Silver Miners’ Q4’16 Fundamentals

The silver miners’ stocks have had a roller-coaster ride of a year so far.  They surged, plunged, and then started surging again last week on a less-hawkish-than-expected Fed.  Such big volatility has spawned similar outsized swings in sentiment, distorting investors’ perceptions of major silver miners.  But their recently-reported fourth-quarter operating and financial results reveal the true underlying fundamental realities.

Four times a year publicly-traded companies release treasure troves of valuable information in the form of quarterly reports.  Required by securities regulators, these quarterly results are exceedingly important for investors and speculators.  They offer a clear snapshot of what’s really going on fundamentally, in individual silver miners and this small sector as a whole.  There’s no silver-stock data I look forward to more.

Normally quarterlies are due 45 calendar days after quarter-ends, in the form of 10-Qs required by the SEC for American companies.  But after the final quarter of fiscal years, which are calendar years for most silver miners, that deadline extends out up to 90 days depending on company size.  The 10-K annual reports required once a year are bigger, more complex, and require fully-audited numbers unlike 10-Qs.

So it takes companies more time to prepare full-year financials and then get them audited by CPAs right in the heart of their busy season.  As a silver-stock trader this additional Q4 delay is irritating, since the data is getting stale by Q1’s end.  But as a CPA and former Big Six auditor of mining companies, I have some understanding of just how much work goes into an SEC-mandated 10-K annual report.  It’s enormous!

This extended Q4-reporting window naturally delays the analysis of Q4 results.  While I can start digging into the first three quarters’ results 5 or 6 weeks after those interim quarter-ends, I have to wait longer for the fiscal-year quarter-ends.  Thankfully the majority of silver miners have reported by 9 or 10 weeks, so we don’t quite have to wait until early Q2 to analyze Q4 results.  The silver miners’ Q4’16 proved fairly strong!

Silver mining is a tough business both 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.  Thus around 2/3rds of all the silver mined worldwide is actually a byproduct of base-metals and gold mining.

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 in order to generate sufficient cash flows.  These often include non-primary-silver ones, usually gold.  More and more traditional elite silver miners are aggressively bolstering their gold production, often at silver’s expense.

So the universe of major silver miners is pretty small, and their purity is shrinking.  The definitive list of these companies to analyze comes from the most-popular silver-stock investment vehicle, the SIL Global X Silver Miners ETF.  This week its net assets are running 5.4x greater than its next-largest competitor’s, so SIL really dominates this space.  With ETF investing now the norm, SIL is a boon for its component miners.

While there aren’t many silver miners to pick from, major-ETF inclusion shows silver stocks have been vetted by elite analysts.  Due to fund flows into top sector ETFs, being included in SIL is one of the important considerations for picking great silver stocks.  When the vast pools of fund capital seek silver-stock exposure, their SIL inflows force it to buy shares in its underlying companies bidding their prices higher.

This week as the major silver miners finish reporting their Q4’16 results, SIL includes 24 “silver miners”.  This term is used rather loosely, as SIL includes plenty of companies which simply can’t be described as primary silver miners.  Most generate well under half their revenues from silver, which greatly limits their stock prices’ leverage to silver rallies.  Nevertheless, SIL is the leading silver-stock ETF and benchmark we have.

The higher the percentage of sales any miner derives from silver, naturally the greater its exposure to silver-price moves.  If a company only earns 20%, 30%, or even 40% of its revenues from silver, it’s not a primary silver miner and its stock price won’t be very responsive to silver itself.  But as silver miners are increasingly actively diversifying into gold, there aren’t enough big primary silver miners left to build an ETF alone.

Every quarter I dig into the latest results from the major silver miners of SIL to get a better understanding of how they and this industry are faring fundamentally.  I feed a bunch of data into a spreadsheet, some of which made it into the table below.  It includes key data for the top 17 SIL component companies, an arbitrary number that fits in this table.  That is a commanding sample at 95.6% of SIL’s total weighting.

While most of these top 17 SIL components have reported on Q4’16, not all have.  Some of these major silver miners trade in Mexico and the UK, and only report half-year results.  And plenty of companies lump their Q4 results into full-year-2016 numbers.  If not explicitly broken out, most of the fourth-quarter results can’t simply be inferred.  So if a field is left blank in this table, that data wasn’t available this week if ever.

The first couple columns show each SIL component’s symbol and weighting as of Wednesday.  A bare majority of these silver stocks trade in the US, with the others in Mexico, the UK, and Canada.  So if you can’t find a symbol here, it’s a listing from a company’s primary foreign stock exchange.  That’s followed by each company’s Q4’16 silver production in ounces, along with its absolute percentage change from Q3’16.

Quarter-on-quarter changes offer a more-granular read on companies’ ongoing operating and financial performance trends than year-over-year comparisons.  QoQ changes are also included for the key data in this table’s right half of cash costs per ounce of silver mined, all-in sustaining costs per ounce, and operating cash flows generated.  Together costs and cash flows reveal the financial health of silver miners.

The Q4’16 silver production is followed by that same quarter’s gold production.  Almost every major silver miner in SIL also produces significant-if-not-large amounts of gold!  While gold stabilizes and augments the silver miners’ cash flows, it also retards their stocks’ sensitivity to silver itself.  Naturally investors and speculators buy silver stocks and their ETFs because they want leveraged exposure to silver’s price, not gold’s.

So a final column reveals how pure the elite SIL silver miners are.  This is mostly calculated by taking a company’s Q4 silver production, multiplying it by the average silver price in Q4, and dividing that by the company’s total quarterly sales.  If miners didn’t report Q4 revenues, I approximated them by adding the silver sales to gold sales based on their quarterly production and the metals’ average fourth-quarter prices.

This exercise of examining the quarterly results of the elite silver miners as represented by SIL’s top 17 holdings is always illuminating.  It offers many important fundamental insights into the individual stocks and this sector as a whole.  These Q4’16 results collectively prove the major silver miners were in no fundamental peril last quarter, despite silver and SIL plunging 16.9% and 27.8% in that post-election Trumphoria.

While unfortunately the silver miners as a whole are kind of lazy in breaking out their Q4 results from full-year or half-year ones, they do report quarterly production.  Together these elite miners produced 76.3m ounces of silver last quarter, almost dead flat from Q3’16’s 76.2m.  But on average most of these top SIL components saw shrinking silver production, which was collectively offset by big growth in a handful.

The reasons for lower silver production vary by company of course, ranging all the way from temporary lower ore grades to depleting mines.  But this wasn’t a symptom of a slower mining tempo in general, as these same top silver miners’ Q4 gold production rocketed 11.4% higher absolutely from Q3’s levels!  That bests the 10.9% QoQ production gains in GDXJ’s elite junior gold miners, which are in the gold business.

The silver miners are collectively deciding to diversify into gold due to its superior economics compared to silver.  No silver-stock investor likes to hear this, but it’s the hard reality today.  Consider hypothetical mid-sized silver and gold miners, which might produce 10m ounces and 300k ounces annually.  What would those cash flows actually look like at last quarter’s average silver and gold prices of $17.12 and $1218?

This silver miner would generate $171m in yearly sales, but the gold miner’s $365m more than doubles that.  Silver mining is often as capital-intensive as gold mining, requiring similar expenses for planning, permitting, and building mines and mills to process the ore.  Similar heavy machinery is necessary to dig and haul the ore, along with similar staffing levels.  So silver’s lower cash flows make silver mining harder.

Silver-mining profits do skyrocket when silver soars occasionally in one of its massive bull markets.  But during silver’s long intervening drifts at relatively-low price levels, the silver miners often can’t generate sufficient cash flows to finance expansions.  So the top silver miners are increasingly looking to gold, a trend that isn’t likely to reverse given the relative economics of silver and gold.  Primary silver miners are getting rarer.

The silver-streaming giant Silver Wheaton, SIL’s third-largest component this week, has long been the pure-silver powerhouse of this sector.  A year ago in Q4’15, it derived 75.9% of its revenues from silver which was the best by far in SIL.  By Q4’16, this had dropped to a mere 50.4%.  Mighty SLW is actually on the verge of becoming a primary-gold play!  This is intentional as SLW itself declared in its Q4 results this week…

“Since 2013, our company has seen a marked increase in gold production, and in the second half of 2016, revenue was evenly split between silver and gold.  In order to better align our corporate identity with underlying operations while maintaining a link to our past and the innovation that the ‘Wheaton’ name has become synonymous with, we have recommended changing our name to Wheaton Precious Metals.”

Technically a company isn’t a primary silver miner unless it derives over half its revenues from silver.  In Q4’16, the average sales percentage from silver of these top SIL components was just 40.6%.  That is right on trend over the past year, with Q4’15, Q1’16, Q2’16, and Q3’16 weighing in at 47.5%, 44.9%, 45.3%, and 42.8%.  At this pace and 40.6% today, the top silver miners are soon heading well under 40%!

While I understand this, as a long-time silver-stock investor it saddens me primary silver miners have apparently become a dying breed.  When silver starts powering higher in one of its massive uplegs and well outperforms gold again, this industry’s silver percentage will rise.  But unless silver not only shoots way ahead but stays there while gold lags, it’s hard to see major-silver-mining purity significantly reverse.

In Q4’16, only 5 of the top 17 SIL components qualified as the primary silver miners that SIL investors are undoubtedly looking to own when buying this “Silver Miners ETF”.  In today’s current Q1’17 it will likely slip to 4 as the soon-to-be-renamed SLW slides below 50% of its sales derived from silver.  I’ve been critical of SIL’s managers in the past on silver-mining purity, but they can’t fight the rising-gold trend.

Moving on, once again SIL plunged a brutal 27.8% last quarter on silver’s own sharp 16.9% plunge.  This serious silver weakness was driven by the post-election Trumphoria stock-market rally slaughtering any interest in prudent portfolio diversification with gold.  That led to a sharp mass exodus from gold, and silver mirrored and amplified gold’s moves as always.  Silver’s average price fell 12.4% QoQ in Q4.

That scared silver-stock investors, leading to sustained selling fueling extremely-bearish sentiment by late December.  As always during a major selloff they assumed the silver miners’ plunge was righteous and fundamentally-justified, instead of purely sentimental and thus irrational.  But it really was the latter as the top 17 SIL silver miners’ recently-reported Q4 results proved.  They were never in fundamental danger.

There are two major ways to measure silver-mining costs, classic cash costs per ounce and the superior all-in sustaining costs per ounce.  Both are useful.  Cash costs are the acid test of silver-miner survivability in lower-price environments, showing the worst-case silver levels necessary to keep the mines running.  All-in sustaining costs reveal where silver needs to trade to maintain current operations indefinitely.

Cash costs naturally encompass all cash expenses necessary to produce each silver ounce, including all direct production costs, mine-level administration, smelting, refining, transport, regulatory, royalty, and tax expenses.  In Q4’16, these top SIL-component silver miners that reported cash costs averaged just $5.28 per ounce.  That’s a major 6.2% sequential improvement from Q3, and less than a third of current silver levels!

But cash costs are understated due to an outlying anomaly.  This week Silvercorp Metals is the 17th-largest SIL component, making it into this table.  A quarter ago it was 18th, and thus not included.  SVM mines base-metals-heavy silver deposits with huge lead and zinc byproducts.  These are sold and credited to silver-mining costs, lowering the cash costs to negative $5.48 per ounce!  That really distorts the overall picture.

Ex-SVM, these silver miners’ cash costs soared 21.1% QoQ from $5.63 in Q3 to $6.82 in Q4.  While that remains far below prevailing silver prices proving these elite silver miners were in no fundamental peril, it illustrates the economic challenges of silver mining.  With most of the major silver miners producing less silver in Q4, their high fixed costs of mining were spread across fewer ounces driving up per-ounce costs.

Way more important than cash costs are the far-superior all-in sustaining costs.  They were introduced by the World Gold Council in June 2013 to give investors a much-better understanding of what it really costs to maintain a silver mine as an ongoing concern.  AISC include all direct cash costs, but then add on everything else that is necessary to maintain and replenish operations at current silver-production levels.

These additional expenses include exploration for new silver to mine to replace depleting deposits, mine-development and construction expenses, remediation, and mine reclamation.  They also include the corporate-level administration expenses necessary to oversee silver mines.  All-in sustaining costs are the most-important silver-mining cost metric by far for investors, revealing miners’ true operating profitability.

In Q4’16 the top SIL components reported average AISC of $10.56 per ounce, up 4.3% QoQ from Q3’s levels.  But again this is heavily skewed by SVM edging into SIL’s top 17 components.  Its anomalous $1.87-per-ounce AISC from its freak silver deposits really dragged down the average.  Ex-SVM again, these silver miners’ average AISC surged 18.6% QoQ to $12.01.  Lower quarterly production was the key cause.

SIL’s top two components are giant Mexican mining conglomerates that produce vast amounts of silver but don’t report all-in sustaining costs quarterly.  Together the quarterly silver production of Industrias Penoles and Fresnillo soared 11.5% or 3.0m ounces QoQ.  Meanwhile the next 15 biggest SIL stocks saw silver production plunge 5.7% or 2.9m ounces QoQ!  That really forced their per-ounce costs higher.

Nevertheless, silver mining is still quite profitable even at Q4’s lackluster silver prices averaging $17.12.  At that $10.56 average AISC, that implies hefty profit margins of $6.56 per ounce or 38%!  CEOs in most industries would sell their souls for margins like that.  Even at those adjusted $12.01 AISC, silver-mining profit margins of $5.11 are still excellent.  The sharp silver-stock selloff in Q4 wasn’t fundamentally justified.

These AISC levels suggest the top silver miners’ profits will remain rock-solid in the current almost-over Q1’17.  Silver has averaged $17.37 so far this quarter, 1.5% better than Q4.  So if AISC remain stable, Q1’s silver-mining profit margins are likely to be a little better than Q4’s.  The silver miners have forecast stable AISC for full-year 2017, with 8 of SIL’s top 17 averaging $11.07.  Ex-SVM, that rises to an adjusted $11.87.

The top silver miners’ operating cash flows fared reasonably well in Q4 considering silver’s sharp drop.  They were boosted by gold performing better relatively.  Its average price only fell 8.8% QoQ compared to silver’s 12.4% drop.  This combined with higher gold and lower silver production led to $537m in OCF generation by the top SIL miners reporting them for Q4.  Compared to Q3’s $1577m, that seems miserable.

But it’s misleading due to Q4-reporting limitations.  Our sample size in Q4’16 was 9 of SIL’s top 17 stocks compared to 14 of 17 in Q3.  And SIL’s top component Industrias Penoles reported $899m of operating cash flows in Q3 but didn’t break out Q4 from full-year results.  If the same other 8 silver miners reporting in Q4 are compared with their own Q3 operating cash flows, Q4’s $509m was only down 14.3% from Q3’s $594m!

So all things considered, the silver miners fared really well operationally considering silver’s big plunge last quarter.  Though their mining costs jumped due to lower silver production, they remained relatively low even compared to low prevailing silver prices.  And higher gold production fed stronger operating cash flows than the sharply-lower silver prices alone implied were coming.  The elite silver miners are doing fine!

But they remain really undervalued after their extreme Q4 selloff.  Silver’s mean reversion higher out of that crazy post-election Trumphoria anomaly is already well underway.  Back in Q3’16 before that, silver averaged $19.55 which was 14% higher than Q4’s levels.  If silver merely returns to there, silver-mining profits will surge 37% higher.  The battered silver stocks are very attractive with their big upside leverage to silver.

Once undervalued silver starts seriously powering higher with gold again, capital will flood back into the silver stocks catapulting their prices far higher.  The silver miners’ operating profitability greatly improves during silver bulls, so their huge silver-stock upside is totally justified fundamentally.  The anomalous post-election silver-stock plunge and its aftermath is a fantastic buy-low opportunity on irrational bearish psychology.

While investors and speculators alike can certainly play the silver miners’ ongoing mean-reversion bull with this leading SIL ETF, individual silver stocks with superior fundamentals will enjoy the best gains by far.  Their upside will trounce the ETFs’, which are burdened by companies that don’t generate much of their sales from silver.  A handpicked portfolio of purer elite silver miners will generate far-greater wealth creation.

At Zeal we’ve literally spent tens of thousands of hours researching individual silver stocks and markets, so we can better decide what to trade and when.  As of the end of Q4, this has resulted in 906 stock trades recommended in real-time to our newsletter subscribers since 2001.  Fighting the crowd to buy low and sell high is very profitable, as all these trades averaged stellar annualized realized gains of +22.0%!

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The bottom line is the major silver miners fared just fine operationally in Q4’16.  Despite all the emotional silver-stock dumping on sharply-lower silver prices, this industry’s underlying fundamentals stayed quite strong.  Costs remained way under prevailing silver prices even at lows, feeding big profit margins.  And the silver miners growing their gold production mitigated the hit to operating cash flows from falling silver.

With silver-stock sentiment remaining so excessively bearish, this sector is primed to soar as silver itself continues mean reverting higher out of its post-election anomaly.  The silver miners’ profits leverage to rising silver prices remains excellent.  And after fleeing silver stocks last quarter, investors and speculators will have to do big buying to reestablish silver-mining positions.  These capital inflows will fuel big gains.

Adam Hamilton, CPA

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