Silver Mining Stocks SIL ETF Q2'18 Fundamentals / Commodities / Gold and Silver Stocks 2018

The major silverminers’ stocks have been thrashed, pummeled to brutal multi-year lows.  They suffered serious collateral damage assilver plunged on gold’s breakdown, driven by crazy-extreme all-time-recordsilver-futures short selling.  All thistechnical carnage left investors reeling, devastating sentiment.  The silver miners’ recently-reported Q2’18results reveal whether their anomalous plunge was justified fundamentally.

Four times a yearpublicly-traded companies release treasure troves of valuable information inthe form of quarterly reports.  Companiestrading in the States are required to file 10-Qs with the US Securities andExchange Commission by 45 calendar days after quarter-ends.  Canadian companies have similarrequirements.  In other countries withhalf-year reporting, many companies still partially report quarterly.

Unfortunately theuniverse of major silver miners to analyze and invest in is pretty small.  Silver mining is a tough business bothgeologically and economically.  Primarysilver deposits, those with enough silver to generate over half their revenueswhen mined, are quite rare.  Most of theworld’s silver ore formed alongside base metals or gold.  Their value usually well outweighs silver’s,relegating it to byproduct status.

The Silver Institutehas long been the authority on world silver supply-and-demand trends.  It published its latest annual World SilverSurvey covering 2017 in mid-April.  Last year only 28% of the silver mined aroundthe globe came from primary silver mines! 36% came from primary lead/zinc mines, 23% copper, and 12% gold.  That’s nothing new, the silver miners havelong supplied less than a third of world mined supply.

It’s very challengingto find and develop the scarce silver-heavy deposits supporting primary silvermines.  And it’s even harder forging theminto primary-silver-mining businesses. Since silver isn’t very valuable, most silver miners need multiple minesin order to generate sufficient cash flows. Traditional major silver miners are increasingly diversifying into goldproduction at silver’s expense, chasing its superior economics.

So there aren’t manymajor silver miners left out there, and their purity is shrinking.  The definitive list of these companies toanalyze comes from the most-popular silver-stock investment vehicle, the SILGlobal X Silver Miners ETF.  Inmid-August at the end of Q2’s earnings season, SIL’s net assets were running6.7x greater than its next-largest competitor’s.  So SIL continues to dominate this small nichecontrarian sector.

While SIL has itsflaws, it’s the closest thing we have to a silver-stock index.  As ETF investing continues to eclipseindividual-stock picking, SIL inclusion is very important for silver miners.  It grants them better access to the vastpools of stock-market capital. Differential SIL-share buying by investors requires this ETF’s managersto buy more shares in its underlying component companies, bidding their stockprices higher.

In mid-August as the silverminers were finishing reporting their Q2’18 results, SIL included 23 “SilverMiners”.  Unfortunately the greatmajority aren’t primary silver miners, most generate well under half their revenues from silver.  That’s not necessarily an indictment againstSIL’s stock picking, but a reflection of the state of this industry.  There aren’t enough significant primarysilver miners left to fully flesh out an ETF.

This disappointingreality makes SIL somewhat problematic. The only reason investors would buy SIL is they want silver-stock exposure.  But if SIL’s underlying component companiesgenerate just over a third of their sales from silver mining, they aren’t goingto be very responsive to silver price moves. And most of that ETF capital intended to go into primary silver minersis instead diverted into byproduct silver miners.

So silver-mining ETFssucking in capital investors thought they were allocating to real primarysilver miners effectively starves them.  Their stock prices aren’t bid high enough toattract in more investors, so they can’t issue sufficient new shares to financebig silver-mining expansions.  This isexacerbating the silver-as-a-byproduct trend. Only sustained much-higher silver prices for years to come could reversethis.

Every quarter I diginto the latest results from the major silver miners of SIL to get a betterunderstanding of how they and this industry are faring fundamentally.  I feed a bunch of data into a bigspreadsheet, some of which made it into the table below.  It includes key data for the top 17 SILcomponent companies, an arbitrary number that fits in this table.  That’s a commanding sample at 95.8% of SIL’stotal weighting!

While most of these top17 SIL components had reported on Q2’18 by mid-August, not all had.  Some of these major silver miners trade inthe UK or Mexico, where financial results are only required in half-yearincrements.  If a field is left blank inthis table, it means that data wasn’t available by the end of Q2’s earningsseason.  Some of SIL’s components alsoreport in gold-centric terms, excluding silver-specific data.

The first couplecolumns of this table show each SIL component’s symbol and weighting withinthis ETF as of mid-August.  While most ofthese stocks trade on US exchanges, some symbols are listings from companies’primary foreign stock exchanges.  That’sfollowed by each miner’s Q2’18 silver production in ounces, along with itsabsolute year-over-year change.  Nextcomes this same quarter’s gold production.

Nearly all the majorsilver miners in SIL also produce significant-to-large amounts of gold!  That’s truly a double-edged sword.  While gold really stabilizes and boostssilver miners’ cash flows, it also retards their stocks’ sensitivity to silveritself.  So the next column reveals how pure these elite silver miners are,approximating their percentages of Q2’18 revenues actually derived fromsilver.  This is calculated two ways.

The large majority ofthese top SIL silver miners reported total Q2 revenues.  Quarterly silver production multiplied bysilver’s average price in Q2 can be divided by these sales to yield an accuraterelative-purity gauge.  When Q2 salesweren’t reported, I estimated them by adding silver sales to gold sales basedon their production and average quarterly prices.  But that’s less optimal, as it ignores anybase-metals byproducts.

Next comes the majorsilver miners’ most-important fundamental data for investors, cash costs andall-in sustaining costs per ounce mined. The latter directly drives profitability which ultimately determinesstock prices.  These key costs are alsofollowed by YoY changes.  Last but notleast the annual changes are shown in operating cash flows generated and hardGAAP earnings, with a couple exceptions necessary.

Percentage changesaren’t relevant or meaningful if data shifted from positive to negative or viceversa, or if derived from two negative numbers. So in those cases I included raw underlying data rather than weird ormisleading percentage changes.  Thiswhole dataset together offers a fantastic high-level read on how the majorsilver miners are faring fundamentally as an industry.  Was their recent plunge righteous?

Production is naturallythe lifeblood of the silver-mining sector. The more silver and increasingly gold that these elite miners can wrestfrom the bowels of the earth, the stronger their fundamental positions andoutlooks.  These top 17 SIL silver miners failed to increase their miningtempos over this past year.  Theircollective silver and gold production deteriorated 4.4% and 2.1% YoY to 75.1mand 1327k ounces mined.

According to the SilverInstitute’s latest WSS, total world silver mine production averaged 213.0mounces per quarter in 2017.  So at 75.1min Q2, these top 17 SIL components were responsible for 35.3% of thatrate.  And their overall productiondecline last quarter is misleading, heavily skewed by two outliers with unusualsituations.  Tahoe Resources and SSRMining reported huge 100.0% and 46.3% YoY production plunges!

Without TAHO and SSRM,the rest of these elite silver miners were able to grow their collective silverproduction by a decent 2.0% YoY.  That’simpressive considering the miserable silver-price environment.  Between Q2’17 and Q2’18, the averagequarterly silver price slumped 3.9% to $16.51. That was really weak compared to gold, which actually rose 3.9% inquarterly-average terms to $1306 across these quarters.

Silver has always been driven by gold, effectivelyacting like a gold sentiment gauge.  Generally big silver uplegs only happen aftergold has rallied long enough and high enough to convince traders its gains aresustainable.  Then the way-smaller silvermarket tends to start leveraging and amplifying gold’s moves by 2x to 3x.  But gold sentiment was so insipid over thispast year that no excitement was sparked for silver.

Yet the top 17 SILsilver miners excluding TAHO and SSRM were able to buck those silver headwindsto still grow production.  That issetting up these companies for stronger profits growth once silver’s priceinevitably mean reverts higher.  It’simportant to understand what’s going on with TAHO and SSRM though, as these arelong-time favorites among American investors. TAHO’s silver production should return.

Tahoe was originallyspun off by Goldcorp to develop the incredible high-grade Escobal silver minein Guatemala, which went live in Q4’13. Everything went well for its first few years.  By Q1’17, Escobal was a well-oiled machine producing5700k ounces of silver.  That provided1000+ great high-paying jobs to locals and contributed big taxes to Guatemala’seconomy.  Escobal was a great economicboon for this country.

But a radical group ofanti-mining activists managed to spoil everything, cruelly casting their fellowcountrymen out of work.  They filed afrivolous and baseless lawsuit against Guatemala’s Ministry of Energy andMines, Tahoe wasn’t even the target!  Italleged this regulator had not sufficiently consulted with the indigenous Xincapeople before granting Escobal’s permits. And they don’t even live around this mine site.

Only in a third-worldcountry plagued with rampant government corruption would a regulator apparentlynot holding enough meetings be a company’s problem.  Instead of resolving this, a high Guatemalancourt inexplicably actually suspended Escobal’s mining license in early Q3’17! Tahoe was forced to temporarily mothball its crown-jewel silver mine,and thus eventually lay off its Guatemalan employees.

That license wastechnically reinstated a couple months later, but the activists appealed to ahigher court.  It required the regulatorto study the indigenous people in surrounding areas and report back, and nowneeds to make a decision.  The governmentalso needs to clear out an illegal roadblock to the mine site by violentanti-mine militants, who have blockaded Escobal supplies and physically attacked trucks and drivers!

So Escobal has beendead in the water with zero production for an entire year, an unthinkable outcome. This whole thing is a farce, a gross miscarriage of justice.  Sooner or later the Guatemalan bureaucratswill get all their useless paperwork done and Escobal will come backonline.  After a few quarters or so ofspinning back up, Escobal’s silver production should return to pre-fiascolevels around 5700k ounces a quarter.

That would boost SIL’stop 17 components’ current overall silver production by 7.6%.  In my decades of intensely researching andactively trading mining stocks, I’ve never seen anything like this Escobaldebacle.  While TAHO’s cashflows are reallyimpaired without this silver mine which was actually the world’s largest primary, it can weather this nightmare because ofits other gold mines that yielded 102.6k ounces in Q2’18.

Thankfully SSR Mining’ssilver-production plunge is far less dramatic. This company used to be known as Silver Standard Resources, and its oldPirquitas silver mine is simply depletingas forecast.  SSRM is exploring inthe area trying to extend the life of this old mine, which was joint-venturedand renamed the Puna Operations.  Butmost of SSRM’s resources are being poured into its far-more-profitable goldmines.

That gold focus amongthese top silver miners is common across SIL’s components.  As the silver-percentage column above shows,most of these elite silver miners are actually primary gold miners by revenue! Only 3 of these 17 earned more than half of their Q2’18 sales frommining silver, and they are highlighted in blue.  WPM, PAAS, and TAHO are also top-34components in the leading GDXgold miners’ ETF!

While they onlycomprised 7.8% of GDX’s total weighting in mid-August, this highlights howdifficult it is to find primary silver miners. SIL’s managers have an impossible job these days with the major silverminers increasingly shifting to gold. They are really scraping the bottom of the barrel to find more silverminers.  In Q3’17 they added Korea Zinc,and it’s now SIL’s 3rd-biggest holding with a hefty 11.9% total weighting.

That was intriguing, asI’d never heard of this company after decades deeply immersed in this smallsilver-mining sector.  So I looked intoKorea Zinc and found it was merely asmelter, not even a miner!  ItsEnglish-language disclosures are atrocious, starting with its homepage reading“We are Korea Zinc, the world’s one of the best smelting company”.  The latest production data I can find inEnglish is still 2015’s.

That year Korea Zinc“produced” 63.3m ozs of silver, which averages to 15.8m quarterly.  That is largely a byproduct from its mainbusinesses of smelting zinc, lead, copper, and gold.  The fact SIL’s managers included a companylike this that doesn’t even mine silver as a top SIL component shows how rare major silver miners have become.  The economics of silver mining at today’sprices are way inferior to gold mining.

The traditional majorsilver miners are painfully aware of this, and have spent years actively diversifying into gold.  In Q2’18, the average percentage of revenuesthese top 17 SIL miners derived from silver was only 36.3%.  That’s right in line with the recent trend,with the prior four quarters seeing 36.1%, 39.3%, 35.3%, and 36.4%.  This relatively-low silver exposure is whySIL isn’t as responsive to silver as investors expect.

Silver mining is everybit as capital-intensive as gold mining, requiring similar large expenses forplanning, permitting, and constructing mines and mills.  It needs similar heavy excavators and haultrucks to dig and move the silver-bearing ore. Similar levels of employees are necessary to run these mines.  But silver generates much lower cash flows due to its lower price.  Consider hypothetical mid-sized silver andgold mines.

They might produce 10mand 300k ounces annually.  At lastquarter’s average prices, these silver and gold mines would yield $165m and$392m of yearly sales.  Unfortunately itis far easier to pay the bills mining gold these days.  So primary silver miners are increasingly becominga dying breed, which is sad.  Thetraditional major silver miners are adapting by ramping their gold productionoften at silver’s expense.

This industry’sflagging silver purity and thus deteriorating responsiveness to silver pricetrends will be hard to reverse.  Silverwould need to far outperform gold, rocketing higher in one of its giganticuplegs while gold lags.  And it wouldhave to stay relatively strong compared to gold for years after that to entice big capital spending back intoprimary silver mines.  While possible,that seems like a stretch in today’s markets.

Unfortunately SIL’smid-August composition was such that there wasn’t a lot of Q2 cost datareported by its top component miners.  Ahalf-dozen of these top SIL companies trade in the UK, South Korea, Mexico, andPeru, where reporting only comes in half-year increments.  There are also primary gold miners that don’treport silver costs, and a silver explorer with no production.  So silver cost data remains scarce.

Nevertheless it’salways useful to look at what we have. Industrywide silver-mining costs are one of the most-criticalfundamental data points for silver-stock investors.  As long as the miners can produce silver forwell under prevailing silver prices, they remain fundamentally sound.  Costknowledge helps traders weather this sector’s occasional fear-driven plungeswithout succumbing to selling low like the rest of the herd.

There are two majorways to measure silver-mining costs, classic cash costs per ounce and the superiorall-in sustaining costs.  Both are usefulmetrics.  Cash costs are the acid test ofsilver-miner survivability in lower-silver-price environments, revealing theworst-case silver levels necessary to keep the mines running.  All-in sustaining costs show where silverneeds to trade to maintain current mining tempos indefinitely.

Cash costs naturallyencompass all cash expenses necessaryto produce each ounce of silver, including all direct production costs,mine-level administration, smelting, refining, transport, regulatory, royalty,and tax expenses.  In Q2’18, these top 17SIL-component silver miners that reported cash costs averaged just $3.95 perounce!  That plunged a whopping 37.6% YoY,making it look like these miners are getting more efficient.

But that’smisleading.  Because of hefty byproductcredits from gold and base metals, Hecla Mining and Fortuna Silver Mines bothreported negative cash costs inQ2.  They are an accounting fiction, asmining silver still costs a lot of money. But crediting byproduct sales to silver can slash reported cashcosts.  In the comparable quarter a yearearlier, there were no negative cash costs at any of SIL’s top 17 miners.

Those super-low cashcosts offset SSR Mining’s crazy-high $14.73 per ounce.  That’s not normal either, the result of thatwinding down of its lone silver mine. Excluding these extreme outliers, the remaining handful of silver minershad average cash costs of $4.83 per ounce. As long as silver prices stay above those levels, the silver miners cankeep the lights on at their mines. Sub-$5 silver is wildly inconceivable!

Way more important thancash costs are the far-superior all-in sustaining costs.  They were introduced by the World GoldCouncil in June 2013 to give investors a much-better understanding of what itreally costs to maintain silver mines as ongoing concerns.  AISCs include all direct cash costs, but thenadd on everything else that is necessary tomaintain and replenish operations at current silver-production levels.

These additionalexpenses include exploration for new silver to mine to replace depletingdeposits, mine-development and construction expenses, remediation, and minereclamation.  They also include thecorporate-level administration expenses necessary to oversee silver mines.  All-in sustaining costs are themost-important silver-mining cost metric by far for investors, revealing silverminers’ true operating profitability.

In Q2’18 these top 17SIL miners reporting AISCs averaged just $10.93 per ounce!  That was down 6.3% YoY, and was way belowsilver’s average price of $16.51 last quarter. Even if the two extreme outliers are thrown out, SSRM’s abnormally-highmine-depletion $17.66 AISC and SVM’s incredibly-low huge-byproduct-credit $0.41AISC, the remaining average is similar at $11.56.  Silver mining remains very profitable!

Even at worst inAugust’s plunge driven by speculators’ crazy-extreme all-time-record silver-futures short selling, silver merely hit$14.44 on close.  That’s still way abovethis industry’s total production costs any way you slice it.  That implies even at peak fear the elite topsilver miners of SIL were still earning hefty 24% profit margins!  So there’s no doubt the recent franticsilver-stock selling wasn’t fundamentally righteous.

SIL getting hammered todeep 2.5-year lows in mid-August was the product of irrational fear run amok,it had nothing to do with how the silver miners are faring.  At Q2’s average silver price and AISCs, theseminers were earning $5.58 per ounce. Most other industries would die for such 34% margins.  And those are going to explode higher assilver inevitably mean reverts back up again, probably violently given thissetup.

Silver stocks plungedin August because silver did.  That wasdriven by truly-extreme silver-futures short selling by speculators.  They ramped their shorts to a wild newall-time record high of 114.5k contracts in mid-August!  All that short selling is guaranteed proportional near-future buying,as excessive shorts must be closed by buying offsetting long contracts.  Short-covering rallies are self-feeding,catapulting silver higher.

The more speculatorsbuy to cover, the faster silver surges. The faster it surges, the more they have to buy to cover or facecatastrophic losses due to the extreme leverage inherentin silver futures.  It would take 73.0kcontracts of buying to return spec shorts to their 52-week low seen inmid-September 2017.  That’s theequivalent of 364.9m ounces, or nearly 43% of last year’s entire global minedsupply!  Talk about big.

And today’s silverprices are super-low relative to prevailing gold levels, portending hugemean-reversion upside.  The long-termaverage Silver/Gold Ratio runs around 56x, which means it takes 56 ounces of silver to equal the value ofone ounce of gold.  Silver is greatlyunderperforming gold so far in 2018, with the SGR averaging a stock-panic-like 80.2xthus far in August!  So silver is overdue to catch up with gold.

At a 56x SGR and $1200gold, silver is easily heading near $21.50. That’s 30% above its Q2 average. Assuming the major silver miners’ all-in sustaining costs hold, thatimplies profits per ounce soaring 89% higher! And the record silver-futures short covering necessary after recordsilver-futures short selling is very likely to fuel a massive mean-reversion overshoot, making thesilver-mining-profits upside much greater.

And silver miners’AISCs generally don’t change much regardless of prevailing silver prices, sincesilver-mining costs are largely fixed during mine planning andconstruction.  The top 17 SIL miners’AISCs in the past four quarters averaged $11.66, $9.73, $10.16, and$10.92.  So Q2’18’s $10.93 was right inline.  Costs aren’t going to rise much assilver recovers, and higher production may even push them lower still.

While all-in sustainingcosts are the single-most-important fundamental measure that investors need tokeep an eye on, other metrics offer peripheral reads on the major silverminers’ fundamental health.  The moreimportant ones include cash flows generated from operations, GAAP accountingprofits, revenues, and cash on hand.  Theywere all decent to healthy in Q2’18 despite the low silver prices and weaksentiment.

These SIL-top-17 silverminers’ collective revenues only fell 1.5% YoY to $3114m.  That reflects higher gold prices which offsetthe lower silver ones.  That droveoperating-cash-flow generation of $758m, which was 27.0% lower YoY.  That’s not unreasonable given the 3.9% loweraverage silver prices from Q2’17 to Q2’18 and the 4.4% lower silver productionamong these elite silver majors.  Cashflows remain fine.

These silver miners’balance-sheet cash and short-term investments still powered 18.0% higher YoY to$3637m.  The bigger their cash hoards,the easier the elite silver miners can weather these weak silver prices.  Big treasuries also give them more capital toexpand existing mines and buy or build new ones.  A fundamental surprise seemed to come in hardGAAP accounting profits though, which soared 110.6% YoY!

But the $343m totalearnings in Q2’18 were wildly skewed by a huge $246m non-recurring gain WheatonPrecious Metals reported.  77% of itsmassive $318m in profits came from gains on the sale of one of its silverstreams.  Back that out of overalltop-17-SIL-component earnings, and they actually plunged 40.3% YoY.  But they were still positive at $97m, andhave incredible upside potential as silver’s price inevitably recovers.

The silver-miningstocks are doing way better fundamentally than they’ve been given credit for.  Their mining costs remain far belowprevailing silver levels, driving strong profitability even at August’s deepsilver-price lows.  That capitulation silver-stockplummeting fueled by cascading selling as stop losses were sequentially runwasn’t justified fundamentally.  It wasan extreme sentiment anomaly that can’t persist.

So a big mean-reversionrebound higher is inevitable and imminent. While traders can play that in SIL, that’s mostly a bet on primary goldminers with byproduct silver production. The best gains by far will be won in smaller purer mid-tier and junior silverminers with superior fundamentals.  Acarefully-handpicked portfolio of these miners will generate much-greaterwealth creation than ETFs dominated by non-primary miners.

At Zeal we’ve literally spent tens of thousands of hours researchingindividual silver stocks and markets, so we can better decide what to trade andwhen.  As of the end of Q2, this hasresulted in 1012 stock trades recommended in real-time to our newslettersubscribers since 2001.  Fighting thecrowd to buy low and sell high is very profitable, as all these trades averagedstellar annualized realized gains of +19.3%!

The key to this success is staying informed and beingcontrarian.  That means buying low whenothers are scared, before undervalued silver stocks soar much higher.  An easy way to keep abreast is through ouracclaimed weekly and monthly newsletters.  They draw on my vast experience, knowledge,wisdom, and ongoing research to explain what’s going on in the markets, why,and how to trade them with specific stocks.  Subscribe today whilegreat silver stocks remain dirt-cheap!

The bottom line is themajor silver miners’ fundamentals remain solid based on their recently-reportedQ2’18 results.  They continue to minesilver at all-in sustaining costs far below even mid-August’s deep silverlows.  Their still-impressive profitswill multiply as silver rebounds higher violently on record futures shortcovering.  Investment capital will floodback into this tiny sector, catapulting silver stocks up sharply.

So traders need to lookthrough the recent frightened herd sentiment to understand the silver miners’hard fundamentals.  These forsaken stocksare radically undervalued even at today’s low silver prices, let alone wheresilver heads during the next major gold upleg. Silver is poised to rocket higher soon as that mandatory extreme shortcovering gets underway.  So theopportunities to buy dirt-cheap miners are fleeting.

Adam Hamilton, CPA

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