Silvercorp: Canadian Mining Profits in China

| About: Silvercorp Metals (SVMFF)

Silvercorp Metals (OTC:SVMFF) is headquartered in Vancouver, Canada, with a sole focus and all its silver mining operations in China. It is China's largest primary silver producer, engaging in the acquisition, exploration and development of silver mineral properties. With its current market cap size of $600M, it is a component of the S&P/TSX Composite Index, the Global Gold Index and the Global Mining Index. And Silvercorp is the only silver producer paying dividend, with the latest announcement of 2 cents per share this quarter.

Several Silvercorp senior managers, Michael Hibbits - VP of Operations; Lorne Walderman - Corp Secretary; and Shirley Zhou - Communications Manager, came to New York City  to discuss their strategy and growth potential in China. Traditionally, many juniors only focus on drilling to grow the resource in hopes of selling out to a major. This may not work in some countries, like China, since there is no benefit to the local community and no tax revenue during the years of drilling and feasibility study phase. Silvercorp has a unique business model in the sense that once a discovery is made, then they start development of mining operations even before its full potential is drilled off, then self-fund future expansion of resources and mining operations without further shareholder dilution. This strategy is somewhat similar to Endeavour Silver's operations in Mexico, which I visited and have written several articles about, but the cost structure in China is even lower.

What has happened in Mexico and China is impossible in the US. In the US,  from the time when there are enough mineral resources or reserves to justify a mine, then mining companies have to go through a lengthy process of regulatory, feasibility and permitting process which could take more than 5 years before generating any revenue. In China, you can do a lot of these things plus construction almost simultaneously at a much lower cost, but more importantly, way ahead of the competition. For geopolitical reasons, investors usually apply a higher discount factor for China than North America, but in this case, the much lower cost, less cumbersome regulatory process, and faster production should offset the geopolitical issues, if not more.

At Silvercorp's major Ying mining operations in Henan Province, with super-high grade around 400 gram/tonne, Silvercorp had produced 4 million ounces of silver in FY 2008, an increase of 100% from previous fiscal year. They are building a new mill right now with capacity of 2,000 tonnes per day, expected to be completed by year end, adjacent to their existing and still relatively new mill with capacity of 1,000 tonnes per day. Both mills combined, Silvercorp is expected to process up to 1 million tonnes of ore per year for mines at Ying, HPG, TLP and LM together in the Henan Province. With these additional new mines near the existing Ying mine, Silvercorp should increase its silver production in this region from 4 million ounces to 7 million in a couple of years. With the resource level estimated to be over 122 million ounces of silver (M&I around 50 million, Inferred 72 million), it is expected to have an additional 12 years of mine life.

Due to the by-product credits from lead and zinc, for the latest quarter Silvercorp achieved a cash production cost of negative $6.8 per ounce of silver. Even with today's silver price at $13, it is almost $20 cash flow per ounce. To be conservative, let us just ignore the by-product credits; Silvercorp can still produce silver at less than $3 cash cost per ounce. In a year or two, when Silvercorp produces 7 million ounces per year in this region, it represents a $70 million [($13-$3) times 7M] operating cash flow per year for this mining operation (In FY 2007, Silvercorp had actually achieved $80 million operating cashflow already, partially due to by-product credits). Since Silvercorp owns roughly 3/4 of majority interest in these mines (interest payout reflected in their income statement under non-controlling interests), the portion for Silvercorp is around $52 million (3/4 of $70 million) with a recent market cap of $600 million. You can imagine the operating leverage here if silver comes back to $20 per ounce and the by-product credits are taken into consideration, thus their operating cashflow can be easily doubled.

Besides mining operations in Henan Province, Silvercorp has recently acquired Gaocheng (GC) and Shimentou [SMT] silver, lead and zinc mines in Guangdong Province. Silvercorp is currently in the process of applying for mining permit and expected to start production in 2011 for GC project, with production capacity of 1,500 tonnes per day. The grade is lower than Ying mine but still high enough for decent profit, around 100-150g/tonne. The current M&I (measured and indicated) resource is 1.8M tonnes with 7.7M ounces of silver, 26K tonnes of lead, 51K tonnes of zinc and 3K tonnes of tin, and the inferred resource is 7.2M tonnes with 29M ounces of silver, 100K tonnes of lead, 218K tonnes of zinc and 9K tonnes of tin. This GC mining operations is estimated to add another 2 million ounces of silver production to Silvercorp in about 3 years, on top of the mining operations in Henan Province.

At the same time, Silvercorp contributed $4M to Na Bao project in Qinghai Province. An additional $8.5M exploration program, including 30,000 meters drilling, tunneling and metallurgical study, is planned for this year. Their goal is to define a resource base that satisfies the Chinese government's minimum requirement, then to apply for a mining permit for silver/lead/zinc mine with 1,000 tonne per day capacity for at least 10 years' mine life.

Overall, with the additional mines near the existing super-high-grade Ying mine, and the new GC project, Silvercorp is expected to double their silver output in the next 3 years. With their by-products of lead and zinc credits, their cash cost of silver production is negative right now, better than free. Even if we don't count those credits, Silvercorp can still produce at less than $3 cash cost per ounce of silver, the lowest cost but highest gross profit margin for a mid-tier silver producer in the industry. In addition, Silvercorp, as a high growth silver producer, has a P/E ratio of only 11 now, with production growth rate of about 25% per year, and the PEG (Price/Earnings to Growth) ratio is less than half, well below one. Most importantly, when silver resumes its bull market, the operating leverage from Silvercorp will provide explosive increase on both revenue and earnings for investors.

Disclosure: I have been long Silvercorp since January, 2006, and I believe Silvercorp Metals is undervalued and provides a good opportunity for a diversified mining portfolio for long term capital gain.