The Gold Report: Chris, Haywood Securities’ estimated silver price for 2012 is $36/ounce (oz), but the “devil’s metal” has averaged less so far in 2012, closing above $36/oz only once. Are you expecting a significantly stronger second half for silver?

Chris Thompson: Silver performed relatively well in Q1/12. We hope that the silver price will find support at current levels of ~$28/oz through Q2/12 and Q3/12, with potential for a strong Q4/12.

Looking at the silver price right now, I see that it’s struggling to hold its head above $28/oz. If we do see a significant breakdown from $28/oz, it may somewhat compromise our forecast for this year averaging $36/oz.

TGR: Do you think investors shy away from the silver space given its overall size and susceptibility to manipulation?

CT: Silver is often referred to as the most volatile of all precious metals. In that sense, it’s not for the faint-hearted investor. However, with volatility comes opportunity as long as timing is right. The benefit that silver provides is that it finds value as a store of wealth, as well as an ingredient used in industrial applications, so it offers investors a dual benefit where silver fundamentals benefit from economic growth as well as economic uncertainty.

TGR: In an April 23, 2012, research report, you told investors to “look for quality over quantity” when it comes to silver equities. What makes quality?

CT: A lot of investors look at the size of an in-situ metal resource hosted by a project when looking for a value opportunity presented by exploration and development-stage companies. They tend to ratio that against the enterprise value (EV) of that company to derive a valuation.

Silver is often mined with other metals as by-products. Just recognizing a straight EV dollar/ounces in the ground valuation can be a little misleading. Also, silver is inherently more challenging to recover metallurgically than other precious metals, which influences operating costs and recoveries.

When you layer these peculiarities into the picture, it becomes a complicated story and one that really cannot be valued based on a straight EV dollar/ounce in the ground valuation. We also look at size potential. We look at operating margins on the tonne, as well as jurisdiction. It’s a sector where participants should be evaluated on a number of factors rather than just how much silver they have in the ground.

TGR: What sort of opportunities is the volatility creating?

CT: Silver has broken down from its highs in Q1/12. The sector has sold off, which has been exaggerated in some instances. If you’re a believer in silver holding its head above the $28/oz mark, opportunities exist where equities have been beaten up more than they should have been based on weakness in the silver price. When the silver price exhibits volatility, volatility in equities is exaggerated, and that creates opportunity.

TGR: The performance of equities has lagged their underlying commodities in the precious metals space for almost 18 months. Why don’t the equities respond the same way when the commodity goes up?

CT: We’ve definitely seen a dislocation between equity valuations and metal price since late 2010. The Toronto Stock Exchange Venture Index is currently at about the same level it was in in the middle of 2010 when the silver price was $17/oz and gold was $1,200/oz. Equities, whether they’re exploration, development or even cash-flowing equities, haven’t reflected strength in metal prices for some time now.

TGR: They are, but only to the downside.

CT: In the last six months, we have seen a lot of worry and concern about operating costs; capital costs; and jurisdictional, geopolitical and permitting risk. It’s not just a story of metal prices anymore. Performance now relates to a whole host of other factors that determine how quickly and easily development-stage projects can advance to production or exploration-stage projects can advance to development.

TGR: Do you expect more mergers and acquisitions (M&A) in the silver space, perhaps based on this garage sale effect that’s going on right now in the equities space? What market factors prompted that conclusion? Is that conclusion unique to the silver space among precious metals?

CT: We have to look at the industry from two points of view. First, we have to look at it from an acquirer’s perspective. What companies are positioned to purchase assets? What companies are looking to grow their production profiles through making acquisitions? Second, you have to look for prospective acquisition targets. What companies have good-quality assets that are suffering in today’s market because of lack of funding and weak investment sentiment for development- and exploration-focused stories?

What we find in the silver sector is that despite the current soft silver price, operating margins that a lot of silver producers are enjoying are some of the best in the sector. The average industry cash costs for silver producers are less than $10/oz, which implies a healthy operating margin at a silver price of ~$30/oz. A lot of silver producers are generating significant cash flow in this environment.

Realizing that investor sentiment in the mining sector is weak, a lot of companies that are trying to advance exploration projects or development-stage projects are battling to finance the advancement of their development and exploration plans. You coined it—it is pretty much a garage sale out there for exploration and development stories. The acquirers have healthy treasuries and the ability to generate additional cash flow to support larger treasuries and the targets are being starved of funds to develop their project—it’s a buyer’s market.

TGR: Endeavour Silver Corp. (EDR:TSX; EXK:NYSE; EJD:FSE), recently paid AuRico Gold Inc. (AUQ:TSX; AUQ:NYSE) $200 million (M) for AuRico’s El Cubo gold mine and a couple of other smaller exploration projects in Mexico. Do you believe AuRico will use that cash for M&A?

CT: I can’t talk about AuRico, but I can talk about Endeavour. Endeavour is an emerging midtier silver producer. It is currently working toward delivering upward of 5 million ounces (Moz) silver production annually over the next two years. Endeavour and other emerging midtier companies are growing their production base through acquisition. What seems to be a more common acquisition target in the sector right now are not development-stage or exploration-stage projects, but companies with operations. Endeavour’s purchase of the AuRico assets fits very well into this focus and is not a surprise. First Majestic Silver Corp. (AG:NYSE; FR:TSX; FMV:FSE) used the same sort of strategy by acquiring Silvermex Resources Inc. (SLX:TSX; GGCRF:OTC). There is, especially in the emerging midtier subsector, a consolidation of players.

TGR: El Cubo’s total resource is 1.14 Moz gold and 53.5 Moz silver. At $1,600/oz gold, that’s $1.8 billion (B). At $30/oz silver, that’s another $1.6B. That’s a total of $3.4B in all categories. Even just the proven and probable reserves of 322,000 oz (322 Koz) gold and 18.5 Moz silver amounts to more than $1B. It seems like quite a bargain. Why did AuRico do that deal?

CT: I would argue that this is not a core asset for AuRico. AuRico has a relatively aggressive production growth plan. It is guiding toward more than 500 Koz gold production by 2014. Obviously, this comes with significant capital cost commitments. As far as silver valuation is concerned, Endeavour will pay about $250M for the asset and some exploration projects. Layering that into a reserve base of about 38 Moz silver equivalent (Ag eq), it is paying about $6.75/oz Ag eq. This is a little expensive, but understand that it’s a producing asset. The same calculation using the resource base arrives at about $1.70/oz Ag eq, which is fair value for an asset portfolio that includes an operating mine. The value opportunity for Endeavour will be its ability to turn the operation around economically.

TGR: What about the exploration potential of the other two projects that were part of this deal—Quadalupe and Calvo?

CT: They present blue-sky opportunity for Endeavour. More important, Endeavour can generate value for the company by improving the operating efficiency of El Cubo, bringing down cash costs, adding ounces at the operation and developing the exploration assets.

TGR: Did you raise your target on Endeavour after that deal was announced?

CT: No. We still have a target of $10.50/share for Endeavour. We’re waiting for the company to finalize the transaction, as well as provide more details about how it’s going to be financing the $250M acquisition.

TGR: You were recently awarded the 2011 StarMine No. 1 Stock Picker award for the Canadian metals and mining sector. Congratulations. What are some of your favorite picks among the primary silver stories?

CT: I define a primary silver story as one that’s more valuable for its silver metal value than other metals using Haywood’s long-term metal price assumptions. We regard Bear Creek Mining Corp. (BCM:TSX.V) as a company that’s of interest primarily because of the development potential offered by its flagship asset, the Corani deposit in Peru. In time, Corani could offer +10 Moz silver production annually supported by byproduct credits. There are not too many projects at the feasibility stage of development that can offer that sort of annual silver production potential. Bear Creek is our preferred large-project developer.

TGR: It’s a world-class deposit, but Bear Creek is having permitting problems that are preventing its low-cost Santa Ana silver project from moving to production. It can’t bring Corani to production without the cash flow from Santa Ana. What’s the likelihood of Bear Creek finding a joint venture (JV) partner?

CT: There’s concern relating to Bear Creek’s ability to finance Corani. The company is in the throes of applying for permits for Corani. We do regard this asset as being financeable. Also, we do regard Peru as a world-class jurisdiction for exploration and project development in the mining space.

TGR: What are the estimated costs to bring Corani to production?

CT: We’re looking at just under $575M.

TGR: And it could do that without a JV partner?

CT: Preferably it would like to sell the project for the right price, but the company isn’t waiting to be acquired. It is aggressively developing the project to production. The company has just under $100M in cash. Santa Ana was the company’s second-tier project. The advantage of Santa Ana was it is a relatively cheap mine to build and bring into production.

TGR: Bear Creek recently hired Renmark Financial to do some investor relations. Will that be enough to change the perception of the company in the marketplace?

CT: We need to see a rebuilding of investor confidence in Peru as a favorable jurisdiction for mine development. The company can’t do much more than what it’s currently doing to develop Corani. The company needs to continue to promote the benefits of Corani, as one of the world’s largest undeveloped and economically viable silver projects, and work with the local communities.

TGR: How about some other primary silver producers? Would you put Kimber Resources Inc. (KBR:TSX; KBX:NYSE.A) in that category?

CT: Kimber, with its Monterde project in Mexico, is a very interesting company. Monterde is a development-stage gold-silver deposit. Based on the company’s current stock price, and what the project can offer, it is cheap. We know the company is in the throes of putting together another resource update for Monterde. We see Monterde as being a very attractive potential acquisition target for a midtier silver or gold producer. There’s a large gold silver resource with a high-grade core, which has been the focus of the company’s current deep drilling program. It’s a neat little project from an acquisition perspective.

TGR: Who are the would-be suitors?

CT: There is a small group of companies: Endeavour Silver, Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE) or First Majestic Silver Corp. (FR:TSX; AG:NYSE; FMV:FSE), a company with operations in Mexico that knows the jurisdiction. It’s an asset that would look good in the portfolio of a midtier producer—a company that is aiming to tag on 2 Moz silver production annually with a good gold credit. The challenge is that this group hasn’t yet showed any interest in buying projects—just operating mines.

TGR: Kimber has had some good drilling results at depth at Monterde. Could those results change the picture for a potential suitor?

CT: They support the high-grade potential offered by Monterde at depth. Monterde has been mistakenly perceived by the marketplace as being a low-grade project. The drill results that the company has released over the last six to eight months suggest there is a high-grade core at depth. It’s going to be very interesting to see what comes out when the company releases its revised resource estimate, which is anticipated in the next month or two.

TGR: We’ve seen some recent examples of nationalization, most notably in Argentina. The Argentinian government recently expropriated the assets of Yacimientos Petrolíferos Fiscales (YPF:NYSE), which is a Spanish oil company. Could there be ripple effects felt in the mining industry?

CT: It paints Argentina in a poor light as a prospective jurisdiction for mining and exploration. It’s very unfortunate this has happened. It creates a lot of uncertainty, worry and fear over development of any resource-based asset in the country. We do like the exploration potential that the country offers. We follow a number of companies in Argentina, one of which has a very substantial land position in the Santa Cruz province.

TGR: Which one?

CT: Mirasol Resources Ltd. (MRZ:TSX.V). It’s unfortunate. It’s these issues that really are beginning to have an overriding influence on the sector and, in many senses, taking away some of perceived opportunity that higher metal prices offer.

TGR: Do you see that having a direct effect on the share price of companies like Mirasol?

CT: It creates uncertainty with regard to how easy it would be for Mirasol, or any company in a similar position, to advance the development of an asset in Argentina. I do see this development as being damaging to the share prices of companies active in Argentina based purely on the uncertainty that comes with this sort of geopolitical risk.

TGR: Tell us about Mirasol’s flagship project and why the company merited coverage.

CT: When we look at an exploration-focused company, we have to be satisfied with the team and the property portfolio that the company offers. Mirasol has a very well qualified, experienced exploration-oriented team and a very attractive property portfolio.

In addition to that, the company has a JV with a major silver producer, Coeur d’Alene Mines Corp. (CDM:TSX; CDE:NYSE). Coeur d’Alene is earning a 61% interest in the Joaquin project, with Mirasol being the JV partner. The Joaquin project is arguably the most important development-stage asset that Coeur d’Alene Mines has, something that is needed to grow its production profile.

TGR: Do you believe that Mirasol is a potential acquisition target given the size and scope of Joaquin and Coeur d’Alene’s majority interest?

CT: I think so. We’ve always looked at Mirasol as being a potential acquisition target. We know Coeur d’Alene’s interest in Joaquin and see that as potentially being a trigger for an acquisition based on consolidation of ownership. We also recognize that the company has a very attractive land position, which ranks as one of the most prospective jurisdictions for precious metals exploration today.

TGR: There are a number of interesting silver explorers, even some developers, on Haywood Capital’s Watch List. Which ones are you following most closely?

CT: Exploration company Soltoro Ltd. (SOL:TSX.V) could potentially deliver a significant resource base at its El Rayo project in Mexico.

International Northair Mines (INM:TSX.V) may deliver a maiden silver resource at its La Cigarra project in Mexico in mid-year.

Developers Kimber, Bear Creek, South American Silver Corp. (SAC:TSX; SOHAF:OTCBB), MAG Silver Corp. (MAG:TSX; MVG:NYSE), Extorre Gold Mines Ltd. (XG:TSX; XG:NYSE.A; E1R:FSE) and Tahoe Resources Inc. (THO:TSX; TAHO:NYSE) may offer development opportunities in the space, as well as producers Endeavour Silver, Fortuna Silver and Aurcana Corporation (AUN:TSX.V; AUNFF:OTCQX) may offer growing production growth profiles.

TGR: How far away is Aurcana from being an American silver producer?

CT: Aurcana is in production. It has two assets, the La Negra asset in Mexico and the development-stage Shafter project in Texas. Our understanding is that it’s in the process of commissioning Shafter right now. We’re also anticipating a revised resource estimate on La Negra. We’re looking at a company that can deliver just over 4 Moz/year silver production at a little north of $8/oz cash costs.

TGR: Tahoe Resources is a very big resource at this stage.

CT: Tahoe is a very interesting company. It’s a development-stage story at the moment, but it offers potential to be a near-term producer. The company recently announced a revised resource estimate that showed a 50% increase in Indicated silver resource to 367.5 Moz.

But it comes at a price. The market cap for Tahoe is ~$2.6B. That’s what you pay right now for one asset that can deliver $20M silver/year and a potentially higher production rate with further development. Escobal also offers potential to achieve good operating margins.

It’s a company we’re watching very closely. We want to see the company get its permits. The permit is a very important milestone because it will remove a level of jurisdictional risk.

TGR: What approach to silver equities, especially those in the exploration and development phases, will best serve the average retail investor?

CT: Looking at silver equities is no different from looking at equities focused on developing, advancing and exploring for other metals. One of the most important attributes of any company is management. You need a good team that can deliver efficiencies in what is a relatively challenging time for mining based on a lot of cost creep and margin squeeze. It’s all about the team. In silver we look for quality over quantity. Look at the ounces in the ground that will work from an operating perspective rather than just the size of the inventory.

TGR: High grade, too?

CT: Grade, good metallurgy, safe jurisdiction. As I’ve said before, people throw out silver projects in many senses as offering size potential, but there is no value in having hundreds of million ounces silver in situ in the ground if you can’t mine them profitably. Also, be wary and recognize that silver is arguably the most volatile of all precious metals and equities, by extension, are also volatile.

TGR: Thanks for your time and insight.

Chris Thompson was trained in South Africa and has over 20 years of industry experience working as a geologist for major through to junior mining/exploration companies, in addition to a stint working as a mineral economist for the South African state. He has a bachelor’s degree from the University of the Witwatersrand, a graduate degree in engineering, a master’s in mineral economics and a PGeo designation. Thompson has been with Haywood Securities for over six years and specializes in junior exploration and the silver and PGM sectors. Thompson was recently awarded the 2011 StarMine No. 1 Stock Picker award for the Canadian metals and mining sector.