Tahoe Resources: Why A Correction Is Warranted In This New Silver Producer
By Ben Kramer-Miller originally posted in Seeking Alpha
Mar. 17, 2014 1:51 PM ET
Investors have bid up shares of Tahoe Resources after the company announced commercial production at its Escobal Mine..
While this is good news the shares have risen too far too fast. .
Investors are becoming too optimistic and they are forgetting that there are risks to owning Tahoe Resources..
Investors should take profits as the shares are no overvalued.
Back in June I wrote an article in which I suggested that investors purchase shares in Tahoe Resources (TAHO) in anticipation of the company bringing its flagship Escobal silver mine into production. Since then the shares have doubled. Furthermore the shares are hitting all-time highs. The reason for this is that we learned in January that the company began commercial production at its Escobal mine. Since the January 14th announcement the stock is up a whopping 45% versus the Global X Silver Miner’s ETF (SIL) which is just up 25%, versus the price of silver as measured by the iShares Silver Trust (SLV) which is up just 6%.
There is no doubt in my mind that Tahoe has accomplished something noteworthy in bringing one of the world’s largest and most valuable silver mines into production. And the stock deserves to climb on this news.
However in my opinion Tahoe shares have made their move and it is a good time to exit and find opportunities elsewhere–the stock has simply risen too far too fast, which is likely due to the positive publicity that the company has received since bringing Escobal into production.
While the company is now going to see a lot of cash-flow, and while it is now going to have a lot of options in terms of future acquisitions and exploration, on a DCF basis the shares are overvalued.
Furthermore, the company is vulnerable to the downside for a couple of other reasons.
First, when I initially wrote about the company I pointed out that there was a risk of mining in Guatemala. Guatemala generates a lot of skepticism from mining executives, as is evidenced by the Frasier Institute’s Survey of Mining Companies. The risk of mining in Guatemala appears to be priced out at the current valuation of $3.5 billion, prudent investors should not get involved in the company until this risk is priced back in. Furthermore, Tahoe Resources was exposed to a particular risk in that local human rights activists were protesting the mine, and that this could hinder development. One commentator argued that I “underestimated the risk,” and suggested that the mine may not be developed. Of course this commentator was proven wrong, but the fact remains that there is the off-chance possibility that we will see a protest-related mine shutdown, and this could send Tahoe shares much lower.
Second, Goldcorp (GG) is the largest shareholder in Tahoe Resources, and we recently saw Goldcorp divest its Primero Mining (PPP) shares. While we don’t know exactly why Goldcorp did this it probably has to do with the fact that it wants to raise capital in order to make acquisitions. We already saw it place a takeover bid for Osisko Mining (OTCPK:OSKFF). While this deal may not go through Goldcorp could go after another company, and it might divest its stake in Tahoe Resources in order to raise capital. If Goldcorp does sell its 40% Tahoe Resources stake this will create a lot of new supply that will almost certainly push Tahoe Resources shares lower.
But while these points could serve as short term downside catalysts the key to my altered position on Tahoe Resources is valuation, and as we look at the Escobal project it becomes evident that despite all of the euphoria that has developed in the company’s shares as of late it is time to let go.
The Escobal Project
The Escobal silver mine is one of the most valuable silver mines in the world. The mine will be able to produce over 15 million ounces of silver for 13 years, and in many of those years the company will break the 20 million ounce mark. Furthermore the company will exceed 12 million ounces of production for another 5 years and produce for a total of 18.5 years.
Most importantly the mine is going to have relatively low sustaining costs. In 2014 the company’s AISC will range from $8.85/ounce – $9.85/ounce. This makes the mine highly profitable at the current silver price of $21.50/ounce–with about $12/ounce in profits and with 20 million ounces of production we get $240 million in pre-tax cash-flow. Furthermore the company has a lot of protection to the downside if the silver price falls. This will give it cash-flow while its peers are languishing, and it will be well positioned to buy them out at a very low valuation. The specifics are illustrated onthe following chart.
(click to enlarge)
But regardless, the fact remains that this does not merit a valuation of $3.5 billion. I will give a more thorough DCF analysis below, but to give the reader an idea as to why this valuation is unreasonable, if we assume 25 million ounces of annual production for 20 years and a $14/ounce profit ($22/ounce silver price and $8/ounce AISC) after taxes (28% in Guatemala), then we get a $3.3 billion valuation using a 5% discount rate. Now consider that the mine’s production will only exceed 25 million ounces of silver in one year, that the mine’s life is 18.5 years, that the silver price is $21.5 and AISC estimates are from $8.85/ounce – $9.85/ounce, and that a 5% discount rate is far too low, especially given the location of Escobal (more on this in a moment). It follows that at the current silver price this $3.3 billion level is a pretty high ceiling for Escobal, and given that Tahoe Resources doesn’t have any other assets of value, it is a pretty high ceiling for Tahoe Resources.
Before I provide details regarding the value of the company’s DCF it is imperative that I address the issue of mining in Guatemala.
First, it is a big deal that Tahoe Resource was able to get Escobal into production when mining executives take such issue with mining in Guatemala, and management should be commended for doing so. Nevertheless I think the risks of mining in Guatemala need to be priced into the stock, and they simply aren’t at a 5% discount rate.
If you look at the Frasier Institute’s Survey of Mining Companies you will find that Guatemala ranks 89th out of 96th in order of most favorable mining jurisdiction to least favorable mining jurisdiction. What is it about Guatemala that mining executive find so abject?
Let us look at a couple of the specific areas where Guatemala stands out as a place to avoid.
Less than 10% of those surveyed believe that Guatemalan regulations and land restriction policies make it a good place to mine.
More than half of those surveyed believe that the Guatemalan regulatory environment is a strong deterrent to investment or is prohibitive towards investment.
Over 80% of those surveyed believe that the environmental regulations in Guatemala are a deterrent to investment, although admittedly most of these people think that the environmental regulations are only a mild deterrent.
Over 90% of those surveyed believe that regulatory duplication and inconsistencies are a deterrent to investment, although most believe it is only a mild deterrent to investment.
Over 90% of those surveyed believe that the legal process is corrupt, unfair, and inefficient to the point that it is a deterrent to investment.
Over half of those surveyed believe that trade barriers, restrictions on repatriation on profits, and currency restrictions are a deterrent to investment, although most of this group believe this to only be a mild deterrent.
Nearly everybody surveyed was concerned about Guatemala’s political stability, although again this was only a mild deterrent to investment.
Nearly everybody surveyed was concerned about criminal, terrorist, or guerrilla activity.
While there are worse countries to invest in there aren’t many according to these data points. The good news is that while nobody seems to want to invest in Guatemala, not too many of those surveyed found anything extremely discouraging. Furthermore we can point to some positive developments. The most obvious of these is that the Escobal mine is now in production. We can also point to the lower corporate tax rate, which has recently fallen from 31% to 28%.
Nevertheless in discounting the cash-flow I think we need to be conservative. Since I am arguing for a short position I will be rather lenient. I recently suggested that investors take a long position in Alacer Gold (OTCPK:ALIAF), which operates a mine in Turkey which was ranked 53/96 in the Frasier Survey. I used a 14% discount rate to make this case with a 10% discount rate for my optimistic scenario. This is opposed to what I usually use which is an 8% optimistic discount rate, and a 12% conservative discount rate.
For Tahoe Resources I am going to use an 8% discount rate to emphasize my short thesis. From the above rough figures I provided one can easily see how the company is going to be overvalued even if we use such a lenient discount rate. It follows that there isn’t nearly enough risk priced into Tahoe Resources’ stock.
From this it is evident that even in an extremely lenient valuation scenario Tahoe shares are overvalued and have 39% downside risk. To recap here are the following ways in which these figures are lenient:
The $7.50/ounce production cost throughout the life of the mine is far too low. While there will be later years where there is a minimal sustaining cost above cash costs $7.50/ounce is a floor, and we should expect $8.85 or more next year by the company’s own figures.
The 8% discount rate is lenient considering the risk of mining in Guatemala.
Annual production figures have been rounded upwards.
Again I am impressed that Tahoe Resources’ management was able to bring such a large mine into production so efficiently. Given management’s acumen and the possibilities provided by incoming cash-flow I wouldn’t have a problem paying a premium for the company’s DCF. But given the current valuation the stock is simply too expensive, and I think prudent investors should wait for a pullback.
Given all of the potential risks I have mentioned in this article there is a good possibility that some negative headline will come along that will generate a correction in the shares, and should this occur I can easily see myself recommending the stock again in the future.
Additional disclosure: Note that I actually have a tiny long position in TAHO given my long position in GG. This position is negligible given GG’s market capitalization.