News Analysis date published New: 
Wednesday, May 9, 2012 - 12:59
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Wednesday, May 9, 2012 - 13:00
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Wednesday, May 9, 2012 - 12:59

Why these Silver Stocks Could Bounce in a Major Way

Wednesday, May 09, 2012 12:59 PM

As I was reviewing the list of stocks hitting 52-week lows this week, I noticed an unusual cluster of stocks: silver-miners. These stocks have been under heavy pressure in recent weeks and are falling anew, leaving them -- at least in the context of recent trading patterns and valuation sentiments -- quite cheap. Then again, just because something is cheap doesn't mean it's a bargain. After all, stocks moving below their 52-week lows can fall yet further before rebounding. So are these lagging silver-mining stocks offering up value, or are they just a value trap?

Here's what I found...

The cycle and costs -- a double whammy
Silver miners, just like any other mining firm, are seeing rising costs as labor and equipment expenses have both risen steadily in recent quarters. Higher expenses aren't a short-term blip -- they're the "new normal." Adding insult, commodity prices have been steadily falling on concerns that a European economic implosion will affect global trading partners from Brazil to China.

Yet here's the most important factor: Even with rising expenses and falling selling prices, silver miners continue to be a solidly profitable group. The EPS (earnings per share) figures noted above actually understate their profitability. High levels of depreciation dampen net income, but operating cash flow per share for almost every one of these companies is solidly higher than that EPS figure.

Emotions rule
Yet these stocks aren't selling off on valuation. Instead, investors are increasingly spooked that the troubles in Europe will put a brake on global economic growth, crimping demand for silver and pushing prices ever lower.

Silver has actually been on a roller-coaster ride since the start of 2011. Roughly a year ago, the global economy was starting to look a bit healthier, and commodities traders were snapping up silver contracts in anticipation of rising demand for this industrial metal. But fresh economic concerns have pushed silver back to levels it touched on two recent occasions.

Make no mistake, Europe's problems should greatly concern you, as I noted in this article. You shouldn't be surprised to see the market take a quick tumble on a day the headlines are especially scary. Yet it's impossible to know when such an event will happen -- if at all. And if you are a long-term investor, then you need to start thinking about buying whenever a deep sell-off emerges. These are precisely the areas that will have the strongest snapback when conditions stabilize and growth returns. And growth surely will return to places like China, Brazil and the United States, all of which are poised for sustained growth.

Right now, the sell-off in these sliver mining stocks looks like a severe overreaction, trading in many instances for half of their 52-week high. Sure, they could fall further, but odds are they will be well higher in a few years once the current economic scares no longer dominate trading sentiment.

Not just cheap, but a bargain as well
So where are the bargains now? Wall Street analysts are starting to compile a list of favorites, each using slightly differing methodologies. Dahlman Rose has been looking at mining stocks in the context of what their dividends will likely be in a few years. They note that Pan American Silver (Nasdaq: PAAS) has heavy capital spending commitments for the next 12 months, but should then be generating solid free cash flow after that. If this company boosted its payout ratio to 50% in 2014, then the dividend would be $1.95 a share, good for a dividend yield above 5%, according to Dahlman Rose.

Merrill Lynch prefers to look at the projected long-term output of a company's mines, in some cases up to eight years, and then figures out what a particular miner should be worth in relation to the cash flow that the silver output will generate. For example, Merrill thinks industry giant Silver Wheaton (NYSE: SLW) is worth $51 a share, roughly twice the current stock price. For Hecla Mining (NYSE: HL), the target is $6, or nearly 50% above the current price.

Analysts at UBS are bullish on Couer D'Alene Mines (NYSE: CDE). The miner released first-quarter results earlier this week that appear to have missed estimates, but after backing out a series of one-time inputs, UBS found that Couer D'Alene actually earned $0.39 a share, well ahead of UBS' $0.18 a share forecast. They note "the significant beat relative to expectations was driven by higher production and lower costs," and see shares rising from a recent $18.50 to $28.

Hecla Mining also reported results this week that were, frankly, uninspiring. Yet as I've noted in a few recent articles, Hecla's results are being dampened by troubles at a key mine, and results in 2013 should look far better. (Its Lucky Friday mine should be back in operation early in the year.) UBS figures Hecla's mines are worth more than $7 a share, well above the current $4 share price.

Risks to Consider: These silver stocks could still fall lower as Europe's troubles deepen and/or if the spot price for silver drops further.

Action to Take --> Don't try to call the bottom on this sector. It may already be in. It may not. We just don't know. Instead, focus on the fact that these silver miners now represent deep long-term value, whether as an asset play or a cash flow play. Commodity plays in general provide great trading opportunities, as they are often oversold in tough markets and overbought in brighter times. Indeed, I wouldn't stick around with these stocks if they were anywhere their 52-week highs. But the 52-week lows that are in place are surely enticing candidates to buy.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.