Silvercrest buyout – is Discovery Silver the next in line?

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Last Friday it was announced that my former silver mining stock idea for my members, Silvercrest Metals, will be acquired. Great on one side, as it confirms through my research work to have found a great company. I had laid out that Silvercrest might be an acquisition target one day due to its high-quality mine in Mexico. Bad on the other, as I obviously closed my case too early at “only” +85.1%, leaving some performance on the table. There’s another interesting silver miner in Mexico, sitting not less than on the world’s biggest undeveloped deposit. Is this an even better Silvercrest in the making?

Summary and key takeaways from today’s Weekly
– My members in September 2023 received a research report with my stock idea Silvercrest Metals.
– The stock performed very well and will be taken over soon by a competitor.
– With Discovery Silver, there’s an even more interesting mining project in the making, steered by a proven CEO. I lay out why I am staying on the sideline, nonetheless.

This will be my third article about silver (see here and here my previous ones).

Somehow, it has become a tradition to write about silver each year after the summer holidays since I started my blog in the summer of 2022. At least it has been the case so far. My first take was in September 2022, when physical silver was trading below 20 USD and the respective mining companies proved to be money graves and destroyers of precious nerves.

Tough to believe, but this was the setup back then!

The sentiment obviously was not great and people weren’t calling out new all-time highs or even triple-digit price targets.

Due to inflation rates not seen for decades (even the official ones), production costs increased dramatically, while the pretend inflation hedges gold and silver tanked. These dynamics, little surprisingly, pressured miners from both sides of the equation, explaining their abysmal performance back then.

With the gold and silver rallies this year, more people started to get interested again.

source: Walter Freudling on Pixabay

My longer-time readers know that I am more interested in silver than gold – which doesn’t mean I cannot publish a gold mining stock idea for my members (see here).

I tend to associate gold primarily with crash prophecy and spreading fear by gold bugs. On top, of course this inflation-hedge nonsense which historically has not proven to be correct – at least not in the same way that it is portrayed. Just look back to the period of a few years ago – inflation was sky-high. What did the metals?

Silver on the other hand is known to be an industrial metal with plenty of real-world use cases in sectors like energy, semiconductors or med-tech, besides being used for jewelry and analog photography. Not to hide it, this makes it more cyclical, but certainly not less exciting.

Today is not a macro or silver article per se.

First, I am taking a look back at my former silver mining pick Silvercrest Metals (ISIN: CA8283631015, Ticker: SILV) which will be acquired soon by a competitor.

Then, I’ll discuss another Canadian silver miner (in the making), Discovery Silver (ISIN: CA2546771072, Ticker: DSV) which is sitting on the world’s biggest undeveloped deposit with even better economics than Silvercrest.

The average total return of my best stock ideas is currently trailing the S&P500 and the Dow Jones. With my risks-first approach (paired with high upside), I am able to find stocks with much better and more favorable risk and reward setups. Time will tell whether the big tech stocks will pull the indices up forever – I prefer not to neglect valuations and optionalities!

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average performance of all my ideas vs. benchmarks

both as per 09 October 2024 market close – since August 2022

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Silvercrest is the past – is Discovery Silver the future?

Both companies have in common that they’re Canadian companies and both have their single-mine operations in Mexico. In the silver mining industry, this is not uncommon as Mexico is the world’s biggest silver producing country with around a quarter of the entire output and many miners having their primary listing in Canada.

So far so good.

For long, I had issues to find a silver mining stock with compelling economics, i.e. primarily low production costs on an all-in sustaining basis (to replenish depleted reserves, so called all-in sustaining costs or AISCs). But also with a relevant share of silver of the entire output, as many “silver miners” struggle to even come close to 50%.

Back in 2022 with cost pressures from labor, energy and materials, the sector’s average estimated AISCs were about 18–20 USD – the majority was operating on low margins at best and happy to post positive earnings.

Below, you can see some prominent silver miners and their operating margins for the year 2022 (the first column is Silvercrest with their Canadian listing with an impressive performance from the get go in a depressed sector).

I think it has become clear why this has become my pick.

source: TIKR

The entire sector until today has not seen a higher total silver output for at least ten years, despite demand being 15–20% higher, pushing silver into a supply deficit.

For me, it was not a question of if, but of when silver would rise.

This proved to be correct, as today we are above the 30 USD threshold.

source: Silver Institute, see here

As I laid out in my article about low-cost commodity producers (see here), my approach is not to go for the highest risk and highest cost options, but for the more defensive, less riskier ones which do not have to necessarily perform much worse.

The safety net in the form of low production costs avoids unnecessary dilution through equity raises at the trough and / or taking on excessive debt.

Or in other words, it gives you more breathing room and time to wait for the turnaround to play out. If it takes longer, but the company of choice is profitable without big capital needs, everything’s fine.

This is how I came across Silvercrest Metals.

If you haven’t done already on other occasions, you can download my complete research report about Silvercrest by clicking here – for free!

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I didn’t publish a report in 2022 because Silvercrest was only a mine in the making, i.e. conducting construction works of its single-mine project in Mexico. First commercial output came to the surface only in Q4 2022.

Besides, and this was the bigger issue, the stock was already richly valued for my taste at 2–3x its net present value (NPV, discounted cash flow projection), based on their then-current technical report. A big success was already expected and priced in, as is often the case with high-quality companies.

On the positive, management went through the whole process until production without debt. On top, they were in time and on budget, which is not for granted in the entire mining sector.

After the release of an updated technical report which presented new and a bit less positive numbers below expectations (though still comparatively strong measured by sector standards), the stock of Silvercrest Metals tanked in late-July 2023 to a level below 5 USD a share.

Quite a lot, considering that it came from 12 USD at the top (which was almost two years before production started) and from almost 10 USD just a few months earlier.

source: Seeking Alpha, see here

This is where I saw a great opportunity and an overreaction.

It is true that production costs had increased dramatically and above expectations, partly also due to lower expected silver grades, i.e. less precious material in the rocks.

But lots of hot air was finally out of the stock and it came close to 1x its NPV.

With strong and sector-leading economics, it was not likely to drop much below 1x and stay there forever, hence I decided to strike.

It took the stock about three months to recover from this shock, strongly supported by a higher silver price, but also due to posting strong results and free cash flows, paired with a buyback managend had initiated at these low prices.

Long story short, almost exactly nine months later, I closed the case again with a performance of +85.1% – not because the company suddenly turned bad (though the valuation was a bit stretched), but because political risks increased after presidential elections in Mexico brought forward an environmentalist and anti-mining administration (see here and a post-close update here).

Officially, it is against open-pit mining, while Silvercrest’s mine is underground.

In theory, this should work out, at least somehow. But with this dramatically higher risk factor and only having a single asset, I decided the company to be too risky from here on. I cannot say for sure that underground mining in which form ever would not be punished in the future.

As at the end of last week the takeover of Silvercrest was announced, this case is off the table anyhow. The management for a second time has sold successfully a company it helped to build up (see here). The first one was a decade ago and funnily, it also had the name Silvercrest, though not “Metals”, but “Mines”.

By the way, the just-arrived bid is an all-share deal with Coeur Mining (ISIN: US1921085049, Ticker: CDE) for ~11.30 USD, so effectively even the buyout wouldn’t have rescued someone who bought the top at 12 bucks.

Just as a side note to what I am preaching day in and day out: valuation matters a lot!

source: Seeking Alpha, see here

With this, I am turning to Discovery Silver which has been on my watchlist for quite a while now.

The company is developing the world’s biggest known silver mining deposit in Mexico, the Cordero mining project. In many aspects, the numbers are even much better than was the case of Silvercrest which was convincing enough for me in this otherwise messy sector.

source: Discovery Silver investor presentation, see here

Just to pick a few points, Discovery Silver’s expected mine life is twice as high, its production costs are 20–30% lower, its yearly production – once online – would be almost four times higher.

For the sake of completeness, Discovery’s Cordero mine would be the world’s new biggest producing mine – we are talking about a giant in the making, not just another silver mine like many others.

source: Discovery Silver investor presentation, see here

Like was the case with Silvercrest, management is holding ~5% of stock of Discovery Silver, which I like to see.

Speaking of management, what I also like is that the company is led by Tony Makuch – the CEO who formed Kirkland Lake Gold between 2016–2022, a former Canadian pure play gold producer, into a major success story with ultra low-cost operations in Canada and Australia. Its stock was on fire and even trading at multiples in the high 20s because it generated tons of free cash flow while the competition was asleep.

The company, however, a few years ago was sold to the world’s number three, Agnico Eagle Mines (ISIN: CA0084741085, Ticker: AEM, see here), and Makuch soon left.

The happier I was as soon as I found out that he was the new CEO of Discovery Silver.

Looking at the valuation, Discovery looks to be more on the cheap side – a bit strange at first sight for such a gigantic project with best in class economics.

The company in its latest feasibility study (the last big study before construction can start) from February 2024 shows a net present value of 1.8 bn. USD – while it is trading only for a market cap of 260 mn. USD (~360 mn. CAD). One could argue that they are using market prices for the metals and not more conservative figures like for example Silvercrest was doing.

However, at 0.15x its NPV it’s given away almost for free – it seems.

source: Discovery Silver investor presentation, see here

For comparison, Silvercrest Metals was not even trading at such a multiple when it released its pre economic assessment in 2019 (PEA, with more studies to follow to confirm the project’s economics, i.e. more uncertainty, see here).

Silvercrest’s NPV was an estimated 400 mn. USD, while the company had a market cap of ~250 mn. CAD or ~180 mn. USD – give or take 0.5x its NPV.

source: TIKR

From then on, Silvercrest only became more and more expensive, despite still being years away from construction, not to mention production.

It was also clear that financing would be needed – as management didn’t take on debt, dilution through equity raises was the only option.

This is the thing with Discovery Silver – despite its impressive numbers, the project is not financed, yet. From my research I have the number of 600 mn. USD in needed capital before me. That’s quite a lot, considering the market cap is note even half of that and cash on the balance sheet per the latest half-year results was less than 30 mn. USD.

And by the way, costs have risen by a third since the last estimate.

source: Discovery Silver feasibility study results presentation, see here

Discovery Silver currently is about two years away from production.

With financing still unclear, a discount is justified, because current equity holders likely will get diluted, even if debt were a component of the financing package.

However, I think what’s also and maybe even primarily weighing on the stock is that, despite the company with Eric Sprott having a well-known major key investor (biggest shareholder with more than 20%), we are dealing here with an open-pit mine.

That’s the type of mine the new Mexican government aims to forbid.

source: Reuters, see here

After the above news came out, please have a look how the stock of Discovery Silver reacted:

source: Seeking Alpha, stock in USD, see here

While the stock is back to where it fell from as these news broke out, I remain skeptical.

In its latest MD&A (management discussion and analysis) for H1 2024, management explicitly added this risk to their risk section.

source: Discovery Silver, H1 2024 MD&A, see here

All in all, a mixed bag.

On one hand, a very compelling setup, when looking only at the mining project.

On the other, two big challenges. The first, financing, would likely be somehow solvable. My strategy would have been to wait until financing is secured and announced to better assess the potential effect of a likely dilution to shareholders. An entry then would maybe result in some missed performance, but the dilution would clearly be circumvented.

The second risk, form the political side, is what made me fade.

I will continue to monitor this case, because it is too interesting not to do so. But there’s absolutely no need to rush in.

Conclusion

My members in September 2023 received a research report with my stock idea Silvercrest Metals.

The stock performed very well and will be taken over soon by a competitor.

With Discovery Silver, there’s an even more interesting mining project in the making, steered by a proven CEO. I lay out why I am staying on the sideline, nonetheless.

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