Should Silver Bulls Buy Silver Standard?

Silver, precious metals

Investors who are extremely bullish on the silver price should consider purchasing shares of Silver Standard Resource (NASDAQ:SSRI). This is the case because the company’s shares are incredibly inexpensive measured against its silver reserves. The catch is that its flag-ship property — Pitarrilla — is not economical at $20/ounce silver despite the fact that it has over half a billion ounces of silver. If the price of silver rises substantially, then Pitarrilla’s value rises dramatically both relative to the silver price and relative to Silver Standard’s market cap. Consequently, I believe that Silver Standard shares will likely provide investors with more leverage to the silver price than shares of most other silver miners.

But this leverage cannot be realized unless management comes out with a concrete plan for developing Pitarrilla. Unfortunately, there seems to be an aura of indecision on the part of management regarding Pitarrilla’s future, or at the very least, management has failed to communicate its intentions. If you look at the company’s most recent investor presentation you will see that its 2013 goal of finding financing for the project has gone unfulfilled (page 9). If you look at the company’s 2014 goals (page 5) you will see the vaguely worded goal — “make decision on Pitarrilla.”

While this language doesn’t give us any reason to be optimistic, I believe that such justification can be found elsewhere. The company has made two deals recently that suggest that it is getting ready to finalize a plan of action that will bring Pitarrilla into production.

The first was the sale of the company’s San Augustin mine, announced November 5, to Argonaut Gold (MKTS:ARNGF.PK) for $45 million in cash, $30 million in Argonaut stock, and a 2 percent net smelter return royalty on the sulfide ore produced at the mine. The second was the sale of the company’s Challacollo project to Mandalay Resources (MKTS:MNDJF.PK) for $7.5 million in cash, $8.9 million in Mandalay stock, 5 million shares of Mandalay stock once production commences at Challacollo, the cash equivalent of 240,000 ounces of silver over eight quarters from the beginning of production at Challacollo, and a 2 percent NSR royalty on silver sales exceeding 36 million ounces up to $5 million.

In raising this capital, I believe management is intent on beginning to develop the Pitarrilla mine for 2017 – 2018 production. But given that Pitarrilla is not economically feasible at $20/ounce silver management is taking a significant risk — it is betting that the silver price will be higher within the next few years. This is a bold move considering the downtrend we have seen in the price of silver since its peak in May, 2011.

Nevertheless, I think it is the right one for two interrelated reasons. First, a closer analysis of Pitarrilla reveals that the risk is worth the reward: the estimated realized cash-flow, even if it is heavily discounted, dwarf’s Silver Standard’s $668 million valuation. Second, the price of silver seems to be bottoming out. While the bottoming process may not happen overnight, the fact that Pitarrilla has a three year development timeline means that this bottoming process should be over as the project goes into production.

With this being the case, a substantive announcement regarding Pitarrilla’s development should be viewed as tremendously positive for the company, and ultimately as a short-term catalyst that can provide significant upside. Given that the shares are currently trading at less than a $100 million premium to the company’s  working capital plus its marketable securities shares in Pretium Resources (NYSE:PVG), Mandalay Resources, and Argonaut Gold, minus its liabilities, I think the shares have limited downside from here. Therefore, the shares offer an excellent short term risk/reward opportunity in addition to tremendous leverage to the silver price for longer term bulls.

Pitarrilla: An Overview

Pitarrilla is Silver Standard’s flagship property in Durango, Mexico. It is an enormous project with 480 million ounces of silver reserves. The mine plan is for an incredible 32 years with 10 million ounces produced annually and 15 million ounces produced annually for the first 18 years of the mine’s life. The profit potential of this one project makes owning Silver Standard shares worthwhile should the silver price rise.

Unfortunately, the project will cost $740 million in initial capex, and this has been an incredible drag on Silver Standard. Thus, despite Pitarrilla’s large size it really isn’t that valuable with silver prices depressed — at this point it is a call option on silver. The company calculates that the mine’s net present value (or, NPV) using $22.5/ounce silver and a 10 percent discount rate is just $175 million. With $20/ounce silver, the mine is basically worthless unless we use a generous discount rate. However, because the mine requires so much initial capital the math works so that a slight improvement in the silver price goes a long way in increasing the project’s overall value.

As the following table shows, the mine’s net discounted cash-flow offers incredible leverage to the silver price. In calculating the project’s value I will use the company’s estimated production cost of $16/ounce and its year by year production figures from the NI 43-101, table 22.9. I will also use a 35 percent tax rate, which takes into consideration Mexico’s 30 percent corporate tax as well as its 7.5 percent mining royalty.

Discount Rate/Silver Price $20 $30 $40 $50 $100
8 percent ($278 million) $572 million $1,309 million $2,043 million $5,754 million
12 percent ($414 million) $263 million $783 million $1,302 million $3923 million

While it may seem somewhat pointless to look at the NPV of Pitarrilla at $100/ounce silver keep in mind that Silver Standard Resources is an investment that makes sense only if the price of silver soars. Investors who are looking for a rise to $25-$30/ounce can find better opportunities in lower cost producers. I think this point becomes fairly clear given this table, which illustrates that Pitarrilla doesn’t really become interesting from an investment standpoint unless we start to play with the idea of at least $40/ounce silver.

Funding Pitarrilla

The fact that Silver Standard is shedding secondary assets and raising capital probably implies that management is going to focus its energies on developing Pitarrilla. Pitarrilla is going to cost $741 million to develop. Silver Standard has the following marketable resources presuming that the company’s Pirquitas mine is operating at “break-even.”

  • $623 million in working capital.
  • $30 million due from Argonaut Gold — $10 million on May 5 of this year, and $20 million on May 5, 2015.
  • $7.5 million due from Mandalay Resources when the Challocollo deal closes.
  • 18,985,807 shares of Pretium Resources worth $121.3 million.
  • Approximately 6.1 million shares of Argonaut Gold worth $27.4 million.
  • 12 million shares of Mandalay Resources worth $9.5 million.

While I include the Pretium shares here, keep in mind that Silver Standard is the top shareholder of Pretium with an 18 percent stake, and that it will not be able to unload such a large position without doing damage to Pretium’s share price. The company also has $184.8 million in outstanding convertible debt that doesn’t mature until 2033, and so this shouldn’t be an issue.

Ultimately, unless the company’s Pirquitas mine starts to generate more cash flow, Silver Standard needs roughly $80 million more going forward assuming it holds on to its equity positions. Before the two deals in question this figure was over $130 million and so I think that real progress is being made. We should expect the company to raise more capital to bridge this $80 million gap in the near future. While it can issue more debt given recent trends, I think we may see the company unload more of its secondary assets as it begins to focus on Pitarrilla.

Silver Is Bottoming

I believe that the price of silver has bottomed, or that it is in a bottoming process. It has found tremendous support just below the $20/ounce level, which is the same price point at which we saw tremendous resistance a few years ago. Additionally, most primary silver miners are not able to turn a profit at the current silver price, and this fact brings with it the threat that primary silver mines will begin to close should the price remain weak. For instance, we already saw Golden Minerals (NYSEMKT:AUMN) close its Velardena mine due to low prices. Thus lower prices will potentially impose supply constraints onto the silver market.

At the same time, demand is rising — especially from investors, who bought a record amount of Silver American Eagles last year. Demand has been especially strong in India, as high tariffs on gold imports diverted Indian savings into silver.

Industrial demand is rising too. While 2011 and 2012 saw declining industrial demand for silver, secular uptrends in production of various silver-containing products such as smartphones, tablets and solar panels should override this shorter term decline in the long run. Furthermore, in the past this rising industrial demand has been somewhat offset by falling demand for silver used in photography, but this usage is so low now (<10 percent of total demand) that its decline doesn’t materially impact demand.

Conclusion

In raising capital late last year, it appears as if Silver Standard has decided to bite the bullet and develop Pitarrilla despite the fact that it is not economical at the current silver price. While the company shed some quality assets in the process, the implicit focus on Pitarrilla is a net positive for the company, and I think that a more formal announcement regarding Pitarrilla’s development will be a driving catalyst for the shares in 2014. This is the case because once investors have a better idea as to when to expect production at Pitarrilla they will be more confident in assigning additional value to the project’s reserves.

Keep in mind that because Pitarrilla’s silver reserves are so plentiful (nearly half a billion ounces), even a slight revaluation upward of these reserves adds significant value to a company with a $628 million valuation. If, for example, reserves at Pitarrilla are valued at just $1/ounce then the shares have over $1 billion in value excluding the company’s other two major projects: Pirquitas and San Luis. This gives the shares at least 50 percent upside.

Ultimately, Silver Standard is still a high-risk/high-reward stock, and investors can only justify owning a position longer term if they believe that the silver price will rise substantially in the coming years. But for these investors I think the time to get in is now. Furthermore, shorter term traders have been given fair warning, through the aforementioned capital raises, that management intends to announce plans to develop Pitarrilla in the not too distant future. This announcement will likely be interpreted as a positive for the company, and it should drive the stock higher.

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