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Since silver reached our
target of $50 last year it has been in a treacherous downhill descent. The
depth of the decline in precious metals is approaching 2008 levels, and many
mining stocks are at 2009 price levels. While it has been painful for bullion
investors, it's been even more disastrous for silver miners and their
investors. Now we must revisit our analysis to determine if silver and miners
are near their trading floor.
We've seen a lot of bearish reports on silver
including a comparison to the Nasdaq bubble crash,
which overlays a projection of silver to continue falling to the $6-$8 range.
Is it possible for silver to reach or hold at those levels?
Using earnings data for PAAS, SSRI, EXK, and AG
from the first quarter of 2012, we divided earnings by actual silver
produced, giving credit for gold and other base metals, in order to determine
the actual break even cost of production. Gold sales averaged $1,700 and
silver averaged $33 for the first quarter. Despite this SSRI wasn't
profitable. EXK had the lowest breakeven point of $14.68 per ounce of silver,
followed by AG at $18.33 and PAAS at $23.87. The average breakeven production
cost was exactly $24 per ounce. Even excluding SSRI, the average was $21.50.
Over the past 11 years, silver has risen by nearly 10 fold; however
production costs have almost risen just as much. Silver's price is
approaching its long term cost of production level, and given the depletion
of silver stockpiles of the last 3 decades, we don't anticipate silver's
price holding below that level for long – if at all. If you're somehow
able to buy silver for less than $21.50 to $24 an ounce we'd argue that
miners are literally paying you to buy it. Given that over the long run
miners need a healthy profit margin as an incentive and buffer against their
depleting resources, we'd argue that $26 to $30 is the long term nominal
floor for silver.
Interestingly, when we began accumulating silver positions at the onset
of the bull market in 2001 our target price was $30. A lot has changed in the
last decade. At that time silver was in the $3 range and its production costs
were in the $3 to $5 range. We anticipate that this nominal $30 range will be
the floor not only for this bull market, but also for the aftermath of the
expected silver bubble in coming years. Just as $3 was the floor after the
hunt brother debacle, $30 will be the floor of silver's next secular bear
market.
We're unable to generate a realistic scenario where the cost of
production significantly declines from current levels. Wage costs aren't
expected to recede, and materials and energy costs will remain near these
levels as their own production costs have increased. Furthermore, we're
confident that governments won't stop regulating, and taxing mine output. As
such, we believe that unleveraged, allocated silver below $30 has very little
risk, and its upside potential remains.
Another significant change since the bull market began is the health and
profitability of silver miners. When the bull market began silver miners were
breaking even at best, and for many years these companies had to resort to
dilution in order to raise capital for development and ongoing operations.
Now, the leading primary silver producers have significant cash reserves,
mature developed properties generating sizeable earnings, and many are giving
back to their shareholders via dividends and buybacks. Over the last year the
prices of miners have declined, however their earnings and financial stability
has increased substantially – which has led to a shocking compression
in PE ratios. Typically, silver miners have traded at premiums in relation to
base metal producers however they are now at a discount. The expected forward
PE ratio for 2013 from analysts is 7.2 for PAAS, 12.1 for SSRI, 6 for AG and
6.9 for EXK, giving an average PE ratio of 8. This has setup a scenario where
these companies could increase by multiples if silver tops its high of $50
and PE ratios expands to match the S&P.
Given the limited downside potential, and our inflationary expectations
that we don't believe our priced into the market, we believe that silver and
silver miners are very close to an important floor with substantial upside.
Chris Mack
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