Endeavour Silver: Valuation Finally Starting To Improve (NYSE:EXK) – Seeking Alpha

The Q1 Earnings Season for the Silver Miners Index (SIL) has finally ended, and one of the first companies to report was Endeavour Silver (NYSE:EXK). From a headline standpoint, the company had a solid quarter, reporting 4% higher production and a significant increase in revenue (+68% year-over-year). However, the latter was driven by inventory drawdown, and while sales were up, margins fell off a cliff to just $2.58/oz. The silver lining is that some of this negativity looks priced into the stock, and further weakness below US$3.20 should set up a buying opportunity from a swing-trading standpoint.

Roughly two months ago, I wrote on Endeavour Silver, noting that chasing the stock above US$5.30 probably wasn’t a good idea. This was because the company was coming up against difficult year-over-year comps from a margin standpoint, and the long-term outlook for margins was better due to Terronera; commercial production was at least two years away. Since then, EXK has been pummeled, sliding more than 40%. The weak performance can be attributed to margin compression in Q1 and what should be an uglier quarter for margins in Q2. Let’s take a closer look below.

Production

Endeavour Silver released its Q1 financial results last month, reporting quarterly production of ~1.31 million ounces of silver and ~8,700 ounces of gold. This translated to a 25% increase in silver production vs. the year-ago period, offset by a 22% decline in gold production, partially related to no contribution from its smallest El Compas Mine, which was placed in care & maintenance. Overall, this translated to a 4% increase in silver-equivalent ounce (SEO) production from the year-ago period.

Based on Q1 2022 production of ~2.0 million SEOs, Endeavour is tracking ahead of its guidance mid-point of 7.15 million SEOs, and is well on track to meeting and potentially beating guidance. In fact, management noted that it expects the high grades from Guanacevi to continue in the near term, and the company is purchasing ore from local miners, providing a further boost to grade performance. While grades were down slightly on a sequential basis at Guanacevi in Q1, they have remained above the 300 gram per tonne mark and above the 3-year average.

Costs & Margins

Unfortunately, while it was a solid quarter from a production and sales standpoint, inflationary pressures put a significant dent in margins. This was evidenced by all-in sustaining costs (AISC) of $20.90/oz in Q1, a 5% increase from the year-ago period despite higher production and sales. The company noted that power costs have increased sharply, mainly sourced from the Mexican Federal Commission of Electricity, and labor and consumables costs have also been up. The only good news is that with Guanacevi and Bolanitos being relatively low volume operations, the company has been shielded from fuel costs more than peers like Coeur Mining (CDE).

Looking at the chart above, we can see that margins fell off a cliff in Q1, sliding from $7.23/oz to just $1.70/oz. While this was partially related to the weaker silver price in the period ($24.48/oz), it was also impacted by the higher costs. Unfortunately, while Endeavour Silver was bailed out by this trend toward higher costs since 2020 due to the sharp rise in the silver price, this benefit is no longer in place. In fact, even if costs remain at similar levels in Q2 2022 ($21.00/oz), we will see meaningful margin contraction on a sequential basis.

The reason for this is that the silver price is trading at its lowest levels in over 18 months, with the quarter-to-date silver price sitting at $23.40/oz. Unless we see a significant recovery in silver prices in June, I expect an average realized silver price closer to $23.00/oz for Q2, translating to margins below $2.00/oz. This would represent a more than 20% decline in margins on a sequential basis ($2.00/oz estimates vs. $2.58/oz in Q1 2022), and the decline could be worse if AISC came in higher than my estimates ($21.00/oz).

Financial Results

Finally, looking at the financial results, some investors might conclude that Endeavour had a blow-out quarter, reporting a 68% increase in revenue year-over-year. However, it’s important to note that the company drew down a significant portion of its metal inventory in the quarter, with ~1.72 million ounces of silver sold vs. ~1.31 million ounces produced. Hence, looking at Endeavour’s year-over-year revenue increases is not that helpful. Besides, even if revenue is trending higher following better performance from Guanacevi, so is the share count, and the margin profile is unlikely to improve in 2023, with costs likely to come in above $24.00/oz next year.

Valuation

Based on a current share price of $3.50 and with an updated fully diluted share count of ~187 million shares, Endeavour has a market cap of ~$665 million. This translates to a P/NAV of just over 1.10 after adjusting for estimated corporate G&A of $60 million, net cash of ~$150 million, and project NPV of ~$500 million. While this figure of ~1.13x P/NAV is the cheapest that Endeavour Silver has traded at since Q2 2020, it’s important to note that EXK is a very high-cost producer, partially explaining its discounted multiple relative to peers like Hecla (HL) that are less sensitive to weakness in the silver price. The above estimate also includes Pitarrilla, valued at $100 million to be conservative.

One could argue that Endeavour will shed its high-cost producer status once its high-margin Terronera Project is commissioned, with commissioning targeted for H1 2024 (assuming timely receipt of financing). While this is a very fair point, there is a risk to cost overruns at Terronera, even if some work has already been completed. Hence, I would not rule out further share dilution between now and commissioning, meaning that investors can’t rely on the current share count of 187 million shares, especially with this team’s track record of consistent share dilution.

To summarize, Endeavour Silver is finally reasonably valued at just over 1.1x P/NAV, but investors must be mindful of the risks. These risks are the fact that we could see additional share dilution in the next 18 months if Terronera goes over budget, and its current operations have razor-thin margins, which will degrade further in Q2 if silver prices remain below $23.00/oz. Given the backdrop of rising costs, I would rather own higher-margin producers at deeper discounts to fair value than Endeavour Silver. Hence, I see the stock as a swing-trading vehicle only, at least until Terronera is online.

Technical Picture

While Endeavour Silver is becoming much more reasonably valued after its 40% decline, the stock has sliced through key support at US$3.90. Following this technical failure, the next support level on the stock doesn’t come in until US$3.05, and a new resistance level is in place at US$4.10. When it comes to small-cap high-cost producers, I prefer to have a minimum 6.0 to 1.0 reward/risk ratio to justify entering new positions. EXK’s current reward/risk ratio comes in at 1.33 to 1.0 ($0.60 in potential upside to resistance, $0.45 in potential downside to support), so I don’t see a low-risk buy point.

In order for EXK to move into a low-risk buy zone, the stock would need to decline below US$3.20, where it would have $0.90 in potential upside to resistance and just $0.15 in potential downside to support. Having said that, in a precious metals market where there are several high-quality producers on sale trading at a discount to net asset value and paying generous dividends, owning Endeavour Silver could be an opportunity cost. Therefore, while I would consider buying EXK from a swing-trading standpoint at US$3.15, I think there are far better ways to play the sector.

Endeavour Silver had a decent Q1 performance, especially given that it was up against difficult year-over-year comps due to having two operating mines vs. three in the year-ago period. However, inflationary pressures are a very real concern, and while a strong silver price briefly bailed out Endeavour in 2021 and Q1 2022, this will not be the case in Q2. In fact, Q2 could be a very ugly quarter, with AISC margins set to come in below 10%. The good news is that some of this negativity looks priced into the stock, and further weakness below could set up a buying opportunity. In summary, I see EXK as a Speculative Buy at US$3.15.