It's been a treacherous 6-month stretch for investors in the precious metals space, especially for investors focused on silver producers (SIL). This is because the group has quickly gone from enjoying healthy margins to having to tighten things up even to maintain razor-thin margins, a result of the collapsing silver price (SLV). However, while most producers are struggling, one producer stands head and shoulders above the rest from a margin standpoint. This company is SilverCrest Metals (NYSE:SILV), and I see it as one of the safest ways to get exposure to the silver price.
The past year has provided a painful lesson for investors in the silver space: investing isn't as simple as buying a thesis that makes sense and paying up for that thesis at any price. This is evidenced by the 50% plus drawdown we've seen in First Majestic (AG), which some experts told us to buy at a 3% free cash flow yield in February 2021 (post silver squeeze), and the 70% plus drawdowns in weaker names like Excellon (EXN), IMPACT Silver (OTCPK:ISVLF), and Kuya Silver (OTCQB:KUYAF). These valuation figures are typically reserved for high-margin tech stocks that are industry leaders, not cyclical stocks with mediocre track records.
While I did not expect a pullback of quite this magnitude, I warned against owning First Majestic at $19.00 and most silver miners. This is because unless the silver breakout continued, the sector and many of these companies would have near insurmountable year-over-year comps ahead, nearly guaranteeing that they would post significant year-over-year declines in sales and cash flow in Q1/Q2 2022. These sharp year-over-year declines tend to put pressure on stocks. Worse, some companies might get a little too confident and make foolish acquisitions, and we've seen a few examples of this as well. One example was Endeavour's (EXK) acquisition of Pitarilla, which was unnecessary with Terronera in the wings.
With the sector now down 55% from its highs, we're seeing less chest pounding from the silver apes, but some investors on the sidelines might believe they're staring down an incredible buying opportunity. Although being a contrarian in this sector is the best formula for success, the problem is that some of these declines are wholly justified. The reason, which might not be apparent yet, is that many producers in this sector use silver prices 25% above current levels to calculate reserves.
The above chart shows the 2021 metals price assumptions to calculate mineral reserves, and it's clear that nearly every producer except SilverCrest and Hecla (HL) is using metals price assumptions for silver that are above current levels. Meanwhile, a few companies are completely out in left field, such as Hochschild (OTCQX:HCHDF) at $26.00/oz, Endeavour Silver at $23.00/oz, and First Majestic (AG) at $22.50/oz. Fortuna Silver (FSM) isn't much better at $21.00/oz. Due to inflationary pressures, these companies will likely see cut-off grades raised to incorporate higher costs, a negative development when combined with the lower metals price environment.
While there is certainly the potential for silver to rebound, and I think we've seen most of the downside for silver, limited downside or a moderate rebound is not enough to escape negative reserve revisions next year if metals prices are adjusted lower. It also makes it very hard to convert resources into reserves when resources are at even higher metals prices than the reserve price assumptions. For this reason, and unless the silver price wakes up from its free-fall with a vengeance, I would not want to own high-cost producers with short mine lives that are already based on metals price assumptions that are not conservative.
Fortunately, SilverCrest doesn't have this issue. In fact, it uses some of the most conservative price assumptions sector-wide of $16.60/oz for silver and $1,410/oz for gold. This means that while much of the industry might be sweating a little as they think about preparing their 2022 Reserve & Resource updates, SilverCrest is in a position to grow reserves, increasing its ~$550 million After-Tax NPV (5%) using metals price assumptions near current levels ($19.00/oz silver, $1,550/oz gold). Hence, the list of available stocks is quite small if one wants to gain leverage to the silver price and doesn't want to sit in a stock that might report reserve depletions in Q1 2023. Let's take a closer look at the company below:
SilverCrest Metals ("SilverCrest") announced the completion of construction at its Las Chispas Mine in late May, which was ahead of schedule and just below the ~$138 million budget. This marks a key milestone for the company as it has transitioned from developer to producer, and this is even more impressive given that it managed to move from first drill hole to production in six years despite wading through a global pandemic and an inflationary boom.
Typically, this period can take up to 15 years for many other companies, and the longer it takes, the smaller investors' piece of the pie becomes given the steady dilution. However, in SilverCrest's case, the company has a unique and superior view of getting an asset into production as quickly as possible and then using cash flow to drill that asset out rather than share dilution. This strategy allows the company to keep its share count low. If it weren't for a contingency capital raise in case it went over budget or was delayed, SilverCrest would have accomplished going from explorer to producer status with less than 140 million shares outstanding, which places it in rare air among the precious metals sector.
Of course, it certainly helps that SilverCrest's Las Chispas Mine is one of the highest-grade mines globally, boasting a reserve grade of ~880 grams per tonne silver equivalent (9.8 grams per tonne gold-equivalent). Combined with continued exploration success, these grades helped the company to delineate a resource that justified a mine-build at break-neck speed. Now that construction is complete, the focus will shift back to exploration, which catapulted the stock from $3.00 per share to $12.00 per share from 2019 to 2021, with results that were among the best we've seen sector-wide.
While SilverCrest is the proud owner of one of the highest-grade orebodies globally, a high-grade asset can only get you so far if management lacks experience or simply isn't fit for the job. We saw this with Pure Gold (OTCPK:LRTNF), which didn't raise contingency capital, didn't have the right team in place to successfully operate its asset, and didn't build a large enough stockpile to ensure a smooth ramp-up if any issues arose. The result was an 85% decline in the share price on the back of consistent share dilution, a reminder that management trumps grade, though high grades certainly don't hurt.
Fortunately, SilverCrest has the total package, meaning that it has a team with a near flawless track record, and it also has an orebody that most majors would salivate over. In fact, the team had considerable success less than 50 kilometers away from its new mine (Las Chispas) at Santa Elena, an operating mine that was acquired for a 35% premium during a secular bear market for precious metals. In my view, this de-risks SilverCrest, with investors not having to be anxious about the usual teething issues for a new mine. Importantly, this strong track record is not only historical (Santa Elena) but extends to current guidance, evidenced by the mine build that was on time/budget.
While success in the construction period for an asset is not always correlated to operational excellence, SilverCrest deserves considerable praise for building Las Chispas on time and budget with its first pour last month. This may not seem like that big of a deal for investors that are not that familiar with the sector. Still, for those following the sector closely, this has been an extremely difficult environment due to labor tightness, COVID-19 exclusions, supply chain headwinds, and inflationary pressures. Due to these headwinds, many companies building mines look to be at least 15% over budget on balance and slightly behind schedule, with blowouts of over 50% in some cases.
This ability to deliver on its goals in an extremely difficult environment should instill confidence in the SilverCrest team and their ability to meet their production targets. In fact, in an industry (silver space) that is high on promotion and blue-sky targets and notorious for missing even base case targets, I have found SilverCrest's management team to be almost too conservative, which is very refreshing in an industry (silver miners) that lacks this trait.
Finally, I'd be remiss not to note that while the recent plunge in the silver price has had a severe dent in margins for most silver producers, especially with all-in costs sector-wide closer to $18.00/oz, SilverCrest's margins are still healthy as ever. This is because the company is expected to produce at an all-in sustaining cost of $6.70/oz for its first seven years, giving the company ~63% margins even at a silver price of $18.30/oz. Meanwhile, its discovery cost is near $1.00/oz, meaning that even if silver prices stay below $20.00/oz, it can easily build on its mine life through exploration. At the same time, some producers might have to consider shutting down their weaker operations if they can't make key discoveries soon.
This industry-leading margin profile allows SilverCrest to play offense at high metals prices and enjoy margins similar to Software-as-a-Service companies at $30.00/oz (~78%) but also play defense in violent downturns. According to famed coach Vince Lombardi who went 96 and 34 in his career, defense wins championships, and when fighting what some might argue is price manipulation, it doesn't hurt to have a rock-solid defense. To summarize, SilverCrest gives investors the best of both worlds, especially in a volatile commodity. So, how does the valuation look?
Like Wesdome (OTCQX:WDOFF), another high-grade producer and top-20 exploration story sector-wide, the only reason that I've stayed away from both stocks in the past is valuation. This is because while both companies are led by strong management and have considerable exploration upside on their properties, they have historically traded at a large premium to net asset value due to their industry-leading grades. In an ebullient market environment, when investors are diving head first into silver miners like during the attempted silver squeeze, paying 1.8x net asset value or greater can pay off. However, when things eventually turn, even the leaders will be chopped down.
Fortunately, after a 55% decline in SilverCrest's share price, the sellers have come out in full force, fixing the one risk to comfortably investing in the name. In fact, this correction has been so violent that it's pushed SilverCrest to a level where it's trading at a market cap of ~$803 million (share price: US$5.50). At first glance, this might appear steep compared to an estimated After-Tax NPV (5%) of ~$550 million at a $19.00/oz silver price and $1,600/oz gold price. However, in my view, this After-Tax NPV (5%) understates the true value of the company.
For starters, the After-Tax NPV (5%) from the Feasibility Study is based on only 15 of 45 veins on the property (~33%), and this is a property that is extremely rich in mineralization. In addition, there are 40 million silver-equivalent ounces [SEOs] outside of the reserve base that aren't included in this NPV (5%) figure. Finally, this Feasibility Study does not contemplate an increase to 1,750 - 2,000 tonnes per day that could be completed for less than $30 million in incremental capital, and it doesn't place any value on the El Picacho Property. I believe we can assign the following value for these assets outside of the current mine plan:
Expanding on these points briefly,  El Picacho lies ~80 kilometers by road from Las Chispas and could be a satellite opportunity long-term if resource size and grades prove to be economic. The resources outside of reserves  look to have a high probability of converting with considerable infill drilling (~110,000 meters) completed in 2021. Notably, much of the drilling has actually shown a slightly higher grade than the resources, pointing to the potential for a slight lift in grades.
Finally, there are multiple new opportunities that have yet to be tested, given that the focus has been on fast-tracking production (allow for exploration with cash flow, not dilution). One key discovery that's not yet included in resources is the Babi Vista Footwall Zone, with 2021 drilling averaging ~3,500 grams per tonne silver-equivalent over an estimated true width of 0.7 meters. This is more than triple the average expected head grade at Las Chispas and could boost project economics if these ounces can be moved into the mine plan at some point. So, not only do reserves look likely to grow, but they are growing at similar or higher grades.
After adding together this upside separate from the NPV (5%) figure attributed to the 2021 Feasibility Study, this pushes SilverCrest's fair value to $880 million (~$550 million + $330 million), and it assumes zero premium to net asset value, while most producers trade at healthy premiums in bull markets. In my view, the above values are conservative figures, given that El Picacho could easily grow into an asset worth $100 million (especially given that it's within trucking distance of Las Chispas), exploration success has delivered well above estimates to date, and the conversion rate is extremely high on resources due to the industry-leading grades.
SilverCrest's valuation is just as attractive from a free cash flow standpoint, with the company on track to generate over $160 million in free cash flow next year at current metals prices. This translates to a 20% free cash flow yield, and it assumes that silver prices stay at these depressed levels. I believe an ultra-high-grade producer like SilverCrest that offers protection against bear markets in metals prices should trade at a free cash flow yield closer to 12%. So, there is considerable re-rating potential both from a cash flow and P/NAV standpoint.
With the silver price sinking below $19.00/oz, it's completely understandable that silver producers have fallen out of favor, and investors are panicking. In my opinion, investors are absolutely correct to be worried, given that, on balance, most silver producers are basing their mine plans on $20.00/oz silver or higher and have all-in costs above $18.00/oz. However, SilverCrest is a rock in a sector full of eggs that will not crack due to metals price weakness. Therefore, the fact that it's been sold off with a similar velocity to some of its peers is nonsensical. Hence, for investors that are patient and want silver exposure, this panic selling has created a buying opportunity.
With the Silver Miners Index down 50% from its highs, many investors might assume that the stocks reduced to pennies that are 75% off their highs are the best buy-the-dip candidates. Unfortunately, the opposite is typically true, and the stocks down 75%+ are the ones to be avoided, often cheap for good reasons. Instead, when we see corrections of this magnitude, it's the time to gravitate towards the highest-quality names, given that outside of violent bear markets, they will rarely ever be available at these valuations. To summarize, I see this pullback in SILV as a gift, and if the stock can confirm a bottoming setup, I may look to start a new position in the stock.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
Additional disclosure: 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. Given the volatility in the precious metals sector, position sizing is critical, so when buying small-cap precious metals stocks, position sizes should be limited to 5% or less of one's portfolio.