Pan American Silver — Lean, mean silver machine

PAAS is one of the largest global primary silver producers and a sizeable gold miner with operations in North, Central and Latin America. Following the acquisition of Tahoe Resources, the company controls four producing silver operations (silver segment), four gold operations (gold segment) and a number of advanced silver projects. While 2020 was affected by the coronavirus related mine closures, and despite the lingering COVID-19 effects, PAAS has seen a gradual recovery in production in 2021. The company’s FY21 silver and gold output was 19.2Moz and 579koz an all-in sustaining cost (AISC) of US$15.6/oz for silver and US$1,214/oz for gold. In addition to the producing operations, PAAS owns the top-tier Escobal mine in Guatemala, which is currently suspended subject to completion of the consultation process with local communities but is capable of almost doubling the company’s silver output once restarted, as well as the large-scale greenfield projects La Colorada Skarn and Navidad.

We value the company based on a DCFE approach, which yields a valuation of US$26.2/share at a 7.0% discount rate. It takes into account Escobal (c US$7/share), which we assume to be restarted in FY24 adding c 15Moz pa in silver production on average over its mine life, but excludes the in-situ derived valuations of advanced exploration projects Navidad, La Colorada Skarn as well as La Arena II, which contribute c US$3.9/share in combined value. Adding these, the company’s equity interest in Maverix Metals and the book value of the recently decommissioned Morococha mine, we arrive at a total valuation of PAAS of US$31.0/share. Given the strength in the precious metals prices, which support share prices, we note that a 10% increase in our silver/gold price deck would boost our DCFE by c 20%.

PAAS trades at FY22e EV/EBITDA and P/E multiples of 8.9x and 28.9x, which imply double digit discounts to comparable silver companies but significant premiums to our selection of gold peers. This could be a reflection of diverging commodity price cycles for gold and silver, with the former being predominantly an investment asset and the latter having a significant industrial exposure. We see the main near-term share price catalysts for PAAS in the stronger than expected commodity prices as a result of visible cost inflation, heightened geopolitical risks and pronounced risks to economic growth, as well as any news on the Escobal consultation and La Colorada Skarn progress. We note that Skarn has significant exploration potential and in the longer term could become a large-scale standalone project, complementing the company’s producing silver portfolio.

While 2021 has seen a gradual recovery in production post COVID-19, it was also characterised by a meaningful increase in costs. PAAS was not immune to the industry-wide cost pressures and shortages of skilled labour, which were also exacerbated by the technical issues at La Colorada, its flagship silver mine, as the company reported a silver segment cash cost of US$11.5/oz in 2021 (vs US$7.0/oz in FY20 before COVID-19 effects). At the earnings level, however, these challenges were to a large extent offset by the strong commodity prices, with FY21 EBITDA coming in at a solid US$593m (36.3% margin) versus US$469m (35.0%) in FY20. We expect a similar performance pattern in FY22 with cost pressures and Morococha closure offset by the strong commodity prices and a further recovery in production. We forecast FY22 EBITDA at US$613m and expect a meaningful improvement in cash-flow generation supported by strong underlying business and working capital normalisation. This should allow growth in dividends, in line with the company’s newly introduced progressive dividend policy.

During COVID-19 pandemic the silver market and pricing have been driven by investment demand, with total silver exchange-traded product (ETP) holdings reaching all-time highs. While investments are likely to remain an important market balancing factor in the short term due to inflation hedging, increased geopolitical tensions and risks to post-pandemic economic recovery, in the longer term, improving global economic growth and inevitable tapering (current market expectations suggest at least five additional interest rate hikes in the US in 2022) point to a gradual shift towards physical and industrial silver demand. Against this backdrop, we believe that e-mobility and PV will become an increasingly important driver behind silver consumption as growing EV adoption and solar power generation will play a crucial role in decarbonisation.

In its latest report ‘Net zero by 2050’, the IEA suggests scaling up solar power generation rapidly this decade, bringing new global solar PV capacity additions to 630GW pa by 2030 (vs 134GW in 2020). Our analysis suggests that this level of solar PV installations alone could imply an annual silver consumption of up to 222Moz, a 2020–30 CAGR of 8% compared to 2011–20 CAGR of 4.4% for silver used in solar PV and -1.7% for total physical silver consumption. Demand will also be driven by higher silver loading in battery electric vehicles (BEVs) versus internal combustion engine (ICE) cars as well as electronics.

Our silver price assumptions are closely linked to our gold forecasts, as we take a view on the silver price through the gold/silver ratio. The ratio normally expands during periods of economic weakness and loose monetary policy due to gold’s prevailing investment nature. However, as macro conditions improve silver tends to outperform thanks to its industrial exposure. At US$24.5/oz, our FY22 silver price forecast implies a ratio of 78x versus 72x in 2021 and 10- and 20-year averages of 73x and 66x. In the near term we expect COVID-19 related economic headwinds coupled with risks to global growth stemming from the Ukraine war (higher energy prices, disrupted supply chains), negative real interest rates and inflation hedging to remain supportive of precious metals prices. However, in the longer term we see a potential for the gold/silver ratio to reduce to more normal levels as the silver price becomes increasingly driven by the growing industrial applications (solar PV, electric vehicles and electronics) as well as physical demand. As such, we model a gradual reduction in the gold/silver ratio to 67x by 2027. We note that in the short run, visible cost pressures across the industry should also provide support to commodity prices in general and silver in particular.

Our analysis suggests that in 2014–21 the company’s producing silver operations (excluding Dolores, COSE and Joaquin) saw their proven and probable (P&P) reserves falling only marginally from 224Moz to 220Moz. Depletion in resources was somewhat more pronounced, with the overall contained silver falling from 442Moz to 407Moz in 2021. While some of the resources were upgraded to reserves, overall the combined reserves and resources depletion of c 6Moz pa (before metallurgical recovery) was visibly smaller than production of c 20Moz pa over the same period.

PAAS’s financials and valuation are highly sensitive to changes in commodity prices, in particular gold, which currently contributes more than 50% to earnings. However, this sensitivity is somewhat mitigated by the company’s relatively high profitability (and low operating leverage). Our base-case valuation is dependent on the assumed restart of the Escobal project. However, visibility on the completion of consultation process remains low. Excluding Escobal, our valuation is somewhat below the current share price. A significant share of the company’s revenue comes from Latin America, a region characterised by relatively high political risks, currency fluctuations and economic uncertainty. It has also been hit hard by COVID-19 and is lagging most of the developed countries in terms of vaccination rates and economic recovery. COVID-19 is likely to continue to affect the global economy, which might be positive for precious metal prices, but represents an operational risk.

PAAS is one of the largest global primary silver producers and a sizeable gold miner. It owns five operational polymetallic silver mines (including the recently decommissioned Morococha project in Peru), four gold operations and a number of high-profile silver assets in Central and South America. The company’s operations were significantly enlarged in 2019 with the well timed and attractively valued acquisition of Tahoe Resources, which was transformational for PAAS. Not only has it allowed the company to more than triple its gold production, but it also provided PAAS with an option to considerably increase its silver output through the potential restart of the large-scale, long-life and low-cost Escobal project in Guatemala. The latter is on care and maintenance, pending completion of the consultation process with Indigenous peoples.

PAAS has seen a gradual recovery in production in 2021, delivering 19.2Moz and 579koz in attributable silver and gold production, an 11% increase versus FY20, a year that was significantly affected by COVID-19 disruptions. The company ranked third in 2021 and 2020 among major primary silver producers, behind Fresnillo and closely trailing Polymetal (although it is predominantly a gold company and its silver production comes from a single deposit, Dukat). As coronavirus-related disruptions continue to ease, PAAS expects further improvements in production, guiding FY22 attributable silver and gold output of 19.0–20.5Moz (Edison FY22e 20.0Moz) and 550–605koz (FY22e 582koz). This guidance is underpinned by expectations of further production recovery at the company’s flagship La Colorada mine, which, coupled with normalising throughput rates at other mines, is expected to offset the recently announced closure of the medium-sized Morococha mine.

The company reports in two segments: Silver and Gold. Each segment comprises four operating mines. Silver consists of La Colorada (Mexico), Huaron (Peru), San Vicente (Bolivia) and Manantial Espejo (Argentina), while Gold is represented by Dolores (Mexico), Shahuindo (Peru), La Arena (Peru) and Timmins (Canada). Except for Dolores, which was reclassified from silver to gold in Q121, all other PAAS gold mines were acquired as part of Tahoe Resources. The company’s fifth silver mine, Morococha, was put on care and maintenance in early 2022 as part of the agreement with Chinalco (see page 6). Geographically, most of the company’s revenues come from Peru (FY21: 44%) and Mexico (29%), followed by Canada (15%).

In FY21, the silver segment produced 16.6Moz of Ag and 39koz of Au, generating US$601m in revenues (FY20: US$631m; including Dolores, which was then classified as a silver mine) and US$199m in direct mine EBITDA (US$235m), implying a margin of 33%. The gold segment produced 540koz of Au and 2.5Moz of Ag and was more profitable with revenues of US$1,031m (US$708m) and direct mine EBITDA of US$472m (US$380m), translating into a margin of 46%. Not included in 2020 numbers are care and maintenance costs of c US$75m, which PAAS incurred at its producing mines due to COVID-19 related closures. In 2020, the company’s operations in Mexico, Argentina and Bolivia were on average suspended for two months, while its mines in Peru were suspended for about five months. The Timmins gold project in Canada continued to operate in 2020 at reduced throughput rates. In 2021, the gold segment’s cash flow generation has been further enhanced by Dolores, which is one of the lowest cash cost and AISC operations in the company’s gold portfolio due to the significant by-product silver credits.

Historically, the company’s output was dominated by silver. However, following the acquisition of Tahoe Resources, the share of gold has almost doubled from an estimated 37% in FY18 to c 68% in FY21 (on a silver equivalent basis, AgEq, for silver and gold only; see Exhibit 3). This shift in production mix coupled with a significant increase in the gold price (US$1,800/oz in 2021 vs US$1,269/oz in 2018) has had a major impact on the company’s financial performance, boosting earnings and profitability. According to PAAS, gold contributed c 60% to revenues in FY21, with silver accounting for only c 26%.

Despite expectations of more pronounced cost pressures in the gold segment in FY22 as well as the gradual recovery in silver production at La Colorada, and given the loss of c 2Moz pa of low-cost silver production from Morococha, in the short to medium term PAAS’s gold mines will continue to generate significantly higher profits and stronger margins than its silver operations. In the longer term, however, if the company succeeds in restarting its large-scale Escobal mine, which we believe is highly likely and factor in our model from 2024, and continues to advance its large-scale greenfield La Colorada Skarn project (with further optionality provided by Navidad), the share of silver in the production mix should recover, potentially returning to above 50%. This is especially so given that some of the company’s gold operations have relatively short mine lives (eg La Arena, Dolores). As we argue later in the note, the higher silver exposure could be beneficial for PAAS should the anticipated increase in industrial demand driven by the accelerating shift towards renewable energy and electrification materialise.

With Morococha decommissioned in early 2022, the company’s key producing silver mines are high-grade, underground operations La Colorada and Huaron. Within the company’s silver portfolio, these assets contribute a significant portion of production, have the longest mine lives and the lowest cash costs. San Vicente and Manantial Espejo are significant silver producers but have higher costs and shorter mine lives. Below we provide a brief description of the main silver mines (also see Exhibit 2 for more detail).

With its FY21 results, PAAS announced the suspension of production at Morococha in line with the 2010 agreement with Chinalco that required relocation of mine’s facilities, including the processing plant, in stages to allow the gradual expansion of Chinalco’s Toromocho copper mine. The company is evaluating a number of options that include monetisation, JV operation or additional exploration that would justify building a new processing plant. Morococha (92.3%) is an underground mine in Peru that operated an 803ktpa processing plant to produce silver in zinc, lead and copper concentrates. Mineralisation at Morococha includes silver-zinc-lead copper veins, with economic widths ranging from 0.5m to 6.0m. In FY21, it produced 2.2Moz of silver (FY20: 1.2Moz) at an AISC of US$13.5/oz. Morococha has P&P reserves of 6.5Mt at an Ag grade of 153g/t and contained silver of 32.1Moz.

The company’s core silver mines are relatively low-cost operations, both in the industry context and historically. Despite coronavirus-related disruptions, the silver segment managed to keep costs under control in 2020, with a total cash cost of US$7.0/oz (up 10% y-o-y) and AISC of US$11.4/oz (up 9%), excluding care and maintenance costs. These compare favourably to some of the direct peers (Exhibits 4, 5 and 7). While the industry-wide cost pressures due to COVID-19, labour shortages and energy price inflation have largely offset positive effects from the gradual production recovery, most of the company’s silver mines saw flat to slightly higher costs in 2021, with La Colorada being the only major exception as its production remained constrained by the technical issues and costs affected by the upgrades to the ventilation system. The silver segment costs were also negatively affected by the fact that Dolores, which had significant gold credits, was reclassified as a gold mine from 2021. Overall, the company’s FY21 silver segment cash cost of US$11.5/oz and AISC of US$15.6/oz compared to the average silver price during the year of US$25.1/oz. Similarly, in the gold segment, the cash cost and AISC were US$899/oz and US$1,214/oz versus the average 2021 gold price of US$1,800/oz.

Escobal is one of the world’s largest silver mines and is capable of producing in excess of 15Moz pa of silver along with zinc and lead concentrates. It was initially commissioned in Q114. However, in 2017, Tahoe Resources announced its licence to operate the mine was temporary suspended due to the claim that Guatemala’s Ministry of Energy and Mines (MEM) violated the indigenous community’s right of consultation ahead of granting the mining licence. While the licence was later reinstated, mining operations are still suspended as MEM has been required by the court to conduct a consultation under ILO Convention 169 (the International Labour Organisation convention on indigenous and tribal peoples). The formal consultation process consists of four stages:

While the actual timeframe for the completion of the full consultation process is not clear, we understand that some progress was made lately by the Guatemalan MEM, with four pre-consultation meetings held since May 2021. The project is on care and maintenance and once its licence is restored, we understand it could take a few months to resume production. In 2016, the last full year of operation before the suspension, Escobal produced 21.2Moz of silver at an impressive silver grade of 477g/t and 87% metallurgical recovery. At an average realised silver price of US$17.6/oz, the project generated revenues of US$356m and reported a cash cost of US$5.8/oz and an AISC of US$8.1/oz after by-products.

Tahoe Resources published a feasibility study on Escobal in November 2014. It envisaged production of c 15Moz of silver per year over 20 years at an average silver grade of 347g/t and a mine operating cost of US$75/t of ore (before smelting and refining charges and royalties). Royalties were estimated at 5.5% of net smelter return, but we would not rule out a higher number as the government of Guatemala goes through the consultation process with Indigenous peoples. LoM sustaining capital was estimated at US$301.2m, or c US$15m per year. These parameters underpin our model for Escobal discussed further in the financial and valuation sections.

In February 2019, PAAS completed the acquisition of Tahoe Resources, a mid-tier precious metals producer. As a result of the deal, PAAS acquired three producing gold mines – Timmins (Canada), Shahuindo (Peru) and La Arena (Peru) – as well as the currently suspended Escobal mine, a top-tier silver project in Guatemala. According to the terms of the transaction, Tahoe was valued at US$1.14bn comprising US$275m in cash, US$796m in PAAS shares and US$72m in contingent value rights (CVRs). CVRs represent c 15.6m of PAAS shares to be issued following the restart of Escobal and first shipment of concentrate.

In Exhibit 6, we provide a summary of the latest available pro forma financials for PAAS and Tahoe Resources. Based on 9M18 results, Tahoe’s EBITDA adjusted for asset impairments was US$170m. On an annualised basis, this implies an acquisition EV/EBITDA multiple of c 5x (including CVRs at the acquisition value). This valuation excludes Escobal, which on its own represents a significant value (see below and the valuation section), suggesting Escobal was essentially acquired for free. The deal was well timed as evidenced by the increase in the gold price, which averaged US$1,773/oz in FY20 versus US$1,269/oz in FY18. We estimate the company’s established gold segment (comprising Tahoe’s three mines) generated mine EBITDA of US$380m in FY20 versus an annualised c US$213m in 9M18. With the addition of Dolores, the gold segment’s mine EBITDA increased to US$472m in FY21.

Below we provide a brief description of the company’s key gold operations:

Looking at the historical cash costs for broadly similar primary silver projects in Central and Latin America (Exhibit 7 and Exhibits 4 and 5 for PAAS), we note the best performers in 2020 (and 2021) were the mines that managed to maintain production and therefore benefited from higher commodity prices for both primary and by-product metals. These were the mines predominantly located in Mexico, such as Saucito (Fresnillo), Palmarejo (Coeur Mining) and San Dimas (First Majestic), which were less disrupted by COVID-19. Dolores enjoyed a similar performance in 2020, reporting a negative silver cash cost of US$2.5/oz and an AISC of only US$6.8/oz as although silver production was down 26% y-o-y, its silver sales and gold output were both down only 17%. We would have expected La Colorada to perform broadly in the same vein (albeit it has a lower gold production), had it not been negatively affected by the ventilation constraints that undermined production in both 2020 and 2021.

Silver mines in Peru and Argentina were more affected by COVID-19-related production suspensions (eg PAAS’s Morococha and Hochschild’s Pallancata mines). However, one notable difference was that mines in Argentina benefited from the significantly weaker local currency, which supported costs. Thus, Hochschild’s San Jose mine saw its cash cost turning negative, despite a sharp reduction in both silver and gold output, while PAAS’s Manantial Espejo mine reported a 20% reduction in cash cost in FY20 (although costs rebounded somewhat in FY21 as the mine approaches its end of life). While the Argentinian peso continued to weaken throughout 2021 and further in 2022, some other currencies such as the Mexican peso and the Peruvian sol have started to recover, but remain weaker than their pre-pandemic levels.

In 2021 most of the comparable operations saw a meaningful pick up in costs driven by the recovery in production as well as labour and energy cost inflation. More cost increases are almost inevitable this year due to higher energy prices. However, they are likely to be at least partly offset by the strong commodity prices.

In general, mine cash costs are very sensitive to the amount of by-product credits (other metals produced in addition to the main metal), by-product metal prices and currency effects (since a significant share of production costs, wages in particular, is denominated in local currencies). This increases cost volatility and makes them difficult to guide and predict. One example of how by-product credits, or the lack thereof, could affect cash costs is Buenaventura’s Uchucchacua silver mine in Peru, which saw its FY20 cash cost more than doubling to US$20.7/oz (on a by-product basis; Edison estimate) on the back of a 53% reduction in silver production (lead and zinc production down c 73%). The mine was suspended in 2021.

We note that companies in Exhibit 7 below report costs on a different basis (costs applicable to sales (CAS), after by-products and on a silver equivalent basis), which somewhat distorts the comparison but nevertheless reveals the dynamics.

PAAS reported its latest mineral reserves and resources estimates as at June 2021. The silver segment total P&P reserves stood at 54Mt and 485Moz of contained Ag (to this should be added silver reserves of the gold operations totalling 44Moz of Ag). Producing silver operations represented c 54% and 45% of the overall tonnage and contained silver respectively, with the remainder accounted for by Escobal. The segment’s total mineral resources (PAAS reports resources exclusive of reserves) were 1,206Moz of contained Ag, with c 67% in the M&I category. A significant part of the M&I resource is contributed by Navidad, while La Colorada Skarn represents c 35% of the segment’s inferred resource. Overall, in terms of contained Ag, the silver segment’s mineral reserves and resources fell 2% y-o-y in 2021. However, adjusted for Dolores, the segment’s resources were flat year-on-year, while reserves were down only 1% versus June 2020.

As of June 2021, the gold segment P&P reserves were 3.8Moz of contained Au, with M&I and inferred resources contributing another 8.1Moz and 5.7Moz. The segment’s mineral reserves are mainly attributable to the producing operations, while the M&I resource is dominated by the non-core projects such La Arena II, La Bolsa and Pico Machay (both on care and maintenance). The company continues to actively manage its asset portfolio, with a number of projects in the gold segment slated for sale. Overall, the company’s three producing gold mines (excluding reclassified Dolores) have seen their P&P reserves falling 6% y-o-y to 3.1Moz of contained Au in 2021. We note that reserves replacement was also negatively affected by COVID-19 as exploration was down during the period.

In this section we consider the company’s track record in replenishing its silver reserves and resources. Unlike the gold segment and with the exception of two small deposits (COSE and Joaquin), the company’s silver mines have a long history of reporting mineral resources, which allows us to take a closer look at the replacement rates. Our analysis suggests that over the last seven years (2014–21) PAAS increased its P&P tonnage from 28Mt to 29Mt, while contained silver fell only marginally from 224Moz to 220Moz (Exhibit 10; silver assets exclude COSE, Joaquin and Dolores). At the mineral resource level, the depletion was somewhat more pronounced, with the overall contained silver falling from 442Moz in 2014 to 407Moz in 2021 (see Exhibit 12). While some of the resources were upgraded to reserves, overall, the combined depletion of c 6Moz pa (excluding metallurgical recovery) was visibly smaller than production at c 20Moz pa (excluding Dolores).

PAAS owns a number of high-profile exploration projects that could potentially represent a significant upside to, or replacement for, the currently producing silver assets.

Navidad is a 100% owned, large scale, open-pittable project in Argentina consisting of eight individual adjacent silver deposits. The company acquired the project in late 2009. As of June 2021, Navidad had 155Mt in M&I resources at 127g/t and 632Moz of contained Ag.

In 2010, the company published a preliminary economic assessment (PEA) for the project. It envisaged production of 275.5Moz of silver over the project’s life of c 17 years, or c 16Moz per year, along with lead and copper concentrates. Initial capex was estimated at US$760m (US$48/oz of annual production), with sustaining capex of US$161m (US$10m pa) and total operating cost of US$27.4/t of ore (including mine G&A, smelting and refining). (Note the difference in cash cost with the underground Escobal project.)

However, in 2003 the Province of Chubut passed a law prohibiting the use of cyanide and open pit mining, with the latter the main obstacle that prevents the development of the project. Although there is no clarity on the project’s potential development timeframe as visibility remains low, there is a view that the loss of oil income as a result of the ongoing shift away from fossil fuels and potentially lower oil prices could eventually force provincial authorities to reconsider this law.

In December 2021, PAAS published an update suggesting that in mid-December a bill was passed by the legislature of the province that would modify the law to allow open pit mining in certain areas. However, it was later reported that the authorities of the province issued a decree to the legislature to repeal this bill. Given the political and economic uncertainty in Argentina, it is not clear whether a change in the mining law alone would lead to the full-scale development of the project.

La Colorada Skarn is a large polymetallic deposit located under the currently producing La Colorada mine. It was discovered in 2018 and is estimated to contain 141Moz of silver in inferred resources at an Ag grade of 44 g/t. PAAS initially planned to release a PEA on the project by end 2021; however, along with a positive exploration update in November 2021 (reporting high grade intercepts in infill and step out drilling), it announced the decision to continue exploration and engineering works in 2022, aiming to increase confidence, potentially expand the resource base and determine the best mining method to develop the deposit. La Colorada Skarn represents a large-scale standalone project whose scale would require own infrastructure and processing facilities. Given the development timelines for the large-scale mining projects, it could be an attractive addition to the company’s portfolio of producing silver operations in the longer term.

Analysis of the silver market is complicated by the fact that only c 27% of all silver mine supply comes from the primary silver producers such as PAAS, whereas the rest is contributed by the producers of other metals such as lead/zinc (32%), copper (25%) and gold (16%), for which silver represents a by-product. Not only does this reduce supply visibility, but it also restricts any possible supply-side response in the event of deteriorating market conditions. Overall, COVID-19 has had a major impact on the silver market in both 2020 and 2021. According to the Silver Institute (SI), global mine silver production fell 7% to 780Moz in 2020 due to pandemic-related mine closures. Primary silver mines saw their production falling c 12%, or c 2x the reduction experienced by lead/zinc (-7.4%) and gold (-5.7%) mines. At the same time, silver output from copper mines (in particular, in Chile) was up 3.5%. At the regional level, the biggest drop in silver production came from Latin America, in particular Peru (-19% y-o-y), Argentina (-30%) and Bolivia (-19%), followed by Mexico (-5%).

In late 2021, the SI provided an updated estimate of silver mine supply for the year, suggesting global mine production could have expanded by 6% to 829Moz (vs 849Moz before). While most mines adapted to the coronavirus disruptions, which coupled with the global vaccine roll out allowed them to return to full production capacity, new waves of COVID-19 continued to weigh on the industry resulting in labour shortages. Recycling levels are expected to remain high (+5% y-o-y in 2021e) due to the elevated silver prices.

The SI expects growth in silver supply in 2022 as mine production continues to normalise and silver prices remain high, encouraging recycling. It sees total global silver supply rising 7% y-o-y to 1,092Moz in 2022 (including recycling). A similar increase of 7% to a six-year high is forecast for the silver mine production.

Excluding ETP investments, silver demand saw a bigger drop in 2020 compared to supply and was down 10% y-o-y to 892Moz. The biggest reduction came from jewellery and silverware, which were more affected by the pandemic than industrial demand and physical investment, due in part to the increase in silver prices. Industrial silver consumption was down 7% y-o-y to 386Moz (excluding PV) on the back of a sharp slowdown in economic activity (global GDP down 3.6% in 2020). The only two growth areas in FY20 were PV, where demand increased 2.3% y-o-y to 101Moz, and net physical investment, which saw an increase of 8% to 253Moz.

The year 2021 was stronger for silver consumption as the global economy gradually emerged from the COVID-19 pandemic. In its latest update (January 2022), the IMF estimated global GDP growth at 5.9% in 2021 and expects it to be followed by a 4.4% expansion in 2022 (down from 4.9%). While the risks to economic growth remain on the downside, given the sharp increase in energy costs and logistical challenges caused by the war in Ukraine, some economic recovery should provide support to industrial demand, which represented c 53% of overall silver consumption in 2020. Other categories of silver consumption should also enjoy a healthy improvement. Overall, SI forecasts total silver demand to grow 15% y-o-y in 2021 driven by jewellery (+18%), silverware (+25%) and net physical investment (+32%). Industrial demand is expected to grow 8% to 524Moz. Of note is an estimated 13% increase in solar PV demand, which is forecast to exceed 110Moz.

Further demand expansion is forecast in 2022, with an estimated 8% y-o-y increase to 1,112Moz in global silver consumption. Growth is expected to be broad based, with the industrial silver use seen rising 5% y-o-y in 2022.

Along with e-mobility and electronics, PV should be one of the main drivers behind the industrial, and more generally physical, silver consumption in the long term. PV was the only area of demand that had a positive CAGR of 4.4% in 2011–2020, bringing its share in overall silver use to 11% from 7% (the overall silver demand CAGR for the same period was negative 2%). This growth was facilitated by the rapid expansion in solar power generation, with silver being a critical element in PV cell production due to its high electroconductivity and amenability to low-cost screen printing. Further strong growth in silver PV demand is estimated for 2021 and forecast for 2022.

Solar PV is expected to play a major role in decarbonisation and the ongoing shift away from fossil fuels and towards renewable energy. It could also benefit from the likely push towards higher energy security in Europe in light of Russia’s assault on Ukraine. In its latest report Net zero by 2050 (May 2021), the IEA calls for scaling up solar power generation rapidly this decade, bringing global annual solar PV capacity additions to 630GW by 2030 (vs record 134GW in 2020). According to IEA, this is equivalent to installing the world’s largest solar park almost every day. As a result, overall electrical solar PV capacity is expected to grow from 0.7TW in 2020 to 5TW in 2030. While an increase in solar power generation is inevitable, for silver it is likely to be partly offset by a gradual reduction in the silver loading in PV cells and an anticipated increase in solar cell output. According to the CRU, the amount of silver used in a solar panel fell from 521mg in 2009 to c 111mg in 2019 and is likely to fall as the industry continues to innovate.

To demonstrate growth opportunities presented by the anticipated solar power generation expansion, we provide a simplified analysis that estimates implied silver demand should annual solar PV installations reach 630GW (see Exhibit 16). We have assumed the average solar cell output increases from c 5W in 2020 to c 6W by 2030, while silver consumption per cell falls from an estimated c 110mg in 2020 to c 60mg in 2030. Our analysis implicitly assumes a reduction in the silver use from 21mg/W in 2020 (cf 53mg/W in 2012) to 10mg/W by 2030. Overall, the above assumptions imply an annual silver consumption of up to 222Moz (8% 2030–20 CAGR vs 4% for 2020–2011) from solar PV alone.

In addition to solar, PV silver use in the electronics and automotive industries is expected to grow strongly on the back of the increased adoption of BEVs, which generally have higher silver loading compared to ICE cars. At present, we do not take a detailed view on other categories of silver consumption such as jewellery and silverware, some of which could experience a reduction in demand in future.

Thanks to the recovery in demand and lower than expected rebound in mine supply, the SI estimates the silver market supply/demand balance was slightly negative in 2021 at c 7Moz. Factoring in an estimated increase in net ETP investments (at 150Moz vs 331Moz in 2020), the overall market balance is believed to have been firmly in negative territory. The second year of strong inflows in ETPs in 2021 was a result of the low interest rate monetary policy supported by the heightened economic uncertainty due to COVID-19. While the post-COVID-19 economic recovery is underway, although at a slower and less consistent rate than was originally envisaged, inflationary pressures, labour shortages and supply-chain-related risks to global economic growth suggest the investment demand for precious metals is likely to remain elevated. It should be supported by the heightened geopolitical risks in light of Russia’s Ukraine invasion. According to the SI, ETP investments saw a 6% increase in 2021 to 1,132Moz and, so far this year, remain close to these record highs. This view is supported by the data from Refinitiv, which suggest a 1% ytd reduction in silver ETF holdings (Exhibit 18). Overall, the high level of investment activity along with gradual recovery in industrial demand should continue to provide support to the silver market in the short term, underpinning silver’s unique position as an industrial metal and investment asset.

Our silver price assumptions are closely linked to our global gold forecasts (see Exhibit 19 and our report Portents of economic weakness, Gold: Doves in the ascendant). We take a view on the silver price through its relationship with gold and the gold/silver ratio. Looking at the long-term price performance, we note the ratio expands during periods of economic weakness and uncertainty combined with loose monetary policy due to gold’s prevailing investment nature. However, as macroeconomic conditions improve, silver tends to outperform gold thanks to its industrial exposure. At US$24.5/oz, our FY22 silver and gold price forecasts imply a ratio of 78x versus 72x in 2021 and five-year, 10-year and 20-year averages of 80x, 73x and 66x. While in the near term we expect risks to economic growth, inflation hedging, geopolitical tensions and potentially slower than anticipated rate hikes to remain supportive of the precious metals prices, in the long run we see a potential for the gold/silver ratio to reduce to more normal levels as economic conditions normalise and central banks implement gradual tapering. As such we expect the silver price to become increasingly driven by the industrial applications (solar PV, electric vehicles and electronics) and model a gradual reduction in the gold/silver ratio to 67x by 2027 (Exhibit 19).

We note that our long-term silver price assumptions are supported by the marginal cash cost of production, with an average global AISC of at least c US$20/oz in the fourth quartile of the cost curve. The current cost inflation driven by labour and energy will push cash costs further up across the industry. And while energy cost increases could reverse, the labour cost increases tend to be more enduring.

At the same time, while we expect silver prices to remain at relatively elevated levels, any sustainable, longer-term price increases seem unlikely as they would negatively affect price-sensitive demand (jewellery, silverware and physical investment) and potentially cause substitution.

Our base metal price assumptions are based on prevailing futures prices at March 2022.

The year 2020 was significantly affected by COVID-19, with mine shutdowns leading to a 33% reduction in silver production and a 7% fall in gold output for PAAS. However, this was almost fully offset by the higher commodity prices, with average silver and gold prices rising by 27% y-o-y. Unit costs have gone up due to production stoppages, but these increases were relatively modest at 9% for the silver and 7% for the gold segments at an AISC level and were somewhat mitigated by weaker currencies and the exclusion of COVID-19-related care and maintenance costs (c US$75m).

While 2021 saw a gradual recovery in production (+11% for both silver and gold), it coincided with a further meaningful increase in costs as unit AISC was up 37% in the silver segment and 20% in the gold segment. This was mainly a result of lingering effects of the pandemic as Latin American countries in general were hit harder by COVID-19 and lagging the western world in terms of vaccination rates, as well as ongoing technical challenges at La Colorada. That said, FY21 EBITDA was a solid US$593m (FY20: US$469m) as higher operating costs were once again offset by strong commodity prices (and lower COVID-19-related care and maintenance expenses). At the cash-flow level, however, strong EBITDA growth was eroded by a visible working capital outflow (US$71m vs US$97m inflow in FY20), resulting in net operating cash flow (OCF) falling 15% y-o-y to US$392m. The free cash flow (FCF) was down 48% y-o-y on the back of the recovery in capital spend.

The company lowered its production and silver cost guidance twice in 2021 on the back of the coronavirus-related uncertainty and slower than expected production recovery at La Colorada. The reported production numbers were within the most recent guidance revision, while the silver cash costs and AISC were slightly below. In the gold segment, cost guidance was maintained during the year and the actual costs were within the original company expectations.

With its FY21 results, the company published a new dividend policy, which is based on a fixed quarterly payment of US$0.10/share, plus an additional amount that depends on the company’s net cash position during the previous quarter. Based on the newly established policy and net cash of US$237.7m at end Q4/FY21, PAAS announced a 20% increase in its quarterly dividend to US$0.12/share. The overall dividend paid in FY21 was to US$0.34/share, a 73% pay-out ratio and a 55% increase on FY20.

The company has also reported its production and cost guidance for FY22, with expectations of total silver and gold production of 19.0–20.5Moz and 550.0–605.0koz, respectively. At the midpoint, this guidance is broadly in line with FY21 production for both silver and gold. In the silver segment, the loss of output from Morococha is expected to be offset by the continuing recovery in production at La Colorada. While 2022 is likely to be another transition year for the project, it is expected to produce an impressive 6.85–7.10Moz of silver in FY22 versus 5.2Moz in FY21. This growth is driven by the investment the company made to resolve the ventilation-related issues the project was facing in 2020 and 2021, as well as the diminishing COVID-19-related operational restrictions.

Despite the current cost inflation, particularly for energy and labour costs, which is likely to persist throughout the year and decommissioning of the low-cost Morococha mine, the silver segment cash costs and AISC are expected to reduce year-on-year. Improved cost performance is a result of the anticipated increase in production at La Colorada and its growing share in the segment’s overall silver output. In the gold segment, PAAS guides an increase in both cash cost and AISC, as all mines except for Dolores are expected to see higher costs driven by general cost inflation and operational factors. Overall, PAAS is not immune to the industry-wide cost pressures, which can be seen in the most recent 2022 cost and production updates from other primary silver producers.

Our near-term earnings expectations for PAAS are driven by three main factors: a broadly flat production profile for both silver and gold, higher costs in FY22, which we expect to start reducing gradually from 2023, and flat to slightly lower near-term annual commodity price expectations. Taken together, this suggests a broadly flat earnings profile in FY22–23. Longer term, we model a restart of the Escobal project from 2024, which should have a pronounced impact on the company’s operating and financial performance due to its large scale and low-cost positioning.

More specifically, we expect FY22 revenue of US$1.7bn and EBITDA of US$613m, slightly up on FY21 thanks to the higher average gold price (US$1,910/oz vs US$1,800/oz in FY21), which we expect to offset weaker silver price (US$24.5/oz vs US$25.1/oz) given gold’s bigger contribution to revenues and earnings, as well as a moderate increase in gold and silver production. In the silver segment, we expect the ongoing production recovery at La Colorada to largely compensate for the loss of Morococha. While we pencil in some cost increases, mainly due to the higher energy and labour costs, our cash cost and AISC assumptions are towards the lower ends of the company’s guidance as we assume higher by-product prices/credits. Given the strength in commodity prices, we note that a 10% increase in our silver and gold price expectations would boost our FY22 EBITDA by c 20%.

In FY23, while we expect to see some initial signs of cost normalisation, mainly due to a reduction in the energy prices but assuming labour cost increases will be difficult to reverse, our assumptions of lower average commodity prices suggest a reduction in revenues and earnings.

Our FY24 base-case forecasts assume a potential restart of the Escobal project, which we include for the full year for the purposes of our model. While visibility remains low, given the recent encouraging progress in the consultation process, we believe our expectations are not unreasonable. Our model for Escobal is based on the 2014 feasibility study. We estimate that the project contributes c 30% to our FY24 EBITDA. PAAS currently burns about US$20m per year in care and maintenance costs on the project, which means once it is restarted these costs should flow straight through to EBITDA.

The company’s core business is highly cash generative. While FY21 OCF and FCF were affected by higher taxes and working capital outflows, we see a potential for cash-flow generation to improve in FY22 on the back of the strong underlying performance and some working capital normalisation. We model a 23% improvement in OCF in FY22 and a 43% growth in FCF despite an increase in development capex. This improving cash-flow generation profile should translate into healthy dividend growth in line with the company’s newly established dividend policy. Based on our estimates, we forecast FY22 DPS of US$0.48/share, a 41% increase on FY21. This translates into a dividend yield of 1.8%.

In FY21, PAAS spent US$254m in capex, comprising US$208m in sustaining (including lease payments) and US$47m in project/development expenditure. Development capex mainly related to the exploration work at La Colorada Skarn (US$40m) and the Wetmore exploration project at Timmins. PAAS guides FY22 sustaining capex at US$176–186m before leases (US$24m) and project capital at US$80–95m. The overall development spend at La Colorada is expected at US$68-81m and will be directed at the continued exploration work, ramp construction, further upgrades to the ventilation system and a refrigeration plant commissioning. Our FY22 total capex estimate is US$270m excluding lease payments.

Having performed strongly in 2020–2021 on the back of the coronavirus-induced economic uncertainty and high silver and gold prices, PAAS shares have started the year on a weaker note as markets have been pricing in expectations of rapid monetary tightening, putting pressure on the precious metal prices and shares. However, while 2022 is expected to be a year of post COVID-19 economic normalisation, the war in Ukraine has significantly increased risks to economic recovery, with higher energy prices, supply-chain disruptions and labour shortages pushing global inflation rates further up. Against this backdrop, precious metal prices have regained ground, with silver and gold now trading c 16% and c 10% higher than their recent troughs. As commodities in general drive earnings and stocks, the current strength in the silver and gold prices provide support to PAAS shares. We believe that the short-term risks to commodity prices and therefore consensus earnings estimates for PAAS are on the upside, which should remain supportive of its share price. Other share price catalysts include progress on the Escobal consultation process and news on the La Colorada Skarn development.

Our fundamental valuation of PAAS is based on the DCFE. In essence, we assume the company pays out all net cash-flow generated during the year as a theoretical dividend to equity holders. Our DCFE is based on a five-year explicit forecast period and a terminal value (see Exhibit 31). While this is not the most common approach to valuing mining equities, we believe that given the size of the company’s mineral resource base and its track record of replenishing its mineral reserves, the use of terminal value is justified. However, our terminal cash flow of US$1.7/share (FY27e) is conservative and assumes depletion of three currently producing mines (Dolores, Manantial Espejo and La Arena), as well as the recent decommissioning of Morococha, but includes Escobal, which we assume will be restarted in FY24. Our operational and financial assumptions for Escobal are based on the project’s feasibility study.

Overall, our DCFE returns a value of US$26.2/share at a 7.0% discount rate. This valuation does not take into account the company’s advanced greenfield projects Navidad, La Colorada Skarn and La Arena II, which together add US$3.9/share based on our estimate of the value of global in-situ silver resources for the first two projects and the book value for the latter. In particular, in valuing the Skarn project, we considered the larger scale silver exploration companies such as New Pacific Metals (PAAS owns c 10%), Silver Mines and Dolly Varden. These trade on an average EV/resource multiple of c US$1.4/oz of contained silver. In addition, PAAS holds a number of investment interests, in particular in Maverix Metals (NYSE: MMX; precious metals royalty company), in which PAAS owns c 17% (c US$120m, or US$0.6/share, at the current share price). Including the greenfield projects, the stake in Maverix, and the Morococha valuation, we reach a total value per share for PAAS of US$31.0 per share.

In deriving our discount rate, we have used the following considerations. While PAAS is virtually debt free, assuming a typical debt/equity capital structure of 30/70%, equity risk premium of 4.7% for Canada (source: Damodaran, Stern School of Business), pre-tax cost of debt of 3.0% (broadly in line with the company’s US$500m revolving credit facility), risk free rate of 2.5% (Canada’s 30-year bond yield), beta of 1.1% and an arbitrary 1.5% country risk premium to account for the fact that the majority of company’s operations are in Latin America, produces a (nominal) WACC of 7.0%. It is based on a cost of equity of 9.2% in nominal terms, or c 5% in real terms.

Our model for PAAS is a mixture of ‘real’ and ‘nominal’ approaches because, although we assume some cost normalisation post COVID-19 and the recent energy price spike, our long-term costs and commodity prices are expressed in real terms. We provide a valuation sensitivity to changes in the discount rate and commodity prices in the table below. In addition to these sensitivities, we note that Escobal contributes c US$7/share, or c 20%, to our base-case DCFE valuation.

The peer group valuation for PAAS is not straightforward as there are very few primary silver producers of comparable size. In addition, PAAS generates a significant share of its revenues and earnings from gold, which also reduces the choice of appropriate peers. In Exhibit 33 we put together peer groups for silver and gold companies. We note that the silver peer group trades at a significantly higher EV/EBITDA and P/E multiples compared to our selection of gold companies. Among other things, this could be a reflection of potentially diverging commodity price cycles for gold and silver, as the former is perceived as a pure investment asset, with prices likely peaking in light of the inevitable monetary tightening, while the former has a significant industrial exposure and should therefore benefit from the longer-term economic normalisation and the role silver is expected to play in the energy transition.

Compared to its silver peers, PAAS trades at a c 16% discount on FY22e EV/EBITDA and a c 29% discount on FY22e P/E based on our estimates. Consensus estimates imply slightly lower discounts of c 13% for EV/EBITDA and c 26% for P/E. Relative to our sample of gold companies, PAAS trades at 31% and 44% premiums based on FY22e EV/EBITDA and P/E multiples.

The difference between Edison and consensus FY23 multiples is likely due to the fact that some expectations of the Escobal restart are already built into FY23 market numbers versus our expectations of the project’s restart in FY24.

We see a number of risks that could affect PAAS’s financials and valuation.