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Introduction

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 and/or the silver miners. In that analysis, we used the FY2012 financials to calculate the combined results of publicly traded silver companies and 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 Gold Resource Corporation (NYSEMKT:GORO). GORO produces slightly more silver than gold on an equivalent basis, thus we have characterized it as a silver miner, but depending on future silver and gold production, this designation could change. Its primary activities are focused on the El Aguila project in Mexico, which hosts the La Arista vein system, which it currently explores and mines.

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, which is an important concept for all precious metals investors to understand.

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 their 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 revenue figures and these pre-revenue costs are not reported 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 GORO - 4Q 2012 and FY2012

Let us now use this methodology to take a look at GORO's results and come up with its 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 gold-to-silver ratio of 53:1, lead-to-silver ratio of 33:1, copper-to-silver ratio of 9:1, and a zinc-to-silver 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 GORO

GORO restated a few quarters from 2012, and so we had to adjust our calculations to incorporate those restatements. Additionally, GORO is a miner that can have significant shifts in cost numbers from quarter to quarter, so investors need to take that into consideration. Finally, costs from previous years have been lower than one would expect due to deferred tax deductions (for example GORO received a tax break of $12 million in 2011 even while reporting positive net income), so comparisons for true cost figures from previous years will be difficult to do without taking tax breaks into consideration.

Observations for GORO Investors

True Cost Figures - GORO's true all-in cost figures for Q1FY13 were an exceptionally high $28.06 per ounce of silver produced. This was a noticeable jump in costs on a sequential and year-over-year basis, and also was a significant jump from the stellar 2012 average of $20.17 per silver-equivalent ounce. Their costs for the first quarter were significantly higher than competitors such as Pan-American Silver (NASDAQ:PAAS) (costs just over $25), Silver Standard Resources (NASDAQ:SSRI) (costs just under $30), Endeavour Silver (NYSE:EXK) (costs around $25), Coeur D'Alene Mines (NYSE:CDE) (costs just over $25), and cost-leader First Majestic Silver (NYSE:AG) (costs just under $22). This should be worrisome for GORO investors, but we would caution them not to read too much into one quarter especially when a company has a history of low-cost production. Second quarter true all-in cost numbers will be very important for investors to examine to see if costs drop back down to industry average levels.

Corporate Liquidity - Liquidity is very important for investors to monitor in this current silver environment, especially for producers like GORO that have true all-in costs currently above the current silver price and which pay a significant dividend. With a little over $35 million in cash, cash equivalents, and bullion inventory, GORO should have enough liquidity for a future quarter or two with negative all-in costs -- which includes maintaining the current dividend. Though we do not believe GORO can maintain the current dividend for longer than a few quarters at current silver prices unless it can significantly cut its costs -- but it should not be in danger until at least Q3FY13. This means even more importance will need to be given to Q2FY13 true all-in costs to see if the company can bring them down to maintain the current juicy dividend.

Production Numbers - One of the main reasons for the significant rise in GORO's true all-in costs was due to the drop in production. Silver production rose from the fourth quarter and is relatively in-line with 2012 figures, but production of all other metals (gold, zinc, lead, and copper) dropped significantly on a sequential basis, which we believe was primarily due to lower grades. We forecast that base metal and gold production for 2013 will be significantly lower than 2012 figures if GORO does not see increases in grades or processing in future quarters -- this is meaningful because GORO gets a significant portion of its revenue from gold sales.

Conclusion

GORO experienced a poor first quarter in terms of costs and production numbers after a pretty decent 2012. Production costs increased to over $28 per silver-equivalent ounce, which puts income at negative levels with current silver prices. Its liquidity is sufficient to keep the company out of a cash crunch and maintain dividends for at least a few quarters, but if costs don't drop significantly (or silver prices rise), we do not think it can maintain its dividend for long. Production of base metals and gold also dropped in the first quarter, which is worrisome for investors, but we would need to see second quarter production totals before we get seriously worried.

Though the first quarter was a rather large negative for GORO, investors should not panic yet because the company does provide them with some opportunities. The short position is rather large in GORO, and if management can control costs while silver prices rise (preferably to the $25 per ounce level), then the dividend would be sustainable and rather large compared to other companies -- which would force a number of shorts out. If second quarter true all-in costs drop and we see a rebound in the silver price, GORO will provide investors with significant upside compared to other silver miners while paying a nice monthly dividend.

Source: What It Really Costs To Mine Silver: The Gold Resource Corporation First Quarter Edition