Gatos Silver: Reserve Update Expected; Speculative Stock Buy (NYSE:GATO)
In July, I wrote an upbeat article on SA about Mexico-focused silver miner Gatos Silver, Inc. (NYSE:GATO), in which I said that I expect the stock price to return to around $10 levels at some point an updated mine plan and reserve estimate have been released.
In August, Gatos Silver released strong second quarter 2022 production results which I believe support the thesis that the errors in the reserve model are primarily related to zinc grade and not silver grade. The new life-of-mine plan is expected to be released before the end of October, and I expect it will act as a significant catalyst for the stock price. Let’s check.
Overview of the production results for the second quarter of 2022
In case you haven’t read my previous articles on Gatos Silver, here is a brief description of the deal. The principal asset is a 70% interest in a joint venture company that owns the Cerro Los Gatos polymetallic mine in Chihuahua State.
The mine started operations in 2019 and is projected to produce approximately 94.5 million ounces of silver, 108,000 ounces of gold, 1.2 million pounds of zinc and 585,000 pounds of lead over 11 years, according to the latest mine life plan. In my view the silver and zinc grades look high and the mine life is long for a silver mine.
Looking at key financials, the mine has been projected to have an after-tax present value of $653.2 million using a discount rate of 5% (based on silver, zinc and lead prices of $18.99 per ounce, $1.09 per pound and $0.87 per lead). pounds over the lifespan of me). The present value attributable to Cerro Los Gatos was therefore $457.2 million.
In January 2022, Gatos Silver disclosed that there were errors in the technical report and that the Mineral Reserve’s metal grade could fall by 30% to 50%. The company’s share price has since fallen about 75%, but I think the market overreacted to the news as I expect the decline will mostly affect the mine’s zinc reserves. In my view, the second quarter 2022 production results for Cerro Los Gatos support this theory.
Daily tonnage milled was down 8.4%, but that was expected as the mine was shut down for about two weeks following a blasting incident in late April. Nonetheless, Cerro Los Gatos achieved record quarterly lead and zinc production thanks to higher grades and improved recoveries. However, when we compare the H1 feedstock grades to those from the 2020 mine plan production plan, we can see that the zinc and lead grades are still below 20% and 16%, respectively, where they were expected. Silver grades, in turn, are 14% below the production plan.
What I like most about the second quarter production results is that feedstock grades have improved for all metals, giving me optimism that the metal grade of the mineral reserve reduction will be close to 30% and not 50%. We will know soon as Gatos Silver announced that before the end of October 2022 it plans to announce updated mineral resources and mineral reserves as well as a new life-time plan for the mine.
What draws our attention to the mine’s financial performance was not looking good as sales fell 24% on low silver prices. In addition, manufacturing costs increased by 15% due to higher production, energy and consumable costs. Gatos Silver anticipates that electricity costs will decrease in the near future as Cerro Los Gatos transitions to a new contract that is 100% renewable. In addition, the mine will commission a new paste backfill facility in Q3 to replace the cemented rock backfill currently in use. The new facility will allow the Company to inject tailings directly into open cavities in the mine, reducing the volume of tailings placed at surface by approximately half.
Turning our attention to Gatos Silver’s balance sheet, I think things are looking good since it received a $10 million dividend from the JV company in July 2022. As of June, the JV company had $40 million in cash while Gatos Silver had $7 million in the bank. Gatos Silver was $13 million in debt at the end of July.
Looking at the risks to the bull case, I think there are two main risks. First, it is critical that silver prices recover in the coming months as the existing mine plan calls for declining silver grades through 2027. If silver prices don’t recover soon, there could be significant stock dilution here.
Second, I may be wrong that the reduction in mineral reserve metal grade is primarily affecting zinc grade and not silver grade.
I believe Gatos Silver reported good production results for Cerro Los Gatos in Q2 2022 as feed grades for all metals improved significantly. They are still lower than the mine lifetime schedule, but the biggest difference is in the zinc content. I believe this further supports the thesis that the forthcoming reserve reduction will not materially affect silver grades.
Considering that the new mine life plan is expected to be released in about a month and that Gatos Silver is currently trading at less than 0.5 times after tax present value, I rate this plan as a speculative buy. I think risk-averse investors should avoid this stock for now.
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