First Majestic Silver: Compelling Valuation Makes It A Buy

| About: First Majestic (AG)

Summary

I have been buying First Majestic aggressively since that time and now have a full position.

How could one justify owning First Majestic at $19 when you had companies more than 2x its size trading at the same valuation?

The main reason for the declining silver output with its core group (pre-Santa Elena), is because the company curtailed investing in these assets during the downturn.

The focus has returned to growth.

I started to load up on gold and silver stocks in early January of 2016 as it was clear that a bottom in the precious metals sector was only a few weeks to a few months away. First Majestic Silver (NYSE:AG) was always on my buy list, so I began to purchase the stock at that time and kept adding to my position as it broke out of its bear market downtrend.

Fast forward six months or so later, in an article that I posted in July 2016, I update my stance on the company:

I sold out of all of my position in AG over the last few weeks as it has run too far compared to other silver producers in the sector and now offers inferior value at the moment. AG was one of the first companies I started buying in January of this year. This was a $2.50 stock at that time and now it's at $15. Nobody wanted it then, but now a lot of people are piling into the shares and not paying attention to valuation.

The stock kept climbing after I liquidated my position, and it proceeded to get even further out of line in terms of fair valuation as it reached $19 a share by early-mid August. In a follow up article on the sector, I was even more bearish on AG:

Last week, the company announced earnings for Q2 and significantly cut guidance for the year...the stock actually traded higher that day...momentum players are moving the gold market, and bad news is sometimes ignored...If I didn't sell in early July I would have most definitely liquidated last week. I like the company, but for now I'm avoiding the stock as I think the bias is to the downside given the news in combination with how overbought the shares are at the moment.

The shares finally broke down a few days later and plunged all the way to $11 (or roughly 40%) by the end of August. In late September, the majority of the froth had been removed from First Majestic's stock price and it was trading at a much more reasonable valuation level. I was buying, but noted that I refrained from establishing a full position as I felt there was still the potential that AG would move to the $9.50-10.00 range. The stock actually declined more than I had anticipated and hit roughly $8.00 a share last week (down almost 60% in just two months). I have been buying aggressively since that time and now have a full position.

I believe the shares are poised for a major rebound from current levels, as the stock went from being wildly overbought to fearfully oversold. I also want to note that momentum has now turned positive again.

(Source: StockCharts.com)

Valuation Matters

With 164.3 million shares issued and outstanding, and at a price of $19 a share this past August, First Majestic had a market cap of $3.1 billion. I'm a firm believer in this bull market in gold and silver, but when you had companies like Pan American Silver (NASDAQ:PAAS) and Hecla Mining (NYSE:HL) trading at the same valuation or even less, then it made no sense to own First Majestic.

At their peaks in August, HL had a market cap of around $2.7 billion ($400 million less than First Majestic), and Pan American was valued at $3.1 billion (equal to the market cap of AG). Yet look at the tale of the tape between these three silver (and gold) miners. Pan American and Hecla produce 50-100% more silver and 3-4x more gold compared to First Majestic. It's the same in the operating cash flow department as well.

(Source: Author)

How could one justify owning First Majestic at $19 when you had companies more than 2x its size trading at the same valuation? You couldn't, which is why the correct strategy at the time was to sell.

Thanks to the hefty decline that has occurred in First Majestic's stock price, it's trading more in line with the group. Today, its market cap is $1.4 billion, while PAAS and Hecla are at $2.6 billion and $2.4 billion.

A Few Bumps In The Road

First Majestic has only shown incremental production growth since 2014 (not that this is a bad thing mind you). There are two sides to this growth story though. On one hand, silver production is basically flat during that time, which is unusual for the company as steadily rising silver output year over year has been its hallmark. However, gold production has jumped from 10,000 ounces per year to 50,000 ounces. Which is why on a silver equivalent basis, the company has been able to show overall growth in output from 2014-2016. This is entirely because of the Silvercrest acquisition in 2015, which brought the Santa Elena mine into the fold. If it wasn't for this purchase, First Majestic would be staring at negative silver and AgEq production growth during this time period.

Click to enlarge

(Source: First Majestic)

First Majestic expects AgEq growth to continue, and it has a few projects planned that will contribute to that increase. But for me, this is about getting the current mines "right." That's been a problem and is why First Majestic had to take down production guidance for 2016.

The main reason for the declining silver output with its core group (pre and post Santa Elena), is because the company curtailed investing in these assets during the downturn. The focus instead was on cash flow generation. First Majestic decreased its investment in exploration and development and had to reduce production at a few operations in order to remain profitable and keep the balance sheet healthy. That hit its Del Toro mine especially hard.

When First Majestic was building Del Toro in 2012, the expected production out of this mine was 6-7 million ounces per year. Del Toro has been a big disappointment as 2016 output at the mine will only be 2.25-2.50 million AgEq ounces.

The company was building a 4,000 tpd mill at Del Toro in 2011, but with the precious metal prices collapsing, it decided to halt any further funding of the project. At the time, there was still $35 million that needed to be invested to finish building the shaft and complete the underground development. As of now, the mill is only running at 1,000 tpd, and the cyanide circuit and zinc circuit are currently on care and maintenance. First Majestic is only operating the lead circuit at the moment.

The Focus Has Returned To Growth

Given the increase in prices we have seen in the precious metals over the last three quarters - in addition to the strong balance sheet of the company - First Majestic plans to open up its pocket book once again and reinvest capital.

It has increased its expected total investment on exploration and development capex to $88.5 million in 2016, compared to its previous guidance of $63.8 million. If you know anything about this company, it's when it spends money on development, good things happen. Just look at the stock chart and production over the last decade compared to other silver producers.

Below is a summary of the company's current portfolio of producing assets (all of which are located in Mexico). Several of these will experience growth in output over the next 1-2 years thanks to this increase in spending.

(Source: First Majestic)

First Majestic doesn't plan to ramp Del Toro to 4,000 tpd at this stage, but it is looking to get it back up to 2,000 and higher by the end of 2017. That's a doubling of production from current levels.

At La Encantada, an $8.8 million roasting plant will be constructed. When it's in production in late 2017, the company expects to recover an additional 1.5 million ounces of silver annually from the reprocessing of above-ground tailings. This roasting facility will have a capacity of 2,000 tons per day, and there are 5 million tons of tailings at La Encantada. There is plenty of discarded mill material ready to be re-processed.

La Guitarra will become one of First Majestic's most important operations that it's going to spend capital on in the next two years. When it bought the mine in 2012, it originally planned to demolish the current mill and rebuild a new modern plant in its place. The company put these plans on hold and just kept things as is because of the declining precious metal prices. This mine has been operating at sub-par production levels because First Majestic didn't want to commit capital at the time. The current mill throughput at La Guitarra is 400 tpd. First Majestic plans to expand it to 1,000 tpd in the short term.

The company also plans to spend $2.6 million at its Plomosas project, which looks to be the next mine it put in production as La Luz is having trouble getting the necessary permits due to an anti-mining stance among the locals. Plomosas is already permitted as it was a past producing mine - it was closed in the mid-80s due to union trouble and has been idle since. The shutdown occurred right in the middle of production, so there is plenty of ore that is still untouched.

It will take a little time before the benefits of all this capex spending show up (12-18 months). But by mid-2017, First Majestic should see silver production start to increase once again.

Exciting Developments At Santa Elena

When First Majestic bought Silvercrest and its Santa Elena mine, recoveries were only in low-60s; now recoveries are in the low-80s. The AISC during the last quarter that Silvercrest had the mine in its portfolio was $12.50 per ounce; now it's at $2 per ounce. This asset is performing much better than expected, and First Majestic is claiming that the geological upside looks better now than it did when it first bought the mine.

In a recent webcast, CEO Keith Neumeyer said:

We did run into a high-grade narrow structure vein crossing the main Santa Elena dam and it looks like it's got some legs to it. And the silver grades in the 500 gram range and the gold grades are in the five to six-gram range. And we're blending this high grade material, which to the ore-grade material, which is really helping out the production there. And we don't see an end to it, quite frankly. The structure on surface looks like, it goes for quite some time, and it could actually even intersect another parallel structure, which we're just going to start drilling in the second half of this year. So, there is a lot going on at Santa Elena that could add to life of mine, it's little bit early to really start getting too excited about it. But, I can tell you some of our technical guys are getting excited.

Santa Elena is by far the company's biggest cash flow producing asset. If it is able to find more high-grade material this will be a boon to the stock price.

I'm Anticipating A Strong Snap-Back Rally In AG

With the 55-60% decline in the stock over the last few months, First Majestic is no longer richly valued and offers a great entry point for those like myself who have been watching and waiting on the sidelines. This stock has traditionally traded at a premium to other silver companies, so while it's currently in line with its peers, it's actually at a discount compared to where it has historically traded. With the company now back in growth mode, pure silver production will start increasing again next year. At that point, the valuation should begin to expand compared to other silver miners who aren't growing as aggressively.

The stock is very oversold in the short term, and if gold and silver can start to move up again, then I expect a strong snap-back rally in AG. I also anticipate it will steadily work its way higher to that $19 level as increased silver prices accompanied by rising production will justify the loftier market cap.

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Disclosure: I am/we are long AG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.