Is Pan American Silver's Valuation Sustainable?

Silver prices have increased only modestly this year, but several silver mining stocks have experienced significant upside. One company whose shares have enjoyed this run is Pan American Silver (NASDAQ: PAAS  ) . So far, its shares have scored a healthy 21% gain. The company is richly valued by investors, and trades at 37 times future earnings. Is this valuation sustainable given the low silver price environment?

Investors favor a strong balance sheet...
Pan American Silver was very conservative in managing its growth and did not make any purchases since the beginning of 2012. As a result, the company possesses $422.7 million of cash on its balance sheet and has a low long-term debt level. The focus on organic growth has paid off so far, and Pan American Silver finished the fourth quarter of 2013 with record silver production of 6.8 million ounces.

Several other silver miners took a different approach and used low price environment as an opportunity to acquire assets at depressed prices. Interestingly, both Hecla Mining (NYSE: HL  ) and Silver Standard Resources (NASDAQ: SSRI  ) moved into gold. While Silver Standard Resources expects to complete the purchase of Marigold mine in April, Hecla Mining has been operating its gold Casa Berardi mine for almost three quarters. Gold has recently outperformed silver, so these companies' moves made sense.

During the last earnings call, Pan American Silver's executives were asked whether the company plans to use the low price environment for asset purchases. The company's CEO, Geoffrey A. Burns, stated that the opportunities are very limited, and the company continues to prefer organic growth. He also mentioned that Pan American Silver could support $400 million-$500 million of debt should the opportunities present themselves. However, it doesn't look like the company is focused on acquisition-fueled growth right now.

... and stable dividends
Unlike other peers in the silver and gold industry, Pan American Silver didn't cut its dividend during the price downturn. The company's healthy operating cash flow provides the means to continue returning value to shareholders. The company reported that its 2013 all-in sustaining costs were $18.33 per ounce of silver, which gives it a substantial safety cushion in case silver prices dip below $20 per ounce once again. What's more, Pan American Silver targets 2014 all-in sustaining costs between $17 per ounce and $18 per ounce.

The company generated 46.2 million of operational cash flow in the fourth quarter, which mostly covered its capital spending and dividend programs. Given the amount of cash on the balance sheet and Pan American Silver's operating performance, the dividend looks sustainable for the foreseeable future.

Bottom line
With a dividend that yields 3.55% at current prices, Pan American Silver is a clear leader in the silver mining sector. The demand from income investors could help shares of the company in case of prolonged stagnation of silver prices. However, the company's production growth will be limited this year. Pan American Silver targets production of 25.75 million-26.75 million ounces of silver in 2014, while it produced 26 million ounces of silver last year.

I doubt that there is further upside potential for the shares of Pan American Silver without a meaningful increase in silver prices, as the company's production growth will be limited this year.

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