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Introduction

In this article, I'll have a closer look at Pan American Silver (NASDAQ:PAAS) which reported its Q3 financials a few weeks ago. As they reported excellent production numbers, I'm curious to see what kind of influence this had on the financials. I will provide my view on the financial statements and the balance sheet, and will briefly talk about the new mining tax in Mexico. This will result in my investment thesis at the end of this article.

My view on the financial results

In the third quarter of this year, Pan American Silver produced 6.7 million ounces of silver and 41,600 ounces of gold, which is a new quarterly record. This excellent production quarter resulted in a total revenue of $213.6M, mine operating earnings of $33.9M and a net profit of $14.2M or $0.09 per share.

However, as I have explained in several previous articles, it's better to look at the cash flow statements instead of at the bottom line, as the cash flow statement usually gives a much better indication about the quality and returns of the underlying business.

There we see the company generated in excess of $40M in operational cash flow (which includes a tax payment of $7.6M). Unfortunately, the company spent $41.7M on capital expenditures, which caused Pan American to turn free cash flow negative. PAAS also invested $7.5M in short-term bonds which absorbed more cash from the balance sheet (although this is just a temporary cash drain as the $7.5M will be added again when the investments have reached its maturity). As Pan American Silver also paid out $18.9M in dividends, the company recorded a net cash outflow of $30.4M.

I'm not a big fan of Pan American paying dividends, as it's obvious the company is free cash flow negative. PAAS had an operating cash flow of $73.5M in the first nine months of the year, but spent $138.7M in investing activities, so the company was effectively free cash flow negative but still decided to pay a dividend.

My view on the balance sheet

The company's balance sheet still looks extremely healthy. Pan American had working capital of $699.3M as of at the end of September this year (of which $421M was held in cash and short term investments), which is just $72M lower than at the end of 2012, even though the amount of total liabilities decreased by $88.6M.

PAAS' current ratio is a very healthy 5.45 (keep in mind a current ratio higher than 1 means the company has sufficient current assets to cover its current liabilities). The balance sheet is extremely robust, and this is very likely the main reason why Pan American Silver wants to continue to pay dividends, even though those dividends aren't paid out of internally generated cash flow.

(click to enlarge)

The book value per share was approximately $16.46, which means the company is currently trading at a discount of 38% to its book value. However, investors shouldn't just blindly rely on this book value, as it's not unthinkable that Pan American will have to record impairment charges on its assets because of low precious metals prices or permitting difficulties.

What to expect next?

It will be interesting to see what the impact of the new Mexican mining tax will be on Pan American's bottom line and cash flow statements. The Mexican Senate approved a bill introducing a royalty of 7.5% on the mine operating income, as well as an additional 0.5% royalty on revenues derived from gold and silver. In addition, the bill proposes a 10% withholding tax on dividends paid to non-resident shareholders, which could also have an impact on mining companies which would like to get their cash out of Mexico. The bill still hasn't been approved by the president yet, but this is expected shortly. Pan American Silver has no idea yet about the final impact on its financials, but it's obvious the impact of this new law will definitely be felt.

Investment Thesis

Pan American Silver had a good quarter, wherein it was able to increase its output whilst keeping its costs under control. Unfortunately, the company is still free cash flow negative, and I don't think this will change in the foreseeable future, as the gold and silver prices remain quite depressed. I would actually prefer if the company would cut its dividend which would save it approximately $75M on an annual basis. However, I do understand the dividend is also an advantage over its peers who don't pay a dividend and might attract a different style of investor.

As most of my readers know, I prefer to write put options instead of just buying the shares. In this case, I'm particularly looking at the P10 JAN 2014 for $0.50 and the P7 July 2014 at $0.30. I already am a shareholder of Pan American Silver, but wouldn't mind increasing my position at a lower cost.

Source: Pan American Silver - Excellent Balance Sheet But Free Cash Flow Negative