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November 1, 2007

By: Don Hansen

     Starting about a year ago, I wrote a series of four articles, each on a different mining company, presenting information and forecasting results that led me to conclude on a market capitalization for these companies as of December 2007 for Endeavour Silver, Great Panther and First Majestic, and May 2007 for Impact. Unfortunately, my forecasts look extremely optimistic at this point given that most of these companies are currently trading at half or less the predicted market cap! The problem was not the silver price, since I used $12/oz. in my analysis and that has been achieved and then some.

     So, what happened?  I think the following developments got in the way:

(1) Production problems were experienced as output was expanded. Comparing forecasts used in the articles to current company forecasts for 2007 production we have: Endeavour -34%, Great Panther -50%, First Majestic -18% and Impact -33% (to be fair to Impact, management did not make an official forecast like the other three).

(2) The amount of money spent and expensed on exploration drilling was not adequately accounted for in my analysis.

(3) Stock options granted by several of the companies were expensed in the current year, and in my opinion these grants were large in relation to current revenue and profits.

     OK, so what to do now? Well, I am not going to forecast market caps again. As an investor in silver mining shares, however, I need to continually evaluate the companies I own in order to make investment decisions. Therefore, I decided to look at silver mining shares using alternate value strategies in order to create a broader picture. I have also added to the roster of companies, compiling and examining data on eleven of them so as to provide a wider base of comparison.

     The companies and their trading symbols are as follows:

     Toward the bottom of this commentary, you will find a number of tables containing what I believe are relevant production, resource and financial data for the purposes of assessing the relative values of these 11 companies. While not offering profit or market cap forecasts at this time, I would like to discuss this data and offer some perspectives that may prove useful.

     Before I do that, I'd like to mention that Pan American is included in this group only because it is the most mature and largest market cap producer in the silver sector, and therefore it provides a good benchmark for comparison purposes.

The Most Mature Junior?

     The most mature producer in the junior group, by the way, appears to be First Majestic. This company came closest to its own production forecast from a year ago, and it already has a large resource base to feed its three plants (24 years of silver production at the projected 2009 rate). In fact, First Majestic compares very favorably to Pan American, which has 9 years of mine life on the same basis. While Pan American's 2009 production rate forecast is about 8 times that of First Majestic, so is its September 30, 2007 market cap. The values of the two company's ores are roughly the same in terms of revenue per tonne, so their relative market caps look reasonable. However, the production rate for 2009 for First Majestic is assumed to be the same as that for 2008 because the company did not wish to commit to a bigger number. And, with the resources already as large as they are, I believe First Majestic has the opportunity to ramp up production substantially in 2009 as compared to 2008. So, I would conclude that First Majestic has more upside potential from here than Pan American, and probably less risk than most of the other juniors. At the same time, I would have some concern for the level of resources that Pan American has delineated in relation to its planned production rate.

All Ore is Not the Same

     A number that I found very revealing, and that I had not closely examined before, is ore valuation. As you can see in the tables below, there are three companies that stand out from the others: Excellon, Fortuna and Silvercorp. To show where these numbers came from, I will go through a calculation of one of the numbers for you. Excellon's ore has around 1,500 gpt silver, so with 31.1 grams/troy ounce and $13/oz. silver, each tonne of Excellon ore has $630 worth of silver.  Since silver is 50% of revenue, the total metal value in Excellon's ore is about double that, or $1,260.

     While studying the data tables below and comparing the ore value numbers to the other data, I noticed a few interesting relationships:

     (1) Companies with ore values in the same range (e.g., either about $200/ton or $1,000/ton) had market caps that were proportional to their production levels. For example, we have previously noted that both the market cap and production level of Pan American is approximately 8 times that of First Majestic. Similarly, when we compare Pan American to Endeavour Silver, we find that both market caps and production rates are about 10 times higher for Pan American. In the case of Endeavour Silver and Genco, the market cap and production ratios are once again about the same at 1.5:1. Coincidence? Maybe, but there must be something more to this given that companies with ore valuations on the opposite end of the scale such as Silvercorp and Fortuna have similar ratios between market caps and production levels as well (4:1 in this instance).

     (2) Comparing companies with $1,000/tonne ore to those with $200/tonne ore, it appears investors award about twice the market cap for companies with superior grades of ore, other factors being equal. For example, comparing Pan American to Silvercorp, we find that the former has about 4 times the production level but only twice the market cap. Similarly, a comparison of First Majestic to Fortuna shows that First Majestic has twice the production rate but about the same market cap as Fortuna.

     What appears to be happening here is that the market values these companies based on very simple assumptions. First, performance is being assessed in terms of silver equivalent ounces giving no preference to silver over base metals. This is a surprise in itself given all that we've heard about the higher multiples afforded to silver production. Instead, it seems that higher ore values are being given a premium. In effect, the market assumes that junior producers with similar ore values will have similar profit margins regardless of the ore type. At the same time, producers with higher ore values ($1,000/tonne) are being valued as if they will earn twice the profit of those with lower grade ore ($200/tonne).

Do Resources Matter?

     I could not ascertain a correlation between the 11 companies using only their resource data, although we all know that the more resources, the higher the market cap should be. For example, if Silvercorp were to increase its resources to 400 million ounces of silver from the current 123 million ounces, its market cap would surely go up. It should therefore follow that my above comparison of Pan American to Silvercorp should no longer work. It is very possible, however, that resource numbers have a much smaller impact on market cap than many investors assume. Whatever the influence, it is mainly at the extremes: either too little resource vis-à-vis production implying a short mine life, or a bounty implying a potential ramping up in future production.

     Something of a relationship can be recognized when we look at producers with credible production forecasts for 2008 and at least 10 years of resources to support that production. To see this, we first multiply the 2008 production forecast by a silver price of $13/oz. to obtain a 2008 revenue forecast. Then, we can apply a multiple to this revenue forecast to arrive at a market cap. Interestingly, when we use a multiple of 4 for the companies with approx. $200/tonne ore value, we come close to the current market caps for quite a few of them. A multiple of 8 gets us to the same point for the companies with approx. $1,000/tonne ore value. Once again, this supports my prior contention of a fixed relationship between market multiples and ore values. I don't know how long this relationship has existed, or how long it will exist in the future, but it is there right now. Here is the math to prove it:

Grades Do Matter

     I think it obvious that if the three companies with superior grades of ore actually have substantial resources at these high grades, they will make big profits for their shareholders. Silvercorp has already proven up 123 million ounces of silver resources and their market cap is about $1.1 billion.  Many writers in this market believe their Ying deposit in China has much more metal to yield, maybe in the range of 1 billion ounces of silver. If proven true, this should greatly increase Silvercorp's market cap as its production, profits and mine life would increase proportionately in the future.

     The next company of the superior grade group is Fortuna. Although the company only gets 18% of its revenue from silver, the ore still contains 450 gpt, which makes it high grade on account of the silver alone. In fact, only Silvercorp and Excellon have a higher average silver grade. As with the other two, Fortuna's ore is both silver rich and also very high grade in zinc and lead. At a market cap of $280 million with 55 million ounces of silver resources that represent only a fraction of total revenue, it appears to me that Fortuna has a great deal of upside from here.

     Last but not least is Excellon in the superior ore grade group. I believe Excellon may be the most undervalued stock of those covered in this analysis. Its rock is the richest of the lot, but the company has too little in terms of resources to really convince investors that they have hit paydirt. But, with a market cap of only $220 million and significant ongoing production bringing in substantial profits, I think there is minimal downside and enormous upside if Excellon can prove up a major resource with the present ore grade. With exploration success, Excellon should look to follow in the footsteps of Silvercorp in terms of valuation. And, the company has Peter Megaw as part of its exploration staff, a geologist who has had tremendous success finding major deposits in Mexico. If memory serves me well, he was recently involved with the MAG Silver team that made a big discovery earlier this year.

The Best of the Rest

     OK, so how about the other companies? Well, I own shares in all eleven, so I don't see a bummer in the bunch. I do believe, however, that Genco is undervalued at only $137 million, especially when considering the resources they have already acquired and the quality of management, which I believe is first rate. Greg Liller has built a mine from the ground up in Mexico before, and I am confident he will do it again with Genco.

     Also, I think Impact may prove to be a big winner down the road as the company develops its properties. The company's market cap is only $77 million, the lowest of the producers (Silver Eagle is conducting test mining only at this point). And although the company is currently mining relatively low grade of ore, it is remarkably doing so at a profit, unlike most of its peers. Management is very conservative financially, so I see minimal downside with the stock at this level.

     If any of these companies might be called overvalued, it would be ECU based on the tables presented in this analysis. The Company is expecting a new 43-101 resource in late November or early December, but its current market cap of $590 million means the resource numbers will be have to more than just impressive to justify the valuation.

     One final thought to keep in mind regarding the companies with a large portion of revenue from zinc and lead is that the prices of these base metals have gone up considerably more than silver and gold up to this point in the resource bull market. If you believe we are headed for worldwide recession and lower base metals prices, then many of the comparisons explored in this commentary may no longer work. For example, ore grade could matter less than the composition of the ore. This in turn would impact market valuations, and producers like Genco with good gold grades and no lead/zinc would likely benefit, while Fortuna would probably suffer. Some writers even advocate favoring gold over silver, and avoiding all industrial metals, most notably Doug Casey.

     My personal view is that silver will experience increasing investment demand along with gold and that its industrial demand is a plus not a minus.  David Morgan says both gold and silver will be sought after as a store of value in the inflationary times in which we live. As the poor man's gold, silver may get a lion's share of the demand for a store of value, seeing that there are more poor men (and women) in this world than there are rich. Furthermore, because 75% of the mine supply of silver is from base metal mining, a recessionary environment that affects base metal production may actually curtail the supply of silver. If investment demand continues unabated due to worldwide monetary inflation, we have the recipe for silver fireworks.

     I hope this information and commentary is of value to you. In the future, I plan to examine other relationships using this data as well as expand the number of companies if warranted. Tom Szabo of www.silveraxis.com has asked if I would consider updating this analysis regularly for his readers, and I have taken it under advisement. Please know that I received no compensation from anyone for writing the above, and I own shares in all eleven companies.

The Tables

     The first data table is production forecasts for 2007, 2008, 2009, and a few for 2010. The numbers are all in millions of silver equivalent troy ounces, and were given to me by the companies as their best estimates. The figures for Pan American and Excellon were calculated by me independently because these two companies provide their production figures for silver and other metals separately. Some of the data represents best guesses on my part as noted with an asterisk.

     The resource data as currently claimed by each company is shown below. Most companies indicated new numbers will be forthcoming this quarter or in the first quarter of 2008.

    The next table presents basic information about the ore that the companies are currently mining (based on current metal prices, which of course will change in the future).

     The following table presents my calculation of the value of the metals in the ore currently being mined by each company. Silver Eagle is not mining enough for this number to mean very much in their case. I assumed a silver price of $13/oz. for this calculation and used the above ore composition table to derive these ore values.

     Finally, we have the share price and market cap data for each company as of September 30, 2007. I am using fully diluted share numbers this time, whereas I used shares outstanding in my earlier articles. I now believe that the fully diluted number is more meaningful since the expected rise in share prices should make most options and warrants "in the money" and therefore likely to be exercised.

 Copyright © 2007 Don Hansen