Every year the stock market offers a number of surprises, and this year it's been the utter domination of precious-metal miners. Whereas all of the major U.S. indexes are near the flat line for the year, the VanEck Vector Gold Miners ETF is up 78% year to date through May 10. Similarly, the Global X Silver Miners ETF has exploded higher by 84% in 2016.
Why gold and silver are on fire
The fundamental reasons behind the rally in physical gold and silver could have legs, too. Precious metals tend to thrive in low-interest-rate environments because physical metals have no dividends attached. If investors see little wealth-creating opportunity in bonds yielding 1% or less, they're more liable to turn to a safe-haven investment like gold or silver. Japan's negative-interest-rate policy, and the Federal Reserve's wait-and-see stance in the U.S. on interest rates, have fanned the fire for gold and silver.
Demand has been another bright point. Gold has seen increased demand from central banks, while ethylene oxide and solar-panel demand has helped provide a foundation for silver. Investors often forget that supply and demand still matters when it comes to the long-term price of gold or silver, even if emotions tend to get the best of traders on a day-to-day basis.
The lone laggard in the gold-mining sector
Within the gold-mining sector there are 28 publicly traded companies with a market valuation above $200 million. A whopping 15 of these miners have at least doubled in price so far this year, and 27 of 28 are higher on the year by at least 42%. That lone laggard? Primero Mining (NYSE: PPP), which has dropped 23% year to date.
Primero's 2016 woes can be traced to two particular events that have derailed its share price.
First, in early February Primero's Mexican subsidiary, Primero Empresa Minera, received a legal claim from Mexican tax authorities that essentially intends to invalidate the company's advance pricing agreement (APA), which the aforementioned tax authorities issued in 2012. Primero's APA is a guideline that spells out what amount of income earned from silver mining is taxable. For its part, Primero has defended the validity of its APA, but it remains a low-hanging cloud of uncertainty over the company.
The second issue relates to Primero's preliminary first-quarter production results, released mid-April. Production in Q1 totaled just 36,158 gold equivalent ounces (GEO), a 41% drop from the 61,073 GEO produced in Q1 2015. Overall, silver production dropped off by 1.01 million ounces, and gold production dipped by 40%. Making matters worse, mill head grades fell by a double-digit percentage for both metals, and all-in sustaining costs (AISC) skyrocketed 49% to $1,555 per gold ounce. The primary culprit for Primero going in reverse can be traced to capital investment in safety at its flagship San Dimas underground mine in Mexico.
Following this preliminary guidance, Primero also lowered its full-year production to between 230,000 GEO and 250,000 GEO with AISC ranging between $975 and $1,025 per ounce. In February, Primero's forecast had called for 260,000 GEO to 280,000 GEO and AISC of $850 to $900 per ounce, a roughly 10% decline from fiscal 2015.
Primero could turn those frowns upside down
Yet for all Primero has put its shareholders through over the past couple of months, it could be primed to deliver significant returns in the coming years.
Primero's best investable attribute is arguably its consistency. While its official Q1 results may not suggest that, the implementation of enhanced ground supports at San Dimas isn't an ongoing expense for Primero. It delayed production for a few weeks, took care of unaddressed safety concerns, and is ready to move on whether Wall Street is ready or not. Thus while Q1 wasn't pretty by any means, it's not indicative of a new norm by any means for Primero Mining.
If we pull back and look at the history or production growth at San Dimas, Primero has been clearly doing something right. Between 2011 and 2015, gold and GEO production rose in each and every year, and sans the production slowdown caused by safety enhancements, San Dimas would be on pace for a sixth straight year of record production. More importantly, San Dimas is consistently a low-cost mine based on AISC. It wouldn't surprise me one bit to see AISC dip below $750 an ounce beyond 2016.
San Dimas also offers numerous ways to boost existing production. In addition to ongoing exploration in an effort to boost mill grades, a secondary crusher should soon be completed that could allow San Dimas to boost its total milling capacity. Assuming mill grades are high enough, Primero could quickly boost profits at its flagship mine -- especially if physical gold and silver prices continue to rise.
Primero's other active mine, Black Fox, which is located in Ontario, has also shown steady improvements, even if its current cost basis is a bit high to merit aggressive expansion.
After reporting AISC of $1,428 at Black Fox in 2014, Primero is forecasting a drop in AISC of more than 10% in 2016 to $1,025. This is noteworthy since drilling efforts in the Froome Zone of Black Fox have demonstrated strong gold concentrations (6.2 g/t gold over 37.9 meters being the most impressive drill), and Primero has stated that it anticipates deciding on whether or not to develop this region in the second quarter. Proven and probable reserve at Black Fox total 237,000 gold ounces, although measured and indicated mineral resources suggest up to 521,000 ounces.
Also, Cerro del Gallo in Guanajuato, Mexico offers Primero the opportunity to pack on up to an additional 95,000 ounces of GEO production each year (Cerro del Gallo contains gold, silver, and copper). Guanajuato is an active mining district, so the infrastructure within the region is already in place, and Primero anticipates that cash costs for the mine would average about $700 an ounce. While development of the mine is still being hashed out, it has proven and probable reserves working out to 712,000 ounces.
Laslty, there's a major disconnect between Primero's current valuation and its estimated cash flow per share in 2017. Once we get past Primero's recent woes, the company could generate around $0.73 in cash flow per share (CFPS) next year. Based on its current share price of $1.75, Wall Street is giving Primero a valuation that's only 2.4 times higher than its 2017 estimated CFPS. Comparatively, miners of its size are trading at around 8.5 times their estimated 2017 CFPS. Even accounting for the uncertainties tied to its APA dispute, this disconnect seems overdone.
Add all of these catalysts together, and you have a gold miner that could be very profitable at $1,250 an ounce beginning in 2017, with rapidly growing production capacity and reasonably low costs. Even a tripling in its share price could have it trading below its peers in terms of CFPS. This certainly isn't a miner for the faint of heart, given its recent volatility. However, for more risk-tolerating investors looking for an opportunity to potentially triple their money over the long-term, I'd suggest Primero Mining is worth serious consideration.