May 14, 2011 - 11:52pm EST by
2011 2012
Price: 4.95 EPS $0.00 $0.00
Shares Out. (in M): 88 P/E 0.0x 0.0x
Market Cap (in $M): 435 P/FCF 0.0x 0.0x
Net Debt (in $M): 52 EBIT 0 0
TEV ($): 487 TEV/EBIT 0.0x 0.0x

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Summary and Thesis:


At current levels, I believe Primero Mining (TSX: P) presents a compelling risk reward profile. I believe that the current stock price reflects only a conservative valuation of the Company's presently sole operating asset. More bullish - but still very reasonable - assumptions yield a value 50%+ above the current share price. Primero's core asset is low risk, producing, and capable of roughly doubling production within three years.

However, the more immediate and less well understood value creation opportunity for Primero lies in remedying the severely deleterious tax implications that exist as a result of a legacy silver purchase/sale agreement Primero assumed when it acquired the mine/assets associated with its core operation.


Simplistically: Primero is currently on the hook to sell the vast majority of the silver it produces (≈5.0mm ounces in 2011) at $4.08/ounce. That - in and of itself - is awfully painful. More painful - and financially oppressive - however, are the tax implications of the arrangement: as it stands, Primero is liable for income taxes associated with selling its silver production with taxes computed based on market prices. (The silver agreement itself will definitely continue to exist).


Based on management's recent commentary and actions, I believe it is likely that Primero will remedy the situation in the near term. In doing so, annual after tax cash flow will increase by $20mm-$40mm+ (depending on the LT silver price one assumes). Using LT gold and silver prices of $1,250 and $25, the NPV of benefit would be ≈$354mm (80% of current market cap) based on a 5% discount rate through 2028 (assumed life of mine). Using $1,400 and $30 prices, the NPV would be $441mm (100% of current market cap). Significantly as well - currently, due to the tax structure, Primero has negative leverage to silver prices; a reversal of the tax structure would result in positive leverage to silver prices.


Therefore, the way to think about Primero is as follows:


  • 1) A core producing asset that based on LT $1,250/ounce gold and $25/ounce silver is worth at least the current enterprise value (assuming present tax structure)
  • 2) A reversal of the tax structure worth ≈$350mm-$450mm+ - i.e. 80%-100%+ the current market cap
  • 3) Substantial exploration (organic growth) and acquisition opportunities


Accordingly, assuming stable gold prices (I don't have a view on that and would advise hedging out with commodity/basket of juniors/specific juniors) I believe risk of permanent capital impairment is low and the opportunity to make 50%-100%+ upside is quite reasonable.


Non-standard disclaimer: Unfortunately, few industries seem more prone to overpromise/underdeliver than junior/intermediate precious metals miners. Most junior/intermediate mining investments rely on management achieving (often lofty) production goals. Such situations often are appealing because of the 'situational' nature of the investment and the frequent appearance - at least on first glance - of asymmetrical risk/reward profiles. I believe Primero is different insofar as the upside is not production driven - it is tax structure driven.


To be sure, the margin of safety is based on production from the core asset. But the production targets appear achievable based on historic results. Again, Primero's core asset is an already producing asset that will organically fund itself.


Should the company deliver on their production goals (near and longer term) I would expect the stock to re-rate as a result of that. But my thesis rests on the core asset simply covering the current stock price with upside a function of a resolution to the tax issue.




Primero came together as a quasi-SPAC and quasi-spin-off of Goldcorp (NYSE: GG). On a nominal basis, Primero was formerly Mala Noche Resources. In reality, that entity was used as an acquisition vehicle to acquire the San Dimas mine from Goldcorp. San Dimas - although prospective, productive, and low cost - was considered a non-core asset by Goldcorp. Accordingly, Goldcrop did not allocate sufficient capital to the project resulting in a decline in tons processed and gold produced.


In August, 2010, Primero completed the acquisition of the San Dimas Mine and related assets for an aggregate purchase price of $489mm (essentially equivalent to current EV). Consideration paid to Goldcorp was as follows:


  • $220mm in cash
  • 31.2mm common shares - Goldcorp owns 36% of Primero
  • $50mm by way of a promissory note - $5mm payable annual for the next four years followed by a $30mm balloon payment
  • $60mm principal amount convertible promissory note - maturity date of August 6, 2011 and payable in either cash or shares


In order to fund the cash portion of the acquisition, in July 2010 Primero issued 50mm 'Subscription Receipts' for $6.00 each, for gross proceeds of $300mm. Each subscription receipt equated to one common share and .4 of one common share purchase warrant. Each whole warrant entitles the holder to purchase one additional common share at a price of $8.00/share through July 20, 2015.

Presented below is a snapshot of the current capital structure of Primero:
Stock price  $       4.95
Shares outstanding           87.8
Market cap  $     434.5
Cash           58.0
Promissory note(1)           50.0
Convertible note(2)           60.0
Net debt  $       52.0
Enterprise value  $     486.5
(1) Goldcorp: 5 year, 6% note repaid $5M/yr with balloon payment at end of year 5  
(2) Goldcorp: 1 year, rolling, 3% note convertible at CDN$6  
Basic shares outstanding           87.8
Combined warrants and options           30.0
Combined warrants and options - weighted average strike price  $       7.22
Cash from warrant exersize               - 
Shares repurchased               - 
Diluted shares outstanding           87.8
Reserve - proven and probable  
Gold - ounces (mm)             0.9
Silver - ounces (mm)           62.9
Inferred resources - exclusive of reserves  
Gold - ounces (mm)             2.0
Silver - ounces (mm)         178.8
Reserves + inferred resources  
Gold - ounces (mm)             2.9
Silver - ounces (mm)         241.7
EV / reserve + resource ounce  
Gold only  $     167.8
Gold ounces equivalent using gold / silver ratio of 200/1  $     118.4

San Dimas - the core asset:


San Dimas is located within the prolific Sierra Madre gold/silver belt of Mexico, a region in which gold and silver production has occurred for over 250 years. According to Primero, San Dimas has produced over 11 million ounces of gold and 582 million ounces of silver. The modern San Dimas complex consists of a number of underground mines (Tayoltita, Santa Rita and Central Block) and two potential deposits (Sinaloa Graben and Arana Hanging Wall), each containing numerous epithermal vein structures. Ore from the underground mines is treated at a centralized processing facility located at the Tayoltita mine. Gold/silver doré produced at San Dimas is shipped off site for processing by a third party.


I recommend perusing the company's presentations or initiation reports from various sell-side brokers for additional background on the asset.


Presented below is a model for San Dimas - the model reflects the following assumptions:


  • 1) Production in 2011 at mid-point of Company guidance
  • 2) Gold equivalent production grows to almost 200,000 ounces by 2014 - in line with Primero's stated goal of doubling production at San Dimas by 2013; Primero is targeting 130K-140K gold ounces upon achievement of plan (I have assumed 130K)
  • 3) $30mm in annual CapEx through 2013; $20mm thereafter
  • 4) Mine life through 2028 - Primero believes the asset has at least 20 year LOM
  • 5) Cash costs per ounce trend down to $450 / ounce by 2014 in line with Company's goal that "Total cash costs are expected to trend below $450 per gold equivalent ounce over the three-year plan"

For simplicity purposes I have used current spot prices for LT prices. If we used $1,250/$20 for LT prices, the NAV under current tax structure (based on my model) is $526mm and the NAV with the tax structure remedied is $789mm.

Fiscal Year Ends December 31 2011 2012 2013 2014 2027 2028
Gold production - (ounces 000's)                 95               105               110               130               130               130
Silver production - (ounces 000's)             4,500             5,500             8,000             8,000             8,000             8,000
Gold price - spot  $         1,500  $         1,500  $         1,500  $         1,500  $         1,500  $         1,500
Silver price - spot  $             35  $             35  $             35  $             35  $             35  $             35
Silver price - contract to SW  $           4.08  $           4.12  $           4.16  $           4.20  $           4.78  $           4.83
Silver production - contract threshold             3,500             3,500             3,500             3,500             6,000             6,000
Silver revenue - actual  $             34  $             54  $            103  $            103  $             68  $             69
Realized silver price - $/ounce  $           7.52  $           9.74  $         12.84  $         12.87  $           8.56  $           8.60
Silver revenue - taxable  $            158  $            193  $            280  $            280  $            280  $            280
Actual revenue ($mm)  $            176  $            211  $            268  $            298  $            263  $            264
Taxable revenue ($mm)  $            300  $            350  $            445  $            475  $            475  $            475
Cash costs / gold equivalent ounce  $            560  $            510  $            460  $            450  $            450  $            450
Gold / silver ratio for gold equivalent ounces (spot gold price / realized silver price)               200               154               117               117               175               174
Gold equivalent ounces produced               118               141               178               199               176               176
Total cash costs  $            (66)  $            (72)  $            (82)  $            (89)  $            (79)  $            (79)
Depreciation  $            (30)  $            (30)  $            (30)  $            (30)  $            (30)  $            (30)
Corporate G&A  $            (18)  $            (18)  $            (18)  $            (18)  $            (18)  $            (18)
Earnings before tax - computed on taxable revenue  $            186  $            230  $            333  $            356  $            366  $            366
Tax rate 30.0% 30.0% 29.0% 28.0% 28.0% 28.0%
Taxes  $            (56)  $            (69)  $            (97)  $           (100)  $           (102)  $           (102)
Earnings before tax - computed on actual revenue  $             62  $            109  $            156  $            179  $            154  $            155
Tax rate 89.4% 63.2% 62.0% 55.8% 66.3% 66.2%
Taxes  $            (56)  $            (69)  $            (97)  $           (100)  $           (102)  $           (102)
Net income - based on actual revenue (taxes computed on taxable revenue)  $               7  $             40  $             59  $             79  $             52  $             52
Operating cash flow  $             37  $             70  $             89  $            109  $             82  $             82
CapEx  $            (30)  $            (30)  $            (30)  $            (20)  $            (20)  $            (20)
FCF  $               7  $             40  $             59  $             89  $             62  $             62
Based on Current Tax Scheme            
NPV  $         601.3          
Discount rate 5.0%          
Earnings before tax - computed on actual revenue  $             62  $            109  $            156  $            179  $            154  $            155
Tax rate 30.0% 30.0% 30.0% 30.0% 30.0% 30.0%
Taxes  $            (19)  $            (33)  $            (47)  $            (54)  $            (46)  $            (46)
Net income - based on actual revenue (taxes computed on actual revenue)  $             44  $             77  $            109  $            125  $            108  $            108
Operating cash flow  $             74  $            107  $            139  $            155  $            138  $            138
CapEx  $            (30)  $            (30)  $            (30)  $            (20)  $            (20)  $            (20)
FCF  $             44  $             77  $            109  $            135  $            118  $            118
Based on Potential Tax Scheme            
NPV  $      1,130.1          
Discount rate 5.0%          


The most substantial upside to my model is likely to come from a significantly longer mine life than I am projecting and from strong organic growth in reserves/production (exploration driven). Primero estimates the mine life of San Dimas is in excess of 20 years. Additionally, San Dimas offers substantial exploration potential. Specifically, the company has just begun targeting exploration at Sinaloa Graben. When Primero was conducting due diligence on the site, the technical evaluators estimates total resources of 1mm ounces of resource potential (not in reserves or resources) at Sinaloa Graben. During the six months under Primero control, the company has been able to recognize 340,000 ounces in resources from Sinaloa Graben with relatively minimal exploration spending.


Note: I am inclined to use low discount rates for gold mining companies because investors are willing to own gold without a return on capital. I believe demanding a discount to NAV, employing conservative assumptions around costs, mine life, etc. are all appropriate for discounting execution risk for a gold producer. Accordingly, I could justify using a 0% discount rate for generating an NPV of the cash flow streams after taking other considerations into account. I have used a 5% discount rate.


Silver Agreement:

Overview of agreement:


Pursuant to Primero's acquisition of the San Dimas Mine, Primero assumed obligations under two silver purchase agreements.


  • 1) Primero's Mexican subsidiary, Primero Empresa, has the obligation to sell all silver produced at the San Dimas Mine - up to a certain annual threshold and 50% of production above that threshold - to Primero's Barbadian subsidiary, Silver Trading, at market prices
  • 2) Silver Trading has the obligation to sell all silver purchased from Primero Empresa to Silver Wheaton Caymans at the lesser of approximately $4.08 / ounce (+1% annual escalation) or market prices


More specifically, the present agreement is as follows:


  • 2010-2014: first 3.5mm ounces of annual Ag production plus 50% of excess sold to SLW at ≈$4; 50% of annual Ag production above 3.5mm ounces sold at spot
  • 2015-LOM: first 6mm ounces of annual Ag production plus 50% of excess sold to SLW at ≈$4; 50% of annual Ag production above 6mm ounces sold at spot


Note: the agreement commenced August 6, 2010 and anniversaries every subsequent August 6th.


The present agreement - an amended arrangement that Primero entered into when it acquired the San Dimas mine - in fact represents an improvement over the previous agreement, under which 100% of the silver produced from San Dimas was sold to Silver Wheaton, further reducing the economics of the operation.  Additionally, under the amended agreement the duration of the contract has been revised to a life-of-mine contract instead of an agreement expiring in approximately 19 years.


Per the new agreement, Primero will indeed have exposure to spot silver once it has produced to the contract threshold levels. Accordingly, Primero will begin to recognize spot silver sales at some point in 2Q and will continue to recognize sales at such levels through August 6 of 3Q. Those sales should boost 2Q and 3Q earnings materially.


Tax issue associated with silver agreement:


Simplified, this issue is this: although on an economic basis Primero recognizes only $4.08/ounce revenue for its silver, on a tax basis Primero recognizes income tax at the spot rate. That arrangement results in massive tax payments with no associated economic income. The opportunity for Primero is to eliminate the tax liability.


The severe tax leakage is due to Primero Empresa's Mexican domicile (≈30% tax rate on spot price based profits) and Silver Trading's Barbadian domicile (≈0% tax rate on contract price based losses). In other words, the company generates a 'profit' is a normal tax jurisdiction and generates a 'loss' in an effectively zero tax jurisdiction. Accordingly, Primero is unable to use the tax losses to offset the taxable gains and thus ends up paying full taxes based on market prices.  


Negative leverage to silver prices:


Based on the current structure and assuming flat gold prices, Primero experiences negative leverage to rising silver prices.


The impact to after-tax cash flows from relative moves in gold and silver prices for 2011:


  • Gold price +10% and silver flat - after-tax cash flow +18%-20%
  • Silver price +10% and gold flat - after-tax cash flow -4%-6%
  • Gold and silver price +10% - after-tax cash flow +14%


Should the tax structure be reversed, Primero will experience positive leverage to rising silver prices - a more favorable situation for a precious metals company.


What has changed?


What leads me to believe that Primero will remedy their tax structure? This is based on comments from the CEO at various conferences as well as discussions with the company.


I advise interested parties to listen to the following (


  • 1) 4Q10/FY10 Conference Call - February 24, 2011
  • 2) Conference Presentation - March 2, 2011
  • 3) Conference Presentation - April 15, 2011


Critically, I want to highlight that at the most April 15th conference, Primero's CEO spoke very confidently about the company's ability to remedy the tax situation, saying they have a solution they believe will work and a plan to detail shortly. I believe the solution

The solution will involve re-domiciling Silver Trading from Barbados to Mexico. That will result in Primero recognizing both taxable gains and losses in Mexico, thereby eliminating the tax liability associated with the spot sales.

Such a restructuring requires the approval of Silver Wheaton. The concern Silver Wheaton will have is this: if Silver Trading is domiciled in Mexico, will that result in the Silver Wheaton entity (also located in a zero-tax jurisdiction) that purchase the silver from Silver Trading having to pay taxes? Primero's tax advisors and lawyers believe that will not be the case - but they will have to convince SW's own counsel of that.

From a purely economic perspective, SW should realize that a restructuring of Primero's entities would result in Primero being substantially more economically incentivized to maximize its silver production from San Dimas. It was for that reason that the previous silver sale agreement was amended (so that Primero now has some spot exposure). Currently, San Dimas represents roughly 20% of SW's silver production. Accordingly, maximizing production from the asset is a high prioerity for SW - but, of course, so is minimizing taxes.

I also note that on March 21, 2011, Primero announced that it had purchased call options on silver at an average strike price of US$39. The options cover two thirds of the estimated silver sales to Silver Wheaton Corp. over the next six months for a total cost of US$2.3 million. The call options were purchased to improve the Company's leverage to silver and reduce the adverse tax impact of the Silver Purchase Agreement with Silver Wheaton, particularly in the event of a dramatic short-term rise in the silver price.

In the release, the CEO states: "We believe that within 6 months we will be able to implement longer term mitigation strategies that should provide significant increases in cash flow to the Company."

At the April 15 conference, the CEO reiterated the six month timeline for full a resolution of the company's tax issue.

Interim solution:

It is possible that Primero will announce an interim solution to the tax situation in the very near term, prior to finalizing a permanent solution. The interim solution would involve an immediate and full amortization of the purchase price of the San Dimas mine. This would create a tax pool that would shield Primero from Mexican taxes for 2-3 years, providing Primero with the additional time - if neccesary - to get both the Mexican tax authorities and SW counsel on board with the tax structure remedy.



CEO Joseph Conway was previously CEO of IAMGOLD Corporation ($7bn listed company) from January 2003 through January 2010. He has geological training as well as substantial experience in the finance/investment industry.


The reasons for Conway's departure from IAMGOLD are not clear. However, based on my reading of the company's activities, Conway was doing a fine job. During his tenure, IAMGOLD stock went from ≈$5.00 to $16.50 - a good result, though not exceptional considering the move in gold prices over the time. But the fact that Conway has experience running a multi-billion dollar company and probably had various options at hand gives me sufficient confidence that he can capably run a $400mm company.



  • The most significant risk is that the tax structure issue cannot be remedied and that the gold/silver ratio significantly tightens. I believe the company will be able to remedy the tax structure and that - in the case they cannot - hedging options by the company are available to limit their exposure should the gold/silver ratio significantly tighten.
  • Generally poor execution
  • Downside to gold prices (hedgable)



- Resolution to current tax structure
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