Pan American Silver: Last Bargain in Silver Mining Sector

Mar.25.11 | About: Pan American (PAAS)

The silver sector's momentum has taken on a life of its own now, and almost is in a mini-parabolic move higher. A parabolic move is when the rate of change higher begins to accelerate rapidly. It then starts to go higher so much faster that the uptrend becomes unstable and leads to an eventual crash.

We don’t believe this is the final move higher for silver, and it is not the end of its bull market; however, you have to tread much more carefully in this kind of market. We really hoped this wouldn’t have happened so fast, but greed and human nature are hard to change. We saw this coming as the March option expiration was arriving, as that is when there is maximum pressure on those who are short silver. We'll have to wait to see what happens with physical silver and the silver miners, but in the meantime there is one stock in the sector that still offers value that we are overweighting at 20% of our silver model portfolio.

The stock that used to be a leader in the sector and was considered a blue chip but suffered recently fundamentally so it has been left behind during the monster rally in the silver mining sector. Pan American Silver (NASDAQ:PAAS) is one of the largest primary silver producers, deriving about 66% of revenue from silver and 13% from gold.

It is one of the most diversified silver miners, with mines in Mexico, Peru, Bolivia and Argentina. Pan America has had a history of consistent reserve and production growth for 15 years until this year. About one month ago, it announced its production would fall from 24.3 million ounces in 2010 of silver this year to 23-24 million for 2011, due to reduced percentages derived per ton of ore. That combined with the fact that some new projects have run into some roadblocks and a weak earnings report, and the stock sold off about 5%. It then surged higher along with all silver stocks, but fell back again and is now 11.7% off its 52-week high of $42.33.

We like to use enterprise value divided by revenue as our main valuation criteria. In this case, we estimate PAAS will gross about $840 million in 2011 revenue. With an enterprise value (market cap + net debt - cash) of $3.7 billion, the stock trades at about 4.4 times revenue. We think the stock's fair value right now should be valued at 5.0 times revenue or 13.5% higher at $42.50. With $330 million in cash in excess of its debt, PAAS has the cash necessary to keep investing in its future projects to grow.

The reason for this discount in the stock price is its lack of growth in the next couple of years in annual silver production. However, with the price of silver rising so strongly, we think the revenue and earnings gains alone will be enough to drive the stock higher over the next 12-18 months. We estimate PAAS will earn about $2.30 in 2011, so the stock is trading at 16.3 times this year’s earnings, a slight premium to the market's average 15 price to earnings ratio. We think its earnings will soar to $2.80 in 2012, which means it is trading at 13.4 times 2012 earnings or just an average market multiple -- an average market multiple for a company whose rising price of silver will drive much higher percentage gains in profits.

There is one huge difference, though, with Pan American Silver than the other stocks in the sector: You pay an average enterprise value and price to earnings valuation for a very good large, geographically diverse silver producer. However, you also get a very large potential future project for free. It recently purchased for $585 million the La Navidad project in Argentina. This is a very large new discovery and the economics of it would make it very, very profitable. This project is projected to be able to produce 19.5 million ounces of silver annually versus current production of 24 million ounces, so it could increase its production 81% in the next three to five years.

There is one big problem with the project, though: It is slated to be an open-pit mine; currently, in this province, open-pit mining's not legal. Pan American claims it thinks the government will write a new mining bill allowing it to go forward. We agree that the project will go forward, but that kind of uncertainty is the main reason the potential value of this future growth is not built into the price of the stock.

Over the next three to five years, if this project went forward, it could be enough to drive the stock price 30-50% higher for long-term investors. However, if it was denied, it could knock the price of the stock down temporarily as it would demonstrate PAAS threw away a large chunk of shareholder value pursuing an impossible project. Since you’re not paying that much for the potential of the project already built into the current stock price, we like the potential reward versus risk in this situation.

The bottom line is, in the silver mining sector -- where it has become much more difficult to find value -- Pan American Silver’s valuation trades at about a 14% discount to our estimate of its current operations. Then it has a very large future project that, if it goes as planned, could add about 40% in value to the stock over the next three to five years.

When you combine the current discount and the future potential, Pan American Silver is the last bargain in the silver mining sector. At the end of 2010, it was reported that George Soros had taken a very small position in Pan American Silver. We suspect he added to his position this quarter, and we think investors are attracted by the big future potential at a reasonable price, along with the developing strength of silver prices.

Disclosure: I am long PAAS.