US Silver & Gold Inc. USGIF
October 24, 2013 - 5:33am EST by
2013 2014
Price: 0.51 EPS $0.00 $0.00
Shares Out. (in M): 70 P/E 0.0x 0.0x
Market Cap (in $M): 36 P/FCF 0.0x 0.0x
Net Debt (in $M): -5 EBIT 0 0
TEV ($): 31 TEV/EBIT 0.0x 0.0x

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  • Gold
  • Mining
  • Nano Cap


Even VIC’s biggest fans of gold and silver hate the companies that mine those metals, so a bullish case on a money-losing silver mining penny stock is certainly a contrary opinion.  Nevertheless, I believe a bet on USGIF (US symbol, or USA CN in Toronto), whose historic underground Galena Complex mines silver in an immense property in the heart of Silver Valley, Idaho, is a “heads you win very big, tails you shouldn’t do too badly” type of speculation, which I like.

What is attractive about USGIF?  1) the company over the next several years should both substantially increase its output and lower the cost/ounce, such that it can be increasingly profitable even in an environment of moderately declining silver prices, 2) should silver prices go up, it can rapidly increase its output without long lags for exploration, capital spending or gaining permits, 3) its properties are in the US, which should be given a higher valuation than nearly all other silver companies, whose assets are mostly in countries with more uncertain politics and rule of law, 4) despite that advantage, it is very underpriced versus nearly all other silver companies, and offers a much larger exposure to ounces of current silver production per dollar of valuation than nearly all others, even forgetting its ability to rapidly ramp up production should prices justify it, implying a big upside should silver prices go back up, and 5) in 2012 its neighbor Hecla (HL-NYSE) made an all cash bid of $110MM, turned down by shareholders, which is three times the current EV; moreover, a good case can be made that the company is worth much more now than then. 

USGIF showed big losses in the last year, but most of that is non-cash write downs and the consequences of some bad choices of previous management, replaced in mid 2012.  Production and cost figures for Q3, out this week, show the company getting set for higher output and lower costs.  Despite the lowest silver prices in over three years, USGIF was close to the black in Q3 if one doesn't count severance from layoffs and the cost of temporarily shuttering lower grade stopes.  With an estimated all in cost of $19/ounce in Q4 versus a current silver price close to $23, the company should be in the black in Q4, and increasingly so in 2014 and beyond, as its production rises and costs drop. 

Of course, if silver prices should plummet soon and stay at $12 or so forever, not likely but not unthinkable, then this stock idea will definitely not work.  Even then there would still be many synergies in combining USGIF with HL: even at $15 silver the higher grade stopes at Galena would still be profitable were the operation part of HL.  So while anything can happen, the stock does not have as high a risk of a zero outcome as one might think, given its current price.  

History and Position:  USGIF has a long and complex history, of which I’ll give just the basics.  Its main asset is the Galena mine, located in the Silver Valley in northern Idaho, near the town of Wallace.  The company owns property and claims covering about 14,000 acres, about nine miles long and two miles wide and fully permitted, with no contractual delivery commitments at low prices and no royalties owed on any of its production.

Mining on its property began in the 1800s, but serious development began in 1953 by Asarco, and then taken over by what is now Coeur Mining (CDE - NYSE).  In June 2006 CDE, which was focusing on larger and potentially lower cost projects overseas, sold the property to newly formed US Silver for $15MM cash. The low price reflected its what was then high cost production, with cash mining costs alone of $8.37/ ounce in 2005, a year in which silver was selling for around $7.

High costs were the result of CDE investing little in the mine for many years, and both exploration to expand reserves and heavy maintenance expenditures to rebuild hoists and other infrastructure were needed for it to operate efficiently.  The new company took on that task, and everything came together nicely by 2011, the year that silver prices peaked around $48 and averaged about $35.  Exploration had doubled its initial proven and probable reserves.  Although production in 2011 was hampered by capital projects, revenues reached $89MM and EBITDA $32MM.  That was in an environment of sharply rising costs, mostly from factors affecting the entire industry, discussed below.

In mid-2012, after the retirement of the CEO, and to add presumably less volatile gold assets to the mix, the company merged with a smaller mining company in Montana, RX Gold, which owned the historic Drumlummon mine, and RX Gold's management took over the combined operations.  In an unsuccessful attempt to thwart the merger and gain control over Galena, neighboring silver miner HL made a $110 million cash bid for what is now USGIF, except without Drumlummon and before HL or even USGIF management was aware of the 150MM+ ounce potential silver resource in the Caladay Zone section of its property, understood for the first time only earlier this year.  Although the silver price is closer to $22 now than the $25 it was when HL made its bid, that cash bid is some evidence that at a $36MM EV, the stock is very undervalued.

The Galena Complex today includes the Galena mine, which has 23MM ounces of silver in reserves as of the last 43-101, in veins that are narrow but high grade, some of which have silver mixed with lead and others silver mixed with copper.  There are two shafts (vertical passages through which hoists move miners and material) in Galena, and a mill on the surface that can handle 1000 tons/day of ore.  This past July USGIF halted production from the ten lowest grade stopes out of the 25 that it had been mining.  This reduced silver output (before some new production kicks in), but by raising the average grade it helps lower the cost/ounce.

To the west of the Galena Mine, but connected underground, is the Coeur mine, which operated for about 30 years ending in 1998.  Exploration has found some promising new areas, and the company was on the verge of restarting the mine last winter, when dropping silver prices made it decide to keep that plan on hold, since limited capital would be much more productively deployed developing the Caladay Zone.

Sitting above the Coeur is a second mill, now temporarily idled after eliminating the low grade production from the Galena mine, since the Galena mill can handle all the output, at least for now.  The two mills collectively can handle 1500 tons or ore per day, and current production is only about 500 tons, providing plenty of excess capacity to handle growth of production from the Caladay Zone and restarting the lower grade stopes if higher silver prices justify that. 

About 1.3 miles to the east of the Galena mine is what was originally planned to be a third mine.  In the early 1980s a fully outfitted shaft was sunk about 5100 feet down, with the intent to find a rich silver/copper vein that went missing at a fault line to the west.  They didn’t find that vein, but found instead a huge body of silver/lead ore, lower grade than the silver/copper vein they sought, and therefore at late 1980s prices uneconomic, albeit quite economic today.

Nothing came of the Caladay Shaft, other than its use today to provide more ventilation to the Galena mine, since the two connect underground.  With time and some flooding at the bottom, the lifts no longer work and a complete rewiring and rehab would be required to return it to good working order.  A year ago, when silver was in the $30s, the company considered borrowing the $30+MM that would be required to do that.  That is out of the question under current conditions, but it also turned out that shaft isn't necessary to get at the massive Caladay ore body.  Exploration, involving over 1100 holes in total, and the digitizing and block modeling of old paper records earlier this year revealed that the Caladay Zone continues much further to the west than previously thought, close enough that the company can get access by extending existing levels of the Galena mine to the east, which it started doing this past quarter. 
Along with bringing in a new management, the merger with RX Gold brought the Drumlummon Mine in Montana, with a history that also dates back to the 1800s, when it was one of the most productive gold mines in US history.  There is good reason to think that there is a vast amount of gold still there at Drumlummon that could be mined economically, because the mine closed in 1910 due to complex litigation, long before there was the technology to explore it properly.  It started up again a few years ago, but when production from the most lucrative vein diminished earlier this year, the mine was temporarily closed and is on care and maintenance, costing about $250,000 per year.  Higher gold and silver prices would probably induce more exploration drilling and an eventual reopening of Drumlummon.

A little aside first on gold/silver mining companies:  Investors hate the gold and silver miners for many good reasons.  Most managements have proven to be poor allocators of capital, making large acquisitions at times of peak prices, and going ahead with projects whose capital costs soared, often in countries whose governments appeared to be mining-friendly when investment was needed, then turned rapacious once the investment was made and production started.

All that is true, but it shouldn’t be a problem again for a long time, because the price of their shares and operating losses have ensured that most mining companies don’t have much capital left to allocate, let alone misallocate.  

The other main complaint about the mining companies involve their sharply rising costs/ounce in recent years, which refuted the previous bullish case that operating leverage would work in their favor if the price of gold and silver went up.  I will argue that those rising costs/ounce are not permanent features of the miners, and seem to be in the process of reversing.

One cause of escalating costs has been the massive Chinese demand for the output of all types of mines, base as well as precious.  Gold or silver mining equipment isn’t much different from that used for industrial metals, and mine labor is relatively interchangeable as well.  The upward pressure on capital and operating costs is now reversing as China’s growth slows, new and used equipment is readily available, and mine closures are making skilled employees available at lower pay. That said, one major cost item to miners which is only partially affected by Chinese demand is the price of energy, which remain a wild card.

The other aspect of rising cost/ounce in precious metals is a consequence of the steady increase in gold and silver prices from 2000 to 2011.  If silver is selling for $10/ounce, no sensible management would intentionally mine ore that would produce silver that costs more than $10.  When silver is over $40, should a mining company produce silver in a lower grade area costing it as much as $30?  Assuming it has the capacity to handle the extra production, probably yes, because that will increase total profits despite also increasing the average cost/ounce.  

Analysts just looking at soaring cost/ounce forget that much of the increase was a voluntary and rational choice on the part of managements to mine lower grade areas because it paid to do so.  With silver back to the low $20s, companies will do what USGIF has done and stop working on the lower grade stopes, cutting production but also slashing cost/ounce.  There is a lag effect here as well due to severance and one time mine or stope closing expenses.  True, there is a trade-off in cutting production, since there are fixed expenses such as corporate and mine overhead which will have to be carried by fewer ounces, so a serious cost cutting effort by a mining company has to address those as well.

There are other complaints about the mining companies, mostly focusing on empire building and corporate governance, but to be a bit too cynical perhaps, these issues only arise in industries when their stocks are down, and are forgotten when things are doing well.

Between a diminishment of overall cost pressures, elimination of production that is no longer economic, as well as general cost cutting due to hard times, the odds are we will see a lot of positive surprises in terms of cost/ounce throughout the industry, which I think is likely to result in a positive change in attitude toward the stocks.

If you aren’t bearish on gold and silver prices, that is an argument for being long a fund or ETF of precious metals mining companies; trouble with that is so many of them have their operations in unfriendly or unstable countries.  You might want to put together your own portfolio of companies whose operations are in the US, Canada, and perhaps a few other relatively safe places.  Because of its terrific risk/reward characteristics, as I hope to demonstrate below, USGIF deserves a place in such a portfolio.

An Aside on Silver Prices:  There are two ways to look at silver prices.  One is to assume that silver is the poor man's gold, and will go up and down with gold, only with more volatility.  Over the decades and centuries the ratio of silver and gold prices can make big swings, from gold selling for roughly 15 times silver in ancient times through the early 20th century, to the 59 times silver that gold now sells for today.  For any given year, however, the correlation between their price movements is high.

The second way is to actually analyze supply and demand.  Unlike gold, where industrial and jewelry demand is trivial compared to the stock of gold in existence, and the output of all mines is equally inconsequential, silver has many applications in a range of products, and the output of mines does make a difference in overall supply and demand.  Gold is always worth retrieving and reusing, so other than perhaps wedding rings that slip down drains and disappear in the sewer system, most of the gold ever mined has been recovered from its original use and is reused or sitting in a gold bar or coin somewhere.  Silver, not as valuable, is often not worth trying to recycle, especially when used in microscopic quantities as it often is.

You'll find many complications and surprises with silver, such as the fact that even though, unlike gold, most of the demand for it is for industrial applications, a slowing economy can actually be bullish for silver prices, because most of the supply of silver isn't from pure silver mines, but comes as a byproduct of mining other industrial metals, especially copper.  Anything that affects copper production, such as economic strength or weakness, affects silver supply.

Life is short, I prefer the first approach:  If gold goes up, silver will too.  Investment (or speculative if you prefer) demand and supply for silver are what have the biggest impact on prices, because by comparison industrial demand and supply are relatively stable.  If you do want to delve into the details of supply and demand, this outfit has the details:

Why the Caladay Zone will make a big difference:  USGIF's focus for the next year is to extend the Galena mine levels steadily to the east to gain access to the ore in the Caladay Zone ("CZ").  The CZ can be divided into two parts, each to be mined differently, but both to help the company increase output and cut cost/ounce.  

The bulk of the CZ is a massive body of mixed silver and lead, with a horizontal length of 1200-3600 feet, a vertical depth of about 3000 feet, and widths of 200-400 feet.  The grade of most of it, at 5-7 ounces of silver (adjusted up for the value of the lead) per ton, doesn't sound like much compared to the 13 average ounces per ton ("opt") USGIF just reported mining in Q3, but the massive widths allow it to be mined with equipment that removes large quantities of ore at once, drastically increasing miner productivity, making lower grade ore as profitable as grades twice as high that are mined using conventional techniques, as has traditionally been done in the Galena mine.  

With narrow veins as in Galena, some only two feet wide, a miner has to be like a surgeon (with dynamite and a jackhammer) carefully removing the silver containing ore and as little ore as possible outside the silver vein, since that is just junk and transporting worthless rock upstairs and running it through the mill adds to costs and brings in no value.  With the veins in the silver/lead part of the CZ running from 25 to in some cases over 100 feet wide, miners using "long hole stoping" equipment can remove large amounts of ore at a time and be confident that it all contains enough silver to be processed profitably

Between the start of the silver/lead part of the CZ and the existing Galena mine is an area of silver/copper that includes some very high grades and widths that, while not big enough to use the bulk mining methods of the silver/lead areas, are still a good bit wider than what has been mined at Galena in recent years.  The company refers to this as the Silver Halo section, and like all the major veins in the Silver Valley, is relatively vertical and appears to get richer as it goes down.  USGIF will probably circle around the Halo over the next year or two, mining down to the lowest levels in which it has infrastructure, while simultaneously going relatively horizontally across the CZ to pick up the silver/lead ore in bulk. 

The two sectors of the CZ will allow a good increase in production over the next two years, and it has the excess hoisting and milling capacity to handle the increase.  Assuming silver dips back to $20 and stays there, production should rise about 40% from its current rate of roughly two million ounces, and with the higher output reducing various fixed costs per ounce, all in costs, estimated to be under $20/ounce in Q4, should dip in two years to perhaps $15-16.

Upside Production Leverage: What is particularly appealing about USGIF as a speculation is its ability to increase its silver output relatively quickly compared to most silver companies if silver prices rise enough to justify it.  Higher output, by spreading fixed costs, of which mining companies typically have a lot, over more ounces therefore also cuts cost/ounce.

Suppose in six months the price of silver has gotten back to $30 or so, where it was most of last winter. Without much delay the company could rehire miners and reopen the ten stopes at Galena it temporarily closed in July.  Yes, they are lower grade, but still profitable at $30, and could add about 400K silver ounces/year in additional production.  With more capital to work with due to much higher profits on existing production, the company could invest in projects to bring on additional sources of supply that would take somewhat longer, but measured in months or quarters rather than years, because most of these options don't require permits or long lead times to put into place.  They include:

1. More aggressive development of the CZ and Halo to open up more working faces.

2. Reopening the Coeur mine, something that would have happened by now were it not for the big drop in silver prices:  That could add about 500K silver ounces/year.

3. Increasing the infrastructure investment at the lowest levels.  Drilling indicates that the CZ, the Silver Halo, and the main Silver Vein at Galena all get wider and higher grade as they descend to lower levels.  Right now work on the CZ and the Halo are occurring at the 4900 level (i.e., nominally 4900 feet below the surface).  The mine has workings at 5200 and 5500, but not yet as fully developed in terms of ability to transport miners, ore, and other infrastructure elements needed to significantly boost production.  Higher grade ore means more silver ounces without having to move or mill more ore.

4. If silver prices go up, probably so will gold, and the Drumlummon gold mine can be reopened.  I would call that more of a medium term project because the area is still very unexplored, and I would expect USGIF's management to start with a thorough exploration effort first, probably lasting at least a year, before taking that step.  The Drumlummon situation is complicated by the need for permits to pump out the parts of the mine that were intentionally flooded over a century ago by the losing party in a bitterly fought lawsuit to prevent the winner from getting the gold there.

If exploration drilling shows that the various major veins at Galena and the CZ keep getting richer much below the 5500 level, as appears likely, then ultimately the company will want to mine there.  That, however, would require a significant jump in capital spending for a new shaft down from the 5500 to perhaps the 7000 level, along with investments in related infrastructure, not something to be undertaken lightly or bringing a quick return.

Similarly, if there were a stray $30+ million lying around, USGIF could rehabilitate the Caladay Shaft and attack the CZ from the east as well as west.  Again, high risk, high cost, and a long delay between spending money and getting silver, so that isn't going to happen anytime soon.

Every mining company has plans it can dust off to expand production if prices rise enough to justify it.  Many of those companies' plans involve opening up whole new areas which typically take a long time and many governmental approvals before producing the first ounce of silver.  I like the fact that USGIF has the ability to boost production more than 50% if the silver price rises a moderate amount without major investments or a long time lag. 

Above Ground Improvements in Operations:  After USGIF's ore comes up to ground level, it first gets sent to a mill (USGIF owns two of them that collectively can handle three times current ore production, and with some moderate capital spending could handle four times) to grind the ore, eliminate a lot of waste rock, and produce concentrate.  That gets shipped to a smelter, either trucked 200 miles to the Teck smelter in Trail BC Canada if it is silver/lead concentrate, or sent by train to the Xstrata (recently bought by Glencore) smelter 2000 miles in eastern Canada if silver/copper.

The relationship between the company and Teck has worked well, but the contract the company's previous management signed with Xstrata was not a good one.  Not only does USGIF not get paid for certain byproducts that have a market value, but it is required to pay the smelter for removing them.

Much worse is how the price USGIF gets for the silver in the concentrate is determined.  There is a long time, from three to six months, between the time when USGIF ships its concentrate and when the smelter has processed it and can sell the silver.  Xstrata gives USGIF a downpayment on the silver when shipped, but the final price is based upon the price on sale, many months after shipment.  When prices drop, as was the case in the first half of 2013, USGIF mined ore that would have been profitable based on the price when it was mined, but actually produced losses based on the lower price much later. This lag produced about $4MM in losses in the first half of 2013.

Fortunately, this contract with Xstrata expires at year end, and the early indications are that USGIF can work a better deal, as the declining fortunes of mining generally have increased competition by smelters to line up concentrate.  With Glencore, historically more trading oriented than Xstrata, now in charge, if nothing else the company ought to be able to work a deal that will allow it to nail down a final price around the time of shipment rather than having to gamble on what the price might be many months later. 

Finances:  There were big losses in 2012 due to impairment charges and other artifacts of the merger with RX Gold in mid year.  Cash flow from operations for the year was positive $10MM.  2013 so far has been rougher due to the price of silver falling almost in half through the end of June.  Despite that, the company was slightly in the black for the first half.  Operationally, the company was helped by having the miners work longer shifts over fewer days, which gave them more time actually digging ore versus being paid to go up and down in lifts, starting up, and shutting down their shifts.  New policies to reduce waste rock helped with grade.  Still, getting paid based upon the price of silver many months after it was mined wasn't pleasant during a time period when prices were dropping sharply.

The only major blunder management made involved an $8MM loan due in July 2013.  That would have been easy to refinance last winter in advance when silver was in the $30s.  Instead, management was then focusing on the possibility of raising a much larger sum to rehabilitate the Caladay Shaft (which turned out to be unnecessary) and procrastinated lining up the replacement finance.  The price of silver was plummeting all through the spring, and when the time came to pay the debt, the only lender willing to refinance demanded onerous terms. The 12% interest was bad enough, but the company was also forced to give five year warrants for 10.63MM shares at $0.68, all totally unnecessary had it refinanced in advance.  Not long after that, with the silver price just barely above its low, the company raised an additional $5.8MM, half bought by Sprott, with a private placement of stock at C$0.60 and warrants at C$0.75.  The net effect of all this is to boost fully diluted shares outstanding to 93MM, and the near-death experience the company had when it almost couldn't repay the loan last July suggests that it wouldn't rule out raising even more money should the opportunity present itself, even at the cost of some further dilution.

But even at 93MM shares outstanding assuming the exercise of all options and warrants, that is half what Hecla was willing to pay in mid-2012, and the company is in so much better shape today.

Why USGIF is a bargain:  You all have access to the RV function on your Bloomberg machines and can compare USGIF versus comparable industry companies in many different ways.  I'll just highlight one ratio that Bloomberg doesn't calculate.

Realistically, if you have read this far and are considering buying the stock, it is either because you believe that silver prices will be going up over the next few years and are looking for a good way to play that, or perhaps you are agnostic about the direction of silver prices but want to have a play on that to counter some other investments that you think would drop in an environment where silver prices were going up.

What favors USGIF versus nearly every other silver company is its very low EV relative to its current production. That is current production of around 2MM ounces/year, and not considering the ~2.8MM ounces it should be able to profitably produce at $20/ounce as it ramps output from the CZ and Silver Halo areas, let alone the 3-5MM ouncesit could produce if silver prices were higher and it had the capital and justification to ramp up various production options discussed above.

A comparison that demonstrates that is a calculation of how many ounces of silver production one buys per $1000 of a company's EV.  That comes to over 52 ounces for USGIF versus 30 to 14 ounces for all except one of the next ten silver mining companies with USGIF's EV or higher.  The only one cheaper was Silver Standard, and its only mine is in Argentina, which involves massive political and currency risks of the sort USGIF need not spend any time contemplating.  The other nine had their mines in Mexico or China; call me a chauvinist, but I think having a mine in the US is worth a premium.

Yes, I know that I am just comparing present production and ignoring reserves and resources, which count for a lot too, but I think USGIF compares well on those factors. 

Risks:  These are pretty obvious:  No one knows what will happen to the price of silver, and it could go down a lot.  All mines are black boxes, in that no one knows for sure what is underground and what is the most efficient way to remove it.  Bad things could happen to close the mine down and drive the company into bankruptcy, such as geological issues, underground fires, tunnel collapses, accidents involving the death of miners, and rubbing regulators the wrong way;  I could go on and on, a 51 cent marginal silver miner has many risks.

At the same time, if the risks can be surmounted and the price of silver rise enough to justify the capital spending to increase production beyond what it will grow to anyway even with flat prices, then in a few years we are looking at a company producing 4MM+ ounces at an all in cost in the low teens, selling the product at let's say $30.  Do the math, annual profits would exceed its current EV, and the stock is likely to be a multi-bagger.
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.


1. Rising silver prices
2. Rising production and reduced costs/ounce producing growing profits, whether or not silver prices rise
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