Pan American Silver: Hands-On Approach Management Wanted

| About: Pan American (PAAS)
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Summary

Pan American Silver is still struggling with a relatively high AISC of $17/oz.

This means that all free cash flow will have to be used to fund the expansion plans at La Colorada and Dolores.

Whilst the output at those two mines would increase and the costs decrease, this only partially tackles the problem of depleting mines.

I expect Pan American Silver to do a strategic acquisition to fill its (empty) pipeline.

Until more accretive projects are added, I'm on the sidelines.

Introduction

I have been keeping an eye on Pan American Silver (NASDAQ:PAAS) just in case I want to add a senior silver producer to my mining portfolio, which mainly consists of smaller companies. I will try to derive a fair value for the company based on its different projects.

Source: company presentation

Even though this is officially a Canadian company, the US listing provides plenty of liquidity with an average dollar volume of $16M per day. As its financial statements are also provided in US Dollars, I don't need to convert CAD into USD, so even though it's a Canadian company, it behaves very much like an American one.

As always, the calculations in this article are my own and should only be used as a starting point for your own due diligence. All images were directly taken from the company's website, presentations and other public documents.

A quick overview of Pan American Silver's assets

As it would be difficult to analyze all assets in depth, I'll just have a quick look at the most important mining projects in Pan American Silver's portfolio. These 4 mines contributed 62% of the total silver output of Pan American Silver in the first quarter of this year.

A) La Colorada

The La Colorada mine in Mexico produced approximately 1.15M ounces of silver and was Pan American's project with the highest silver output in its portfolio. The mine is located in Mexico's Zacatecas district which is very likely one of the best known silver districts in the world. La Colorada is an interesting asset with a rich history as mining has been going on since before the Mexican Revolution in the early 1900's. Historical mining was started during the pre-colonial times and tens of millions of ounces of silver were recovered with relatively primitive methods.

Source: company website

In the first quarter of this year the mine produced 1.15 million ounces of silver which was an 8% increase compared to the same period last year. This was caused by a higher throughput (+7%) and slightly higher silver grade (364g/t vs 359g/t). As you can see, La Colorada's average grade is pretty high at almost 9 ounces of silver per tonne of ore. There's also a small gold, zinc and lead kicker as by-product, which actually has a very nice influence on the cost per ounce of silver (I estimate the value of the by-product credits to reduce the cash cost of the silver by $6-7/oz). It's interesting to see that the average grade of the reserves at La Colorada is actually higher than the head grade in Q1, so there must be a possibility to implement some operational improvements. At the current reserve estimate of 6.5 million tonnes, the remaining mine life at La Colorada is approximately 14 years. However, the company is planning an expansion (and is actually already executing the expansion program as it already spent $3.6M in Q1 in capital expenditures at La Colorada). This expansion would increase the output from 4.7-4.8Moz per annum to 7.7Moz per year by the end of 2017 for a total price tag of just $80M, which is very reasonable given the fact the payback period would be just 2.5 years as the cash cost of the silver would decrease by a stunning 35-40%.

I think the expansion plan is a great move, as it will allow the company to increase the production rate by 60% whilst decreasing the costs by 35%. If I'd translate that in numbers, the operating cash flow at a silver price of $20/oz would increase from the current $55M to $105M per year. That's an additional $50M in annual operating cash flow for a $80M investment, and is definitely accretive! The IRR of 22% doesn't sound exciting, but the simple explanation is the fact that the expansion would happen in several steps over three years time.

B) Dolores

Pan American Silver acquired ownership of the Dolores gold and silver mine in Mexico when it acquired Minefinders in a $1.5B transaction. This transaction caused a lot of headaches later on, as Pan American Silver had to take an impairment charge on the asset due to the low silver and gold price.

Source: company presentation

As the recoveries of the gold at Dolores were much higher than the silver price, I actually considered it to be a gold project, but Pan American has done a great job in increasing the recovery rates of the silver (up to 54% from 39%) as well as the gold (up to 90% from 76%) and at this moment the revenue from gold and silver is split evenly. The silver production increased by 20% even though the head grade decreased by 20% as well.

Source: company presentation

And there's more to come. Pan American has big plans for Dolores as it's gearing up to add a mill and pulp agglomeration circuit, which should enable the company to increase the recoveries of the higher grade zones of the mine. This will be necessary as PAAS is planning to re-open the underground mine at Dolores which will have substantially higher grades (2.5-3g/t AuEq) than the ore which is currently being processed. This should increase the production rate to just over 5 million ounces of silver per year at a price tag of $105M and would have an IRR of 27% based on a silver price of $19/lbs, because the underground ore has a lot of gold as by-product which results in a negative cash cost for the silver (as the gold revenue covers the entire production cost). So just like the La Colorada expansion, the Dolores expansion makes a lot of sense and should be beneficial to its shareholders.

C) San Vicente and Manantial Espejo

San Vicente is expected to produce approximately 4 million ounces of silver this year at a cost of $12-13/oz. However, this project is located in Bolivia, and as you probably already know, I'm not a big fan of protectionist countries whose hobby it is to nationalize mining projects. So investors should be aware that 15% of the company's production is coming from a country which could easily be described as 'problem country'. Additionally, the mine in Argentina's Santa Cruz province contributes about the same amount to PAAS' total output, so these are two mines I'd place in the 'higher risk' category.

That being said, I would generally consider Argentina to be safer than Bolivia (I think the recent strike at San Vicente will only be the beginning of the problems), so I'm not immediately worried about the Manantial Espejo project which will produce 4Moz of silver this year and a very nice 70,000 ounces of gold. This excellent gold kicker allows the company to produce its silver at a negative cash cost (-$4.82/oz in Q1 2014). So Manantial will very likely be the biggest contributor to the company's operating cash flow, and I hope Argentina continues to play it nice (I have no indication to believe otherwise).

What's the value of the company? But first, a really important issue

Let's make it a bit more difficult now to try to derive the fair value of the company including the expansion plans in the longer term. As all of Pan American's assets are in production, I think a discount rate of 6% is sufficient. When compiling the expected production rates for the next 10-15 years, it's immediately noticeable that a lot of Pan American's projects will be out of production before the end of the next decade. This is a synthesis of the remaining mine life per project. Keep in mind, this is a rough calculation based on the currently known reserve estimates and expected throughput rates. I might be off by a year, so you should only consider it as 'something to look at'.

Mine

Remaining Mine Life (yrs)

La Colorada

11

Alamo Dorado

4

Dolores

12

Huaron

11

Morococha

9

San Vicente

8

Manantial Espejo

5

As you can see, two mines (producing 7.6 million ounces per year) will be out of reserves within 5 years, and I'm afraid Pan American's development pipeline isn't sufficiently filled. The Pico Machay project in Peru is just gold and seems to be too small to be developed and the Navidad project in Argentina won't get permitted anytime soon. This means that PAAS only has one project in its pipeline, the Calcatreu project in Argentina but you should also put a value of zero on that one, as the local government of the Rio Negro province has banned the use of cyanide, making this project a no go as well.

So two large contributors to the production profile will be out of reserves within five years, and whilst I do realize that vein-type deposits usually aren't fully drilled out immediately, the resources are also quite small, so Pan American will have to either A) get more aggressive in drilling or B) fill its pipeline by acquiring another company, preferably with one flagship project and several projects in the pipeline.

So let's run some numbers on things we do know. The AISC is $17/oz and I don't expect this to change any time soon (keep in mind the AISC includes the sustaining capex on the projects but NOT the expansion capex). My expected average corporate tax rate is 30%, and the mine lives will be based on the currently known reserves. The used silver price is $20/oz.

Cash Flow

Corporate Tax Rate (30%)

After-tax cash flow

Discount rate (6%)

NPV 6%

-

-

-

26,000,000.00

30.0%

18,200,000.00

1.00

18,200,000.00

35,000,000.00

30.0%

24,500,000.00

1.06

23,113,207.55

46,000,000.00

30.0%

32,200,000.00

1.12

28,657,885.37

67,500,000.00

30.0%

47,250,000.00

1.19

39,672,011.12

65,000,000.00

30.0%

45,500,000.00

1.26

36,040,261.68

66,000,000.00

30.0%

46,200,000.00

1.34

34,523,327.59

65,000,000.00

30.0%

45,500,000.00

1.42

32,075,704.59

54,000,000.00

30.0%

37,800,000.00

1.50

25,139,158.89

48,000,000.00

30.0%

33,600,000.00

1.59

21,081,055.68

45,000,000.00

30.0%

31,500,000.00

1.69

18,644,801.60

48,000,000.00

30.0%

33,600,000.00

1.79

18,762,064.50

15,000,000.00

30.0%

10,500,000.00

1.90

5,531,269.02

301,440,747.59

So at this point the total NPV6% of the reserves would just be over $300M. Why is that? First of all, the company's AISC is quite high at $17/oz. Whilst this is expected to go down in the future (until Manantial Espejo ceases production), the operating margin will never be very high. Additionally, Approximately $200M will be needed in the first three years to pay for the expansions at La Colorada and Dolores. If you'd assume a straight three-year expenditure, the expansion cost per produced ounce of silver is approximately $2.50, which means that at $20 silver, PAAS will really struggle to meet the capex requirements with its operating cash flow. The situation gets better from year 4 on, but unfortunately that's when I expect the first mine to run out of reserves.

Investment Thesis

I'd like to congratulate the Pan American Silver management with its excellent balance sheet, but I think it's time to put the $680M working capital position to work, as two mines will be depleted before the end of the decade and the company has no long-term plan to compensate for the loss of two large mines, other than expanding the production rate at Dolores and La Colorada.

And the lack of long-term views is the main reason why I wouldn't feel comfortable to own Pan American Silver. Remember this is the company which hedged a part of its output, only to unwind this hedge at a LOSS just three weeks after announcing it. This doesn't really fill me with confidence and I would like to see a strategic long-term growth plan (well, it doesn't even have to be a growth plan, just a plan to keep the production steady would already make me happy). Despite the strong balance sheet, I have no intention to initiate a position in Pan American Silver, unless the company can substantially decrease its AISC even further towards $15/oz, and unless the company tackles the problem of depleting mines.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.