In an earlier article, we 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, PSLV, and/or the silver miners. In that analysis, I used the FY2012 financials to calculate the combined results of publicly traded silver companies to come up with a true all-in industry average cost of production to mine each ounce of silver.
In this analysis we will calculate the real costs of production of Silver Standard Resources (SSRI), a primary silver miner with a large producing mine in Argentina (the Pirquitas Mine) and two major development projects in Peru and Mexico.
Calculating the True Mining Cost of Silver - Our Methodology
In the previously mentioned article, we gave a thorough overview of the current way mining companies report their costs of production and why it is inaccurate and significantly underestimates total 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 concept.
Explanation of Our Metrics
Cost Per Silver-Equivalent Ounce is the costs incurred for every payable silver-equivalent ounce. It is Revenues minus Net Income, which will give an investor total costs. We use payable silver and not produced silver because payable silver is the silver that the miner actually keeps and is more reflective of their production. Miners also use payable silver and not produced silver when calculating cash costs, so this is pretty standard.
We then add Derivative Gains (or minus Derivative Losses), which will give investors total costs without the effects of derivatives. Finally, we add Foreign Exchange Gains (or minus Foreign Exchange Losses) to remove the effects of foreign exchange on the company's costs.
Cost Per Silver-Equivalent Ounce Excluding Write-downs is the above-mentioned "cost per silver-equivalent ounce" minus Property/Investment Write-downs and Asset Sales. This provides investors with a metric that removes exceptional gains or losses due to write-downs and asset sales.
Cost Per Silver-Equivalent Ounce Excluding Write-downs and Adding Smelting and Refining Costs is the above-mentioned "cost per silver-equivalent ounce excluding write-downs" adding in smelting, refining and all other necessary pre-revenue costs. This is a new metric that we are now introducing to our true all-in cost series because it will more accurately measure all-in costs and allow comparisons between miners.
Most investors are unaware that many miners will remove smelting, refining and other costs BEFORE reporting their total revenues figures and it will not be present in the income statement. The result of this is that it skews all-in costs higher for miners that refine themselves or include the costs in their income statement while inaccurately showing lower costs for miners that remove it before reporting revenues.
A simple test can be done on any miner to see if there are any pre-revenue costs that are not reported in the income statement. Simply take payable production and multiply it by average realized sales price and this should come relatively close to the total revenues figure. If it gives you a number much higher than reported revenues then there are pre-revenue costs that are not being reported.
This line should alleviate these issues and allow comparisons on a fair basis.
Real Costs of Production for SSRI - 4Q 2012 and FY2012
Let us now use this methodology to take a look at SSRI's results and come up with their average cost figures. When applying the 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 zinc ratio of 37:1. We like to be precise, but minor changes in these ratios have little impact on the total average price - investors can use whatever ratios they feel most appropriately represent the by-product conversion.
Note About Adjustments to True Costs Values for SSRI
SSRI restated its Q1FY12 results and this resulted in a minor change to our calculated numbers. SSRI may restate future quarters but we do not expect these changes to significantly change the true costs above.
Observations for SSRI Investors
The first thing that investors should notice from the table above is that SSRI's true all-in costs are extremely high for both Q1FY13 and FY2012. Investors who are skeptical about the costs can simply do the math themselves. According to its income statement, SSRI earned $241 million in 2012 on sales of 8.6 million ounces of silver at an average price of $31.13. Yet operating income was only $9.7 million - which is before interest expenses, investment gains losses and taxes. That means that on an operating level they earned very little on 8.6 million silver ounces sold, which affirms that their costs are very high.
In terms of true all-in costs, Q1FY13 costs of $29.25 were slightly more than 2012's costs of $29.01 - so management did limit cost increases to around 1% which was the same increase PAAS experienced in the quarter. But SSRI is starting at a much higher all-in cost level so investors would need to see significant improvements in costs before they start applauding SSRI management.
Since SSRI's true all-in costs are $29.25, which is well above the price of silver, investors need to pay close attention to the company's liquidity because if it is not liquid enough a cash crunch could occur and tank the stock. Fortunately for SSRI, its cash position is very strong and it has $461 million in cash, $81 million in other receivables, and $118 million in investments (mostly in Pretium Resources (PVG)). They have plenty of cash to make it through this low-price silver environment for quite a while - though we are not sure how much of that cash is domiciled in Argentina, which would make using it a little trickier than simply transferring it to another nation.
In terms of production, Q1FY13 production numbers were down slightly on a year-over-year basis, but down significantly on a sequential basis. Silver production was down around 250,000 ounces from the fourth quarter, with zinc production up slightly. Management is focused on restructuring costs at the Pirquitas mine (in Argentina) and will give revised forecasts for production in the second quarter. If SSRI stays on this pace of production, we expect their silver production will be down anywhere from 7-10% for 2013 - with these production figures before the major silver drop. Investors should focus on guidance given by management in the second quarter.
SSRI is producing silver at significantly higher true all-in costs than most of its competitors. This situation is only going to be exacerbated with silver prices hovering in the $22 range, and we expect significant losses in the upcoming quarters if silver prices do not recover. But on the positive side, SSRI does have hoard of cash and investments to keep the company afloat for quite some time even if it is operating at a loss. Investors should look to see if SSRI can start significantly lowering costs and management may want to use the cash to purchase properties or finance cash-starved junior miners.
For those who invest in the silver ETFs (SLV) or silver as a commodity, it is important to note that another major silver producer is producing silver in the high $20s while the silver price languishes at $22 per ounce. SSRI also is on track to produce less silver in 2013 than in the previous year (and this was before the big silver price drop). Both of these are positives for those who hold silver as a commodity. It may be a little counter-intuitive, but the more the silver miners struggle to stay afloat and produce silver profitably, the lower the future supply picture becomes. SSRI's report just reinforces the fact that silver miners are struggling to produce silver at current spot prices. Investors should look to this as an opportunity to buy an asset that sells for below production costs - especially when the fundamental picture for precious metals remains bullish.