Endeavour Silver: More Share Dilution To Start The Year (EXK)

Just over two months ago, I wrote on Endeavour Silver (NYSE:EXK), noting that any pullbacks below US$1.67 would provide buying opportunities. Since dropping into this buy zone, the stock has rallied over 70% to its recent highs, making it one of the top performers sector-wide. The view that the stock was finally a worthy swing-trading candidate was related to most of the negatives already being priced in, evidenced by the stock shrugging off the higher capex estimate at its Terronera Project and another year of margin compression, with AISC margins plunging to 3.5% in FY2023 (FY2022: 9.5%). In this update, we’ll dig into the Q4 and FY2023 results released last month, recent developments, and where the stock stands today after its sharp rally.

Q4 & FY2023 Results

Endeavour Silver released its FY2023 results last month, reporting annual production of ~5.67 million ounces of silver and ~37,900 ounces of gold. This translated to a slight miss vs. its guidance midpoint of 6.0 million ounces of silver and 38,000 ounces of gold and resulted in lower revenue year-over-year ($205.5 million vs. $210.2 million) despite higher metals prices. On a per share basis, the results were also disappointing given the 9% increase in weighted average shares outstanding, with silver-equivalent production per share slipping nearly 20% to 0.04 (~8.7 million silver-equivalent ounces produced vs. ~217.2 million shares). Unfortunately, this figure has only worsened to start the year, with Endeavour Silver issuing ~15.9 million shares at US$1.51 under its At-The-Market Equity Facility [ATM] in Q1, putting a further dent in its per share metrics.

The weaker production in FY2023 was related to a dip in grades at its flagship Guanacevi Mine, with the 5% higher throughput (~433,400 tonnes processed) more than offset by a 10% dip in average silver grades and an 11% decline in gold grades to 417 and 1.19 grams per tonne, respectively. These lower grades were partially because of changes in mine sequencing to focus on improving ventilation at the underground mine, with grades dipping below budget in Q2 and Q3. And with fewer ounces produced plus the impact of inflationary pressures and persistently strong Mexican Peso (MXN/USD), all-in sustaining costs [AISC] at Guanacevi soared to $22.23/oz vs. $18.43/oz in the year-ago period, resulting in Endeavour’s consolidated costs coming in over 17% above its guidance midpoint of $19.50/oz.

Digging into the financial results, there wasn’t much to write home about despite the backdrop of rising metals prices, with revenue declining 2% year-over-year to $205.2 million on the back of lower sales, and operating cash flow before working capital plunging 31% to $37.0 million vs. $54.0 million in FY2022. Meanwhile, adjusted earnings slipped to $1.7 million (FY2022: $6.9 million), and while Endeavour finished the year with ~$35 million in cash and a net cash position, it had significant share issuance to thank for its stronger balance sheet, with over $62 million in proceeds from equity sales, including ~23.4 million shares issued under its previous ATM (June to November 2023) at $2.47, and an additional ~2.3 million shares sold at $2.06 in December 2023 under its new ATM. Unfortunately, the selling looks to have continued since its year-end report, with the company currently having closer to 240 million outstanding shares.

Costs & Margins

Looking at costs and margins, we saw continued margin compression in FY2023, with AISC margins sinking to $0.83/oz vs. $2.10/oz in FY2022. This translated to a 600 basis point decline in AISC margins (3.5% vs. 9.5%), impacted by inflationary pressures, a stronger Mexican Peso, and fewer ounces sold, offset by lower sustaining capital spend for the year. Unfortunately, this resulted in significant free cash outflows when combined with higher capex because of construction at its Terronera Project, and the increase in annual AISC from $19.97/oz to $22.93/oz was despite the benefit of higher gold by-product credits with an average realized gold price of $1,968/oz (FY2022: $1,814/oz).

Digging into the Q4 results, Endeavour focused on the fact that costs improved sequentially from Q3 2023 levels, but this was largely because of being up against easy comparisons. And while Q4 AISC improved from $29.64/oz to $21.48/oz, costs were still well above the industry average and margins were razor thin at just $2.30/oz. Plus, costs were up sharply on a year-over-year basis from $19.38/oz and direct costs per tonne increased 10% year-over-year to ~$171/tonne, with Endeavour calling out “increased labor, power, and consumables costs”. The only good news is that Guanacevi is back into better grades as of Q4 and FY2024 guidance has been set at $22.50/oz net of by-product credits, with the potential to come in below this figure if the gold price can continue to climb. On a negative note, the MXN/USD continues to power high, making another set of new highs, which isn’t any help to Terronera construction costs (which have already increased materially) nor its operating costs at Guanacevi and Bolanitos.

Recent Developments

Fortunately, there is some good news. This news comes in the form of its Terronera Project, which is nearing 50% completion, albeit at higher capital expenditures of ~$271 million vs. ~$230 million previously. For those unfamiliar, Terronera is a high margin silver-gold project in Jalisco state, Mexico, with a 10-year mine life, and estimated annual production of ~4 million ounces of silver and ~7 million silver-equivalent ounces [SEOs]. Endeavour has spent over $120 million on direct development to date, with over 60% of the updated capital budget committed and continues to expect Q4 2024 commissioning, suggesting commercial production should start in Q2 2025. Per the most recent update, surface construction is 50% complete, development rates continue to improve, with 2,200 meters completed in 2023 and the first ore development is expected in Q2, with long-hole mining set to begin in Q3 to build a stockpile ahead of commissioning.

Although we’re still a year away from commercial production, Terronera is one of the better-undeveloped silver assets that’s set to have operating costs in the bottom quartile of the cost curve. And while the project’s estimated all-in sustaining costs [AISC] of ~$9.80/oz are looking far too ambitious given where the Mexican Peso sits today and the impact of inflationary pressures, even ~$12.00/oz AISC would be a very solid outcome for a company currently struggling to hold costs below the $22.00/oz AISC level. And while Endeavour will see another year of significant free cash outflows as it sits in the heart of the build out phase in 2024, 2025 will be a far better with the potential to generate upwards of $60 million in free cash flow even at conservative metals price assumptions. So, while the current financial results leave a lot to be desired, Terronera is a major upgrade for the company.

Valuation, Per Share Growth & Technical Picture

Based on ~243 million fully diluted shares and a share price of US$2.85, Endeavour Silver trades at a market cap of ~$695 million. This is a significant increase from where I highlighted the stock as a Buy below US$1.67 earlier this year at a market cap of ~$350 million. The material increase in the market cap is partially related to the fact that we’ve seen a sharp rally in the share price, but we’ve also seen over 13% share dilution since November 2023, with the fully diluted share count increasing from ~211 million to over 240 million shares currently. Hence, even on a constant share price basis, the stock is nearly 15% more expensive given the share dilution that investors have seen at depressed levels.

“Subsequent to December 31, 2023, the Company issued an additional 15,861,552 common shares under the December 2023 ATM Facility at an average price of $1.51 per share for gross proceeds of $23.9 million, less commission of $0.5 million.”

As discussed in past updates, the addition of a larger and lower-cost operation (Terronera) is certainly a positive, but the monsoon of share dilution that’s rained on investors has meant that the benefits of Terronera are not being felt as much as investors might have hoped. This is evidenced by silver-equivalent production per share being down materially from 2018 levels, even when factoring in the production boost from Terronera. In fact, while Terronera will provide a 60% plus boost to annual SEO production, EXK’s share count has nearly doubled in the past six years from ~130 million shares to 240+ million shares. Hence, investors are not seeing the benefit of this production growth on a per share basis, which is all that should matter to investors.

If you are investing in precious metals, it is likely because you wish to preserve the purchasing power of your wealth and avoid the erosion caused by constant inflation of the money supply over time. Holding physical gold and silver bullion can help provide that long-term protection. If one wants additional leverage on that same thesis, the logical extension is to own the mining companies finding and extracting that gold and silver. However, this latter strategy only works if those gold & silver producers are at least holding the line or preferably growing their per-share metrics, meaning that production, reserves/resources, net asset value and cash flow per share are growing. And while industry leaders like Agnico Eagle (AEM) and Alamos Gold (AGI) have excelled in this department and continuously grown their per share metrics, this is not the case for Endeavour Silver.

This does not mean that the stock does not make a good swing-trading vehicle, and it has certainly rallied sharply off its lows. However, names that cannot grow per share metrics and have a poor track record of delivering shareholder value are trades, not investments, and they are best treated as hot potatoes. This means that when they are no longer offering a margin of safety, it’s often best to pass them on and lock in at least some profits. And while a rising tide (silver price) will lift all boats, EXK now trades at ~1.3x NAV which is a premium to more diversified and better-run producers in superior jurisdictions like Agnico Eagle, and a premium to some higher-margin royalty/streaming companies like Sandstorm Gold (SAND).

Looking at the technical picture, this corroborates this view, with EXK running straight into its prior broken support level in the US$2.85 – US$3.00 region. This area may be a sticky point for the stock as those who bought at these levels over the past two years might be anxious to get out at break-even, and it doesn’t help that the stock is no longer oozing value like it was one short month ago below US$1.70 per share. So, while EXK could head higher medium term, I don’t see any way to justify chasing the stock above US$2.90.

Summary

Endeavour Silver is less than a year away from commercial production at Terronera, a milestone that will help morph the company from a high-cost producer into a more competitive producer. However, unlike some other companies adding new operations that are seeing a jurisdictional improvement like Calibre (OTCQX:CXBMF), Terronera does not provide diversification outside Mexico or shield the company from the strong Mexican Peso. And as a solely Mexican producer, I think it’s difficult to make a case for paying over 1.30x P/NAV for the stock today. So, while I would consider EXK if we were to see it move onto a new technical buy signal, I continue to see far more attractive bets elsewhere in the sector, with one name being i-80 Gold (IAUX) that trades at ~0.25x P/NAV in a Tier-1 ranked jurisdiction with one high-grade mine and three high-grade projects (Cove, Ruby Hill, Granite Creek Open Pit) and a path to production of ~400,000 gold-equivalent ounces later this decade.