Improving Costs, Clean Balance Sheet Not Sparing Pan American Silver

| About: Pan American (PAAS)
This article is now exclusive for PRO subscribers.

If you mine anything, 2013 was probably a painful year and if you mine precious metals, it was a horror show. The Market Vectors Gold Miners ETF (NYSEARCA:GDX) is down more than 50% over the past year, the Junior Gold Miners ETF (NYSEARCA:GDXJ) is down more than 60%, and the Global X Silver Miners ETF (NYSEARCA:SIL) is down about as much as the GDX (52%). It's not hard to figure out why, as falling prices, rising costs, and debt-laden balance sheets have all contributed to a mass exodus from the space.

In the rush to the door, I think Pan American Silver (NASDAQ:PAAS) may have been unfairly trampled. It is absolutely true that PAAS is going to be hard-pressed to attract investor interest if silver prices keep falling, but there is at least the downside protection of an improving cost structure, lower capex, and a clean balance sheet. Trading just under its net asset value, I believe Pan American may be a good place to look for those investors who still want to own a silver miner.

Diverse Assets With Growth And Profit Improvement Potential

Pan American has grown from just over 7 million ounces of silver production in 2012 to a targeted goal of 25 million to 26 million for 2013. This growth has come in large part from a series of acquisitions in the 1990s, when few were interested in silver, and prudent development of those assets over the past decade. While Pan American is still dwarfed by producers like BHP Billiton (NYSE:BHP), Fresnillo (OTCPK:FNLPF), and KGHM (OTC:KGHPF), it is nevertheless the largest silver miner headquartered in North America (Fresnillo is technically headquartered in London).

Pan American is relatively diversified, as it operates mines in Mexico, Argentina, Peru, and Bolivia. In point of fact, though, this is a relatively concentrated company as two-thirds of the company's net asset value is tied to Mexico, with another approximately 15% attributable to Peru. Both Argentina and Bolivia score badly on Fraser Institute political risk ratings, but though neither Peru nor Mexico are at the top of the charts, they have been improving in recent years.

Looking at the reserves, Pan American boasts over 300 million ounces of silver in 2P reserves (and 2.4 million ounces of gold), and over 1 billion ounces of measured and indicated silver reserves. The company also has economical deposits and reserves of copper, lead, and zinc that it produces as byproducts of the silver and gold mining operations.

Improving Costs No Longer A "Nice To Have"

When metal prices are running hot, nobody pays much attention to production costs and "dig, baby, dig" production growth is paramount. That is no longer the world that mining companies live in, and this company is working hard to improve its cost structure.

Mining costs rose from under $10/ounce in 2009 to over $12/ounce (NASDAQ:CASH) in 2012 and prices were on a trajectory to exceed $13/ounce this year. Management has been getting more serious about costs, though. Greenfield exploration spending has been cut in half and management targeted some serious productivity initiatives at its Peruvian mines.

So far, it looks as though this is helping. For the third quarter of 2013, cash costs were down 25% from the year-ago level and 14% from the prior quarter, to a very attractive $10.40/ounce. All-in costs followed a similar trajectory (down 22% and 17%), coming in at just under $18/oz. I am a little concerned as to whether this is sustainable. While mining cost improvements in Peru may have helped, the company also benefited from higher silver sales and better byproduct credits (payment received for the copper, lead, and zinc Pan American produces as part of its core silver/gold mining). I'm not trying to look a gift horse in the mouth here; rather, I simply want to point out that byproduct credits can go the other way.

Even so, Pan American is on the wrong side of the cost curve. The Silver Institute has reported a global primary cash cost average of $8.88 per ounce for 2012, while CPM Group reported a figure of $10.04 for the year. Coeur Mining's (NYSE:CDE) silver cash costs are close to par with Pan American's (although PAAS is at the high end of Coeur's range), but Fresnillo produces silver at cash costs almost half those of Pan American's, and BHP Billiton is in the high single digits as well.

Pan American may still have some levers to pull when it comes to cost. Higher royalties in Mexico won't help, but management is sticking to an all-in cost target of below $20 an ounce. Expansion in Mexico may help - the company elected to go forward with an expansion (including a second shaft) at the La Colorada mine and this expansion could not only meaningfully lower costs (better utilization of overhead/fixed costs), but generate a 20%-plus return even at $19/oz silver prices. One lever that does not appear to be available is further M&A - management reportedly evaluated 50 projects and could not find any that met its return requirements.

Navidad May Be The Biggest Other Unknown

It probably goes without saying that the future level of silver prices will play the biggest factor in where Pan American's profits and cash flows go in the coming years. Free cash flow should go back into the black in the coming years with significantly lower capex spending, but there is always the risk that silver prices fall further.

Next to silver prices, the future of the Navidad project in Argentina may be the biggest unknown. While this resource could add 20 million ounces a year to Pan American's silver production, Argentinian politics may be an insurmountable obstacle. The provincial government in Chubut (where Navidad is located) seems willing to back off its ban on open-pit mining, but the proposed requirements are problematic.

Legislation (which was never formally introduced), would have hiked the royalty rate from 3% to 8% and given provincial government-owned Petrominera at least 4% of sales, not to mention required 80% of the workforce to come from residents of the province. Those proposals appear to be tabled now, but it doesn't sound like the company would have gone forward with them and there is considerable uncertainty remaining. Walking away from this project (and a $500 million investment) would be a shame, but it would be an even bigger shame to invest capital in a project that cannot earn back a suitable return.

The Bottom Line

Not unlike gold stocks, silver stocks have been trading at a premium to their NAVs during the past five or six years. With the steep declines in silver prices and expectations, that has changed. Just a 1.1x multiple to NAV would suggest a fair value above $12.50 for Pan American, with the stock currently trading just under NAV. EV/EBTIDA likewise suggests undervaluation (a fair value of over $14 with an 8x multiple on 2014 EBITDA), but EBITDA isn't an oft-used metric with precious metal miners.

Given its cost structure, Pan American has above-average sensitivity to silver prices, and should outperform its peers if silver prices recover. In the meantime, the company has a clean balance sheet (over $2/sh cash) that can cover its near-term capex and dividend demands, and an improving cost and capex structure that should lead to positive free cash flow again next year. Although I'm not generally a fan of owning precious metals companies, Pan American does look like a name worth watching for investors who want to go contrarian and add exposure to silver.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.