A Bullish Inflection Point For First Majestic Silver

Summary

• Recent moves in First Majestic Silver are likely only the start of a rerating.
• The company’s revenue mix is a key differentiator and will likely attract fund flows.
• The ongoing Mexican tax case generated negative headlines, but is digestible.
• Bulls have misunderstood and overstated the ostensibly large short interest, which will finally become a catalyst in earnest after March.

First Majestic Silver (AG) stock is attractive with a 6-12 month horizon even after the Reddit-fueled buying frenzy seen this week. Operational challenges and a tax dispute with the Mexican government weighed on the stock over 2020, seeing the U.S.-listed shares rise only 10% against a 47% increase in spot silver prices over the same period. However, a bullish outlook for silver prices, the prospect of a recovery in production post-Covid, and the potential for a redemption of an outstanding convertible are likely to trigger a bullish re-rating in the stock price.

A Bullish Outlook on Silver

Even after a 50% rally over the last 12 months, the outlook for the silver, which represents approximately 60% of AG’s revenues, is decidedly positive.

First, the weight of history implies higher silver prices relative to gold prices. Having hit a peak of 126x during the March Covid-induced panic, the gold/silver ratio has fallen, but even after this week’s strong moves, remains towards the high end of the 45-73x range it has held to for much of the last two decades. Moreover, it is well below the 30x level it saw during the 2011 silver bull market, and nearly five times the 16x ratio that held for centuries prior to the gradual demonetization of silver in the nineteenth century. Mean reversion alone strongly favors higher silver prices.

Second, silver’s supply/demand balance is very tight. Mine supply fell for the fifth year running in 2019, according to the Silver Institute’s 2020 World Silver Survey, reflecting both years of miners’ underinvestment and operational disruptions due to Covid. Meanwhile, demand remains robust, and may well increase thanks to industrial and investment demand.

A differentiated revenue mix

The universe of silver-focused mining companies is much smaller than that of gold companies. Moreover, even notionally silver-focused companies derive a majority of their revenues from non-silver sources, notably gold. First Majestic is the only major and liquid producer of silver which derives the majority of its revenues – approximately 60% in 2019 – from silver. As the outlook for silver improves, and as investors seek out silver mining exposure, First Majestic gives the greatest current earnings leverage to silver price movements in a liquid stock.

A digestible tax dispute

The company’s ongoing dispute with the Mexican tax authorities has generated significant negative headlines, which dampened sentiment for much of the last year. Yesterday saw a rare bit of good news when a Mexican judge refused to charge the miner with criminal tax fraud. While the judge has allowed prosecutors to try again, the dispute is likely entirely digestible given the company’s production profile and the likely trajectory of silver prices.

According to the company’s filings, the notional size of the claim is approximately USD 200mm, before interest and penalties. In practice, such claims are often negotiated down from the headline figure, and the final number could well be lower.

At the same time, the company’s production profile is improving, with the company guiding for 2021 silver production of 12.5-13.9mm oz vs. the 11.6mm seen last year.

Assuming actual 2021 silver production is 12.8mm ounces and gold production if 105,000 ounces – both at the low end of company guidance – implies overall revenues of approximately US$518mm, or 65% above 2020 levels. Conservatively assuming 10% inflation in total cash costs and overheads implies EBITDA of approximately $363mm, or 44% over 2020 levels.

A more bullish metals price scenario – of $35/oz silver and $2000/oz gold – would imply revenues of US$636mm and EBITDA of US$490mm.

These figures crucially do not account for the company’s higher-cost, mothballed capacity that could well be brought online in the future were a sustained run of higher silver prices to materialize.

Clearly, the company’s operating income in one year alone could cover the tax claim.

The real short squeeze has yet to materialize

First Majestic shares jumped this week amidst a general rally in heavily-shorted stocks. Yet bulls on the stock – including the company itself – have been flagging the heavy short position in the stock, in excess of 20% of the float, as a potential catalyst for a re-rating for more than a year now. As of Friday, 29 January, Bloomberg reported a 45.8mm share short position, amounting to more than 23% of the float.

Bullish commentary on the large notional short position often ignores key details buried in the notes to the company’s financials. Specifically, a large number of outstanding shorts is likely due to hedging by holders of the company’s convertible bonds, which are deeply in the money, having a strike price of $9.59. The notes mature in March 2023, and holders of the convertibles have an implicit call option on the stock. Shorts that hold the convertible are therefore insulated against a short squeeze, which is why the notionally high short interest in the stock failed to trigger a squeeze even during violent silver rallies over the course of 2020.

The coming weeks may see a turning point, however.Effective March 6 of this year, the company will have the option of calling in the convertible notes. Doing so would obviate the need for investors in the notes to hedge their equity exposure – indeed, would turn a hedge into a naked short position. Shrewd holders of the notes will be cognizant of the risk the notes are called, and would start unwinding their shorts before March. Either scenario involves a substantial unwinding of shorts in coming weeks.

In fact, calling in the notes would be a powerful mechanism for the company to boost its stock price. Moreover, with the notional amount outstanding of the issue amounting to only $151mm, calling in the notes is well within the company’s means. At end 3Q20, the company reported $232mm in cash on hand, and the above-cited forecast suggests it should easily be able to cover a call with operating income.

Valuation and risks

At Thursday’s closing price of $16.86, the shares imply a 2021 EV/EBITDA multiple of 8.7x on the basis of a $35 silver price and $2000 gold price for 2021. This is well below the 5-year historical average of 10.6x, and well below peaks in the low teens tracked by Bloomberg. Just trading to 1 standard deviation above the 5-year mean would imply a stock price of $29.15, or 57% upside from Thursday’s close.

First Majestic is not without risks. Ultimately, it is a leveraged play on silver spot prices, and a prolonged decline in silver prices would have a magnified impact on the company’s earnings. Furthermore, the ongoing tax dispute is a reminder that the company is exposed to the jurisdictional risks inherent in operating in an emerging market.

Conclusion

Even after an explosive move in recent days, First Majestic shares offer upside. The coming weeks are likely to see a short-covering rally continue, especially if the company were to exercise its conversion option in early March. Risk/reward remains favorable.