Endeavour Silver: An Inferior Buy-The-Dip Candidate

Summary

• Endeavour Silver is one of the worst-performing precious metals stocks the past few months, down more than 45% from its June highs.
• The poor performance can be attributed to Endeavour's razor-thin all-in sustaining cost margins, which will remain below 20% if the silver price remains below $23.00/oz.
• This weakness in the silver price could weigh on Endeavour's ability to generate free cash flow to help fund Terronera, suggesting share dilution could be back on the table.
• After a precipitous decline, Endeavour Silver is short-term oversold, but at a valuation of ~1.50x NPV (5%), I see much better value elsewhere in the sector.

SL_Photography/iStock Editorial via Getty Images

While the Silver Miners Index (SIL) started the year strong by massively outperforming the Gold Miners Index (GDX), we've seen a reversal of fortune since. This is evidenced by the Silver Miners Index now down 19% year-to-date vs. a 17% decline for the Gold Miners Index, with some silver producers like Endeavour Silver (NYSE:EXK) sliding over 45% in barely three months. The outsized weakness in Endeavour is likely attributed to its razor-thin margins, making it one of the highest-risk ways to play the silver sector. After a steep decline, Endeavour Silver is short-term oversold, but at a valuation of ~1.50x NPV (5%), I see much better value elsewhere in the sector.

Bolanitos Mine, Company Presentation

Endeavour Silver is preparing to report its Q3 results next month and remains on track to beat its FY2021 output guidance mid-point of ~6.6 million silver-equivalent ounces [SEOs]. However, while the company is set up for a strong year from a production standpoint, costs could come in above guidance of $19.50/oz at the mid-point and are sitting at $22.69/oz as Endeavour prepares to report its Q3 results. A slight miss on guidance wouldn't have been an issue for profitability if silver prices remained robust, as they did in Q1 and Q2. However, with the average silver price for Q3 coming in at ~$24.40/oz and starting Q4 below $22.50/oz, Endeavour could see meaningful margin pressure on a sequential basis. This suggests limited if any free cash flow generation in FY2021 and minimal free cash flow generation in FY2022 if prices do not recover. Let's take a closer look below:

Endeavour Silver AISC Margins, Company Filings, Author's Chart

As shown in the chart above, Endeavour Silver's all-in sustaining cost [AISC] margins dipped sharply on a sequential basis in Q2, attributed to a 27% increase in the company's all-in sustaining costs. The increased costs were partially related to increased royalty costs at Guanacevi due to increased mining at El Curso, and a higher average realized silver price, but inflationary pressures weighed on margins as well. Endeavour noted that this was related to increased labor costs, Mexican Peso strength, and global supply chain constraints. The company didn't get much help from a weaker Peso in Q3, with the USD/MXN exchange rate coming in at $19.96, only down ~1% from the Q2 average ratio ($20.19). Fortunately, a strong average realized silver price of $26.82/oz in the period allowed the company to still report an AISC margin of $1.43/oz.

The good news is that the lower average realized silver price should contribute to lower AISC in Q3, with AISC likely to come in closer to $20.00/oz. The bad news is that this dip in all-in sustaining costs should have translated to a meaningful improvement in margins sequentially, but the silver price had different plans. Given the more than 10% drop in the silver price vs. Q2 levels, we should see another quarter with AISC margins below $4.00/oz, down nearly 50% from Q1 2021 levels ($7.23/oz). Unfortunately, Q4 is not starting out much better, with the average realized silver price hovering below $23.00/oz, suggesting H2 2021 margins should come in much lower than H1 2021 margins, given that Endeavour's average realized silver price is likely to come in below $24.50/oz in H2 2021 vs. nearly $27.00/oz in H1 2021.

So, why is this an issue?

Outside of Endeavour's higher-cost profile making it more susceptible to volatility in the silver price, many investors were hoping that Endeavour could generate meaningful free cash flow this year if prices stayed above $28.00/oz, which would help strengthen the balance sheet. This would have allowed the company to fund its Terronera Project almost entirely from its cash balance, assuming upfront capex remained at reasonable levels. However, at the same time as the free cash flow outlook for FY2021 has become moderated considerably, Terronera's upfront capex has nearly doubled to ~$175 million ($99 million previously). This suggests that Endeavor may need to use its At-The-Market [ATM] Equity Offering to raise cash to completely fund the higher Terronera capex bill, unless it decides to take on some debt. So, while I would expect minimal share dilution if Endeavour does go ahead with a capital raise or use its ATM, potential dilution to fund Terronera is back on the table.

Terronera Study, Company Presentation

Some investors will argue that after a nearly 50% decline in Endeavour Silver's stock price, the weakness in the silver price is more than priced in and that the stock is a steal at current levels. Generally, this would be the case, especially after the steep drop we've seen (more than 45% in less than 90 trading days). However, at the same time as EXK has been declining, the updated Terronera NPV (5%) came in below my estimates of ~$200 million from a base case standpoint, and earnings estimates have continued to plunge. This has left Endeavour Silver trading at more than 25x FY2022 earnings estimates ($0.16). The valuation isn't any more enticing on an NPV (5%) basis, with Endeavour Silver trading at roughly ~1.5x NPV (5%). This is based on a combined ~$310 million NPV (5%) for Guanacevi and Bolanitos and $174 million for Terronera. $730 million market cap fully-diluted / ~$484 million NPV (5%) = 1.51x NPV (5%).

Endeavour Silver Earnings Trend, FactSet.com, Author's Chart

With much of the precious metals sector trading below 1.0x NPV (5%) and at less than 15x FY2022 earnings estimates, I struggle to see any reason to pay up for Endeavour Silver here at $4.15 per share. This doesn't mean that the stock can't bounce, given that it is very oversold short-term. However, from a valuation standpoint, there is no real margin of safety, given that I prefer to buy small-cap precious metals producers at 1.0x NPV (5%) or less. Obviously, a significant rally in precious metals prices would boost this NPV (5%). However, other companies are trading at below 1.0x NPV (5%) like Alamos Gold (AGI), and investors don't have to rely on higher metals prices to bake in a margin of safety.

So, what's the good news?

EXK Chart, TC2000.com

As noted previously, Endeavour Silver has pulled back to within 5% of its first potential support level at US$4.00, and the reward/risk has improved considerably at current levels. Meanwhile, the company has a very high-grade, high-margin project in the wings (Terronera) and could see production double from current levels by FY2024. Therefore, buying below US$4.00 could provide solid upside from a swing-trading standpoint, as long as one is willing to sell into strength. My issue, as discussed earlier, is that it's hard to rule out share dilution in the next 12 months, and the valuation doesn't offer enough margin of safety. For this reason, I much prefer names like Alamos Gold in the precious metals space, trading at ~0.80x P/NAV with a better jurisdictional profile.

Endeavour Silver had an exciting Q1, but I warned that there was no reason to pay above $6.50 for the stock in May. This is because there was too much optimism was priced into the stock at 30x earnings, and the price of silver had to remain near $30.00/oz to justify the valuation. With the silver price tumbling since the irrational exuberance we saw in early March, it's no surprise that Endeavour has corrected sharply, and it's hard to argue that it's investable even after the decline. Given Endeavour's razor-thin margins relative to the average silver producer and potential for further dilution in the next 12 months, I see Endeavour as an inferior way to buy the dip. So, while a rally is certainly possible, I would view rallies above $5.20 before year-end as an opportunity to book some profits.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of AGI either through stock ownership, options, or other derivatives. 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.

Disclaimer: Taylor Dart is not a Registered Investment Advisor or Financial Planner. This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Taylor Dart expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.