The silver miners recently finished reporting their third-quarter results, offering a hard fundamental look into this sector. This reality check is valuable given the fierce winds of bearish sentiment buffeting silver stocks in recent months. Despite their huge correction, the elite silver miners’ fundamentals remain strong. They are producing at costs far below prevailing silver levels, with profits poised to soar as silver recovers.
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. 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 4.8x 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 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 stock prices higher.
As of mid-November when silver miners finished reporting their Q3 results, SIL included 24 major “silver miners”. This term is used somewhat loosely, as SIL includes plenty of companies that simply can’t be described as primary silver miners. Most generate well under half their revenues from silver, greatly limiting their stocks’ upside to silver-price increases. One is even a gold miner that doesn’t report any silver production!
I’ve been a silver-stock investor and speculator for decades, and my biggest reservation about SIL is its heavy weighting of metals other than silver. When traders buy a “Silver Miners ETF” which is what SIL advertises itself as, they expect to get silver miners with natural upside leverage to silver gains. While pure silver miners are nonexistent due to the geology and economics of silver mining, SIL could do better.
The greater the percentage of revenues any miner derives from silver, naturally the higher its silver-price exposure. If a company only earns 20%, 30%, or even 40% of its sales from silver mining, it’s definitely not a primary silver miner. Technically that designation should just apply to miners deriving at least half of their revenues from silver production. SIL’s managers could build a far-superior ETF if they stuck to that rule.
This leading silver-stock ETF has long been dominated by primary gold miners and even worse mining conglomerates. Because these non-primary-silver miners generate only relatively-minor fractions of their sales from silver, their stock prices aren’t very responsive to silver-price moves. SIL shareholders would be far better served by replacing these inappropriate components with smaller primary silver miners.
Nevertheless SIL is what we’ve got, so I’ve spent recent weeks digging into the Q3’16 10-Q reports filed by this ETF’s top 17 components. That number was chosen because that many stocks fit neatly into the table below. But as these silver miners command fully 95.5% of SIL’s weighting, they are essentially all that matters. Every quarter I collect a bunch of key data for each, and feed it into a spreadsheet for analysis.
Some of that data made it into the following table. If a field is blank, the company didn’t report that data for Q3. SIL includes foreign miners trading in Mexico and the UK, where publicly-traded companies are only required to report in half-year increments instead of quarterly. So they generally don’t release any detailed financial information for Q1s and Q3s. They do tend to report on production though, which is helpful.
The first couple columns show each SIL component’s symbol and weighting in SIL as of the middle of November when Q3 reporting finished. If you can’t find a symbol here in the States, it is a listing from a company’s primary foreign stock exchange. That’s followed by each company’s Q3 silver production, along with its quarter-on-quarter change from Q2. That’s probably more relevant than year-over-year today.
With a major new silver bull market underway in 2016, this year has proved radically different for silver miners than last year which was mired deep in a bear market. Thus traditional YoY comparisons are so distorted that sequential QoQ ones make more sense today. Bull years don’t compare well with bear years and vice versa. Once silver’s young bull is a couple years old, then we can switch back to YoY analysis.
Q3’16 silver production is followed by gold production. Every single top silver miner included in SIL also produces significant if not large amounts of gold! While gold stabilizes silver miners’ cash flows, it also retards their stocks’ sensitivity to silver itself. Silver-stock investors and speculators need to know how pure silver miners really are. So I included another column showing each SIL component’s percentage of silver.
This is mostly calculated by taking a company’s Q3 silver production, multiplying it by the average silver price in Q3, and dividing that number by the company’s total quarterly sales. In a couple cases where miners didn’t report Q3 revenues, I approximated them by adding the silver sales to gold sales based on quarterly production and Q3’s average gold price. Either way, it reveals how focused on silver these companies are.
That’s followed by cash costs and all-in sustaining costs per ounce of silver produced. They reveal just how profitable silver miners are and how easily they can weather silver corrections. Finally operating cash flows generated in Q3 are shown, which are the best proxy for how silver miners are currently faring. Some of the elite silver miners included in SIL enjoyed amazing quarterly gains in operating profitability.
Compared to everything else including gold, silver is a tiny market. The world authorities on supply and demand in each are the World Gold Council and Silver Institute. Using their respective numbers on global demand last year, world silver demand was worth just $13.9b compared to $162.0b for gold! With silver’s market only about 1/12th the size of gold’s, there is a lot less interest in and data available on silver.
Together these top 17 SIL components produced 76.2m ounces of silver in Q3. Annualize that, and it equates to 304.8m or about 34% of 2015’s global silver mine production. But that’s misleading too, as the largest silver miners included in SIL definitely aren’t primary silver miners. The top 3 in Q3 were led by Mexican mining conglomerates Industrias Penoles and Fresnillo, closely followed by the UK’s Polymetal.
Despite their huge absolute silver production, silver is just a minor overall byproduct for Penoles and Polymetal. Their silver production in Q3 was responsible for just 26% and 30% of their total revenues! Neither should be included in SIL, because their small silver percentages render their stock prices very unresponsive to silver. Fresnillo didn’t provide enough data to calculate for Q3, but in Q2 it ran a respectable 49%.
Now you could definitely argue that companies deriving over 40% of their revenues from silver qualify as silver miners, but anything under that seems pretty questionable. Investors buy silver-stock ETFs solely because they want mining profits leveraged to silver-price upside. SIL’s managers really ought to take that into consideration. Including so many non-primary miners really dilutes SIL’s usefulness to investors.
SIL’s 9th-largest component in mid-November, Alamos Gold, actually reports zero silver production! It should be kicked out in favor of the smaller silver miners that didn’t make the top 17. Two other SIL components, Klondex Mines and McEwen Mining, produce so little silver that they don’t even report silver costs. SIL really needs to establish at least a 40% silver threshold to live up to its billing as “Silver Miners ETF”.
Interestingly SIL’s top 17 component companies actually saw silver production fall 2.1% QoQ, which is fairly steep. But this entire sequential drop came from sharp production declines in those big Mexican mining conglomerates Penoles and Fresnillo. Without them, the other top 15 SIL component companies actually saw silver production grow 1.3% QoQ. But gold production grew even more, diluting silver percentages.
The average QoQ growth rate in these elite SIL components’ silver production ran just 1.5% in Q3, way behind their average 8.7% gold-production growth! That helped drive their average percentage of sales generated by silver down from 45.3% in Q2 to 42.8% in Q3. On the bright side, SIL’s top 17 companies still included 6 that were definitely primary silver miners with 50%+ of their revenues derived from silver.
Their silver percentages are highlighted in blue in this table. Investors looking for pure silver miners with profits and therefore stock prices heavily levered to silver would do far better owning some combination of these individual stocks rather than SIL. A common problem among all sector ETFs is the upside of the best stocks they hold is retarded by the lower performances from laggard peers, reducing gains.
That’s why I’ve always preferred handpicking the best individual stocks to own in a sector instead of settling for an ETF’s over-diversified holdings. While ETFs like SIL usually contain the best a sector has to offer, they are also burdened with many underperforming companies in a somewhat-misguided quest for diversification. While diversification indeed reduces risk, it also reduces reward. It is a double-edged sword.
Understanding how the elite silver miners fared fundamentally in Q3 requires looking at their costs. The classic way to measure these is cash costs per ounce. They include all direct production costs of mining silver, mine-level administration, smelting, refining, transport, regulatory, royalty, and tax expenses. They are the acid-test measure of silver-miner survivability, revealing silver prices necessary to keep the doors open.
In Q3’16, the top 17 SIL component stocks that reported silver cash costs averaged $5.63. That proved a steep 5.8% QoQ jump from Q2’s $5.32. I suspect this was partially due to Q3’s sharply-higher average silver prices. They averaged $19.55 last quarter, a whopping 16.4% higher than Q2’s $16.79! That was silver’s best quarter in a couple years, since Q3’14. That gave silver miners some breathing room on grades.
Silver deposits certainly aren’t homogeneous, with different areas in the same ore bodies having major variations in silver mineralization. Miners often have to dig through lower-grade ore to get to higher-grade ore underneath. They can sometimes alter their mining plans to take advantage of higher prices by mixing in lower-grade ore that has to be eventually mined anyway with higher-grade ore, raising costs.
Since the throughput of mines’ mills which process the ore is essentially fixed, lower-grade ore results in lower quarterly production. That spreads the big fixed costs of mining across fewer ounces, pushing up per-ounce costs. It is not clear that’s what actually happened in Q3, as most of the elite silver miners had higher quarterly silver production than Q2. But higher silver prices generally facilitate higher costs.
That happened to a lesser extent in all-in sustaining costs too, a far-superior cost measure introduced by the World Gold Council in June 2013. AISC give investors a much-better understanding of what it actually costs to maintain a silver mine as an ongoing concern. They include all direct cash costs, but then add on everything else 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 administrative 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 Q3 these top 17 SIL companies which reported AISC averaged an impressive $10.13 per ounce! As long as the silver price stays above all-in-sustaining-cost levels, the silver miners can operate indefinitely. This shows how overdone the bearish silver-stock psychology has been since the election, with silver’s lowest price seen in Q4 still way up at $16.36. These are still very-profitable levels for elite major silver miners.
Q3’s AISC among these SIL miners rose a modest 0.8% from Q2’16’s $10.05, much less than the 5.8% QoQ jump in cash costs. The fact the silver miners held the line on all-important AISC despite sharply-higher silver prices is very impressive. That helped generate big operating profitability. On average the elite silver miners were earning $9.42 per ounce in profits with silver’s $19.55 average price seen in Q3!
This was a whopping 39.8% higher than the $6.74 margin earned in Q2 when silver averaged $16.79, nicely leveraging the 16.4% jump in average silver prices quarter-on-quarter! Silver miners’ big inherent profits leverage to silver is the primary reason investors want to own these stocks. The more of any miner’s sales are driven by silver, the greater its profits leverage to the white metal and thus the bigger its stock’s upside.
These strong margins naturally fed big growth in cash flows generated from operations, the best read on current operating profitability. On average the top 17 SIL component silver miners that reported financial results in Q3 saw strong 19.6% QoQ operating-cash-flows growth! This is very impressive, certainly way up among the best sectors in all the stock markets. Silver-stock fundamentals supported surging prices.
Because of the half-year reporting by foreign silver miners, a straight comparison of the total operating cash flows of these top 17 SIL components isn’t righteous. But as Polymetal and Hochschild didn’t break out Q2’16 operating cash flows in time for my last analysis on silver stocks either, we only have to exclude Fresnillo. It reported Q2’16 operating cash flows as part of half-year results, but didn’t report Q3’s.
Without Fresnillo, these top SIL-component companies collectively generated $1577m in operating cash flows in Q3. This was 30.2% higher than Q2’16’s total ex-Fresnillo! Seeing an entire industry’s cash flows generated from operations surge by nearly a third sequentially in a single quarter is amazing. This even beat the major gold miners’ gains, showing why investors flock to silver stocks during silver bulls.
On an actual accounting-profits basis, which isn’t shown in this table, SIL’s top 17 silver miners ex-Fresnillo earned $382m in Q3 compared to $301m in Q2. That is hefty 26.9% QoQ growth in earnings! Can you imagine Wall Street beating down the doors to flood into any other sector where something like this occurred? The fundamental improvement in silver miners this year has been nothing short of enormous.
But today silver-stock investors and speculators are ignoring the miners’ strong Q3 results to get caught up in the bearish prevailing sentiment. Silver has been hit hard in Q4 due to heavy gold-futures selling in early October and then again after early November’s election. So far in Q4, silver has only averaged $17.59. That’s down 10.0% from Q3’s $19.55. Does the fundamental impact justify the sharp silver-stock selloff?
Let’s conservatively assume that silver doesn’t bounce even though a big rebound higher is overdue, so Q4-to-date’s average silver price will hold until year-end. If the silver miners can maintain Q3’s $10.13 AISC, that yields profit margins of $7.46 per ounce. While 20.8% lower than Q3’s $9.42, that still leaves silver mining very profitable. The sharp drops in silver-stock prices in recent months have dwarfed that impact.
As measured by SIL, the silver stocks peaked in mid-August. Since then, SIL has plunged 36.6% at worst! And that significantly understates recent months’ downside in primary silver miners, since SIL’s higher weightings are commanded by non-primary silver producers. So it’s definitely safe to say that the recent plunge in silver-stock prices is nearly double the probable fundamental impact of Q4’s lower silver levels!
Thus the recent silver-stock correction is wildly overdone compared to underlying fundamentals. Like usual when sentiment swings against silver stocks, investors and speculators have gotten caught up in the popular bearishness and forgotten about fundamental reality. The silver miners’ strong Q3 results are a big wake-up call. The silver miners’ fundamentals have strengthened dramatically on silver’s new bull.
And that is far from over. The post-election silver plunge was driven by heavy gold-futures selling which sucked silver in. But that extreme gold selling was anomalous and will soon reverse. Sooner or later the overvalued stock markets’ euphoria at the prospects of fiscal stimulus will be shattered by the hard realities of actually getting it done. As stock markets inevitably roll over, gold and silver will catch major bids.
Once undervalued silver starts powering higher again, capital will flood back into the beaten-down silver stocks catapulting their prices higher. The silver miners’ operating profitability improves massively during silver bulls, so their huge silver-stock upside is totally justified fundamentally. The anomalous post-election silver-stock plunge is an incredible buy-low opportunity on excessively-bearish psychology.
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The bottom line is the major silver miners’ recently-reported Q3’16 fundamentals were incredibly strong and bullish. Stable all-in sustaining costs combined with sharply-higher silver prices drove explosive growth in operating cash flows and accounting profitability. The fundamental transformation the silver stocks have undergone in 2016 has been amazing, and it is only starting as silver’s new bull remains young.
But unfortunately most investors and speculators today aren’t paying attention to the silver miners’ strong fundamentals. Instead they are all wrapped up in the fearful prevailing sentiment. That’s a big mistake as always. While silver-mining operating profitability will decrease in Q4 if silver prices remain low, that will be short-lived before silver’s bull resumes. Higher silver will fuel far-higher silver-stock levels.
Adam Hamilton, CPA
November 25, 2016
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