Gatos Silver: Reserve Update Expected; Stock Speculative Buy (NYSE:GATO)

Introduction

In July, I wrote a bullish article on SA about Mexico-focused silver miner Gatos Silver, Inc. (NYSE:GATO) in which I said that I expected the share price to eventually return to levels of around $10 once the updated mine plan and reserve estimate were released.

In August, Gatos Silver posted strong production results for Q2 2022 that I think strengthened the thesis the errors in the reserve model are mainly related to the zinc content, and not the silver content. The new life of mine plan is expected to be released before the end of October, and I expect it to act as a significant catalyst for the share price. Let’s review.

Overview of the Q2 2022 production results

In case you haven’t read any of my previous articles about Gatos Silver, here’s a short description of the business. The main asset is a 70% stake in a joint venture company that owns the Cerro Los Gatos polymetallic mine in the state of Chihuahua.

The mine started operations in 2019 and according to the latest life of mine plan, it is expected to produce about 94.5 million ounces of silver, 108k ounces of gold, 1.2 million pounds of zinc, and 585k pounds of lead over a period of 11 years. In my view, the silver and zinc grades look high, and the mine life is long for a silver mine.

Looking at the key financial figures, the mine was projected to have a post-tax present value of $653.2 million using a 5% discount rate (based on silver, zinc, and lead prices of $18.99 per ounce, $1.09 per pound, and $0.87 per pound over the life of mine, respectively). The present value attributable to Cerro Los Gatos was thus $457.2 million.

In January 2022, Gatos Silver revealed that there were mistakes in the technical report and that the metals content of the mineral reserve could decrease by 30% to 50%. The share price of the company has declined by about 75% since then, but I think that the market has overreacted to this news as I expect the reduction to affect mainly the zinc reserves of the mine. In my view, the Q2 2022 production results for Cerro Los Gatos confirm this theory.

Tonnes milled per day declined by 8.4% but this was expected as the mine was shut down for about 2 weeks at the end of April following a blasting incident. Yet, Cerro Los Gatos achieved record quarterly lead and zinc production thanks to higher feed grades and improved recoveries. However, comparing the feed grades for H1 with the ones from the production schedule from the 2020 mine plan, we can see that zinc and lead grades are still below 20% and 16% where they were expected to be, respectively. Silver grades, in turn, are 14% below the ones in the production schedule.

What I like most about the Q2 production results is that the feed grades improved for all metals, which makes me optimistic that the metals content of the mineral reserve reduction will be close to 30% and not 50%. We’ll know soon, as Gatos Silver revealed that it plans to announce the updated mineral resources and mineral reserves and a new life of mine plan before the end of October 2022.

Turning our attention to the financial performance of the mine, things didn’t look good as sales declined by 24% due to low silver prices. In addition, the cost of sales rose by 15% as a result of higher production as well as increased costs for energy and consumables. Gatos Silver expects electricity costs to decrease in the near future as Cerro Los Gatos is transitioning to a new contract based on 100% renewable supply. In addition, the mine will commission a new paste backfill plant in Q3, which will replace the cemented rock fill backfill that’s currently used. The new facility will allow the company to directly inject tailings into open voids in the mine, which will reduce the volume of tailings placed on the surface by around half.

Turning our attention to the balance sheet of Gatos Silver, I think the situation looks good as 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 held $7 million in the bank. Gatos Silver had debt of $13 million at the end of July.

Looking at the risks for the bull case, I think that there are two main ones. First, it’s crucial that silver prices recover over the coming months, as the existing mine plan envisages declining silver grades until 2027. If silver prices don’t rebound soon, there could be significant stock dilution here.

Second, it’s possible that I’m wrong that the reduction in the metal content of the mineral reserve will affect mainly the zinc content and not the silver content.

Investor takeaway

I think that Gatos Silver posted good Q2 2022 production results for Cerro Los Gatos as the feed grades for all metals improved significantly. They are still lower than the ones in the life of mine production schedule, but the largest difference is in the zinc content. In my view, this further strengthens the thesis that the upcoming reserve decrease will not significantly affect the silver content.

Considering the new life of mine plan is expected to be released in about a month and that Gatos Silver is currently trading at below 0.5x after-tax present value, I rate this one as a speculative buy. I think that risk-averse investors should avoid this stock for now.