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Endeavour Silver, An Undiscovered Silver Mine by Wall St.?

I was part of a group that visited two major mining operations owned by Endeavour Silver Corp (EXK) in Mexico at the end of last month. The 1st mining project is at Guanajuato, and the 2nd one is at Guanacevi. Both are in the historically silver rich central Mexico region. It was an intensive 4 day trip with 2 days of busy schedules. Our visit was definitely adventurous, educational and exciting.

Mexico is the 2nd largest silver producing country in the world next to Peru, and may potentially overtake Peru to become #1 in the future. It has over 400 years of silver mining history, dated back to the Spaniards in 1500s. Both Mexico and Peru are relatively geopolitically safe, with Mexico at even lower political risk by being a NAFTA member. Especially in 1993, Mexico revised its mining regulations and codes and since then it has become a mining-friendly and favorable country. Mexico is also one of the fastest growing emerging economy in the world with low taxes to attract foreign investment.

The silver mining area in Mexico is mainly along the rich Sierra Madre belt through the center of Mexico where both Guanajuato and Guanacevi are located. Due to its long history and geology of rich silver reserves, today, you will find most of the public traded silver companies having operations in central Mexico. Some people call it the modern day silver rush, similar to the good old days of Gold Rush in California. Except this time, Mexico has a longer history and a lot more silver reserves than the case of California Gold Rush. Should we call it the Mexico Silver Rush?

Endeavour Silver (EXK) is a Canadian junior silver mining company with its headquarters in Vancouver. However, almost all its manpower, assets and resources are in Mexico. Their main focus is to grow their silver reserves, resources and production and generate cash flow and profit in Mexico. The two main operating and producing mines are Guanacevi project near Durango and Guanajuato project at Guanajuato. We started with the Guanajuato, the smaller of the two, then proceed to Guanacevi the next day.

A. Guanajuato trip

I spent more than half a day flying from New York City to Leon airport which also serves the city of Guanajuato. We all got up early the next morning to start our tour. The mining operations of Guanajuato is about 30 minute drive from the city. Endeavour owns properties on two veins in this area, one is called Veta Madre vein and the other is La Luz vein. After a presentation in their office, we started with the tour and inspection of their San Jose shaft and vein exposure along the La Luz vein. This area is still under exploration but with great potential for increasing reserves and production in the future.

Then we toured the exciting Bolanitos plant now owned by Endeavour. This plant takes the ore, crushes it in several steps, and reduces it from over 14" size ore to fine particles. Then there is a chemical process which separates silver from the rest and creates high concentrates of silver mud. The mud is subsequently shipped to and processed by an outside plant to turn into silver bars. This plant has a capacity of processing 500 tonnes of ore per day, but currently is running at only 100 tonnes per day. The goal is to increase the current volume by threefold and to be at 300 tonnes by yearend and to reach its full capacity of 500 tonnes next year.

The next stop was even more exciting. We all squeezed into a small elevator that barely fits 4 people, and went down 180 meters underground in San Elias Shaft at the Veta Madre vein area. This is one of the 3 main shafts operated by Endeavour for this project. It is a great experience to go under the surface and to see how the actual mining operation works. During the whole visit, most of us had collected many beautiful mineral rocks.

Endeavour owns some large properties here, what we visited is only a very small portion. Two other similar shafts will be operational to triple the current output by yearend. An area with even more potential is the adjacent section 3785 where Endeavour is drilling holes and exploring at the moment, with easy access by building a tunnel from the existing mining area if it turns out to be feasible. If this potential materializes, Endeavour can easily increase its silver reserves from current 7.3 million oz of reserves and expand the Guanajuato production substantially.

Endeavour acquired their Guanajuato project from Industrias Penoles only recently in 2007, along with the Bolanitos processing plant mentioned above. Endeavour is investing capital to ensure the safety of the mines and to improve efficiency of the plant and this is why both of them are not fully operational yet. This reflects a higher working standard and long term commitment by Endeavour management.

Due to the current low volume at 100 tonnes per day, the silver production cost is actually very high at the moment, about $24 per oz. However, by tripling its production to 300 tonnes per day, Endeavour should bring it down to around $11 per oz as we were told, since they are now fully staffed for full capacity or quite overstaffed at current production level. In other words, they don't need to go out and hire more workers in order to triple their production. A large component of the production cost is fixed cost such as workers and depreciation. This will remain relatively stable in the future with fixed labor cost and decreasing capital expenditure, but there will be incremental increase in costs of fuel, power, chemicals, explosives and supplies.

I did a quick calculation on this. At $11 per oz, if Guanajuato produces 400K silver out of their 2.5M oz of total production estimate for 2008, it will cost them a cash outflow of $11*0.4M = $4.4M (excluding depreciation). However, if Endeavour can triple its production next year to 1.2M oz (their goal is 1.5M oz), but their cash cost only doubles to $8.8M due to labor costs staying flat, the cash cost will be only $8.8M/1.2M = $7.3 per oz (excluding depreciation). This is consistent with management's target of $6-7 cash cost for 2009 given to us at their presentation, since the cash cost may not need to be doubled. If cash cost only increases by 50%, or $6.6M, the unit cost will only be at $6.6M/1.2M = $5.5 cost per oz.

This operational leverage gives management a great incentive to control costs. $7 per oz seems to be a doable target. If silver price stays at current level of $16, as an average for 2009, an almost $10 net cash flow for an annual production of 1.2 million oz, or $12 million, just at the Guanajuato project, the smaller of the two core mining operations, is a very positive prospect for Endeavour. And I won't be surprised to see the real production to be higher at 1.5 million oz, which is Endeavour's target next year.

B. Guanacevi trip

Through the whole trip, the airplanes I flew since taking off from New York City had been getting smaller and smaller every time. It was Continental commercial jet from New York City to Houston, then Continental Express took over, a much smaller plane, that flew us from Houston to Guanajuato. At the end of the Guanajuato tour, Endeavour chartered a very nice small plane called Metroliner, which seated only 16 people, flew us from Guanajuato to Durango.

The next day, the trip became even more adventuresome. From Durango, we flew by several Cessna planes which seated only 4 people at one plane, and traveled from Durango to Guanacevi. They put me at the co-pilot seat, so that I could get a much better view while we flew for an hour through the beautiful mountains and forests in the central Mexico region. It was a very smoother flight than I expected, no wind at all. Not quite the same situation in the afternoon, as you will see later.

Most of the silver produced currently for Endeavour is coming from the Guanacevi project, which has Proven & Probable reserves of 14 million oz, Measured & Indicated of 13 million oz, and Inferred of 9 million oz of silver. We toured the Porvenir mine on several tractors by going through various tunnels inside the mine (we didn't need to go 180 meters underground this time). We made many stops along the way, and actually saw the workers drilling inside the mine.

Endeavour owns four main zones in this area, with drilling in fifth zone that is also promising. In the afternoon, Endeavour gave us a quick tour of the Guanacevi plant. In this process plant, visitors can actually see the last steps of silver liquid being burned at a furnace, poured and cooled down in the mold. We were all excited to touch and try to lift the finished product of real silver bars. The bar itself weighs about 75 lb, so unfortunately it is a little too heavy to be carried around and run away with.

The plant has a recovery rate of 70% now but has a target to reach over 85% by yearend. It processes 800 tonnes of ore at the moment but Endeavour is in the process of increasing its capacity to 1,200 tonnes per day, a 50% increase. The capital investment in this plant in 2008 is estimated to be at $7M.

Guanacevi project is located at the Santa Cruz vein, and in 2004, this was the 1st acquisition by Endeavour, which has re-defined the whole company and re-shaped its business model. Endeavour's business strategy has been to acquire old mines on the cheap, invest its capital to improve its standard and efficiency, and wherever successful, to continue to acquire more properties and expand in the nearby area along the veins.

The Guanacevi project is a miracle from the start. They inspected the old mine in 2004, quickly made the decision to purchase the mine along with nearby properties and the old process plant with only a $7M initial payment. Then they expanded the mining further along the vein into an un-mined area, and discovered high grade silver, and started production in half year from the purchase, which is record time in the industry, and a proud achievement for Endeavour. They did all this in 2004, right at the start of the current silver bull market - talk about perfect timing!

As I alluded to earlier, the afternoon flight from Guanacevi to Mazatlan was very bumpy. Our flight had to take off before 3 pm due to the gusty wind in the late afternoon. Since the airstrip is right at the foothill, our planes had to climb up fast after taking off to fly over the mountain. My plane was the 2nd in line to take off, about 5 minutes to 3 pm. There was only one short unpaved dirt runway, and I was told sometimes people have to chase the horses or other animals off the runway before the plane can actually take off. Luckily that was not the case that day, otherwise we wouldn't have enough time. I heard the last Cessna took off barely beating the 3 pm deadline in the middle of a strong gust, and the pilot managed quickly and skillfully to maneuver between a couple of trees to finally reach a safe altitude. Due to the strong gust, first half of the flight was as exciting as riding the roller coaster at Disneyland. But the wind gradually became calmer when we got closer to Mazatlan, a tourist city along the coast, which was the last stop of our exciting trip to Mexico.

C. Financials and Discussion

In general, I am very impressed by Endeavour Silver, their management, their reserves and properties, their business model, their potential, and their future. All top management are long term veteran miners and have spent their whole career life in the mining industry, and they all love this business. Their head of Mexico operations is a life long, experienced Mexican who knows all the in's and out's on mining in central Mexico. He was instrumental to introduce Endeavour to the Guanacevi project, to help them to acquire the properties and later on to start production in only half year from the purchase.

Besides the Guanajuato and Guanacevi projects, Endeavour is also exploring at the Parral area in Chihuahua, currently under feasibility evaluation, and at the Arroyo Seco property located in south-eastern Michoacan, still under discovery phase. To be conservative, the following analysis totally discounts those two projects which we didn't visit this time.

By considering all the nice silver rich properties they have at their current operating mines and in the nearby high potential exploratory areas in just Guanajuato and Guanacevi, It won't surprise me that Endeavour reserves will increase substantially in the near future, which will further add more value and make Endeavour more attractive.

I did some number crunching and analysis after coming back from my trip, the more I do, the better I feel about this Company. First, let us look at the cash flow this year. Endeavour will spend about $13M on capital expenditure this year, mainly on both the Guanacevi and Guanajuato plants (around $7M to improve the Guanacevi process plant, $3M on underground mining development at Guanacevi, and $3M on the Guanajuato plant and its mining operations). From their 1st quarter report, cash cost is $10 per oz (with Guanajuato higher but Guanacevi lower), or $5M cash outflow per quarter, likely going higher at the 4th quarter due to the tripling of production at Guanajuato but with lower unit cost.

Let us say $25M ($5M for Q1 & Q2 each, $7M for Q3 and $8M for Q4) cash cost in 2008, with total operating cash outflow at $38M ($13M capital plus $25M mining operations), excluding exploration and general & administrative. The expected production for 2008 is about 2.5 million oz silver (0.5 million oz already achieved in the 1st quarter). Endeavour realized $18 per oz for silver in sales, resulting $10.7 million revenue in Q1. Let us only use average $16 silver for the whole year conservatively, 2.5 million oz means $40M cash inflow, higher than $38M cash outflow. In other word, Endeavour should achieve positive operating cash flow this year by about $2M.

For the total cashflow of the whole Company, we need to add exploration and general & administrative (both are cash items), which I estimate $8M for exploration and $5M for general & administrative in 2008, or another $13M. This will put Endeavour about $11M in the negative cashflow territory. However, if they can realize the same price as Q1 at over $18 in the 2nd half, they should get over $45M revenue in 2008, only $6M from breakeven in total cashflow. This means Endeavor will not need to dip very deep into their $21M cash reserves, or refinancing by issuing more dilutive shares, with the exception of any major purchase and acquisition.

Secondly, let us look at the earning this year. Again the 1st quarter revenue is at $10.7 million, but let us use the same $40M revenue for the whole year with average $16 silver price as discussed above. Cash cost is assumed to be around $10 per oz (4th quarter should be lower with higher production), 2.5 million oz will cost $25M, consistent with my cashflow assumption above. We then need to add back depreciation, which I estimate to be around $7M, with total operating cost at $25M + $7M = $32M, less than $40M revenue. Again, Endeavour should achieve positive operating earning this year by about $8M. This figure is higher than net operating cashflow due to higher capital expenditure in 2008.

For 2008 earning of the whole Company, we need to add exploration, general & administrative and stock based compensation incentives (stock option value based on Black-Scholes model). I estimate them roughly as follows: $8M for exploration, $5M for general & administrative, and $5M for stock based compensation (non-cash item), totaled to be another $18M. By adding $18M on top of the $32M operating cost discussed earlier, we have $50M at the total expense line. This will put Endeavour at a loss of about $10M, not far from the $11M net negative cashflow discussed earlier. Again if they can realize over $18 per oz as they did at Q1, resulting over $45M revenue, they are only $5M from breakeven this year.

More importantly, let us look forward for the next two years. Endeavour's target is to produce 5 million oz of silver annually, doubling from 2008, by running at full capacity at both plants with improved recovery rate, efficiency and output. I estimate the time frame that they should achieve this goal on an annual basis is from mid-2009 to mid-2010.

Again let us look at cashflow first. Conservatively I use only $16 per oz with 5 million oz production, or $80M on the revenue side. With production doubled, the target for cash cost by management is around $6-7 per oz. Let us use $7, or $35M cash cost annually. In next two years, Endeavour will reduce its capital expenditure to around $5M per year, no need to maintain at this year's $13M level anymore. Thus the total operating cash outflow will be around $40M ($80M - $35M - $5M). This represents a net $40M positive operating cashflow annually and 50% of revenue.

For the forward looking cashflow of the whole Company, we need to add exploration (around $6M for 2009, $2M lower than 2008), general & administrative (say $6M for 2009, $1M higher than 2008), resulting net positive cashflow at $28M ($40M - $12M). This is more than their cash reserves of $21M at the moment.

Now let us see what the forward earning power will be once Endeavour reaches its 5 million oz annual production. We need to include depreciation (estimated around $8M for 2009) but remove capital expenditure to get operating earning, resulting $37M ($80M - $35M - $8M), not far from the net operating cashflow figure of $40M. Again, it shows great operating earning power and high gross profit margin of 46%.

For the forward looking earning of the whole Company, we need to include exploration ($6M), general & administrative ($6M) and stock based incentives (say $6M, $1M higher than 2008, a non-cash item). That is another $18M expenses, plus $43M from above ($35M cash cost and $8M depreciation), which equals $61M at the total expenses line. In other words, Endeavour should achieve $80M - $61M = $19M profit with 53 million fully diluted shares, or 36 cents of earning per share, and 52 cents of net cashflow per share ($28M / 53M shares). The forward implied P/E ratio is only 9 at current $3.2 price ($3.2 / $0.36). With a company showing ability to grow its reserves at about 50% per year for last several years and potentially for future years, a P/E ratio twice of 9 at 18 even seems very low once the market realizes its future earning power. At P/E of 18 with $0.36 earning per share, Endeavour should be at $6 per share, which is my target for the next 12 months, doubling from current level.

In above calculations, I ignore other miscellaneous items such as loyalties, foreign exchange impact, investment income, etc., which I feel they are not material and sometimes offset each other when combined, and most likely they won't change the whole picture that much. I also tried to be conservative in my calculations. In the near future, I see earning will be lower than cashflow due to: 1) depreciation will increase due to large capital expenditure for the last 2 years but decreasing next year; 2) stock based incentives (options) will increase. Both are non-cash items, especially stock option expenses were not even included in and part of anyone's financial statement until a couple of years ago.

During the whole trip, Endeavour Silver is very open and transparent about their financials, and it is a company easy to understand and evaluate. It is simple, blue-collar and straight forward. It has tangible assets you can actually see and touch, unlike some hi-tech companies with products that either go up to the sky or fall to the hell, or some non-tangible banking assets which become huge liabilities overnight.

Gold and silver correlate closely with each other. I fully expect both gold and silver will do well in the next two years, with silver probably outperforming gold and junior miners entering an explosive phase. If it happens as predicted, with its operating leverage, all my estimates here on Endeavour's cashflow and profit could turn out to be quite at the low end. Currently Endeavour receives very little institutional coverage, even at market cap of about $160M. Once its story of high potential, high growth and high profit becomes broadly aware, it is expected to draw more institutional interest, coverage and ownership, which will help its stock price. The timing at the moment seems right too, since Endeavour is at the turning point of becoming profitable.

Silver production is often a by-product of other minerals, and there are very few stand alone silver companies around. Once the precious metals and junior miner sector come back to life after the current correction phase, we should see a nice run-up of many juniors including Endeavour, which is on its way to become a mid-tier silver exploration and production company.

I am long Endeavour Silver in my portfolio since December 2007. My basic travel expenses to tour Endeavour mining operations were covered by Endeavour. However, I receive no compensation whatsoever for my time, or for writing this report.


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