and then by including byproduct sales, bumped the number up to $31.10 per ounce.

Since AG produced a significant amount of byproduct metals in FY12, they should have gotten a much better price than they actually realized. So even though equivalent ounce true costs of production looks very good, it is based on the assumption that AG is selling at market rates for these byproducts - significantly lower rates for these byproducts will make true production costs per ounce of silver higher than the calculated $18.88 for 2012. This would mean that they really did not keep costs as low as they should have based on realizing the revenues from byproduct sales.


The combination of a lower silver price in 2012 and the low prices that AG received from their byproducts seemed to contribute to the poor net income performance. Wall Street was let down and sold the stock.

But both factors leading to the weak performance, the low silver price and the low sales price for byproducts, are things that are temporary in nature and are not structural corporate deficiencies. If management can receive a better price for their byproduct production, and we are confident that they can, then future earnings should be pretty strong compared to their peers based on the fact that their true costs of production should be lower than the other miners.

With AG's very low cost of production per ounce, we believe that this quarter's underperformance on a net income level is an aberration. In future quarters, AG should receive better byproduct prices which will translate into a much better bottom-line.

What would be of concern for AG investors (and all silver industry investors) is share dilution. AG increased its shares by 5% last year (though they did acquire SilverMex Resources) and these increases would negate any improvement in net income on an EPS basis. This is something AG investors need to monitor.

In conclusion, if management can prevent more share dilution then AG should be a very promising miner with its low costs and increasing production. They can survive with silver in the mid-twenties without having a major cash crunch, and they are a safe company for investors to consider while silver prices languish below $30 per ounce.

Disclosure: I am long AG, PAAS, PSLV, SIVR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.