Discovery Silver (DSV:CA): Short-Term Pain, Long-Term Gain

Thesis

Discovery Silver (OTCQX:DSVSF) (TSX:DSV:CA) is an exploration stage company whose business model is based on acquiring and exploring mineral properties, which feature strong grades, meaningful size, and access to existing infrastructure in mining-friendly jurisdictions, primarily Mexico. DSVSF is currently focused on advancing its 100% owned Cordero project in Mexico.

In this article, we take a look at DSVSF’s valuation based on an NPV analysis of the Cordero project (the “project”). Besides, we consider how the project’s mining dynamics could improve, going forward. We also highlight major milestones over the near term that are likely to have a notable impact on DSVSF’s share price. We will conclude our discussion with an assessment of the potential risks that could impact Cordero’s long-term growth prospects. Let’s get into the details.

PEA versus PFS – What has changed?

The Cordero project is an open-pit, low-cost mining project that’s capable of becoming one of the world’s largest open-pit silver deposits. In November 2021, DSVSF released the PEA (read: Preliminary Economic Assessment) on the project, which was recently updated with the issuance of the PFS (read: Pre-Feasibility Study). The following table compares the key metrics between the PEA and the PFS of the Cordero project.

Parameter	2023 PFS	2021 PEA
After-Tax NPV@5%	$1,153 MM	$1,160 MM
Internal Rate of Return	28%	38.2%
Mine Life (Life of Mine)	18 years	16 years
Initial CAPEX	$455 MM	$368 MM
Payback period	4.2 years	2.0 years
Strip Ratio (waste: ore)	2.1:1	2.2:1
Average Annual AgEq production	33 Moz	26 Moz
Total LoM AgEq production	591 Moz	426 Moz
AISC (Years 1-12)	$12.82/AgEq oz	$11.73/AgEq oz
AISC – LoM	$13.62/AgEq oz	$12.35/AgEq oz

Click to enlarge

Based on the above data, I note the following:

1. On the plus side, there’s an improvement in the project’s LoM (read: Life of Mine or mine life), strip ratio, annual AgEq (read: silver-equivalent ounces) production, and total LoM AgEq production.
2. On the minus side, there’s an increase in Cordero’s estimated initial CAPEX, payback period, AISC (read: All-In-Sustaining-Costs) through the first 12 years of production (the ‘peak production years’), and AISC throughout the project’s LoM. Likewise, there is a slight decline in the project’s after-tax NPV (using a 5% discount rate).

NPV analysis

The PFS report identifies multiple scenarios of after-tax NPV of the Cordero project based on different price levels of the underlying metals (mainly silver, lead, and zinc). In our analysis, we will consider the base case scenario and the spot price scenario. Take a look at the table below:

Is 5% an appropriate rate for discounting the project?

In my view, those mining projects whose underlying mineral resource is mainly based on precious metals can be discounted at a rate between 6-8%. This is because precious metals usually have an established market and fewer barriers to selling. In contrast, hybrid projects which contain a mix of precious/base metals should attract a slightly higher discount rate; between 8-10%.

Although DSVSF defines Cordero’s mineral resource in terms of silver equivalent ounces, the project’s mineral resource and expected future revenues are primarily based on silver (a precious metal) and lead/zinc (base metals) sales. Hence, I believe that Cordero falls in the second category. For reference, take a look at the following table which shows Cordero’s expected future cash flows over the project’s mine life.

Nonetheless, other factors should also be considered including:

• Mining jurisdiction – Mexico is generally considered a mining-friendly jurisdiction, especially for silver miners. I believe this factor points in favor of selecting a low discount rate.
• The project owner’s size and prior working experience – DSVSF is a junior, exploration-stage mining company. In this context, selecting a low discount rate (say 5%) would be appropriate for a large-sized, experienced company like First Majestic Silver (AG). In the case of DSVSF, however, this factor points against selecting a low rate.
• Stage of project development – A project in the later stages of development could be discounted using a low discount rate. Given that Cordero is in the steps of preparing its FS (read: Feasibility Study) and obtaining construction permits (expected 2024), I believe this factor points against using a low discount rate.

When we consider all the above factors in tandem, we may be tempted to believe that the 5% discount rate is an unrealistic assumption and that an appropriate discount rate should be somewhere between 6-7% instead of 5%.

For the time being, let’s assume that the 5% discount rate is correct. Now, if we are to take Cordero’s base-case after-tax NPV (@5%) of $1,153 MM and divide it over the fully diluted outstanding shares of ~374 MM, we get NPV/share of ~$3.08. Meanwhile, the stock’s share price (at the time of writing) is ~$1. This implies that every ~$1 invested in DSVSF’s Cordero project could potentially generate a return of ~3x. In a more optimistic scenario, we take an after-tax NPV of ~$1,723 MM which is based on spot prices (refer to the table above). Here the NPV/share is ~$4.61 and implies a potential return of ~4.5x.

Do I challenge the 5% discount rate? I don’t.

At this point, some readers might wonder why I rely on the 5% discount rate particularly when other factors discussed above point against using a lower rate. That’s because I believe there are a couple of other positive catalysts capable of improving the Cordero project’s mining dynamics, which justify assuming the lower discount rate (of 5%). These catalysts are detailed below.

Project enablers

In my view, other project enablers that can increase Cordero’s returns over the long run include the following:

1) Scalability: Cordero’s PFS highlights an impressive resource profile. In my view, these resources have the potential to be revised upwards. First, note that the project’s P&P (read: Proven & Probable) reserves comprise 302 Mt (read: a million metric tons) of ore at a head grade of 27 g/t silver, 0.08 g/t gold, 0.44% lead, and 0.70% zinc. Next, the M&I (read: Measured & Indicated) resource category comprises 716 Mt of ore at an average head grade of 20 g/t silver, 0.06 g/t gold, 0.29% lead, and 0.54% zinc. Finally, the mineral resource also incorporates an ‘Inferred’ resource of ~145 Mt at an average head grade of ~14 g/t silver, 0.02 g/t gold, 0.23% lead, and 0.38% zinc.

The important thing is, the Cordero project claims cover a large land package of ~35,000 hectares, and the resource estimate mentioned above is based on the prospecting results of a relatively small portion of the property. Look at the figure below (the area in the circle represents the area covered by the PFS).

As shown above, the ‘PFS Pit Outline’ is only based on ~4-5% of the claim area. Interestingly, the resource estimate for the PFS Pit Outline is estimated to be ~1 billion AgEq ounces. Note that this does not imply a linear relationship between the claim area and the underlying mineral resource. Nonetheless, it indicates that there’s potential for significant resource expansion through targeted drill programs in the future since the majority of the claim area remains unexplored.

It’s pertinent to mention here that the 2023 Work Program incorporates a 26,500 meters drill plan which is further bifurcated between Feasibility Study (~17,500 meters) and Property-wide Targets (~9,000 meters). The ~9,000 meters initial drill program is planned across four nearby target zones: Sanson, Dos Mil Diez, La Perla, and Cordero Deep Skarn (refer to the figure below). If geophysics surveys reveal additional drilling targets, the program may be expanded to potentially upscale the project’s mineral resource.

2) Optimization: DSVSF can optimize the existing resource block in terms of metallurgical performance, mining costs, and mine life extension.

• Metallurgical performance: The company plans to undertake further testwork to improve recoveries and optimize the mine schedule by modifying the blending of rock types and oxides/sulfides. At this point, it’s worth noting that the PFS assumes an oxide-sulfide blend in the proportion of ~10% oxides: ~90% sulfides. DSVSF aims to test higher proportions of oxides (~20% or higher oxides) for blending with sulfides. Generally, oxides have a lower ore grade than sulfides. However, oxides are more abundantly available than sulfides, which means that they can be processed at a lower cost than sulfide ores.
• Mining Costs: DSVSF will further assess optimal bench height (thickness of the horizontal layer of the mineral deposit) and mine equipment sizing to potentially increase the size of mining equipment and reduce mining costs.
• Mine Life Extension: Finally, it also plans to incorporate an additional ~30,000 meters of drilling results in the FS targeted in and around the PFS pit outline (refer to the figure above), to upgrade the resource classification. This is expected to potentially extend the mine life in a favorable metal price environment.

3) Liquidity: DSVSF’s balance sheet includes cash and equivalents of ~C$45 MM, and is free from debt. The company’s cash position is sufficient to fund near-term exploration activities.

4) Healthy Operating Margins: As noted earlier, the LoM average silver equivalent production is expected to be ~33 Moz/year. Compared with the LoM average AISC of ~$12.82/AgEq oz, this implies a potential operating margin of ~$10/AgEq oz at the prevailing silver price of ~$22/oz. These margins are likely to improve in a bullish metal price environment.

5) Growth Prospects: Another aspect to consider is the planned throughput. The project’s initial CAPEX is estimated at ~$455 MM which will enable a processing capacity of ~25,000 tpd (read: tons per day). This CAPEX is planned to be incurred over 2 years. From the third year of production, the company plans to expand mill capacity to ~51,000 tpd. I believe the company’s strong cash flow generation during the first few years of production will help support the expansion CAPEX of ~$289 MM as noted below. In turn, these CAPEX investments will further enhance future operating margins (through capacity expansion) and generate significant cash for supporting exploration activities.

Strategic Milestones – What to Expect

DSVSF is advancing the Feasibility Study on the Cordero project, which is targeted for completion in Q1 2024 (~1 year from now). In my view, there’s no reason to anticipate a delay in the release of the FS especially since the company managed to release the PFS in line with the targeted timeline (that is, Q1 2023). It’s worth noting that the FS will be focused on optimization opportunities including improved mining and processing efficiencies.

Meanwhile, the submission of the project’s Environmental Impact Statement (or MIA) with the relevant authority (SEMARNAT) is also targeted for completion in H1 2023. This is part of the construction permitting process which is targeted for completion in 2024.

If the above milestones are completed within the planned course of the next 12-18 months, DSVSF would be in a position to make a construction decision in H2 2024. In my view, DSVSF’s price is likely to witness an upside as and when the above-mentioned strategic milestones are achieved. However, the stock is likely to see sustainable price appreciation once DSVSF takes a construction decision, and makes a financing arrangement for the Cordero project.

Risk Factors

Having taken a detailed look at the positive catalysts that support an investment case in DSVSF, let’s now consider the risk factors that need equal consideration from potential investors:

Funding Requirement – If DSVSF moves with a construction/development decision on Cordero (next year), it would need to finance the initial CAPEX of ~US$455 MM ($114 MM in year 1, $341 MM in year 2). The existing cash balance of ~C$45 MM will primarily be used for funding the drilling/exploration activities under the Initial Works Program (budgeted at ~C$26 MM). It’s unclear how the company will finance project construction. DSVSF has an unlimited number of authorized share capital. If it finances the project through the issuance of additional shares, this could result in possible dilution in shareholder value. On the other hand, if the company goes for project financing through debt issuance, the prevailing metal prices at that time will impact the cost of debt; a higher metal price environment will favorably impact the cost of debt and vice versa.

Commodity prices: In a previous table, we have seen how Cordero’s after-tax NPV (@5%) significantly improved from ~$1,153 MM (base-case) to ~$1,723 MM (spot prices) given a moderate increase in the prices of the underlying metals (silver, gold, lead, and zinc). Our calculations showed that based on these two scenarios, the project’s returns ranged from ~3.0x to ~4.5x. Nonetheless, NPV estimates could move south if there is an adverse metal price environment at the time when Cordero begins commercial production.

Jurisdiction: Although the Cordero project is located within a well-established silver mining jurisdiction (check the figure below), however, certain risks need to be factored in. Mining permits for open-pit mines in Mexico will likely be subject to strict scrutiny before approval. Mexico’s tax environment is uncertain; regulators try to find ways to slap more taxes on mining companies to cash in on the commodities boom.

Investor Takeaway

In the preceding discussion, we have seen how DSVSF looks undervalued based on an assessment of the after-tax NPV of its flagship project, Cordero. The ongoing two years (2023-2024) are important in that DSVSF is likely to achieve multiple milestones regarding Cordero’s development. These milestones include the completion of a Feasibility Study, a final decision by DSVSF’s Board regarding project construction, arrangements for project financing, and most importantly obtaining the Environmental Permit (or MIA) from the regulator. In my view, the execution of each of these milestones will have a notable positive impact on the share price. Meanwhile, the mining economics of the Cordero project is likely to improve based on the results of targeted drilling/ exploration activities.

In contrast, we are witnessing consolidation in silver prices within the range of $22.5-24.5/oz. This is a negative catalyst that could prevent any major upside in DSVSF’s share price in the near term unless the prices of silver witness a rebound. Thanks to a strong US jobs report for January 2023, the turbulence in silver prices is likely to continue. Meanwhile, technical reports indicate that the silver price may find support at ~$21/oz.

Given the above, I believe DSVSF’s price is less likely to see a notable upside in the near term unless there is a rally in silver prices. Nonetheless, a long investment in the company makes sense due to the attractive mining dynamics of the Cordero project.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.