Silver Miners’ Q2’16 Fundamentals

The silver miners’ stocks have enjoyed an epic year, skyrocketing higher with silver’s new bull market.  At best since mid-January alone, some of these elite stocks had actually septupled!  Naturally such extreme gains beg the question of whether they can possibly be fundamentally justified.  The recently-released second-quarter financial and operational results of the top silver miners offer much insight on this.

Back in mid-December leading into the Fed’s first rate hike in 9.5 years, silver was pounded to a dismal 6.4-year secular low.  Sentiment was overwhelmingly bearish, the breeding ground of major bottomings.  Indeed silver soon started climbing with its primary driver gold heading into 2016.  As usual silver got off to a slow start, with traders skeptical until gold rallied far enough and long enough to entice them back.

In Q1’16 silver really lagged gold, with a weak 11.7% advance to gold’s 16.1%.  Once silver bulls get underway in earnest, silver tends to amplify gold’s upside by 2x to 3x.  And that already started happening in Q2’16, which saw silver surge 21.4% higher on a mere 7.4% gold rally!  This acceleration is what ignited silver stocks.  Was their buying fueled purely by greed, or did it have real fundamental underpinnings?

This crucial question for investors couldn’t be addressed until mid-August, when silver miners’ Q2’16 results were fully released.  Publicly-traded companies in the US are required by the Securities and Exchange Commission to report their earnings four times per year.  The deadline for filing is 45 days after quarter-ends.  I first looked at gold miners’ Q2 results, then gold juniors’, and now it’s silver miners’ turn.

Silver mining is a tough business geologically and economically.  Primary silver deposits, those with enough silver to generate over half their revenues when mined, are quite rare.  Most of the world’s silver ore formed alongside base metals or gold, and their value usually well outweighs silver’s.  According to the venerable Silver Institute, only 30% of 2015’s global mined supply came from primary silver mines!

Well over 2/3rds of the 886.7m ounces mined last year was simply a byproduct of base-metals and gold mining.  And as scarce as silver-heavy deposits supporting primary silver mines are, primary silver miners are even rarer.  Since silver is so much less valuable than gold, most silver miners need multiple mines.  And these often include non-primary-silver ones, usually gold, to bolster the lower silver-mining cash flows.

So the universe of major silver miners is pretty small.  The definitive list of these companies to analyze comes from the most-popular silver-stock investment vehicle, the SIL Global X Silver Miners ETF.  SIL dominates the silver-stock-ETF space, with net assets running 5.0x its next largest competitor’s.  Since ETF investing is becoming the new norm, inclusion in SIL is a major boon for silver-mining companies.

While there aren’t a ton of silver miners to pick from, major-ETF inclusion shows silver stocks have been vetted by elite analysts.  It also ensures the fund capital flowing into leading silver-stock ETFs benefits their components.  The ETF managers shunt excess differential buying pressure on their shares directly into the underlying component silver miners held by these ETFs, bidding their individual silver stocks higher.

As of the middle of this week, SIL included 21 major “silver miners”.  This term is used somewhat loosely, as SIL includes the massive silver streamer Silver Wheaton that doesn’t actually mine, Mexico’s giant mining conglomerate Industrias Penoles for which silver is just a minor byproduct, gold miner Alamos Gold which doesn’t mine any silver, and MAG Silver which doesn’t have its silver mine in production yet.

Nevertheless SIL is what we’ve got, so I dug into the Q2’16 10-Q reports released by this ETF’s top 17 components.  That number was chosen because that many stocks fit neatly into this table below.  But with these top 17 SIL components commanding fully 97.2% of SIL’s total weighting, they are really all that matters.  I collected a bunch of key data from each, and fed it into a spreadsheet for sector-wide analysis.

This table starts with market-level information including each SIL component’s stock symbol, exchange traded on, current weighting in SIL, and market capitalization.  After that is a critical metric for investors looking for purer silver-mining exposure, the percentage of each company’s quarterly sales that actually came from silver mining.  Silver-stock investors generally want silver exposure, not gold or base metals.

The formula for this silver-percentage approximation is simple.  Each company’s Q2’16 silver production is multiplied by that quarter’s average silver price, and the result divided by total quarterly revenue.  This number isn’t perfect, it can be skewed.  Sometimes silver miners sell more or less silver in a quarter than they produced, due to the timing of actual sales.  Byproducts and hedging can also pull this number around.

The true primary silver miners that derived over half their Q2’16 revenues from silver have percentages highlighted in blue.  That column is followed by cash costs per ounce of silver mined, all-in sustaining costs per ounce, and AISC guidance for full-year 2016.  Next comes quarter-end cash balances and the cash flows generated from operations in Q2’16.  Finally last quarter’s silver and gold production is noted.

Provocatively there isn’t a single major silver miner today that doesn’t generate a large portion of its total sales from gold mining.  That’s both as a byproduct in silver mines and in separate primary gold mines the silver miners also own.  Pure silver miners don’t exist!  Depending on your view, they are either all augmented by gold or adulterated with it.  That helped silver miners’ fundamentals improve dramatically in Q2’16.

When I last did this top-SIL-component analysis using Q1’16 data several months ago, 7 stocks qualified as primary silver miners with over half their quarterly sales from silver.  All of the top 17 SIL components that provided enough data to compute their silver percentages averaged out to 44.9%.  I figured that as silver’s gains started outpacing gold’s, these key numbers would rise.  But they were essentially flat in Q2’16.

Only 6 of the top 17 SIL components generated 50%+ of their revenues from silver last quarter, and the average only rose modestly to 45.3%.  This may sound rather odd considering silver’s average price rose 12.7% sequentially from Q1 to Q2, compared to just 6.3% for gold’s.  That didn’t translate into a higher overall silver percentage because these silver miners collectively increased their gold output quarter-on-quarter.

Overall silver production of these top miners impressively rose 4.6% in Q2 compared to Q1, to 77,852k ounces.  But their collective gold production growth even exceeded that, up 6.1% quarter-on-quarter to 1273k.  Silver miners’ outpacing gold-mining growth was driven by their active diversification into gold.  The cash flows from silver mining are rarely spectacular, since silver’s price is always low relative to gold’s.

And that perpetual disparity of cash flows between silver and gold mining ballooned to gaping extremes in the recent dark years.  As silver languished near major secular lows, silver miners sought to augment their cash flows by buying gold mines.  Naturally this process takes time, as it isn’t easy to find a suitable acquisition target, prepare and execute the purchase, and integrate the new mine into current operations.

This trend is far from over, as gold mining’s far-higher cash flows really reduce the operational risks of silver mining.  Tahoe Resources is a prime example.  Spun off by Goldcorp as a totally-pure silver miner operating one of the world’s largest silver mines, Tahoe bought the gold miner Lake Shore Gold and is now overwhelmingly a primary gold producer in terms of revenue.  Silver purity is fading among its miners.

Since some of these elite silver miners use gold as a byproduct credit, its sales directly reduce the costs of mining silver.  This is evident in silver miners’ costs last quarter, which fell considerably.  Cash costs are the classic way to measure silver-mining costs.  They include all direct production costs of mining silver, mine-level administration, smelting, refining, transport, regulatory, royalty, and tax expenses.

Cash costs are the acid-test measure of silver-miner survivability, revealing the silver levels needed to keep the doors open and pay the bills.  Incredibly in Q2’16, they averaged just $5.32 per ounce!  This was not only far below silver’s $16.79 average price, but a whopping 11.2% lower than Q1’s cash costs.  This is almost exclusively due to higher byproduct credits, primarily gold but also base metals in some cases.

Far more important are the elite silver miners’ all-in sustaining costs.  This vastly-superior measure was introduced in June 2013 by the World Gold Council.  In addition to all direct cash costs, AISC also add on everything necessary to maintain and replenish operations at current silver-production levels.  This includes exploration for new silver to mine, mine development and construction, remediation, and reclamation.

All-in sustaining costs also include the critical corporate-level administration that oversees silver-mining operations.  In Q2’16, the top 17 SIL silver miners reporting AISC had average levels of just $10.05 per ounce.  That’s 2.2% better than Q1’s average, but far more importantly way below that $16.79 average silver price in Q2.  That implies the silver-mining industry’s operating margins have soared to $6.74 per ounce.

That’s a staggering 46% jump sequentially in Q2 alone, a massive increase!  This stock-market-leading surge in operating profitability helps explain why silver stocks were bid sharply higher in Q2.  Profits ultimately drive stock-price levels, and silver-mining profits were exploding as silver’s new bull started to accelerate.  The sole reason investors own silver stocks is for their great profits leverage relative to silver.

Silver mining costs are essentially fixed in the mine-planning stages.  That’s when mining engineers decide which ore bodies to extract, how to dig to them, and how to process that ore to recover the silver.  The vast majority of these costs of moving and processing rock are fixed, they don’t change much no matter what silver’s price does.  This ensures silver-mining profits soar far faster than silver’s own gains.

At AISC near $10 per ounce, silver miners earned about $7 in Q2’16.  Yet so far in Q3, silver’s average price has powered up another 17% to $19.69.  Thus silver-mining operating profits are likely now up near $10 per ounce, another 43% gain!  The higher silver runs, the greater the profits growth the silver miners will enjoy.  And silver remains relatively low, with its young bull market still having lots of room to soar.

Back in 2012 for example before the Fed’s wildly-unprecedented open-ended third quantitative-easing campaign started grossly distorting the markets, silver averaged $31.19.  While that’s only another 58% higher from Q3’16’s average price, such silver gains would fuel a gargantuan 219% jump in operating profits from Q3 levels!  The underlying fundamentals of mining silver definitely support big stock-price gains.

These rapidly-improving silver-mining fundamentals are readily evident in silver miners’ operating cash flows and cash balances.  Cash flows from operations are the best proxy of current profitability, as the trailing-twelve-month price-to-earnings ratios of silver miners are now extremely distorted by huge non-cash writedowns.  These accounting-construct losses flared in late 2015 thanks to silver’s deep secular lows.

One of the core tenets of accounting is conservatism, which demands companies anticipate possible future losses but not gains.  So Q4’15’s low silver prices had to be assumed to persist indefinitely, slashing the economic value of silver mines and deposits.  These were written down, with resulting non-cash losses flushed through income statements.  Until these writedowns roll off trailing P/Es, they will mask real profits.

Quarterly cash flows generated from operations are the purest measure of actual profitability, avoiding all the short-term accounting fictions inherent in the GAAP earnings that feed P/E ratios.  And in Q2’16, these elite top SIL components’ operating cash flows skyrocketed a mind-boggling 135% quarter-on-quarter to $1449m!  This is truly all the fundamental justification silver stocks need for their massive Q2 gains.

These radically-higher operating profits naturally fed growing cash hoards among the top silver miners.  Their total cash on hand at quarter-end soared 69.6% sequentially between Q1 and Q2 to $3537m!  This proves that there was far more than greedy sentiment underlying silver stocks’ epic gains so far this year.  This young new silver bull has already vastly improved the economics of extracting this precious metal.

Unfortunately most investors don’t yet understand what’s going on in the silver-mining realm.  Not many even pay attention to contrarian investments like silver stocks.  And many of those who do are scared of the silver miners’ super-high or nonexistent trailing-twelve-month P/E ratios.  They don’t realize that once last year’s big non-cash writedowns roll off the latest 4 quarters, silver-mining P/E ratios are going to collapse.

By the time trailing P/Es reflect true ongoing operating profitability in future quarters, the silver stocks will have surged much higher than today’s levels.  Digging deep into quarterly reports is necessary to really understand what’s going on in an industry, as trailing valuation metrics mask major reversals in fortune for up to a year.  Silver miners’ immense growth in operating profitability remains hidden to all but a few.

Another thing investors must consider is where the silver stocks came from.  Since gold drives silver, the silver stocks follow the gold stocks.  Back in mid-January, the leading gold-stock index slumped to a truly fundamentally-absurd 13.5-year secular low.  As I warned that very week, it was ludicrous for gold stocks to be trading as if gold was near $305 when it was actually way up at $1087!  Silver stocks were sucked in.

Precious-metals sentiment was so overwhelmingly bearish that silver stocks were trading as if they were on the verge of bankruptcy.  That was a silly assertion even then, as their cash costs and even all-in sustaining costs were well below even silver’s deep secular lows.  Silver stocks had to mean revert much higher out of such unsustainable extremes, and that’s exactly what has happened so far in 2016.

So when silver stocks’ enormous year-to-date gains are considered, it’s critical to realize they emerged out of some of the most-extreme silver-stock lows ever witnessed.  This year’s mighty rallies were born in epic fear, not mounting greed leading into a topping after a long bull.  Since a huge mean reversion higher out of such extremes was inevitable, silver miners’ fundamental justification is just icing on the cake.

Silver miners’ latest quarterly results recently released for Q2 prove that they are not only fundamentally strong today, but rapidly strengthening.  This entire industry that was left for dead in late 2015 is going to see some of the best operating-profits growth by far in all the stock markets in 2016, helping to justify the epic gains in silver-stock prices this year.  They are rooted in real profits growth, not ethereal sentiment.

As silver-stock prices continue to rise in coming quarters, fueled by soaring earnings driven by higher silver prices, great gains are still to be won.  While SIL is fine, the largest gains will be witnessed in individual silver stocks with superior fundamentals.  Investors need to look for the elite miners with the best combination of percentage of revenues from silver, operating margins, and coming silver-production expansions.

And man, what an incredible gift this past month’s sharp silver-stock correction is!  Many of the world’s best silver stocks were pummeled 20% to 30% lower since their latest bull highs in early August.  They are now on sale at deep discounts, wonderful buying opportunities.  If you liked silver stocks a month ago when everyone else did, you should love them today at far-superior entry prices.  Talk about a great boon.

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At Zeal we’ve spent literally tens of thousands of hours researching individual silver stocks and markets, so we can better decide what to trade and when.  This has resulted in 844 stock trades recommended in real-time for our newsletter subscribers since 2001.  Their average annualized realized gains including all losers are running way up at +23.4%!  And that’s excluding big unrealized gains on our books today.

Despite the sharp correction, we still have plenty of doubles this year alone.  We also have a major new gold-stock and silver-stock deployment well underway to ride the coming uplegs, as it’s a great time to buy relatively low.  You can read about our new trades and market timing in our acclaimed weekly and monthly newsletters.  They draw on our vast experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks.  Subscribe today!   For just $10 an issue, you can learn to think, trade, and thrive like a contrarian.

The bottom line is the major silver miners just reported an amazing Q2’16, with silver’s young new bull fueling radically-higher operating earnings.  The great inherent leverage of silver-mining profits to silver prices was the fundamental justification underlying silver stocks’ epic gains so far this year.  And with silver’s bull only just starting, the best gains in silver-mining profitability and thus stock prices are yet to come.

Unfortunately most investors don’t yet realize what’s going on fundamentally.  They see silver miners’ extreme or non-existent price-to-earnings ratios and assume this industry is really struggling.  But once last year’s massive non-cash writedowns of silver-mining assets roll off the books, the silver miners’ big operating profitability will be reflected in conventional valuations.  Smart investors will be fully deployed long before.

Adam Hamilton, CPA

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