These days stock market price-to-earnings multiples are low, but the revenues that drive corporate earnings rely on seemingly unsustainable growth in government debts. Such is the yin and yang that confronts analysts in 2010.
Given this perplexing situation, I am partial to companies that can thrive both in weak or strong economic outcomes. As an example of this class, I offer Pan American Silver Corp. (TSX: PAA; NASDAQ: PAAS), which faces either growing industrial demand for its production in a strengthening global economy or, alternatively, a strong chaos-trade demand for silver should the markets descend again into crisis.
And for those who would ignore macro-economics altogether, another simple thought appeals to me. Having flat-lined for the past two years against a 40% gain in silver, Pan American is overdue for an upward re-rating.
For the uninitiated, Pan American is Vancouver’s flagship silver mine operator, with seven significant silver mines distributed through the Americas. The company’s total production in 2009 was 23 million ounces, and its resource base, on a broadly defined basis, is over 900 million ounces. The company has significant production of other associated metals, including gold, lead, zinc and copper, which combined amounted to nearly 40% of revenue in the trailing 12 months.
Pan American sports a clean balance sheet. The company has no debt and net working capital exceeds $300 million. Conservative, perhaps, but useful in consideration of the major capital development projects on the company’s plate, most notably the very large Navidad project in Argentina.
Silver miners represent a value play in the precious metals universe. Although silver has a better industrial consumption profile, more short interest and much lower inventories than gold, the price ratio between gold and silver (currently about 65:1) has rarely been as lopsided. Back in the days of gold and silver money, the value ratio between silver and gold coins was typically about 15:1, and even as recently as the 1970s gold typically traded in a 30:1 ratio to silver.
With respect to Pan American itself, I find management to be shareholder-friendly. While share-count has edged 15% higher since 2007, total assets have more than doubled in the same period. In highlighting his priorities, CFO Rob Doyle emphasizes return on invested capital over production growth for its own sake.
Upside surprise for Pan American might be delivered by a couple of different sources. The first driver is the potential rebound in the prices of base metals. Chilled by deflation fears, lead and zinc have been beaten back to 20-year lows in relation to silver. A rebound in these prices to the levels experienced in the middle of the last decade could boost Pan American’s profitability enormously. It’s worth noting than in 2006, base metals accounted for 40% of company revenue compared with 22% this year.
The second source of upside relates to the potential amendment of the current mining law in Argentina’s Chubut province, where Pan American’s Navidad project is located.
The project requires open-pit mining, which is banned in Chubut. In view of this uncertainty, the market is ascribing very little value, if any, to Navidad. If and when the law is amended, Pan American’s silver output could rise significantly upon full development of Navidad.
No investment is without risk, and a company whose entire operating portfolio is comprised of Latin American mineral deposits is hardly immune from such consideration. And beyond the obvious political risks, there is always the potential for a 2008-style silver price deflation.
But on an overall basis, Pan American Silver strikes me as a good risk/return opportunity with potential to double over the next three years.
I base this estimate on bringing Pan American stock back in line with its 2008 multiple to silver prices and bringing silver prices back in line with the long-term average value ratio against gold. Layering on an improvement in base metal pricing, or perhaps a “Christmas present” in the form of a Navidad mine approval, might send today’s $25 Pan American Silver stock well beyond $50 per share.