Pan American Silver — Mixed Q2 results, Escobal progress

PAAS’s Q222 results were affected by higher costs, lower commodity prices and sales as well as non-cash one-off items. The company saw revenue falling 22.6% q-o-q to US$340.5m and EBITDA coming in at just US$17.9m, a reduction of 86% versus Q122. Sequentially, production was broadly flat for both silver and gold, however sales were down 13.0% q-o-q for silver and 19.4% for gold. Coupled with the industrywide cost pressures and a single-digit quarterly reduction in silver and gold prices, this has resulted in a visible squeeze in profits (see Exhibit 1). At the project level, all operations performed broadly in line with management expectations, except for Dolores, which underperformed in terms of both open-pit grades and production and where the decision was taken to suspend underground mining operations due to cost escalation. As a result, PAAS incurred a one-off adjustment to the net realisable value of inventories (NRV) and an impairment charge, in total amounting to US$155m. Adjusted for these items, the Q2 net loss was US$6.5m.

While the P&L was heavily affected by one-off items, the company’s cash flow performance in Q2 was more positive, as it reported operating cash flow before tax of US$63m (US$21m post tax). However, with capex of US$72m, the free cash outflow for the quarter was US$51m.

PAAS remains well capitalised with a net cash position of US$178m (including short-term investments of US$46.4m and gross cash of US$195m) at end June 2022 and US$500m in an available sustainability linked credit facility. In line with its dividend policy, the company declared a cash dividend of US$0.11/share for the quarter.

The silver segment maintained its strong production momentum in Q2, as the company’s flagship La Colorada project continued its operational recovery on the back of the improved ventilation rates, which allowed access to higher grade zones and higher throughput. Having produced 1,675koz of silver (1,419koz in Q122), La Colorada reported an impressive cash cost of US$9.4/oz (Q122: US$9.7/oz) and an all-in sustaining cost (AISC) of US$13.3/oz. Among other projects that contributed to the segment’s strong performance was San Vincente, which saw a 36% q-o-q increase in silver production and a reduction in cash cost to US$12.0/oz (Q122: US$19.4/oz). At the same time, the project that detracted the most from the performance was Manantial Espejo; its silver production and costs were affected by lower grades.

Despite some inevitable increase in production costs, the silver segment demonstrated an impressive cost performance, with an overall cash cost of US$12.1/oz (Q122: US$10.2/oz; Q221: US$12.7/oz) and an AISC of US$17.3/oz (Q122: US$13.4/oz; Q221: US$16.4/oz).

The gold segment’s performance was mixed, with Timmins and Shahuindo delivering solid operational and financial results, while Dolores was disappointing, which caused an impairment, the revision to mineral reserves and resources and the suspension of underground mining at the project. The segment’s overall cash cost was US$1,132/oz in Q222 versus US$1,070/oz in Q122, while the AISC adjusted for NRV inventory revaluations was US$1,540/oz.

Gold production at Shahuindo was down 8% q-o-q to 31.6koz, mainly due to the lower estimated gold recovery, while payable gold sales were 11% lower at 30.1koz. The project’s cash cost came in at US$1,032/oz versus US$915/oz in Q122. Compared to Q221, gold production was up 4% as a result of higher throughput. At Timmins, gold production was up 19% q-o-q to 37.8koz thanks to the higher gold grades, while payable sales were down 2% to 34.8/oz. The project’s cash cost was down 9% q-o-q to US$1,288/oz, while the AISC was 8% lower at US$1,556/oz.

According to the company, Dolores has underperformed year to date in terms of both silver and gold production due to the lower than expected open-pit grades. In addition, inflationary cost pressures have led PAAS to suspend underground mining operations at the project and reclassify its underground reserves into resources. In H122, Dolores produced 1.1Moz of silver, a reduction of 13% versus H121, and 80koz of gold (-13% y-o-y). The project’s Q222 cash cost was US$1,066/oz (Q122: US$977/oz), while AISC jumped to US$3,138/oz (Q122: US$1,683/oz). Stripping out the US$58m NRV inventory adjustment, AISC was US$1,446/oz (Q122: US$1,362/oz).

In the latest technical report on Dolores published by the company in March 2017 (effective December 2016), the project was estimated to have 64.1Mt in proven and probable reserves at 0.73g/t gold (Au) and 54g/t Ag, comprising 53Mt in open-pit ore, 4Mt in underground ore and 7Mt in stockpiles. Both open-pit and underground mining was initially expected to continue until 2024, with stockpiles processed for another two years. Nominal processing rates were envisaged at 20ktpd, including 14.4ktpd (c 5.3mtpa) in the crushing circuit and 5.6ktpd (c 2.0mtpa) in the pulp agglomeration circuit. Underground ore was expected to be processed through the agglomeration circuit at a rate of c 0.6mtpa, with the open-pit ore and stockpiles processed via both pulp agglomeration and crushing.

As of June 2022, Dolores was reported to have proven and probable reserves (both open-pit and stockpiles) of 17Mt at 0.58g/t Au and 20g/t of Ag. Assuming the agglomeration circuit remains fully utilised, at full nominal processing capacity the updated reserves would allow production for about another two years. It also remains to be seen to what extent the suspension of the underground mining will affect production costs, as open-pit mining costs and crushing circuit processing costs are significantly lower compared to underground and pulp agglomeration. In its updated FY22 guidance, the company reported that it expects Dolores’s H222 AISC to be US$1,275–1,375/oz (excluding NRV adjustments), which given the Q2 AISC of US$1,446/oz implies a reduction of US$71–171/oz.

One of the positive highlights of the results announcement was that the ILO 169 consultation process for the Escobal mine has progressed to the consultation stage. The pre-consultation phase consisted of eight meetings, with the final one held on 20 July 2022. To recap, the purpose of pre-consultation was to define and agree the terms, timelines and mechanisms under which the consultation will take place. The process is led by the Ministry of Energy and Mines and includes various parties along with the Xinka indigenous community and PAAS. The current consultation phase represents the formal dialogue process, with the aim of reaching final agreements among the main participants. The final stage of the process is the Supreme Court verification. The first meeting of the consultation phase is scheduled for 21 August.

Escobal is a large-scale, top-tier silver project in Guatemala that is capable of producing on average 15Moz of silver per annum over 20 years. The project is currently on care and maintenance pending the completion of the ILO 169 consultation process, and once its licence is restored, we understand it could take a few months to resume production. In our model, we continue to assume that Escobal is restarted in 2024.

Along with its Q222 financial results, PAAS has also reported its latest mineral reserves and resources estimates as at June 2022. The company’s overall proven and probable reserves stood at 515Moz of contained Ag and 3.6Moz of contained Au, compared to 529Moz of silver and 4.2Moz of gold as of June 2021. In terms of contained silver, the total measured and indicated resource saw an increase of 21Moz, while the total inferred resource was 47Moz higher than June 2021. These increases came on the back of the strong resource replacement rates at the company’s producing silver operations. Contained gold estimates were marginally lower in both measured and indicated and inferred resource categories.

In the silver segment, producing operations drove a significant increase in the mineral resources, which saw an increase of 50Moz of contained Ag, while mineral reserves were down 5Moz. At the project level, Huaron enjoyed a healthy boost to both mineral reserves and resources, adding 2.8Moz of contained Ag in proven and probable reserves and 9.1Moz in combined measured and indicated and inferred resources. At La Colorada, proven and probable reserves remained broadly flat, while total mineral resources increased by an impressive 58Moz of contained Ag.

Mineral resources for non-producing operations were unchanged. The published resource update did not include any changes to the mineral resources at the company’s development La Colorada Skarn project. The company plans to provide a resource update on this project in Q322.

In the gold segment, producing operations saw a reduction in the proven and probable reserves of 0.5Moz of contained Au, with measured and indicated and inferred resources falling by 0.3Moz compared to June 2021. Of note however is that at La Arena the company replaced 46% of mined production and extended the mine life by six months, at Shahuindo 81% of mined production was replaced, while at Timmins the reserves replacement rate was 26%.

The company maintained its FY22 production outlook provided in February, noting that production is likely to be towards the lower end of the range for both silver (19.0–20.5Moz) and gold (550–605koz) and is also expected to be second-half weighted. With the exception of Dolores, production in H122 was consistent with the company’s original operational outlook. Cost performance in the silver segment has also been in line with management expectations and the cost guidance for the segment has therefore been reiterated at US$10.7–12.2/oz (H122: US$11.1/oz) for cash cost and US$14.5–16.0/oz (US$15.2/oz) for AISC. In the gold segment, due to the underperformance of Dolores, cash costs are now expected to be at the higher end of the original guidance (US$970–1,070/oz), while AISC expectations have been raised to US$1,450–1,550/oz from US$1,240–1,365/oz, before NRV adjustments. This compares to the segment H122 cash cost and AISC before NRV adjustments of US$1,097/oz and US$1,467/oz, respectively.

In addition, the company revised its FY22 capital expenditure guidance from US$280–305m to US$295–310m (H122: US$140m), with the sustaining capital estimate increased from US$200–210m to US$240–250m (US$112.5m). The main reason for this revision is the company’s decision to fund a number of investment projects (in particular at La Arena and Shahuindo) internally rather than via construction loans. This decision affects the timing of the expected cash outflows, but not the overall capital spend on the projects.

We have updated our earnings estimates to reflect the Q222 results, revised guidance and the recent commodity price fluctuations. We now assume an average silver price of US$21.9/oz in FY22, a reduction of 5% versus our prior estimate, and a gold price of US$1,830/oz, down 1%. We have also slightly adjusted our production expectations factoring in management’s revised guidance and now expect FY22 silver production of 19.3Moz (from 20.0Moz) and gold production of 570koz (from 584koz). In addition, we have slightly adjusted our cost estimates. While our silver segment cash cost forecast remains broadly unchanged at US$11.1/oz, we raise our gold segment cash cost estimate from US$1,048/oz to US$1,090/oz, slightly above the top end of the company’s guidance range. Our revised gold segment AISC excluding NRV adjustments is US$1,453/oz (US$1,582/oz after NRV), at the lower end of the company’s revised guidance.

The above adjustments lower our FY22 revenue estimate by 6% to US$1,615m and our EBITDA estimate by 29% to US$400m. Our revised estimates compare with FY22e consensus revenues of US$1,583m and EBITDA of about US$369m (source: Refinitiv). We have also lowered our FY23 estimates, with EBITDA down 12% to US$510m, mainly due to the higher cost expectations as a result of the higher FY22 cost base.

We reduce our combined valuation of PAAS from US$29.5/share to US$27.5/share on the back of the revised earnings estimates. We maintain our resource-based valuation of the La Colorada Skarn project while we await the release of the updated resource estimates later in the quarter. PAAS shares have come under renewed pressure recently after somewhat disappointing Q2 results and are now trading c 30% down year-to-date. Commodity prices remain volatile as investors continue to digest a flow of mixed economic news, gauging the severity of the global economic downturn as well as the speed of monetary tightening and the potential reduction in inflation. Having gained some support recently, the silver price is now c 12% below the levels seen at the beginning of the year, while the gold price is down only 3%, with the gold/silver ratio still elevated at c 86x. While slower economic growth and lower disposable incomes will undoubtedly affect industrial and physical silver consumption in the near term, some support could come from the booming solar photovoltaic (PV) industry, relatively resilient electric vehicle demand as well as inflation hedging on the investment side. Based on the latest data from Refinitiv, total silver ETF physical holdings have recently shown some signs of stabilisation after falling c 5% year-to-date (10% from the 2022 peak). The gold price remains supported by current expectations of the slower interest rates increases due to global macroeconomic risks, but the inevitable monetary tightening should continue to put pressure on gold in the medium term. We continue to model a gold price (real) of US$1,749/oz in FY23.

On our updated estimates, PAAS is trading on FY22e EV/EBITDA of 8.4x, falling to just 6.6x in FY23e. Despite the currently reduced short-term earnings visibility, this appears to be a relatively undemanding multiple compared to silver peers. While investors’ focus at present seems to be mainly on the near-term operational challenges, cost inflation and weak global economy, we believe that silver’s longer-term role as one of the energy transition metals and a strong beneficiary of decarbonisation should not be overlooked by investors. In our view, PAAS represents an attractive exposure to the commodity due to its quality project portfolio and the relatively long-life and low-cost nature of its core silver operations.