Digging For Dividends Pt. 1: Pan American Silver Corporation

Summary

• Pan American Silver is a world-class operator which boasts superb operational metrics and a pristine balance sheet.
• The company's "Navidad" deposit adds a 'lottery ticket'-like element to the investment thesis.
• Investors should wait until after the May 10th earnings call before coming to a final decision about whether or not to invest in Pan-American.

As a dividend growth investor, I tend to focus on safe, reliable companies that have a track record of steadily raising their dividends. On the other hand, focusing solely on these companies can leave investors underexposed to certain sectors of the equity markets. One of these sectors is the mining sector. Over the next few weeks, I will analyze a handful of both precious and non-precious metal mining companies. These companies will all be dividend payers, but not necessarily of the sort that dividend growth investors tend to include in their portfolios.

Why Look At Mining Companies?

Investors who are putting money to work in dividend growth stocks are, in many cases, doing so at record high valuations. Mining stocks, on the other hand, are still in the process of recovering from the drastic decline in commodity prices that occurred in 2015-2016. This can be reflected by the performance of an ETF that tracks a basket of non-precious metal stocks relative to that of the S&P 500 or that of a diversified dividend ETF over the past 5 years.

PICK data by YCharts

In addition to trading at less lofty prices on a relative basis, mining companies may be on the cusp of finally benefiting from increasing inflation. In the aftermath of the most recent meeting of the Federal Reserve, the US central bank noted that "Inflation ... is expected to run near the Fed's symmetric 2% objective over the medium term". This is after nearly a decade in which both central bankers and policymakers "threw the kitchen sink" at the US economy in an attempt to engender just such inflation, and the economic expansion which it typically accompanies.

If inflation does indeed take hold of the US and world economy, it is possible --albeit unlikely-- that nonprecious metals could be in for a repeat of their performance during the mid-2000's, when many of them doubled or tripled in price over less than a decade's time. If this were to be the case, companies engaged in the extraction and production of these base metals will stand to benefit.

Base Metal Price Index data by YCharts

Of course, the commodity which occurred in 2004 - 2008 was unprecedented in terms of the breadth of the rally and the extent to which prices rose. The likelihood that we see a repeat of that "super-rally" is very small. Nonetheless, looking back at the conditions that preceded past upswings in commodity prices and comparing them to present day conditions within the world economy yield some interesting comparisons. Consider the chart below, which the World Bank produced as part of a report released in the immediate aftermath of the end of the 2000s commodity bubble. Across the four major commodity booms examined, geopolitical conflict, infrastructure investment, an extended period of low prices/investment, and an initial rise in the price of oil figure prominently. This is especially true for the two most recent commodity booms (1973-74 and 2003-08).

Source: "The Commodity Boom: Longer - Term Prospects" by the World Bank

Fast forward to today. With the Trump administration flexing its muscles on the international stage with missile strikes in Syria and tough talk on Iran, an inflation rate that has remained relatively muted for much of the past decade, continued infrastructure expansion by China (both at home and abroad), and oil prices reaching a multiyear high after a major commodity crash only a few years ago, it would seem that there are similarities between where we are today and conditions that helped to precipitate commodity booms in the past. As such, investors might want to consider dipping their toe into nonprecious metal mining stocks in order to capture the possible upside that may occur should commodities as an asset class experience a new bull market in the next few years.

Mining companies which specialize in precious metals are also trading at relatively attractive levels. Given the moderate correlation between precious metals prices and the companies that mine them, investors who are looking for some exposure to precious metals might consider diverting a portion of their precious metals portfolio allocation to a mining company which specializes in these metals.

Gold Price in US Dollars data by YCharts

The silver miner which I will be taking a closer look at in this article is Pan American Silver Corporation (NYSE:PAAS). Pan American is the second largest primary silver-producing company in the world. It's operations span North and South America, with its most productive assets located in Mexico. In 2017, the company produced 25 million ounces of silver and over a quarter million ounces of gold.

Source: April 2018 Pan American Silver Investor Presentation

As the production figures mentioned above indicate, silver is the primary revenue producer for Pan American, although gold, zinc, lead, and copper each make up a healthy slice of the company's revenue mix. Together, these four metals actually comprise the majority of the estimated 2018 revenue. Potential investors should keep this revenue mix in mind, as a drop in "base" metal prices could potentially hurt Pan-American Silver. At the same time, if "base" metals rally on the back of strong demand, investors in Pan-American will be able to come along for the ride.

Source: April 2018 Pan American Silver Investor Presentation

Pan American has also been relentless in controlling its costs over the years, as the chart below illustrates. With silver prices around $16.50 per ounce, Pan American's all-in sustaining costs per silver ounce sold, or AISCSOS, of just over $10 leaves room for a healthy profit margin. ASICSOS is a non-GAAP measure which is Pan-American's preferred method of calculating the true cost of operating itself. ASICSOS takes into account traditional cash costs per ounce, as well as the cost of replacing those ounces through exploration, the cost of ongoing capital investments, and other relevant expenses. Currently, the company's three-year outlook has ASICSOS rising to as much as $11.50 in 2019, before stabilizing somewhat in 2020 around the $8.50-$11 /ounce level.

Source: April 2018 Pan American Silver Investor Presentation

Pan American Silver has also been an exemplar of financial discipline in terms of its balance sheet. The company, which currently has over $200 million in cash and cash equivalents on hand, has only $10.6 million in total outstanding debt. It also has access to an undrawn $300 million line of credit. This suggests that no matter which direction commodity markets go in the short- to medium- term, Pan American will be able to weather the storm and --if the opportunity arises-- make opportunistic acquisitions.

Source: April 2018 Pan American Silver Investor Presentation

Pan American Silver's solid operating and balance sheet metrics have allowed it to increase its quarterly dividend by 40% this past February. This is the second year in a row in which the company has boosted its dividend. However, these recent increases still leave the dividend below the level it achieved in the run-up to the commodity crash of 2015-2016. This fact, combined with the fact that the company currently yields a paltry 0.67%, may dissuade some more traditionalist dividend growth investors from including Pan American in their income portfolio. However, I would argue that "silver stackers" who buy and hold precious metals themselves (or a fund that represents an ownership stake in the metals) are receiving zero income from their investment. In fact, they are likely incurring expenses associated with their investment, be it storage fees or fund management fees. Seen in that context, Pan American's small but growing yield makes it a relatively attractive place for precious metals bulls to put a portion of their investment dollars to work. By doing so, they can preserve their exposure to the price of silver while also receiving a stream of passive income.

PAAS Dividend Yield (TTM) data by YCharts

Pan-American is also sitting on a "lottery ticket" in the form of the 'Navidad' silver deposit, located in Chubut province, in Argentina. This deposit, possibly one of the largest in the entire world, is estimated to contain over 67 million ounces of silver. The company estimates that, once fully operational, a mine built on the site can process 15,000 tonnes of ore per day. At a silver concentration of 137 grams per tonne, that works out to a simple average of about 66,000 troy ounces of silver extracted per day. That's serious money.

Source: Company Website

Unfortunately, Pan American has yet to recoup a single penny of its multi-hundred-million dollar investment in the Navidad deposit. The reason? The Argentine province of Chubut, in which Navidad is located, passed a law in 2003 which forbids open pit mining and the use of cyanide in mineral processing. Thanks to this law, Pan American hasn't been able to get a single ounce of precious metal out of this "mother lode" of silver. While the company continues discussions with both local and federal Argentine officials, the project has been on hold for so many years now that it is difficult to envision it receiving any sort of exemption from the Chubut mining regulations any time soon. Nonetheless, the possibility remains that the political deadlock --which has been ongoing for almost a decade now -- will be broken. If that occurs, a rapid re-pricing of Pan-American Silver stock to the upside is not an unlikely event.

Closing Thoughts

Inflation, rising international demand, and geopolitical uncertainty could potentially converge in the next few years to create a positive market environment for commodities. If this occurs, investors who are positioned within mining stocks are likely to benefit. If it does not occur, then investors who chose mining stocks with a history of paying dividends can at least be partially consoled by the fact that they are at least receiving a stream of passive income from their investment. Pan American Silver, with its pristine balance sheet and impressive operating costs, represents a best-of-breed player within the silver mining space. The potential for a massive payoff from the Navidad deposit holds out the possibility for capital appreciation, while management's commitment to paying a dividend to shareholders provides investors with a quarterly stream of income. If you are an intrepid income investor, or a "silver stacker" looking to wring some income out of your precious metals exposure, I would give some serious thought to allocating a small portion of your portfolio to this company. Before doing so, however, I urge you to remember that silver is an extremely volatile commodity and, as such, this company is not a SWAN (sleep-well-at-night) investment. I also urge you to postpone your investment until after the company's first quarter 2018 earnings announcement, which is scheduled for Thursday, May 10th at 10:00 am Eastern Time. Information is an investor's greatest ally, and you should have the most up-to-date data at your fingertips before deciding whether Pan-American Silver belongs in your portfolio.

Disclaimer: Use my work as a starting point for your own due diligence, not as a substitute. All investments involve the risk of loss of income as well as the principal. Consider consulting with an investment adviser before making any investment. I am not a tax professional or investment adviser. Please consider consulting with a tax professional before making any investment. Author-generated charts are subject to error due to discrepancies in source data or securities being listed on multiple international markets.

Like what you read? Click the "Follow" button at the top of this page!

Analyst’s Disclosure: I/we 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.