We at thesilvershortage.com have been searching for the best silver mining stock, and in the last three months we have researched and owned Silver Wheaton (SLW), Pan American (PAAS), Endeavor Silver (EXK), Coeur d’ Alene (CDE), Silvercorp Metals (SVM) Hecla Mining (HL) and U.S. Silver (OTC:USSIF). We also owned a couple of junior mining stocks: Fortuna (FVITF.PK) and Avino Silver and Gold (ASGMF.OB).
The silver market was very strong during the period we bought and sold these stocks so that helped make up for some of our research mistakes along the way. The more you look at each of these stocks we owned, they are all good companies, but each one of them has one or two fundamental drawbacks in their business. Then you combine the effect that their valuations have increased so much percentage wise in the last six weeks and that combination makes them vulnerable to pullbacks even if physical silver metals prices remain fairly strong.
A couple of months ago when all of these stocks were at lower valuation levels they all offered good potential future value. However, now that those valuations are much higher in the sector, you must only own the best in breed. The three things we think it’s all right to own right now are the physical ETF (SIVR), First Majestic Silver (AG) and possibly Silver Wheaton. We are actually nervous about silver prices and if silver falls the mining stocks will surely follow. Of those three right now we choose to only own the first two. That is because we have such strong long-term opinions on them that if we experience a correction, we won’t get shaken out by the volatility. We love Silver Wheaton’s business model but its valuation prices in so much future growth already we are leery of the stock for the time being.
We have been looking through the silver stocks for three months now, searching for a stock that I can get behind long-term. Our ideal company would have the following traits:
1. A company that has great leverage to rising silver prices. Many silver companies get a percentage of revenue from other base metals mining or gold mining.
2. A great balance sheet with little or no debt and cash. This gives the company the flexibility to invest in the future, make acquisitions or be that much more attractive to another company to be acquired.
3. Has a plan for growth in the next 1-2 years that will significantly increase annual production to drive revenue and earnings growth. A company that has things coming on line 3-5 years out just means a lot of expenses with no revenue gain for the market to anticipate or pay for.
4. Great management that has a proven track record of meeting projections. We prefer management that under promise and over delivers. We accept mistakes if management is honest and forthright. It also is nice that management has made a few mistakes with projections because they rarely forget what a bad situation that is and it humbles them.
5. A company that is solidly profitable with solid earnings that has a chance to go from a 13-15 PE multiple to 18-20 in the next two years as the market revalues the quality miners upward.
6. We prefer a company that when you include debt in its enterprise value (market cap + net debt) is between three to five times’ annual revenue. Any more than five times revenue and the company is less of a takeover target and offers less potential for future appreciation.
Coeur d’ Alene Mines was the closest stock that met these criteria that we had previously found because of its relative low valuation (3.5 times revenue) and quality of assets. However, Coeur d’ Alene's recent growth has been mostly achieved and the last earnings report showed its progress to the market and the stock surged to where the market finally factored in the turnaround that had occurred. With its still relatively high debt level and now high silver mining stock prices, an acquisition for growth gets that more difficult. Our problem with Coeur d’ Alene is how they are just tripping over themselves to sell stock and exercise their options. After every good announcement, they sell more and file multiple SEC filings to report it. The reason this troubles me is it tells us management and officers don’t believe this is a multi-year bull market. They must believe it is more of an investment fad and they should sell while the getting is good. Since I began writing this CDE fell under $30 from $36, and under $31 they are attractive again.
In the last few months we liked and owned various stocks that told a good story about their growth and then disappointed. One by one we started to discover the flaws in their business model. One of them simply has no growth and should be totally avoided. Some have higher cost structures that hurt their relative profitability. Some of them are more in the mode of promotion than actually building the scale to go from a junior to major minor. Some of them simply are valued too richly than they deserve. Bottom line, we just couldn’t find the one stock that we could get behind and hold long-term because we feel that strongly about the assets and potential of the company. But now we have that company.
Ironically one of the problems we have found with management of the silver companies ... they aren’t bullish enough in their outlook for silver. After silver went from $29 to $36, they just recently admitted $50 silver is possible. First Majestic Silver CEO Keith Neumeyer is different. First of all he owns 3% of the company stock so he has about $45 million invested in the performance of the stock. He had the guts to found the company in 2002 when the outlook for all metals was in the toilet and raising capital was difficult. He has been bullish on silver prices for years. He has built this company from almost nothing into a $1.7 billion market cap and has been for saying for at least a year that he thinks silver could be north of $100 in a few years. I like the company actually states this in its mission statement:
“Management feels strongly that investors will continue to witness a dramatic bull market in precious metals over the coming years. For this reason, a focus to continue to develop and increase production at its core assets will continue. In addition, management is determined to expand First Majestic's asset base and thus continues to investigate other interesting advanced stage silver projects in Mexico. With a management team comprised of proven company and mine builders, shareholders are poised to capitalize on First Majestic's rapid evolution into a world class silver producer.”
That is the kind of bullishness and outlook I want the silver company I choose to invest in to have. I think some of the management at metals companies that have been in the business for 30 years are burdened by all the years of low silver prices and endless disappointment with those low prices which led to little profits in such a capital intensive business. It is understandable because I would be traumatized too if the only time silver became overpriced in the last 30 years was in 1979-80 and that was because a horrible economic situation and a public mania drove silver to almost $50. I don’t want a management that is pie in the sky with their outlook and are promotional in nature. We don’t want them betting on marginal projects but I do want management that realizes the silver market has fundamentally changed right now and this is the business opportunity of their career to excel and accomplish things they never thought possible. First Majestic’s management team is incredibly experienced for a mid-cap company with about $260 million in annual revenue. The chief operating officer worked for Mexico’s largest silver producer and is the former President of Plata Panamerican SA de CV, a subsidiary for Pan American Silver. They seem to have a good combination of experience, track record and most importantly a vision that the company can be much more than the stock market currently sees in them.
First Majestic Silver is less well known as currently only four analysts cover the company. They aren’t as over owned by institutions as other names in the sector. They were just listed under the symbol (AG) on the NYSE recently so there is more liquidity in the stock. Now we aren’t as early in the stock as we would prefer but we’re not too late either, which we like at thesilvershortage.com. Management has a track record of meeting projections on the big picture things like how many silver ounces of production per year. They made a mistake a few years ago where they didn’t meet their projections and we think the CEO learned his lesson and remains conservative in his projections.
First let’s examine First Majestic's overall business strategy. First Majestic has three operating silver mines, all located in Mexico. They are fairly low cost production mines and the company averages about $7.10 in production cost per ounce. However First Majestic has a major advantage over all other silver mining stocks other than Silver Wheaton, which is they are a silver royalty company, not an actual miner. Almost 80% of its current estimates of 8 million silver equivalent ounces this year are in the form of Dore bars, not silver concentrate that needs further refining. Dore bars are not deliverable by COMEX standards but they need much less refining and transportation which gives First Majestic an inherent profitability advantage. To give you an idea it costs most silver companies about $4 per ounce to refine the final product ready for delivery to customers. Silver Dore, on the other hand, costs about 50 cents to refine into the final deliverable product. This is a huge cost advantage that has made them solidly profitable and now generating great cash flow. They already had 30% profit margins and 37% gross margins and those numbers only increase if silver prices continue escalating over the next few years.
In fact since they don’t have a lot of other base metals like lead and zinc they are the most leveraged company in the sector to increasing silver prices, including Silver Wheaton. Silver Wheaton derives 90% of its revenue from the sale of silver, but First Majestic is actually now achieving 93% of revenue from silver. In fact, in the fourth quarter, they actually achieved 96% of revenue from silver. Some other companies in the sector only get 50-70% from silver. In fact they now have $65 million in cash and no debt. That is not a large war chest and significant cash will be needed to keep investing for future growth in new mines. However, no debt and net cash makes a company a lot more attractive to other companies as a takeover target.
They don’t meet our sixth criteria on trading between three to five times revenue. At $15 they have a 1.575 enterprise value net of cash. That is about six times our 2011 revenue estimate of $260 million. However, with a credible plan to go from eight million to 16 million ounces of silver by 2014 we are comfortable paying 20% more than normal for this company's powerful revenue and earnings growth. In fact we’re most impressed at the low PE multiple. The stock at $15 trades around 14.8 times our 2011 estimate of $1.05 per share. We also think they can earn $1.30 in 2012 which makes them about only 11.5 times 2012 earnings of $1.35. Once again less than 15 times earnings this year’s earnings, which are only an average market multiple for a very above average business with much better potential than an average company. Then to be paying less than 12 times earnings for a solidly profitable company with $1.30 in 2012 earnings makes it a real bargain. Here is a simple valuation comparison to other stocks in the sector with similar silver ounces per year of production:
Company, Ounce per year, Market Cap + net debt.
Hecla Mining, 7.8 million, $2.3 Billion
Silver Standard Resources, 6.5 million, $2.3 Billion
First Majestic Silver (SSRI), 8 million, $1.6 Billion
With First Majestic Silver you get more current production, more future growth, better profitability at a 25% discount to similar companies. This is the best combination of financials at the most reasonable price, with the best plan for growth in the entire silver mining sector, including Silver Wheaton.
Now that we have covered the basics of the financials and business model, let’s talk about the plan for growth. All of their three current mines are in Mexico and all their future exploration and development are also in Mexico. Mexico revised its laws after NAFTA and it has encouraged billions in new development in the silver mining industry, so the political environment is favorable to the industry. First Majestic basically has plans to expand the current three mines tons of production per day. They also have their fourth mine, the Del Toro project, which they feel very strongly about developing. In fact they should be coming out probably by the end of this quarter with a larger budget and bigger plans for this operation. This is the key to their future growth.
So the bottom line is relative to all other mining stocks, First Majestic is the Silver Miner with the most shine. They have the best combination of quality management, leverage to the price of silver, great balance sheet, a plan for achievable growth in the next two to three years. They also are solidly profitable which will only get better if silver prices continue rising. So if you want exposure to silver or silver mining stocks we at thesilvershortage.com think First Majestic Silver is our core long-term holding and we overweight the stock significantly.