A Look at Domestic U.S. Silver Producers

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Includes: AGQ, CDE, DBS, EXK, HL, SIVR, SLV
by: Mark Thomas

When the market gets too giddy on the upside, I like to be a contrarian and take some profits. So When I made my sale Monday of my remaining 10% position in of Endeavor Silver (NYSE:EXK) for a very nice almost 25% gain, I intended to leave that 10% of my portfolio in cash for some time. There is some takeover chatter about the miners but that is always suspicious. What I sense though is just a general and building tightness in the physical silver market. I have heard that customers who became net sellers of physical and ETF silver holdings in the recent correction, have quickly switched back to being solid net buyers. While institutional investors won’t be attracted to the silver sector again until it demonstrates enough momentum for their short-term thinking, individual investors are definitely buying silver on any pullbacks.

I will explain more in this weekend’s newsletter some new facts I have recently collected about the tightness in physical silver and help build the case for why I’m predicting over that over the next three to five years silver prices will double, triple and even more. We could possibly be close to a new move back to recent highs above $30 in spot silver prices. That is starting to reoccur very much sooner than I envisioned just a couple of weeks ago. For now though I want to just inform you I’m making another purchase in the silver mining sector of Hecla Mining (NYSE:HL) on Tuesday. I will make half my purchase at the opening price and half later in the middle of the day.

In the silver mining sector foreign producers, especially the Latin and South American miners are viewed as more attractive by investors and awarded higher valuations because their cost per ounce of silver mined is less than their American counterparts. That cost advantage leads to higher profit margins that are usually awarded higher relative valuations which is logical. However, I’m currently approaching the silver sector differently for a number of reasons. China already realizes the strategic importance of their nation’s silver supplies and has not only cut exports of silver but has also significantly increased their net imports of the metal.

As the supply demand imbalance in silver grows over time, I have a theory about why you should own domestic U.S. silver producers with a significant market share instead of just the lowest cost producers in the world:

  1. Domestic supplies will become more valuable because of their reliability of supply for US Industry and Defense.
  2. Larger- cap stocks like Coeur d'Alene Mines (NYSE:CDE) trade at three times revenue and Hecla trade at 4.9 times revenue. Less than lower cost producers with more growth but still with decent potential for upside.
  3. Less geopolitical risk of a country nationalizing them or imposing significant new taxes on them.
  4. While the American workers are paid much more than counterparts in other countries, they are also significantly more productive, offsetting some of that expense.
  5. Besides if silver prices just stay where they are and especially if they continue rising if their cost of production is $6-10 vs. $3-6 per troy ounce for the lower cost producers their disadvantage percentage profit margin wise becomes smaller than if silver was still at $15.
  6. Institututional investors will be attracted to the companies with the larger market capitalizations because they are more liquid, have more established and predictable revenues and earnings.
  7. Another reason is it never ceases to amaze me how institutional investors will mark up a stock 10%, 15% or 20% of a company with their collective herd type thinking. They also will leave just as quickly as they came but the volatility they create is great for shorter-term trading even though it is really hard on long-term investors. It is also easier for me personally to predict what institutional investor’s consensus and therefore their future actions will be with regard to a stock price than when I’m trying to understand just individual investors.

So the bottom line is with the domestic larger cap producers, I think you get two plays to the upside:

  1. A narrowing of the difference in valuations relative to the smaller cap producers and the longer-term trend of both higher silver and gold prices. Then you add the fact that the companies have longer track records and the financial scale to make an acquisition or reinvest in their business to expand without selling additional stock diluting you as an existing share holder.
  2. Finally, these companies deserve a higher premium than the market currently awards them because they are now and this point going forward going to be recognized as more of vital to the national interest. This will become even more obvious as the silver market supply demand imbalance becomes more pronounced over time.

With regards to Hecla Mining specifically, it is America’s largest and lower cost silver producer with 11 million ounces of annual production which is almost 30% of all U.S. production. The company has been around since 1891. Its Lucky Friday mine in the silver valley of Idaho has been one of the most prolific silver mines in American history. It also has the most productive silver mine in Alaska that also produces gold. Hecla has more leverage to silver prices than Coeur d’Alene. The company’s revenue breaks down about 75% silver vs. 25% gold. Coeur d’Alene in comparison has become less reliant on silver at 50% silver vs. 50% gold. Hecla has two exploration projects and an expansion of Lucky Friday but those aren’t expected to add to production for years. Hecla basically produces about 11 million ounces of silver and about 68,000 ounces of gold per year with some minor lead and zinc production too.

On a valuation basis, Hecla is not as cheap as I prefer my miners to be. I estimate in 2011 they will gross about$ 550 million in revenue and that is estimate is very aggressive. They have a mandatory convertible outstanding that when you assume dilution for equal’s 304 million shares outstanding which gives them a market cap of $2.94 billion at today’s stock price of $9.67. However with the enterprise value divided by revenue formula I use market cap + net debt. In this case they have 240 million in cash net of debt, so their enterprise value is $2.7 billion which means they are pretty fully valued at 4.9 times my very optimistic revenue estimate of $550 million. So this is basically a solid silver producer with almost 30% of U.S. production with a great balance sheet to fund limited growth over time that is highly leveraged to rising silver prices. Not a screaming value but I think worth a 10% position in my personal portfolio for now and as other stocks in the sector have recovered. The stock is still about 15% off the high it made in December last year.

See the company’s fact sheet.

See a company presentation.

I know with a strategy like this in the larger cap mining stocks, I’m not going to pick the stocks that will go up 300-500% in the next few years. These types of stocks just fit my personality and tolerance level for volatility better than their smaller peers. Also you will notice when we were deeper in the correction for silver prices and therefore silver mining stocks, I was buying smaller cap junior mining, now have sold some at a profit, moved up the food chain to buy some that still offer value. Soon, I won’t even suggest buying those large caps and even the silver ETF temporarily. Hopefully, we will book some more gains on these miners over the next weeks or 1-2 months and then repeat the process again and again.

Disclosure: I am long SIVR, HL, CDE, PAAS.