Description

This is going to be a quick write-up because there isn’t all that much to say. It’s a play on odds. For those of you with a sense of adventure, a small position probably is worth it. For the more skittish value guys, this is a pass. I’m going to quickly parse the financials and then speak mostly about why it is cheap. This one has more hair than an 80’s rock star.

Apex Silver owns the San Cristobal silver-zinc lead mine. When/if this comes online, it will be one of the largest silver and zinc mines in the world, producing 22 million ounces of silver and 180,000 tonnes of Zinc a year at a cash cost of $1.31/oz silver and $.860/tonne zinc. Over the life of the mine, it should produce 275mm tonnes of silver, 3mm tonnes of zinc and 1.1mm tonnes of lead. There are a number of exploration targets that will likely increase the mine-life significantly beyond the 16 years currently anticipated. The project is fully financed and more than half the construction work is complete. It should enter production in the third quarter of 2007 and based on current metal prices, it should have pre-tax free cash flow of roughly $570mm assuming it was un-hedged. This works out to around $9.50 a share (59.5 million FD shares). The banks made them hedge some early production and this will reduce cash flow by a dollar or two a share in the first few years of production versus current metal prices depending on where metal prices ultimately settle out. If you are like me, and think the secular bull market in metals continues, at $15 silver/oz ($10.25 now), $1.80 zinc/lb ($1.50 now) and $.65 lead/lb ($.50 now) you end up with over $700m in pre-tax cash flow.

I have chosen to gloss over these numbers because they are largely irrelevant. All that you need to know is that this is an incredibly large, incredibly low cost, incredibly profitable mine that is trading at an even more incredibly cheap price in the mid 13’s or less than two times pretax cash flow. Now for the hairball…

There is a mountainous country where armed militia bands roam aimlessly; the budget is financed largely by selling drugs and disparate indigenous tribes routinely fight it out with each other. In fact, the only thing holding the country together is that they hate us more than each other. You may think I’m speaking of Afghanistan, or even Iraq, but I’m referring to Bolivia. The Afghanistan of the West; which has abandoned three years of intermittent riots to support coca grower Evo Morales in his quest to nationalize foreign assets and essentially ‘stick it to us’. This may make things seem hopeless for Apex, but it also creates a lot of opportunity.

In short, a mine of this scale is not a simple endeavor, and the Bolivians probably cannot manage it themselves. They need western know-how and an outright confiscation is out of the question. Instead, they’ll use legalized confiscation (taxes) to take the cash flow. With around $9 a share in cash flow, they can take a whole lot and the shares will still remain cheap. Even if they take two thirds of the cash flow, if the shares then traded at 8X the remaining $3/shr in earnings, it would represent a double from current quotes. I recommend buying the January 2008 15 call that trades around 4.50. You eliminate around $9 of risk if something really hairy happens, and a move upwards into the mid 20’s would be at least a triple. As I will explain later on, I think there’s a good chance that the ultimate tax rate is much lower, Morales is more sensible than Western media portrays him and the shares ultimately trade into the 40’s or more. For a point of reference, just two months ago, the shares traded as high as 27.

Bolivia Primer

Bolivia is the poorest country in Latin America. Indigenous groups make up a significant percentage of the population, yet until recently were powerless against Spainsh descendants who controlled most of the government apparatus, land and wealth. This is a natural flashpoint and after three years of riots and presidents who could not hold power for long, Evo Morales was elected in a landslide vote despite widespread fear amongst the wealthier classes who live in the cities. Evo was a former coca grower and leader of a group of coca growers who were a bit peeved that Americans would repeatedly use herbicides on their crops in the hope of destroying some coca in the process. Successive governments had little choice because the country has been held together mainly with US subsidies in exchange for letting us destroy their crops. You can see how this would cause issues. For those who do not know, coca is the feedstock for cocaine, but for the natives, unrefined leaf is a part of life and grown alongside potatoes and corn. It is used in teas, cookies, salads and chewed during work. In this form, it is not addictive and from reading a cookbook, moderately appetizing. Morales’ group was using it for traditional uses, not cocaine—though I am sure some ended up in NYC nightclubs anyway.

Morales used this resentment amongst Indian groups to seize the presidency on a campaign of legalizing coca growing, land redistribution, reducing American influence and nationalizing natural gas assets.


Natural Gas

Unlike mining, natural gas needs much less maintenance capital. Not to oversimplify things, but you stick a straw in the ground and you suck out cash. Boliva has massive natural gas resources and this has always been a sore point for the people. The assets are owned by foreign companies, operated under leases signed with prior governments who agreed to favorable terms after a good deal of bribery. The way the contract works is that the foreign companies extract the natural gas, pay a tariff based on the price they receive when selling it to an offshore entity (through interlocking partnerships, they control this company) then pipe it through their infrastructure to Brazil and Argentina where it is sold to another company they admit to controlling for a much higher price than the well-price and finally it is sold to a local company. By paying a low price in Bolivia, the Bolivian royalty is trivial and the foreign company gains all the profits. I may make it sound complex, but most kindergarteners can explain the shell game and injustice it creates.

Bolivians have long memories, the largest natural gas company (Repsol) is Spanish owned, and to many, this is just another chapter in the theft of Bolivian resources dating to the fifteenth century. Adding insult to the whole situation, the Argentine companies supplied with gas then sell some to Chile. For those of you not steeped in Latin American history, between 1879 and 1883, Chile, Peru and Bolivia engaged in series of violent wars over (you won’t believe this) bird crap. Yup, bird crap is high in nitrogen and thousands died over who would get the royalty offered by the European company purchasing it. I digress, but it should be remembered that Bolivia and Chile have had only intermittent diplomatic relations ever since and in the extraction treaty with the gas companies, it specifically forbid any sales to Chile.

Morales promised to fix this injustice and on May 1st, he ‘fixed’ the matter. He was adamant that it was not nationalization. Instead, the tax rate was raised to 82% from 50%. However, this tax is irrelevant as the main issue is that Bolivians will now charge for the sale price of the gas and not the well-price. Call it a hunch, but the tax will eventually decline back towards that 50% level, but Bolivian revenue will increase significantly as they count the gas better. Previously, the foreign corporations repeatedly lied about how much gas they exported. Morales will also ensure that Bolivians are employed in the process. Previously, most employees were foreigners.

I think we have to look at the timing here. Besides it being Mayday in a socialist country, the big issue is that Bolivia has an election coming up on July 2nd to retool their constitution. Morales is trying to ensure that his party comes away with a massive majority of the assembly seats as it will give greater legitimacy to whatever gets written up. Seen in that timeline, the recent rhetoric coming from him and his party takes on a new light. There are really two Evos at work here. There is the public tough guy who acts paranoid about US assassination attempts, fulfills campaign promises to fix century long injustices, and threatens multinational corporations. Then there is the real guy who is pragmatic and realizes that the country cannot advance without foreign capital and jobs created by this investment. I think you can count on the rhetoric becoming more violent as we near this election. Afterwards, it will be time to renegotiate some contracts and make sure that he fulfills campaign promises, but there will not be any more 82% tax rates.

Evo Morales


Here is what I think the real Morales looks like, using some of his own words and those of his cabinet along with his actions.

"We're ready to negotiate a trade agreement with the United States that benefits the productive sector." From Celinda Sosa, minister of production and small business. Morales had promised never to negotiate a free trade agreement with “the empire.” This looks like a significant about face as the country realizes it has endangered previous treaties which greatly help the poor. Morales is in a tough spot, he has to preach against the US, but he needs us as an outlet for Bolivian production of goods. Clearly, he called us “the empire” one time too many and had to soothe some people at the State Department.

Foreign companies can operate in Bolivia if they will adjust to the "national development strategy ... generating employment, exporting with added value, transferring technology to Bolivian companies and reinvesting its profits back in Bolivia." This is from the new economic plan released on June 16th. Sounds like doing business with any first world nation. He’s not looking to ‘stick it’ to the capitalist invaders like he preaches while talking to his constituents.

“Currently, the top 10 percent of Bolivians earn 25 times what the bottom 10 percent earn. The government seeks to reduce that to 21 times by 2011.” Again from the Bolivian economic plan released on June 16th. This doesn’t sound like a guy who is looking to take everything the wealthy have. This is a slight adjustment in the economic pyramid. Ted Kennedy sounds scarier than this guy.

Essentially, Morales talks tough, while his lieutenants make sure that his real message is carried to the people that matter, those that will do the investment in Bolivia after the new constitution is ratified.

San Cristobal

I do not know what the new tax rate will be. However, I think we should look at the only sizable deal the Morales government has signed thus far for mining rights.

Jindal Steel won the rights to a 40 billion tonne iron ore mine. They will pay a royalty of 8-9 percent for iron ore, 10% for pellets, 7% for sponge iron and 5% for steel on all exports. They will also pay the standard Bolivian tax rate of 25%. Jindal has agreed to set up a fully integrated steel plant with a capacity to produce around 17 million tones a year of products. The total investment will be $2.3 billion and provide 2,000 direct jobs and 10,000 indirect jobs. Clearly, an investment of this size is not taken lightly and I’m sure that a lot of homework was done. The main issue is the number of jobs provided. Morales biggest problem is unemployment. Had this project not gone forward, I think he would have an uprising on his hands. He faces a similar issue at San Cristobal. If he scares Apex off and they do not finish the mine, thousands of jobs will be lost. Morales cannot afford the risk. He has to negotiate something where he gets his pound of flesh, but does not scare off the jobs. A middle ground will be reached where everyone saves face.

While San Cristobal is a flashpoint because of its size, most mining activity in Bolivia is done by small artesian groups who are Morales’ main supporters. These guys are violently in favor of large scale mining activity. Apex will pay significantly more than the locals currently make scratching out ore on a hillside, and the working conditions will be far safer. In addition, there will be housing and medical care for their families. If Morales overtaxes Apex, he will overtax his own people. Unlike natural gas which only employed a few dozen Bolivians, tens of thousands mine the hillsides.

Finally, the government has repeatedly said that they want to create growth by bringing in outside investment and capital. The natural gas issue will be resolved and seen as a one time event. If they go after San Cristobal, they will forever destroy any hope of foreign investment as it is one of the largest projects in the country.

This is what I see happening. The company pays the standard 25% tax rate along with some small royalty. Following a payback of the investment capital, the tax rate will be tiered with the company paying a higher rate approaching 50% during times of higher metal prices and a lower rate during periods with lower metal prices. Unlike natural gas which is local and has a set price, metal prices fluctuate. The Bolivians will have to make allowances for that. Even at a 50% tax rate, there should be $5 a share in cash flow that will increase as debt is paid down.

Finally, the company will have to set up a smelter to handle the concentrates that they had previously planned to ship to Chile for export to smelters outside of Latin America. This will bring jobs into the country and fulfill a promise of Morales that he would advance the country away from raw materials and towards the higher margin finished products. There will be a cap-ex expense, but this will be the cost of keeping their mine.

Of course all of this is conjecture, but I have spoken with over a dozen people at various mining companies and mining groups along with read everything produced in local and American papers. I could very well be wrong, but if I am right, I think the upside could be ten-fold. Even if the odds are 50/50, those seem like Vegas odds if it is a small gamble. Even if wrong, and the tax rate is higher, I think this still trades in the high teens and it's a break even trade.

Catalyst

Clarification on the status of San Cristobal and new mining laws.