The Nut Shell
This article will tell the story of a diversified mining company that has been flying under the radar with little or no fanfare. We consider this company a rare gem in the mining sector that has yet to be discovered by most contrarians willing to invest in this beat-down neck of the market.
We are referring to Sierra Metals (OTC:DBEXF) which controls three producing assets in Peru and Mexico. Across this mine portfolio Sierra Metals produces a mix of silver, copper, zinc, lead and gold.
Our analysis has led us to believe that Sierra Metals has set itself up in a sweet spot which will lead to substantial value creation in 2014. We expect this junior mining company to graduate to the next level and emerge as a highly profitable mid-tier diversified miner at the other end of 2014.
In summary, we are exceedingly bullish on this particular company for the following reasons:
- All three assets have substantial growth potential to be realized within the next year and beyond;
- Institutional money has yet to flow into this stock;
- Directors and management are high caliber and have delivered on promises in the past;
- The commodity mix provides downside protection in the currently volatile commodity market;
- Balance sheet and cash flow are strong; earnings are, too; but don't let the bottom line fool you;
- Both Peru and Mexico are safe mining jurisdictions;
- A dividend policy has been implemented earmarking $10M per year as return to shareholders.
Sierra Metal's share price has been dragged down a fraction (-13.7%) by the general sector (-65.5%) during the past year. However, in analyzing Sierra Metal we need to keep in mind that the past year has been characterized by significant investments that are starting to bear fruit now. The projected growth is only partially priced in just yet, and we expect the share price to appreciate significantly as the growth starts to take hold and leave its mark on the bottom line.
In our view Sierra Metals should be one of only very few mining stocks to rally in 2014 even if the mining sector continues to sag. And should the mining sector start its long overdue recovery, then we see this stock as riding the wave ahead of peers.
Are there risks? Yes of course there are risks, as always when one meddles in high-rewards opportunities, especially when mining is involved. However, in the context of Sierra Metals the risks are manageable and dwarfed by the potential rewards according to our extensive analysis of this particular company.
In the following we will be discussing the bullet points listed above in more detail and will try to put them into context to crystallize our thesis that Sierra Metals is a compelling BUY even and especially in the presently volatile commodity price environment.
Organic Growth From Existing Assets
Sierra Metals has set itself up for significant organic growth from the three assets it already operates. Considering the company's history another acquisition is always a possibility and we would expect it to be opportunistic if it occurs; but no deal is necessary for the company to grow substantially in the coming years.
Growth in the context of Sierra Metals is achieved by increasing production and also by increasing margins and lowering costs. It's worth the effort to look at the three existing assets individually and understand where this growth is going to come from.
In doing just that we would like to emphasize that all the mentioned capital programs are either finalized, or well advanced. Capital spending is set to decline going forward setting the company up to harvest the earnings from these investments into the assets.
Assets 1/3: Yauricocha (Peru)
The Yauricocha mine south of Lima in Peru is a high-temperature, carbonate replacement silver-lead-zinc-copper deposit. The mine is operated by a Peruvian JV company owned 82% by Sierra Metals. The remaining 18% are controlled by a private entity. Since purchasing this asset in 2011 the company has been able to increase the reserves at the Yauricocha mine almost six-fold and much of this awesome ore body remains to be explored and incorporated in the mine plan. Significant further extension of the mine life can be expected.
The company is executing major capital projects at this mine. A new 5.5km tunnel is more than half completed and will provide a direct link of the ore body with the mill. An internal shaft is being sunk and will facilitate access to lower portions of the ore body and a bored raise from the tunnel level to the surface has already been completed.
By-product cash costs per ounce silver are reported (negative!) -$11.25/oz in 2013, and are forecast to drop to -$16.70 in 2014. This is an eminently profitable mine, open at depth with several near-mine exploration targets yet to be assessed.
The JV company operating Yauricocha pays dividends to its owners. In the first two years of operating under this regime, the mine has already generated roughly $100M in dividends for Sierra Metals; more than a third of the purchase price for this mine.
Our financial base case model considers a conservative 25% production increase at Yauricocha within 2 years with steady state production thereafter for a mine life of 7 years.
Assets 2/3: Bolivar (Mexico)
The Bolivar mine is a copper-zinc-silver asset exploiting a skarn-type deposit in Chihuahua state in Mexico. Ore from this mine is trucked to the Piedas Verdes mill some 6km away. Sierra Metals owns 100% of this asset.
Capacity of this mill has just been doubled to 2000 tpd which has helped to lift production in 2013 to exceed last year's output by 30%. However, next year's scheduled increase by another 40%+ really underscores the value of the expansion. The company is currently assessing the possibility of stepping up the mine even further to 3000 tpd at the end of 2014 which would ensure growth at this asset well beyond 2015.
Economies of scale should ensure that cash costs will drop from respectable $1.81/lb of copper in 2013 to $1.0/lb in 2014. In other words: not only will production rise, but margins will also increase; we dare say independently of which direction the copper price heads.
Our base case for this mine assumes the expansion that has been completed in 2013 to work at name plate capacity for a mine life of 10 years.
Assets 3/3: Cusi (Mexico)
The two assets already described above are each set to outperform in their own right; but it is the 100% owned Cusi asset that has been singled out as the company's growth driver by Thomas Robyn, Senior Vice President of Explorations, in a recent audio interview.
"The big thrust for the company, and where we see the greatest organic growth coming from, is from the Cusi mine, a silver dominant mine."
The Cusi mines exploit typical Mexican high-grade low sulphidation epithermal silver-lead-zinc deposits. Reopening of two old mines and starting a new mine has set this asset up to become the growth driver for 2014.
Sierra Metals is currently milling only 300 tpd at this mine but are ramping up to double this rate by the middle of 2014, followed by an expansion to 1000 tpd which has already been budgeted.
All going to plan Cusi will still be the smallest of the three operations by the end of 2014. However, relative to 2013 the value creation rate at Cusi should beat the other assets hands down.
Our base case economical model for the Cusi mine assumes production of 1M ounces of silver in 2014 doubling to 2M ounces in 2015 and a steady growth from then onwards at cash costs falling from $15/oz in 2013 to $11/oz in 2014. We assumed a mine life of 7 years.
Jurisdictions
Both Peru and Mexico are top jurisdictions for metals mining. Both have their peculiar issues, but both are among the safest places to invest.
Miners in Peru have seen a few years of difficulties in getting new mines permitted, but this phase seems to have come to an end with several mining licenses granted just recently. Operating mines have not been affected unjustly and Sierra Metals is not reporting any problems either.
Changes to the Mexican mining royalty and tax regime have dominated industry headlines of late. Life is certainly set to get harder for mining companies in Mexico as a result of new rules coming in as of next year.
Sierra Metals estimates that this new royalty and tax regime in Mexico will not affect the company in 2014, and in 2015 it will add $2M to $3M to the tax bill compared to current conditions. Not a big hit, and quite manageable considering the expected revenues, but still enough of a nuisance to stop and take stock of future ambitions.
Balance Sheet, Cash Flow and Earnings
Looking at the financial statements for the third quarter of 2013 we note $33.7M in cash and $22.6M in working capital. The current ratio computes to 1.35 indicating sufficient funds to pay bills in the foreseeable future.
Sierra Metals has almost $40M in debt repayments due in the coming 12 months plus $40.6M in longer-term debt obligations. All of this debt is owned by Peruvian banks who assisted in financing the acquisition of the Yauricocha mine. The company has just recently re-negotiated the terms of this debt and has been able to secure more favorable conditions, plus a $60M debt facility for the Peruvian subsidiary operating the Yauricocha mine.
We diagnose a healthy balance sheet and move on to assessing the company's cash flows.
Sierra Metals reports positive operating cash flow of $10.2M before changes in working capital in Q3 despite difficult times created by commodity price volatility. Ongoing capital expenses and other investments have chewed down on this income from operations. The bottom line is nothing to behold showing a net loss of $0.04 per share for the quarter and $0.07 per share for the nine months ending September.
However, don't let this bottom line fool you into believing that this company is not profitable. This bottom line is heavily skewed by a non-cash effect that calls for a more detailed explanation.
Each quarter the company is required to consider a non-cash depletion charge for the Yauricocha mine. This charge is based on the aggregate fair value of the Yauricocha mineral property at the date of acquisition ($364M) amortized over the total reserve of the mine. For the first nine months of 2013 this charge has added up to $49M.
When Yauricocha was acquired in 2011 for a consideration of $286M, it had only 1.1M tons of reserves. Through rigorous exploration reserves have increased to 6.4M tons.
Every time the reserves can be increased this non-cash charge will be reduced proportionally. And from the available information, we can safely assume that reserves will continue to increase for many years to come. However, every time this charge can be decreased the underlying cash flow can come to the fore a little more and the underlying profits will start to show up in the bottom line of Sierra Metal's financial statements.
This effect spoils the bottom line and presumably puts off numerous potential investors. Adjusted for this non-cash effect, the company is profitable which is further evidenced by the dividend policy providing for $10M of returns to shareholders per year on top of the ongoing share repurchase program.
Corporate Snapshot
Sierra Metals is listed on the Toronto and Lima Stock Exchanges. Shares of the company are also trading on the pink sheets in the US. It is our recommendation to use the TSX if possible when performing transactions of Sierra Metal's securities due to liquidity advantages at the primary exchange.
Shares of the company were trading for $1.85 at the time of writing which translates into a market capitalization of $292M. Taking into account the reported cash and debt balances we estimate an enterprise value of $339M.
The majority of the company's equity is held by a private equity firm called Arias Resource Capital Management that focuses on investments in the resource sector, in particular in Latin America. While this private equity firm will presumably continue to call the shots with Sierra Metals we feel comfortable with this situation due to the convincing credentials of this particular fund.
This firm was founded by a former Goldman Sachs Managing Director of Metals & Mining Research and name sake by the name of J. Alberto Arias, who also serves as Chairman for Sierra Metals.
Arias Resource Capital Management owns 51.7% of the outstanding shares. BlackRock Group owns 9% plus there are a few other larger shareholders and insiders owning low single-digit percent packages. This leaves roughly a third of the outstanding shares for retail investors, and institutions who might wish to participate in Sierra Metals in the future.
But What About the Mining Sector?
It's no secret: the resource sector has been suffering of late. So the question bears: why would anyone wish to invest in this beaten down sector? As far as the sector is concerned, we would like to reply that contrarian investors will aim at buying low and selling high. The sector might move lower before moving higher again. But now is certainly a good time to buy low in the mining sector in our opinion. And on top of this general statement we have come to the conclusion that Sierra Metals represents deep value that will do well regardless of the sector.
Of course, there is no denying that many mining companies currently fit the bill for deep value, and depressed share price. The whole sector is bargain galore, after all. Sierra Metals distinguishes itself from its peers in that this particular company is on the verge of graduating from junior status to mid-tier status. If the company can achieve this graduation, then this step should be accompanied with a re-rate in share price since it will become an investment option for a whole new group of institutional and retail investors.
Consider First Majestic Silver (AG), or Regis Resources (OTC:RGRNF) for example. These two companies have accomplished this particular feat in recent years. Both these companies saw their share price re-rated as a result. Will Sierra Metals join their ranks in the coming year? We tend to believe that this may well be the case.
It is often the companies that hold up well during sector down turns that are the first movers on a trend change, and that outperform peers during the ensuing rally. Sierra Metals is a case in point. While the junior mining sector has been punished, Sierra Metals has performed remarkably well. The company is therefore in pole position to move early and to move fast when the sector finally recovers.
To conclude this section: while the resource sector in its currently bearish mode is certainly a drag on the share price, we believe that Sierra Metals will do well regardless, buoyed by its growth plan and the deep value of its assets.
Valuation
Sierra Metals is not a steal, as many of its peers are at the moment. While the company's present valuation would have been considered a joke not too long ago, it appears almost rich considering the present state of peers in the wider junior mining sector.
In our valuation, we employ discounted cash flow models with an 8% annual discount for each of the three mines. When using present mine performance and ignoring all mentioned growth and cost-cutting potential (although some of these factors are already operative) then we compute a sum-of-parts total value of just over $350M. The current enterprise value reflects this valuation. In the diagram below this case is termed "downside case" for good reason.
Full asset valuation is unheard of for junior miners in the current market climate, but 80% is a reasonable target which we will employ.
Keeping in mind that our base case is decidedly conservative in its assumptions, and keeping in mind that management has routinely delivered, we believe that our target is eminently achievable.
At the end of 2014 debt will be reduced by the current portion of $40M. If we assume a similar cash balance and outstanding share count as today we arrive at a market capitalization that translates into a target share price of $3.88, or 110% above current levels.
This gives us good reason to suggest that the share price could double within a year for Sierra Metals.
Downside
The company has three assets, and each one is delivering free cash flow at the moment. Sierra Metals is fully valued for these assets. If the described growth plans turn awry, then we would expect the company to get penalized, but ultimately the company can sustain its current level from its existing asset base. The operational downside is therefore quite limited in our view.
Metal prices are the tide that lift ships in the sector we are considering here. In an environment of falling metal prices Sierra Metals has maintained a steady share price as can be seen in the chart at the start of this article, outperforming peers by a country mile. If volatility continues we can reasonably expect this performance to continue. Again, we see limited downside.
Black swans? Well there are plenty of options for catastrophic events in metals mining and one can never discount this possibility. The company appears to run a tight ship and manage risks that can be controlled appropriately. The fact that Sierra Metals has three independent assets provides some insurance even if a black swan decides to settle on one of the mines. The fact that the company mines a range of commodities provides some additional insurance.
Investing in metals mining is risky business. Sierra Metals is no exception, but the risks seem to be outweighed quite asymmetrically by the rewards we have identified in this particular case.
Catalysts & Time Line
Reports for the fourth 2013 and first 2014 quarters should already show a noticeable step-up in production and margins from the Bolivar mine. We should also be able to see dropping costs and increased margins from the Yauricocha mine, combined with further reduced write-down requirements from the Peruvian asset due to the recently announced reserve increase. As 2014 progresses contributions from the Cusi mine will also start to leave their mark on the cash flow and balance sheets.
As the company will presumably validate the published growth plans we expect the share price to react accordingly, driven by entries of more institutional money and interest from the retail investment sector. We would not be surprised at all if our target can be reached by the end of 2014.
We will be looking for the following events in company reports and announcements to confirm our growth assumptions:
- Successful ramp-up at Bolivar to nameplate production at 2000 tpd.
- Completion of the tunnel and the internal shaft and associated improved efficiencies at Yauricocha.
- Successful expansion from 300 tpd to 600 tpd and onwards to 1000 tpd at Cusi.
- Increase in production, and decrease in costs as a consequence of these measures at all mines.
- Continued quarterly dividend payouts and share buyback program confirming the sustainability of returns to shareholders.
These milestones should be reached, one after the other throughout 2014 and push the share price north towards our stated price target.
We will also be keeping a hawk's eye at the list of substantial shareholders. So far not many institutions have taken a position in Sierra Metals. As milestones are achieved in 2014 we would expect institutional holdings to increase. Such moves typically represent strong catalysts for share price re-ratings since most institutions will be looking to build comparatively large positions.
The fact, that Sierra Metals is already paying dividends will act as an additional attraction for institutions. It signifies a will to return money to shareholders, and it is a display of confidence in the company's ability to produce free cash flow.
Why has The Market Not Noticed?
Sierra Metals has been severely under-hyped to put it mildly. The company has not been attending many of the industry conferences, has not advertised in the typical spots for retail investors to take note and has generally been pulling its head in to go about its business in relative quiet. Only two sell-side analysts are currently following Sierra Metals. The company does not even have a management position for investor relation or corporate communication.
In one of his rare interviews, chairman Arias explains this distinctive lack of promotion with the fact that through all the corporate activities plus the name change from Dia Bras to Sierra Metals about a year ago, it has been difficult to explain the story to retail investors. Of course, it has also helped that Arias Resource Capital Management has always been there to provide financing when this was needed.
Institutions that provide venture capital for junior miners have not participated in private placements with Arias Resource Capital Management providing the development funds. And institutions who like to invest in established mining companies usually turn a blind eye on the junior sector.
Additionally, to the fleeting retail investor's eye the bottom line has not looked too attractive in the quarterly reports since the acquisition of the Yauricocha mine due to reasons explained earlier in the article. It actually takes a certain amount of research to understand the mine write-down issue that has been skewing the earnings. We presume that this fact has also deterred retail investors in the past.
The heading to this section is misleading, however. It's mostly the retail market that has not noticed, while the smart money has already started to take note. For example, Sierra Metals was named Junior Mining Company of the Year 2013 by PriceWaterhouseCooper.
Moreover, we have noted a marked increase in promotional activities by company representatives recently. A news item here, an interview there... and we would not be surprised if pretty soon the general retail market will also start to prick an ear, providing yet another catalyst for the share price to appreciate.
The Wrap
Sierra Mining is an investment opportunity for which we believe to have identified 100%+ upside due to a compelling growth story. While this growth will need a year at least to mature we believe that the probability of our target being reached is comparatively high, outweighing the downside to this opportunity convincingly.
And while we sit and wait for the story to unfold, our impatience is somewhat alleviated by the fact that Sierra Metals has started to pay a modest dividend earlier this year.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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