Gatos Silver: Good Upside Potential, But First A Dip (NYSE:GATO)

A Hold Rating for shares of Gatos Silver

This analysis confirms a “Hold” rating on shares of Vancouver, Canada-based silver company Gatos Silver, Inc. (NYSE:GATO) (TSX:GATO:CA) – which owns 70% interest in the Los Gatos Joint Venture (hereafter “LGJV”).

LGJV operates the Cerro Los Gatos Mine 111 km southwest of Delicias, Chihuahua, Mexico in a silver and base metal-rich mineral district in southern Chihuahua State, Mexico.

In the previous analysis, this stock was also given a rating of Hold in the sense of continuing to keep shares of Gatos Silver in the position for the following reasons:

• Good growth opportunity and the share price, which is still in a strong recovery after an error in the Cerro Los Gatos Mine resource report in early 2022. However, the possibility of a significant short-term decline in the stock price was seen looming, as uncertainty over whether the disinflationary process was actually on the way to an annual inflation rate back to 2% fueled the scenario of a postponed first interest rate cut by the Federal Reserve. The risk of repeated Houthi attacks on merchant ships in the Red Sea increased the risk of a rise in inflation, but market participants seemed unaware of the bigger picture, as happens very, very often. Indeed, investors had to lower their interest rate cut expectations for the Fed’s March meeting as soon as the Fed Chairman announced that they were unhappy with inflation trends. Precious metals markets reacted quickly, notching a decline from December’s all-time highs for the first time. Headwinds were also strong for Gatos Silver shares as they were in sharp correction, hitting a bottom on 20 February. Shares corrected 20% as GATO was $5.6/share while GATO:CA was CA$7.5/share as of February 21, 2024, compared to GATO $7/share and GATO:CA CA$9.3/share on January 27, 2024, when the previous analysis was online. Maybe investors have taken advantage of the attractive lower price level and bought shares.
• A positive trend in throughput processing rates at the Cerro Los Gatos mine, with higher sales volumes and declining operating costs. Also, a bright future was predicted for silver prices amid robust industrial demand and investor confidence in the precious metal’s safe-haven qualities. Previous analysis suggested that the market would have welcomed these upside catalysts: Ideally if LGJV’s net income had been higher on upward catalysts, Gatos Silver, as LGJV’s majority shareholder, would also have benefited from higher earnings, a key driver of share prices.

Following the previous article on January 27, 2024, GATO is up 71.56% versus the S&P500 +6.61% at the time of this writing. Following a different rating from me but a Buy rating on November 7, 2023, GATO increased by 127.20% compared to S&P500 +19.09%, at the time of writing.

Upside Catalysts on Play for Higher Stock Price: Improved Ounces of Silver Equivalent

After market close, May 6, 2024: Gatos Silver reported a 203% increase in Q1-2024 net income to $2.5 million, a 300% increase in Q1-2024 earnings per share to $0.04, and an increase in the EBITDA up 107% to $1.8 million in Q1-2024, primarily due to higher equity income from LGJV, the company indicated in the earnings and operating report. Higher earnings occurred as the stated drivers worked broadly as expected: higher LGJV revenues ($72.2 million, up 3% YoY), were indeed supported by higher sales volumes compared to Q1 2023, though not also by metal prices, which had to discount a slightly lower realized value “due to final settlement adjustments on sales.” Silver ounces sales volumes increased by 0.9% year-on-year to 2.24 million in the first quarter of 2024. In equivalent ounces terms, sales volumes must have increased too because in the report the company indicates that zinc pounds sales rose 14.2% YoY to 13.7 million, lead pounds sales increased by 12.4% to 10 million and gold ounces sales rose 5.4% to 1.18 thousand and initial sales of copper pounds were 0.07 million.

The ongoing program of Cerro Los Gatos Mine to de-bottleneck mine operations and enable higher throughput at the LGJV plant was a key ally in sales volumes in Q1 2024. At the same time, the LGJV plant continued to increase throughput rates per day as part of an ongoing program: In the first quarter of 2024, it was 3,210 tonnes per day compared to 2,894 tonnes per day in the first quarter of 2023.

For the sake of the information in the table above, the company has calculated the silver equivalent as follows:

First Quarter 2024, Results, Gatos Silver, Inc. Corporate Report: “Silver equivalent production for 2024 is calculated using prices of $23/oz silver, $1.20/lb zinc, $0.90/lb lead and $1,800/oz gold to “convert” zinc, lead and gold production contained in concentrate to “equivalent” silver ounces (contained metal, multiplied by price, divided by silver price). For 2023, silver equivalent production was calculated using prices of $22/oz silver, $1.20/lb zinc, $0.90/lb lead, and $1,700/oz gold. For comparative purposes, the calculated silver equivalent production for the three months ended March 31, 2023, would be 3.64 million ounces using price assumptions for 2024.”

The higher sales volume was supported by improved operational efficiency, which resulted in higher production volume. Despite the planned decline in metal grades (284 g/t), production in the first quarter of 2024 was in line with the higher grade (329 g/t) production in the first quarter of 2023, a sign that the planned expansion of the processing activities bears fruit.

The increase in ounces was fundamental, as was the higher silver price on the market where the commodity improved with the silver spot price (XAGUSD:CUR) rising 3.5% from $22.57/oz in the first quarter of 2023 to $23.35/oz in the first quarter of 2024. As pounds of base metals were converted into equivalent ounces of silver while silver market prices trended upward, the Q1-2024 vs. Q1-2023 sales volume comparison skewed in favor of the Q1-2024 level, and this dynamic still had a positive impact on the stock price even though the average realized price was lower on a year-on-year basis. The company indicates that for comparison purposes, using 2024 pricing assumptions (which reflect recent market trends), the calculated silver equivalent production for the three months ended March 31, 2023, would be 3.64 million ounces instead of the reported 3.69 million, versus 3.7 million for the three months ended March 31, 2024.

Upside Catalysts on Play: Lower Costs

Before market open, February 21, 2024: For the full year of 2023, LGJV recorded strong operational performance. The full-year 2023 featured improved operating efficiencies that helped offset inflationary input cost pressures and the impact of the stronger Mexican currency, bringing the full-year 2023 All-In Sustaining Cost per ounce of silver (or “AISC/oz”) close to the lower end of the forecast for 2023. Energy savings through increased throughput in the mill facility and the switch to a more efficient mining method both enable a reduction in site costs, which have fallen by approximately 9% over the last three years.

Byproduct AISC/oz of payable silver equivalent was $15.51, while the original guidance ranged from $15.50 to $17.50 per ounce of payable silver equivalent.

The byproduct AISC/oz of payable silver was $11.33, while the original guidance was between $11.00 and $13 per ounce of payable silver.

According to the chart below from Gatos Silver’s May 2024 corporate presentation, the Cerro Los Gatos Mine’s byproduct AISC/ounce is becoming increasingly competitive relative to the average peer group as the optimization continues to offset upward pressure on costs.

The operational efficiencies, which resulted in improved costs, were possible thanks to the ongoing debottlenecking at the mine coupled with the capacity expansion of the LGJV plant, as previously described: The medium-term target is to maintain 3,500 tonnes per day beyond 2024, following, as seen earlier, the improvement occurred in Q1-2024, which was preceded by improvements also in the fourth quarter of 2023 and throughout 2023: In the fourth quarter of 2023 the throughput milled was 3,014 tonnes per day (compared to 2,847 tonnes per day in the fourth quarter of 2022), and for the full year 2023 it was 2,935 tonnes per day (compared to 2,662 tonnes per day for the full year 2022).

For the sake of the information in the table above, the company has calculated the silver equivalent as follows:

Fourth Quarter and Full Year 2023 Results and Guidance for 2024, Gatos Silver, Inc. Corporate Report: “Silver equivalent production for both 2022 and 2023 is calculated using prices of $22/oz silver, $1.20/lb zinc, $0.90/lb lead and $1,700/oz gold to “convert” zinc, lead and gold production contained in concentrate to “equivalent” silver ounces (contained metal, multiplied by price, divided by silver price.”

As the plant approaches its target of 3,500 tonnes per day (vs. 2,935 tonnes per day in 2023), its increased capacity puts it on track to welcome increased throughput from the Cerro Los Gatos mine until at least 2030 as the drilling to build up reserves has grown by 3 years the expected life of mining. Plus, ~66 km of infill drilling further completed in the South East Deeps zone of the Cerro Los Gatos mine from April 2023 to March 2024 has the potential to update mineral reserves and mineral resources expected in the third quarter of 2024, and further extend the life of the mine.

Returning to the full year 2023 financial results, driven by the increased price of silver in the market ($23.53/oz in 2023 vs. $21.79/oz in 2022) and lower operating costs at Cerro Los Gatos Mine, the joint venture company distributed capital of $85 million in 2023, of which $70% (approximately $59.5 million) went to Gatos Silver resulting in a 227.6% year-over-year increase in Gatos Silver’s free cash flow to $47.5 million.

In addition, Gatos Silver recorded lower general administrative expenses and lower legal settlement costs on its balance sheet related to the Cerro Los Gatos resource report error in early 2022.

Thus, Gatos Silver improved its earnings throughout 2023, resulting in earnings per share increasing 157% year-on-year to $0.18 in the last quarter, net income increasing 160% year-on-year to $12.3 million and EBITDA increasing 116% year-over-year to $11.8 million.

Next Mineral Activities to Be Financed

A financial condition that has been strengthened on capital distribution received by LGJV for $21 million in Q1-2024 and an additional $17.5 million on April 22, 2024, gives Gatos Silver liquidity of $85.4 million as of April 30, 2024. The financial condition is further improved by the absence of debt and can use the $50 million available under the revolving credit facility. The joint venture company will continue to work on the growth catalysts identified in this analysis and engage in exploration projects as high-grade mineralization results from the South-East Deeps zone are consistent with a target of production through 2035 plus mill throughput up to 4,000 tpd as well as the possible existence of district satellite deposits. Approximately 66,300 meters of drilling have been conducted and completed in the area of the South-East Deeps zone, indicating “excellent potential for multi-year mine life extension“.

Regarding the possible existence of regional satellite deposits: The exploration team is mapping the Esperanza, Cieneguita, Lince, San Agustin, and La Paula areas of the Cerro Los Gatos mine. Researchers have found that the Portigueño area is more complex than previously thought but has good mineral widths that support further drilling southeast of the CLG mine and into the basin, as it appears that further mineralization is trending deeper into the zone. Also, there is the San Luis area for greenfield exploration activities and the previously identified Cascabel which is an interesting mineralized zone.

To continue to fund the upside catalyst identified in this analysis and the company’s exploration and drilling projects, an estimated $63 million in funding is required, 72% of which will be for 2024 alone. Against this budget, the LGJV has cash on hand of $20 million as of April 30, 2024, excluding future mining cash flows. As a major shareholder and therefore investor, Gatos Silver could potentially increase its stake in LGJV if necessary or potentially participate in an expanded shareholder base to provide additional resources for catalysts’ growth.

If the Fed shifts its tight interest rate policy to cheaper credit, the long-term growth target of life-of-mine extended to 2035 could gain momentum. Meanwhile, there is a signal from the stock market of continued confidence in Gatos Silver’s low-cost silver mining project near Delicias in Mexico’s Chihuahua province. GATO shares are up more than 60% over the past 5 years following the Cerro Los Gatos resource reporting error in early 2022 and are now targeting the VanEck Gold Miners ETF (GDX) +74% and the SPDR® S&P 500 ETF Trust (SPY) +80.78%. GDX is the benchmark for the US-listed precious metal companies, while SPY is the benchmark for the US stock market.

GATO shares on the NYSE compared to the silver spot price over the last 5 years:

GATO:CA shares on the TSX compared to the silver spot price over the last 5 years:

In addition to the 5-year return of GATO or GATO:CA compared to the 5-year return of silver, the two charts above contain a gray area curve indicating a positive correlation between the stock price and the price of silver. Since the gray area curve has been above the zero line for almost all the past five years, there is a strong positive correlation between the two assets. Assuming that silver is acting bullish in its market, a positive correlation means that the North American stock markets are most likely in a bullish mood when it comes to shares of Silver Gatos as well. This is true regardless of the returns, which can also differ greatly between the two assets: how much the two assets performed at the end of the observed period has nothing to do with the relationship explained. The correlation is about the way the two assets develop: positive when they tend to develop in the same direction (both in an upward or downward trend), negative in an inverse relationship (one in an upward trend while the other in a downward trend, and vice versa).

The Growth Prospects

Looking ahead to the full year 2024, LGJV will continue to fund activities to improve the utilization of the flotation circuit by increasing the processing plant’s capacity to 3,500 tonnes per day, or 40% well above the plant’s nameplate capacity. The resulting operational efficiencies, combined with efforts to de-bottleneck the mine, will maintain the opportunity for further cost savings and robust sales volumes in the context of rising silver prices. The company forecasts strong plant throughput performance in 2024, with silver and silver equivalent production in the top half of guidance ranges of 8.4 to 9.2 million ounces and 13.5 to 15 million ounces respectively, and co-product and by-product AISCs in the lower half of guidance ranges of $14.00 to $16.00 per ounce of payable silver equivalent and $9.50 to $11.50 per ounce of payable silver.

As for silver prices, they are likely to be driven by upward pressure from what is expected to be the second-biggest market deficit of 215.3 million ounces in more than 20 years because, as the Silver Institute said, amid robust demand for industrial uses and safe-haven investments, as it continues to decline on lower ore grades, the silver supply will be largely inadequate. Beyond its traditional uses and growing role in the energy transition, the Silver Institute indicates that industrial demand for silver is being driven by increasing artificial intelligence, which is expected to be used in a wide range of sectors, from transportation to healthcare to computing and data center energy.

Safe-haven protection from recession fears and geopolitical tensions such as those in the Middle East will be the main driver of demand for silver for investment purposes. Gold is the safe-haven par excellence, but the consensus agrees that silver also protects the value of the portfolio against headwinds and is not called “poor man’s gold” for nothing. As previous analysis also pointed out, silver recently had the opportunity to show that it is seen as a means of protecting investor portfolios from headwinds, and since Gatos Silver shares are positively correlated with the price of the metal (as seen above), they therefore had an advantage, which you can see in the following chart: In a short period of time, demand for silver (also gold actually) skyrocketed as a safe haven remedy against the US regional banking crisis in the spring of 2023 and against inflation fears sparked by the Hamas attack on Israel in early October 2023.

Given the increased risk and uncertainty due to geopolitical tensions (due to the wars in Ukraine and Gaza) and the headwinds to economic growth from the Federal Reserve’s “higher-for-longer” interest rate policy in the face of elevated inflation, the market continues to favor the safe haven properties of silver and gold. The Fed’s hawkish stance is actually aimed at slowing down the economy somewhat in order to curb inflation. Markets remain confident that the Fed can lower inflation without causing the shock of a serious slowdown. However, an unexpected economic shock resulting from the Fed’s hawkish stance would be a powerful trigger for strong safe-haven demand for precious metals, including silver. According to economist Ben Ayers, such a shock is still possible.

The Stock Price: Good Growth Prospects, but a Lower, More Attractive Share Price Is Possible

Shares of Gatos Silver, Inc. under the symbol GATO on the NYSE are trading at $10.59 apiece at the time of writing, for a market capitalization of $751.31 million. Shares are currently trading high compared to historical trends, with the share price much closer to the upper limit than the lower limit of the 52-week range of $3.51 to $11.06. On top of this shares are also significantly above the MA Ribbon.

A higher share price level does not mean that the GATO share price cannot continue to trade upwards, provided the conditions are right to do so. Indeed, this analysis has highlighted positive catalysts that make GATO stock well poised to move further up, so investors may want to continue to hold their position in this company.

However, before the uptrend continues, the share price needs to ease somewhat, and if it does fall, more attractive levels could emerge. Let’s see how this could be done:

The RSI of 70.77 suggests that GATO stock does not have much room to move significantly beyond current levels. This could only happen in the presence of something that causes a strong tailwind, but we don’t see any coming in the very near term. Instead, there could be negative winds that could even cause GATO stock to drop significantly in the short term. If, as it appears, the Fed continues to hint at the start of a rate cut later this year, subsequent downward pressure on silver prices – as higher for longer interest rates do not favor no-yielding silver – could also drag GATO shares lower. If the shares retrace significantly to the lower part of the stock price cycle, the investor could consider increasing his position, but for now, the rating is Hold.

The same considerations apply to shares in Gatos Silver, Inc. under the symbol GATO:CA on the TSX: They were trading at CA$14.83/share at the time of writing, for a market capitalization of CA$ 1.03 billion. The shares are trading well above last year’s trends, as evidenced by their higher prices compared to the MA Ribbon. Shares are also closer to the upper limit than the lower limit of the 52-week range of CA$ 4.80 to CA$ 15.11.

The 14-day RSI of 70.28 suggests there is plenty of room for shares of GATO:CA to pull back from these levels under downward pressure from the Fed’s “higher for longer” stance on silver prices in the short term.

Conclusion

Gatos Silver’s stock price is at a high level compared to last year’s trends: it has recovered well following the incident with the erroneous resource estimate report released for Cerro Los Gatos in January 2022.

The share price is likely to rise further, and the following factors are essentially the catalysts for the upside: A) Bright outlook for silver prices amid robust demand for industrial applications and safe-haven investments. B) The company is making progress in extending mine life through increased mill throughput and increased reserves through successful exploration activities.

Stock prices could decline sharply in the near term as headwinds from the Fed’s delay in rate cuts hurt no-yielding silver, creating attractive share price levels investors can use to expand their position. In principle, investors may want to hold this stock in their portfolio.