I hope to provide some perspective on Pan American's recent press release: Pan American Silver Plans Production Expansion at San Vicente Mine (PDF file, 108k).
VANCOUVER, BRITISH COLUMBIA – Pan American Silver Corp. (“Pan American”)(PAAS: NASDAQ; PAA: TSX) today announces it plans to proceed with a project (the “Project”) to expand production at its San Vicente silver-zinc mine located near Potosi, Bolivia (“San Vicente”). The Project will include the construction of a new 750 tonnes per day processing facility, together with the related underground mine development necessary to achieve sustained production at this rate.
In connection with expanding production at San Vicente, Pan American has purchased Empresa Minera Unificada S.A.’s 40% interest in Pan American Silver (Bolivia) S.A. (“PASB”), the operating entity of San Vicente, for $9.0 million plus a 2% NSR payable only after Pan American has recovered its capital investment in the Project and only when the average price of silver in a given financial quarter is $9.00 per ounce or greater. As a result of this purchase, Pan American has increased its ownership interest in PASB to 95%, with Trafigura Beheer B.V., an international commodities trading company, retaining its 5% minority interest.
Based on engineering studies conducted for the Project1, Pan American estimates that, once the Project is complete and the mine is operating at capacity, San Vicente should produce approximately 2.8 million ounces of silver annually, on a 100% basis, at an average cost of less than $2.00 per ounce, net of zinc byproduct credits, for the first five years of the operation. Based on 100% of the mine’s proven and probable reserves of approximately 3.1 million tonnes2, San Vicente should have a 13 year mine life. The Project should take 18-20 months to complete, at an estimated capital cost of approximately US$40.5 million, which includes a 10% allowance for unforeseen escalation in construction costs, in addition to a 15% contingency.
At price assumptions of $9.00 per ounce of silver and $2,100 per tonne of zinc, Pan American’s 95% share of the mine is expected to provide an undiscounted after-tax value of $64.8 million, generate an internal rate of return (“IRR”) of 26% and have a capital payback of 2.6 years.
In my view, the key question is, is Pan American deserving of a reduced valuation because of its investment in Bolivia? My answer is a resounding no.
The press release was issued on 6 June 2007, when the closing price was $28.40, which translates to a market capitalization of $2.17B. The closing price on Friday, 8 June was $26.85, which translates to a market capitalization of $2.05B. That is a market capitalization loss of $120M, yet the purchase price and construction costs combined are less than $50M. So if we believe that Pan American has been penalized because of its investment in Bolivia, that penalty was overdone.
However, I do not believe that the share price fell because of the press release. If you look at a Kitco's graph of silver's price in June 2007, you will note that silver dropped about $0.40 over the three day period.
Moreover, I believe the information in the press release is positive. While it is true that the mine is in Bolivia, a country that has recently given the mining as well as oil industries fits, I trust that Pan American has had some conversations with government officials. The mine itself is very profitable at $9 per ounce of silver, with an internal rate of return (not the best measure to use) of 26% and a capital payback period of only 2.6 years. Obviously with today's prices of $13+ per ounce for silver, the IRR will be significantly higher and payback period even shorter. The company has already anticipated the higher tax rates recently proposed by the Bolivian government. Assuming no further tax rate increases and no nationalization during the 20 months of construction followed by 2.6 years of operations, the company will do well with its investment.
Commenting further on the tax and nationalization risks, I believe Bolivia is unlikely to raise taxes again within a short window. It wants and needs foreign investment, so it is likely to keep its new tax rates for a few years at least. If it wants an operating plant, Bolivia is unlikely to nationalize the project during the construction phase. So that leaves the remaining 2.6 years. My belief is that Pan American management has managed its risk in a prudent manner by first, having a strong economically viable project with a short payback, and second, having meaningful discussions with various government officials. None of this guarantees a good result, however, but at least the company has assessed its risks in a prudent manner and should have a strong viable project.
I began writing this article before the market opened, and I note that Monday Pan American Silver is up slightly. I remain positive on Pan American.
Disclosure: I am long Pan American stock.
PAAS 1-yr chart: