This deal radically changes Silver Standard's portfolio and it alters my previous investment thesis.
In August I argued that Silver Standard Resources was among the best ways for investors to buy inexpensive in-ground silver. If you backed out the cash, you could basically buy silver reserves for $0.20/ounce. Much of this silver isn't economical to mine at the current silver price, but for investors who thought the price of silver would rise substantially, Silver Standard shares offered more leverage than virtually any other primary silver mining company.
Investors seemed pleased with the deal, having bid up shares more than 15% since it was announced. I have to agree with the investors who bid up the shares. One the one hand, the Marigold acquisition doesn't detract from the company's leveraged exposure to the silver price. If the price of silver soars so will Silver Standard shares. At the same time, the company now has a cash-flow positive asset, and this gives it the ability to fund its development of the Pitarrilla mine by issuing debt in addition to using cash.
This added cash-flow is especially valuable since the Marigold mine has a long life, and a long history of consistent production. Furthermore, this production is in Nevada, which significantly reduces Silver Standard's exposure to Mexico and Argentina. As a result, I think that the company is going to attract a new kind of investor who values cash flow and stability rather than just high leverage to the silver price.
With that being the case, I think Silver Standard has additional upside stemming from the Marigold acquisition.
The Marigold Mine
The Marigold Mine in Nevada is an open pit mine in northern Nevada. It has nearly 5 million ounces of gold reserves and another 1.7 million ounces of resources that have not yet been proven to be economical to mine.
The mine has a long history of production going back to 1988. While it produced 162,000 ounces last year, it typically produces less than this at about 140,000 ounces. The following chart shows the past 6 years of production data.
With 5 million ounces of reserves and a 70% recovery rate, we can predict that the mine can produce for another 25 years at this pace. However, Goldcorp last predicted a 16 year mine life. A conservative middle ground would be 20 years of production with enough resources to extend the life of the mine beyond this.
One pressing issue that needs to be addressed is production costs. As the following chart shows cash costs at Marigold have risen nearly 50% since 2008.
In addition to inflation in mining costs, which has affected the entire industry, Marigold in particular has been adversely affected by a decline in the grade of the ore that is being mined.
|Time Frame||Ore Grade|
|Quarter ended 9/30/2012||0.46 g/t|
|Quarter ended 12/31/2012||0.65 g/t|
|Quarter ended 3/31/2013||0.4 g/t|
|Quarter ended 6/30/2013||0.34 g/t|
|Quarter ended 9/30/2013||0.36 g/t|
Fortunately this pattern is likely temporary. The average grade of the ore is 0.52 g/t. Furthermore, when CEO John Smith was asked about this issue on the conference call (which you can access from this page) he said that the mine should return back to higher production grades in the coming years. Presuming this to be the case, we can expect cash costs to come down substantially from the $894 figure reported for 2013.
But the real cost issue has been all in sustaining costs (AISC). This figure looks at costs such as SG&A, equipment replacement/repair, and exploration in addition to the direct costs associated with mining. Goldcorp reported that this figure was a whopping $1,604/ounce for the first nine months of 2013! Even if we go by the 2012 figure -- $1,274 -- the mine is apparently still losing money.
The high cost is the result of a massive $150 million infrastructure upgrade that was undertaken by Barrick and Goldcorp: the companies bought new larger mining equipment.
This is great news. Not only will AISC be far lower than the figures reported over the past two years, but the mine can potentially be more efficient now that it is operating with new equipment.
Because we likely won't see the kind of infrastructure expenditures that ate into the mine's profits over the past couple of years, Marigold will be cash flow positive at $1,250/ounce gold.
Assuming that the company is able to mine higher grade ore, and assuming that the new mining equipment can be operated more efficiently, it is safe to assume that cash costs can revert down to $800/ounce. This is still well above the $600/ounce figure that we saw from 2008, which suggests that more efficient mining equipment and higher grade ore can lead to significantly lower mining costs than $800/ounce. Furthermore, the bulk of AISC expenses in the past couple of years have been the result of the $150 million expenditure, which works out to a whopping $500/ounce. If we look at the difference between cash costs and AISC for 2013 and 2012, they come to an average of about $620/ounce over cash costs, meaning that without these expenditures, the figure drops to $120/ounce over cash costs. If we conservatively assume $150/ounce plus cash costs as our AISC figure, then we get $950/ounce production costs. Again, for the sake of being conservative, let's use $1,000/ounce. Using the following metrics, we get the succeeding matrix of valuations:
- $1,000/ounce AISC
- 35% tax rate
- 140,000 ounces of production
- 20 years of production
|Discount Rate/Gold Price||$1,000||$1,250||$1,500||$1,750||$2,000|
For conservative investors who like to use larger discount rates, $275 million appears to be a slight over-valuation, especially since there is uncertainty attached to some of the above estimates, and especially since the gold price can fall further. However, I would like to remind readers that I added $80/ounce in production costs after coming up with my estimates. I also limited the mine's life to 20 years when it has enough reserves to operate for 25 years, and when it also could potentially operate for several years longer than this if we assume that some of the mine's measured, indicated, and inferred resources are produced. Furthermore, I used 140,000 ounces of production when we saw more than 160,000 ounces in the most recent year. Finally, the mine's location and its long and steady history of production merit leniency when choosing a discount rate. With these points in mind, and considering that investors in Silver Standard Resources are generally bullish on the price of gold, I think $275 million is a fair price for Marigold.
The "New" Silver Standard Resources
By adding the Marigold mine to its portfolio, Silver Standard accomplishes several things.
First, the company is utilizing a great deal of its large cash hoard. Prior to the Marigold deal, Silver Standard had over $600 million in working capital. While many investors anticipated that the company was saving in order to finance the development of its flagship silver mine -- Pitarrilla -- this is evidently not the case. The company has less working capital now and it is going to need to raise capital in order to fund the development of Pitarrilla which will cost $740 million. But while the company is going to have to raise capital in order to finance this project, the estimated $22.75 million in post-tax cash flow from Marigold at $1,250/ounce gold can be used to service the debt it will incur in the process.
This $22.75 million in annual cash flow is a big deal considering that in the first nine months of 2013 the company generated less than $5 million from operating its Pirquitas mine. Furthermore, with the silver price lower now than what it averaged during the first nine months of 2013, there is a good chance that Pirquitas is not generating any free cash flow for the time being. With interest rates still relatively low, Silver Standard can take advantage and borrow the money it needs in order to finance its Pitarrilla development.
Second, the Marigold acquisition results in geographic diversification. Silver Standard makes a big deal out of this in the company's Marigold acquisition presentation. Management illustrates the radical geographic shift using the following two pie charts.
Finally the company has diversified into gold. While I am more bullish on silver than I am on gold, I can take solace in the fact that the company divested cash -- not silver -- in order to buy Marigold.
In fact, the company remains heavily leveraged to the silver price. Pitarrilla remains an effective out of the money option on the silver price. At $20/ounce silver it will generate cash flow, but this won't be enough to cover initial capital costs. As the following table shows, the mine's net discounted cash flow is highly leveraged to the silver price. In calculating the project's value matrix, I use the company's estimated production cost of $16/ounce and its year by year production figures from the NI 43-101, table 22.9. I will also use a 35% tax rate, which takes into consideration Mexico's 30% corporate tax as well as its 7.5% mining royalty. All value are in millions.
Discount Rate/Silver Price
Thus while Marigold is currently Silver Standard's most valuable asset, and while it has changed the general character of Silver Standard's portfolio, I believe that Silver Standard retains, to a large extent, its silver focus and its appeal for silver bulls.
By buying the Marigold mine, Silver Standard has changed its investment appeal for the better. Before the deal, Silver Standard was akin to an out of the money option on the silver price. While it was a producer at its Pirquitas mine it was not generating cash flow, and ultimately, like an option, it was a deteriorating asset.
Now the company has less cash, but it has cash flow with the silver price still depressed at $20/ounce. This widens the set of scenarios in which Silver Standard offers good value at the current valuation of $750 million.
If the price of silver rises, then that's great! Silver Standard shareholders will benefit substantially. Pirquitas will start to generate cash flow and Pitarrilla will be economical.
If the price of silver doesn't rise in the near term, then at least the company has cash flow. At $1,250/ounce gold it will have $22.75 million in annual free cash flow from Marigold. This may not be a lot for a company the size of Silver Standard, but this cash flow comes in addition to:
- The aforementioned embedded optionality to the silver price
- The company's $300 million in working capital vs. its $185 million in long-term debt
- Its $150 million in stock (Pretium Resources (PVG), Argonaut Gold (OTCPK:ARNGF) and Mandalay Resources (OTC:MNDJF)).
As a result, I think that Silver Standard is in the midst of a re-valuation. Investors have been avoiding this company for too long because its assets were gathering dust. Now that this is no longer the case, at least to a certain extent, I think investors will revisit the company and ultimately bid the shares higher.