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Message: Glows on Strong Management and Chances of Higher Inflation

Glows on Strong Management and Chances of Higher Inflation

posted on Apr 07, 2009 02:10PM

Pan American Silver Glows on Strong Management and Chances of Higher Inflation

by: Kevin Stecyk April 06, 2009 | about stocks: PAAS / SLV
I will discuss the Pan American Silver Corp. (PAAS) fourth quarter conference call held on 19 February 2009. More specifically, I will provide a short summary of the conference call's major themes and then discuss the company's individual mines, all in point form. And I will wrap up by discussing the company's outlook.
In addition to transcripts of the company's conference call (see Seeking Alpha's transcript and the company's website for its transcript (PDF, 72.1 kb)), I used the company's press release and financial statements (PDF, 2.3 mb). Pan American's information, though somewhat chaotic, is worthwhile reading.
General Comments
  • In prior quarters, the company endured unprecedented volatility in construction and wage costs, energy prices, metals prices, and foreign exchange movements;
  • Reduced headcount by 500 employees and contractors;
  • Senior executives took a 10% wage rollback;
  • Deferred almost all of the Greenfield exploration programs and significantly reduced Brownfield exploration programs;
  • Canceled discretionary capital expenditures;
  • Reduced or eliminated external consultants and contractors and where elimination was not an option, company requested that charge-out rates be reduced;
  • Believes that it effectively replaced all the proven and probable reserves that were mined, or were lost due to lower price assumptions, and the company started 2009 with a healthy 224 million ounces of silver in proven and probable reserves;
  • Completed construction of Manantial Espejo silver and gold mine in December, and is ahead of planned commissioning timetable;
  • Expansion of San Vicente was 92% complete at the end of December;
  • Produced 4.6 million ounces of silver at a cash cost of $8.24 per ounce;
  • Recorded a net loss of $33.3 million or $0.41 per share, which included an atypical charge of $35.5 million;
  • Generated a very modest positive adjusted cash flow from operations of $4.3 million;
  • Produced almost as forecast; company record 18.7 million ounces of silver, at a cash cost of $5.96 per ounce, registering its 13th consecutive year of growth;
  • Recorded net income for the year of $24.6 million or $0.31 per share;
  • Generated a record adjusted cash flow from operating activities of $95.6 million or $1.19 per share;
  • Produced 1.7 million ounces of silver in January of 2009 at a cash cost of $5.97 per ounce, reflecting the successes of its cost saving initiatives that were launched in the fourth quarter of 2008, where it had produced 4.6 million ounces of silver at a cash cost of $8.24 per ounce.
Alamo Dorado, Mexico
  • Fourth quarter production was again led by Alamo Dorado's 1.4 million ounces of silver in Mexico, at a cash cost of $6.18 per ounce;
  • Production was slowed in mid October after hurricane Norbert hit the mine in the surrounding areas;
    • The surrounding communities and access roads incurred heavy damage, but fortunately the Alamo Dorado mine had minimal impact and its environmental protection systems held up well;
  • Produced over 518,000 ounces of silver at a cash cost of less than $5.50 per ounce in January of 2009; and
  • Company anticipates delivering a solid first quarter 2009 performance.
La Colorada, Mexico
  • Produced 962,000 ounces of silver at a cash cost of $8.50 per ounce in the fourth quarter of 2008;
  • Significantly reconfigured the La Colorada operation during the fourth quarter and into January of 2009, reducing the overall mining rate 27%, from 31,250 tonnes of ore per month in the fourth quarter, to 22,800 tonnes per month planned for 2009, while increasing the grade of ore mined;
  • Targeting grades of 436 grams of silver per tonne and 1.57 grams of gold per tonne during 2009. This compares to 362 grams per tonne of silver and 0.43 grams per tonne of gold achieved in the fourth quarter of 2008; and
  • This reconfiguration allows the company to knock out marginal ores reducing the operating costs from $8.50 per ounce achieved in the fourth quarter to an estimated cost of $8 per ounce in 2009; the mine has been successfully reconfigured and the company has just completed three critical ventilation raises, setting us up well for achieving the 2009 forecast.
Peruvian Operations
  • Company's Peruvian mines are heavily reliant upon byproduct metal prices;
  • Peruvian operations produced 1.8 million ounces of silver at a cash cost of $10.33 per ounce; heavily burdened by falling base metal prices and the lingering cost escalation, as well as production disruption caused by a pinion and gear failure on the primary ball mill at Huaron and a loss of a drive motor on the main underground access shaft at Morococha, which has both been rectified going into 2009;
  • Reduced workforce by 724 individuals;
  • Minimized discretionary spending, and limited mine development to less than two years and reconfigured mine plans to target higher grade ores;
  • Company announced in early 2009 that it was beginning preparations to suspend operations at Quiruvilca as a consequence of the lower prices;
  • Changes are beginning to show benefits as operating results improved during January 2009 show 686,000 ounces of silver produced at a cash cost of $6.53 per ounce or a 37% improvement over the fourth quarter of 2008 including achieving the positive cash flow from its Quiruvilca mine as it prepares for suspension;
  • After the fourth quarter conference call, the company reported on 3 April 2009 that Union workers at its Morococha mine in Peru initiated a strike yesterday after the Company and Union representatives failed to reach an agreement with respect to an increase in base pay and benefits.
    • Contract workers are currently carrying out underground mining operations at a reduced rate while the company attempts to resolve the matter;
    • Taking advantage of reduced production rate to perform maintenance;
    • Believes that production disruptions at Morococha will not materially change the company's overall annual forecast of 21.5 million ounces of silver.
San Vicente, Bolivia
  • Producing 361,000 ounces of silver at a cash cost of $6.10 per ounce, while advancing the plant construction project to 92% complete at year-end;
  • Opened first mining level under new high grade litoral vein, which was largely responsible for lifting the ore feed grade in the fourth quarter to 472 grams per ton of silver, compared to the previous quarter of 324 grams per ton of silver, along with 2.6% zinc and 0.4% copper;
  • Total capital expenditure through yearend was $64.7 million with a total estimate on completion now at $71.3 million, within about 10% of its previous estimate;
Manantial Espejo, Argentina
  • Company very pleased to report that its startup at Manantial Espejo in Argentina is advancing extremely well following the first doré poured on December 29, 2008;
  • Overcame tremendous obstacles at Manantial Espejo relative to unprecedented demand for mine development equipment, materials, and personnel in a country that is just beginning to accept the benefits of mining and the company endured some incredibly hostile climatic conditions in this remote location;
  • Produced 207,000 ounces of silver and doré bars at Manantial Espejo in January 2009 at a cash cost of $2.22 per ounce, with gold as a byproduct credit;
  • Had another 114,000 ounces of silver contained in precipitant waiting for melting at the end of January; Company had to put double shifts on in the refinery, which is a kind of startup problem everybody only dreams about;
  • Plant processed nearly 38,000 tones of high grade ore in January, which is about 61% design capacity and ahead of ramp up projections; the silver and gold recoveries in January were 84% and 93.5% respectively which is within 9% of the silver design and 1% of the gold design, also well ahead of ramp up expectations;
  • February is progressing well and company expects to reach design capacities and recoveries by the end of March 2009 and to declare commercial production in the first quarter;
  • Achieved positive cash flow in February and established final mine development costs at $224.6 million inclusive of $29.7 million of recoverable VAT tax; and
  • Confident that Manantial Espejo will achieve its annual average 4 million ounces of silver and 60,000 ounces of gold production for many years to come.
Exploration Plans
  • Exploration program covered and defined during 2008 a total of 26.9 million ounces of silver, more than replacing the 22.2 million ounces mined;
  • Lower base metal price assumptions, coupled with higher cut-off grades, downgrades of 8.8 million ounces from reserves to resources, resulting in a corporate proven and probable reserve of 223.7 million ounces as of December 31, 2008, only 1.8% lower than the year before while ore reserves increased by 1% to 701,000 ounces.
  • Note that reserve quantities are highly dependent upon metal prices and are thus volatile;
Huaron, Peru
  • Proven and copper reserves increased 5% or 3.2 million ounces after subtracting ore mined during 2008, to a total of over 62 million ounces. Measured and indicated resources stand at 11 million ounces, and inferred resources contained over 30 million ounces, making Huaron one of the company's largest silver resources;
  • The most significant increase came from the Pozo D area where the company added 5.7 million ounces.
Morococha, Peru
  • Proven and probable reserves increased by 10% or 3.1 million ounces net of 2008 production, to a total of over 35 million ounces; measured and indicated resources, add another 15.7 million ounces, while inferred resources account for additional 40.8 million ounces.
  • Best exploration results have been achieved in the Morro Solar vein, where the company added over 10 million ounces of resources, of which 4.5 million ounces have been upgraded into proven and probable reserves; exploration will continue at Morro Solar and parallel veins in 2009, as only a small portion of the 2.5-kilometer long vein has been drilled.
Quiruvilca, Peru
  • Experienced a loss of 4.1 million ounces because of mine production and the Company’s intention is to prepare the mine for a period of care and maintenance.
Mexico
  • La Colorada added 4.6 million ounces of silver, and at San Vicente 1.4 million ounces—basically replacing all the reserves mined during 2008; and
  • Alamo Dorado experienced a reserve loss of 5.9 million ounces because of mine production during the year.
Manantial Espejo, Argentina
  • Company holding over 25,000 hectares of land around Manantial, which contains a very large number of outcropping quartz veins. Some of them have been partially drilled but most are completely unexplored.
Concluding Exploration Comments
  • 2009 Exploration Program contains a total of 53,000 meters of diamond drilling at a cost of approximately $4.8 million.
  • Exploration efforts will remain largely focused on operations and on a limited number of select high-potential projects in Mexico and Peru, while maintaining important land positions in both countries.
Financial Details
During the conference call, the company's chief financial officer, Robert Doyle, discussed metal price disappointments, capital expenditures, unexpected foreign exchange rate movements, write-downs, and various financial ratios. While important, I am not going to burden you with those details. You can, if interested, read the transcripts.
What did catch my attention, however, were the company's metal price assumptions for 2009:
  • Silver: $10.00 per ounce;
  • Gold: $725 per ounce;
  • Zinc: $1150 per tonne;
  • Lead: $1300 per tonne; and
  • Copper: $3500 per tonne.
In the company's press release and financial statements, it indicated that for 2009 it expected sales as percentage:
  • Silver: 58%;
  • Gold: 16%;
  • Zinc: 14%;
  • Lead: 6%; and
  • Copper: 6%.
Let's return back to the conference call. Doyle also mentioned that the company has no debt and has an undrawn $70.0 million revolving credit facility. In today's environment, that's a huge positive.
Management's Outlook
  • In forecasting its 14th consecutive year of growth in 2009, the company plans to produce 21.5 million ounces of silver at an average cash cost of $6.28 per ounce. Moreover, it plans to more than double—actually almost triple—its gold production; and is planning on producing 85,000 ounces of gold in 2009;
  • With the start-up of Manantial Espejo, and the expansion of San Vicente fuelling its growth, the company anticipates a significant reduction in its overall exposure to base metals. It estimates that in 2009 silver will account for 58% of its revenues, while gold sales should account for another 16%. 74% of its revenues are now exposed to precious metals;
  • Preparing its highest cost operation, Quiruvilca, for a period of care and maintenance (read: retired);
  • With the company's recent financing, no debt, an untapped line of credit, and expected positive operating cash flows this year, Pan American Silver is exceedingly well positioned to aggressively look for new growth opportunities where it can make a positive contribution; and
  • Company believes that, with the current financial and economic global chaos, gold and silver have the potential for significant price appreciation this year.
My Overall General Impressions
Please note that you can click through the above chart to view a full size version.
The above chart shows Pan American Silver versus iShares Silver Trust (SLV) for about the past two years. The iShares Silver Trust is an ETF that tracks silver. As we see, for the first year, both Pan American Silver and iShares Silver tracked reasonably closely to each other. But in the past year, Pan American has fallen relative to iShares Silver. And that's not good.
In a perfect world where silver prices rise, silver mining companies should rise faster. They should rise faster because they have fixed and variable costs that should be largely independent of silver prices. In reality, however, when prices are high, everything is high, including costs. Commodities prices, as well as labor and construction costs are also high. In Pan American's situation, rising silver prices, which are good, were met with higher labor and other costs, which are bad. And then commodity and precious metal prices tanked while costs came down much more slowly. This challenging problem is not unique to Pan American. Many commodity related companies experienced this painful situation.
Looking forward, prices for gold and silver have risen off their lows but down from when the conference call took place in mid February. How will gold and silver fare for the remainder of the year? That's impossible to answer. Some might believe that we are through the worst of the financial and economic turmoil. If true and the economy does begin a modest recovery, investors might dump precious metals and move into other areas. Conversely, if the recovery seems weak or does not take hold, investors might want greater exposure to precious metals to protect themselves against the fallout.
Where do I stand? I am hopeful that the international leaders will be able to ease us back toward a recovery. My fear, however, is that with all the exuberant printing of money, there will be, or at least there's feared to be, a strong bout of inflation down the road. Put differently, I am confident that in five year's time the ratio of U.S. dollars in circulation to the tonnes of gold in existence will have increased, perhaps substantially so. Thus, I like having exposure to gold and silver. And, I believe that Pan American Silver is the best managed silver mining company.
Incidentally, iShares Silver trust currently has 270.4 million ounces in trust, and back in September of 2007, it had only 139 million ounces.
I further believe that Pan American Silver will outpace iShares Silver Trust. There are substantial risks, however, that it might not. According to the company's press release and financial statements, the company's expected sales by jurisdiction are as follows:
  • Peru: 34%;
  • Mexico: 31%;
  • Argentina: 28%; and
  • Bolivia: 7%.
Unfortunately, some of these countries are interesting places in which to conduct business. Pan American has no political risk insurance, probably because it is very expensive and does not protect against rising royalties and taxes. If not protected against rising royalties and taxes, then what's the point?
As an aside, some investors believe that certain price ratios should prevail. That is, gold should be X times the price of silver. Or that there is a relationship between the S&P 500 to gold and silver prices. Or that gold and silver price should be priced relative to oil. I don't subscribe to those theories.
I greatly respect Bill Fleckenstein of Fleckenstein Capital (subscription site). He informed his subscribers of both the dotcom and real estate bubbles well before they were popular with the mass media. He has repeatedly stated on his site that the gold silver price ratio is just that—a ratio. In fact, in responding to a subscriber on 17 August 2005, he stated, "the gold silver ratio - is just that - a ratio...it has no real value...there is no 'norm', imo." And for those of you unaware, Bill Fleckenstein is a director of Pan American Silver.
Wrapping up, I am long Pan American Silver because I believe that it is an extremely well managed company. I further believe that there is a strong chance that with central bankers printing money as fast as they can, there will be inflation once the recovery takes hold. And that higher inflation will cause higher commodity prices, including higher silver prices. Put differently, there will be a greater increase of dollars in circulation tomorrow than an increase of gold and silver in existence. And that should bode well for the shareholders of Pan American Silver.
Disclosure: I am long Pan American Silver Corporation shares.
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