Research Report: ECU Silver Mining Inc. - written by Mike Kachanovsky    

Tuesday, April 26, 2005. 

I recently traveled to the city of Torreon, Mexico to visit the office and operations of ECU Silver Inc.  The company controls excellent properties in a prolific mining district and operates a recovery mill, but a series of issues have limited the investment performance during the last few years.  I believe the management has done and exceptional job to resolve these issues, and that the company is now on the verge of delivering growth and earnings that will result in much higher share values for investors in the years ahead.  Although the company funded my travel expenses to review the mine workings and recovery plant, I have not accepted any compensation for my work to produce my report.  I do own shares and warrants of ECU that I subscribed for in the last private placement offering, and may purchase more shares in the market in the future. – Mike Kachanovsky 

Overview

 Office Address: 559 Boul. Temiscamingue, Rouyn-Noranda, Quebec, J9X 7C8

Telephone:  (819) 797-1210

Fax:  (819) 797-1214 

Corporate Office:  J.I. Jimenez #663, Colonia Los Angeles, Torreon, Coahuila, Mexico

Telephone:  011-52-871-717-8633 

Website:  www.ecu.ca 

Exchange listing symbol (TSX-V):  ECU 

Share structure:              Issued:                          152,745,250

                                    Fully diluted:                 192,745,250 

Market capitalization:                $39.7 Million 

ECU Silver Mining is a Canadian company engaged in the production of precious and base metals in Mexico, that appears to be on the verge of turning the corner from a checkered past towards achieving a bright future.  Its history reads like a work of fiction, filled with setbacks and disappointments, lawsuits, triumph and tragedy.  However the company was able to surmount all of the various hurdles in its path and has now reached the respectable stage of stable production and positive earnings from operations.  Mining is a difficult business under the best of circumstances.  Only a tiny minority of junior mining companies ever advance to level that ECU has achieved, and the future prospects look very good.  The company has managed to carve out a niche for itself, working a prolific vein system of the Velardena mining district in the state of Durango.  While the ore from these veins is very high grade, it is deposited in such narrow intervals that the larger producing mining companies in Mexico would have no interest in it, based on marginal economics.  However, ECU Silver has managed to not only prove they can mine the system efficiently, they have thrived and are now advancing exploration to the point that a much larger system with robust economics may be awaiting development on their property. 

When attempting to accomplish any complex and challenging endeavour, it is determination and perseverance that are probably the most important characteristics that define those that are successful.  The current management team at ECU, President Michel Roy (accepted the position in 1999) and Executive Vice-president Richard Hamelin (since 2004), have certainly endured their share of challenges since they assumed leadership of the company.  They have negotiated a mutually agreeable settlement in a lawsuit regarding ownership of their flagship property, raised the necessary capital through equity offerings to keep the company solvent, and then patiently implemented a development strategy to generate a revenue base necessary to allow for growth.  Michel Roy has been active in the mining industry for thirty years, serving at the senior management level with several mining companies, and as an independent consultant.  Richard Hamelin achieved distinction in the brokerage industry before his tenure with ECU.  While these gentlemen have progressed competently and quietly in their careers prior to joining the company, both men are to be congratulated for their success in turning around the fortunes for ECU Silver, and based on their accomplishments to date, they can be considered brilliant project managers.  They recently hired Pierre Gagnon to serve as their project engineer, and his knowledge acquired through decades of experience in operating mines will assist the company to advance the underground development necessary to continue growing production. 

Projects and Operations 

The principal asset owned by the company is a 4.65 square kilometer property hosting a cluster of 7 mines in the Velardena district of Mexico.  Two of these mines are currently in production:  the Santa Juana and the San Mateo, working epithermal systems bearing gold, silver, lead, zinc, and copper.  While the property itself has been in production at various intervals for over 450 years, the geologists working with ECU have recently compiled a database of the entire structural trend across the region to better understand the nature of the mineralization of the vein systems.  The geological model for the property suggests that the ore bodies are within an extension of the same geology as the Santa Maria Mine operated by Grupo Mexico about 5 kilometers away across a valley, where it is estimated that over 5 million tons of ore was extracted before that mine was closed.   The Santa Juana Mine is positioned at a slightly higher elevation, and while past production occurred in mostly narrow, higher grade veins, they are now beginning to develop deeper levels.  The 18th level recently opened at Santa Juana has encountered carbonate replacement mineralization that compares very closely to the ore of the Santa Maria Mine at the same depths.  If indeed the same geological process led to the formation of both deposits, then the potential exists that several million tons of ore remain to be extracted from the ECU property.   

The ore from Santa Juana Mine presents some difficulties arising from high arsenic levels that are in the areas bearing the richest grades of gold, silver and base metals.  This has the effect of lowering the value of the gold pyrite concentrate that is produced.  The arsenic levels are lower in ore that is produced at the deeper levels however and will have a reduced impact in future operations.  The system remains open laterally and at depth, and more exploration work is necessary to confirm additional resources.  Fifteen other veins in this system have been identified, some traced to surface, and it is hoped they will contain similar mineral grades in the range of 300 g/t silver and 6-10 g/t gold that has been achieved to date. 

Further to the south lies the San Mateo Mine where limited development has been completed.  The ore from this mine contains no arsenic so it will become an important source of future production.  Higher grade silver values have been encountered up to 2,000 g/t from the workings of this mine, illustrating the attractiveness of this future exploration target.   

Some work has also been completed at the nearby Terneras Mine, and the San Juanes Mine.  Exploration activity has been limited however in an effort to preserve working capital, since they have enough ore available from the current workings to supply several years of production.   

It should be noted that 8,900 meters of surface drilling has been completed at the Santa Juana Mine, and only 2,000 meters for all of the other mines combined.  The geologists in charge of the development program are very confident that significant new resources remain to be discovered at these mines.  There have also been other surface showings identified on the property through sampling and mapping that have not seen any exploration activity, and some shallow historic workings that have been discovered are also prime targets for future exploration. 

The company also controls the San Diego property, located approximately 10 kilometers to the northeast.  This property has an estimated historic resource of 1.4 million tons of near-surface silver-lead-zinc mineralization, with lower grade gold values, but it too has seen almost no exploration activity from ECU to date. 

Of the mines that are currently in production, several miles of underground drifting has been completed.  The host rock formation is consistent and stable, with limited potential for rock falls and requiring only a minimum of bracing.  Flooding from water seepage at the lower levels is not an issue and in fact the lack of ground water represents a challenge at the processing plant, where access to water is critical to keep the concentrators operating.  The property is well serviced with road and rail infrastructure in place, and is connected to the hydro grid with abundant access to reasonably priced power. 

A low tech approach has served as the most efficient method for operations.  Well trained local mining crews with years of experience working in the district advance the various levels of mine, with three shifts operating around the clock.  The mostly older equipment at the mine is maintained in excellent working condition. 

The company rents a fleet of trucks that transports the ore approximately five kilometers down the valley to the mill and recovery plant.  The ore is then dumped into a hopper and directed into a jaw crusher, before processing in a ball mill for fine grinding.  This is then mixed with water and chemical reagents to form slurry that is processed through one of four operating flotation cell banks (2 for lead and 2 for zinc).  Oxygen is pumped into the cells and the concentrate is floated off and recovered.  All of the equipment at the plant was operable and in excellent condition.  Allowing for periodic maintenance and downtime, it is estimated that the plant will run 27 days per month. 

Another low tech process utilized by the company is the use of a pit to dry the concentrate material, instead of a power drying unit.  The concentrate is dumped in the pit and then manually spread to a thickness of eight inches, allowing the sunlight and dry air to do the work.  While this approach is cost effective, in the winter months when the sunlight is less intense, it reduces the output of the plant.  There are plans in place to install a modern drying unit as the production capacity increases, to streamline the operation and ensure consistent residual moisture levels in the concentrate.  This upgrade will be financed through internally generated cash flow. 

The concentrate is then shipped to a smelter operated by Industries Penoles.  The revenues paid for the concentrate vary with the grades and purity that is shipped.  In recent months ECU has realized increasing revenues for their product due to improved efficiency of the flotation process. 

Outlook 

Working narrow width veins that are periodically offset by faulting is a challenging set of circumstances for an underground mining operation.  The company relies on experienced engineers and geologists to interpret the path of the vein system and direct the drifting to intercept the ore zones.  Specialized equipment is employed to ensure minimum dilution from the excavation of waste rock, allowing for stopes only one meter in width. 

There are only three ways for a mining company to improve their bottom line.  They can increase production, they can lower their cost base, or they can benefit from receiving higher prices for their product.  Management identified targets in each of these areas that had to be addressed and then set about to achieve their objectives.

The engineers and geologists working at the mines tour the workings several times a week to ensure that development is directed to intercept the ore zones efficiently.  New levels have been developed at the mine to allow multiple access points across several veins. This will provide the ability to sustain increased production as the capacity at the milling operations improves.  It is estimated that the operation is able to extract ore for the exceptionally low cost average of $17 per ton. 

Management has directly contributed to lower administration costs by moving their offices to a lower cost building in a residential district of the city of Torreon, and by opting to engage in daily business activity without the services of a support staff.  This willingness to take on the additional workload has resulted in a lower cash burn rate while the company made the transition to profitable operations. 

At the recovery plant facilities, efforts have been directed towards increasing capacity.  A thorough overhaul of critical machinery was completed, including refurbishing the flotation cells and replacing the liners in the 200 tpd ball mill.  A new electric transformer has been installed to support new machinery, and this power supply has allowed for the operation of a fifth bank of flotation cells, and the smaller 70 tpd ball mill.  The immediate effect of these improvements is that the capacity of the facility has now increased to over 250 tpd.  Additional flotation tank capacity allows a longer retention time for the slurry from the mill, thus increasing the percentage of metal recovered in the process.  The company plans to further increase capacity to over 300 tpd with the installation of another ball mill, and there is room on the property to continue to grow the capacity as additional equipment is sourced.   

Progress has been made to fine-tune the operations to recover higher percentages of the mineral content.  By adjusting the crushing equipment to produce a feedstock with the texture of fine soil they have improved the efficiency of the flotation process.  They are currently working to optimize the recovery process further by blending various amounts of lower and higher-grade ore in the feedstock.  A lab based in the state of Durango provides most of the assay information for the grades of the feed material and the tailings, in order to generate the data for to establish the recovery percentages. 

Improvements at the operating level are also coming as a result of the higher ore grade in the lower levels of the mine, that has been found to have a lower arsenic content, and the smelter pays a higher price as a result for the concentrate produced.  They currently process an even mix of the low-grade development ore, and the higher-grade production ore.  As the recovery plant efficiency improves, the percentage of higher-grade ore in the mix will increase, thereby increasing the quantity and the value of the concentrate.   

In the months ahead, ECU is positioned for strong earnings growth due to the effects of all the improvements that have been implemented.  These accomplishments include increasing the production capacity at the mine, increasing the capacity and efficiency of their recovery plant, reducing costs at all levels of operations, and shipping higher quantities of concentrate produced with a higher market value per ton. 

One wildcard that will factor into forward earnings estimates is the utilization of the Nichromet Extraction process, a technology that promises to radically improve the recovery levels to over 90% of the gold, silver, lead, zinc and copper contained in the ore.  Current operations only recover a fraction of the gold content, and it is estimated that over 50,000 tons of tailings leftover from past production grading 4-5 g/t gold will serve as feedstock for this process.  Now that operations have become cash flow positive, the company plans to use operating profits to fund the installation of a Nichromet circuit.  This will result in a dramatic increase in production revenues that will go straight to the bottom line. 

The company would also like to acquire an additional milling facility with the capability to process oxide ore.  The mines are capable of supplying up to 1,000 tonnes per day of feedstock.  Also, a significant tonnage of oxide ores bearing high-grade gold values has been encountered along the fault zones of the mines, which cannot be processed with the existing circuit.  This ore is being stockpiled at surface until such time as a cyanide leaching circuit is found to process it.  Once the company has achieved a level of maximum production at the current milling facility, it is anticipated that the operation will be spinning out sufficient cash flow to begin aggressively searching for an additional mill. 

It should be noted that the capability of the Santa Juana Mine to produce ore well beyond the maximum capacity of the recovery plant is a good problem to have.  The vast majority of small mining ventures in production in Mexico are unable to supply enough ore to keep their recovery operations running near capacity, and the profitability for these operations is impaired.  It is estimated that ECU only requires production of 170 tons per day to break even on all operating and administrative costs.  To have a mine that can easily supply double that throughput at the mill, putting the company well into a profitable range, is an advantage that cannot be overstated.  The potential to double or triple production in the years ahead with the installation of additional processing capacity is a bonus that shareholders should not take lightly. 

One other significant wildcard going forward is the potential for the company to begin producing copper.  There is lower grade copper present in the ore from the Santa Juana mine that adds marginal value to the revenues the company currently receives for their concentrate.  However, significant copper resources grading up to 3% have been encountered in the ore mined at the San Juanes vein system, which could amount to a very large boost in revenues if a recovery circuit is installed targeting copper.  So far only limited scale mining and near surface drifting has been completed at this part of the mine, but it represents an intriguing possibility as copper continues to hover near multi-decade highs in the commodity markets. 

Some discussion is appropriate this point on the fundamentals for pricing of the various metals produced.  ECU Silver is fortunate to mine ore containing economic quantities of so many metals.  The combination of base and precious metals production serves as a natural hedge offsetting the uncertainty of future metals prices.  During the last few years, strong demand from China and India has served to push prices for lead, zinc, and copper to the upper end of their long-term price ranges.  While there are no significant new sources of supply expected to balance this demand for several years, if the economies of these areas slow down, then it should be expected that the base metals would decline in price.  However, silver and gold account for a large part of the gross production revenue for the company and would serve to counterbalance any weakness in the base metals going forward. 

Investment performance considerations

ECU Silver is currently valued in the market with a multiple more befitting an explorer, well below the valuation that could be justified as the operator of a producing mine.  There are a number of reasons for this.  The company has endured a troubled past, including having trading temporarily halted on three separate occasions in the last two years while regulatory and reporting issues were resolved, and an ongoing legal challenge to their ownership of the Velardena property that was recently settled.  The balance sheet is weak, as the company struggled to remain solvent while funding operations and maintaining payments on a long-term debt amounting to $6 Million USD.  To meet their working capital needs the company issued several equity offerings completed in non-brokered private placements that were priced at the lower end of the trading range due to inopportune market conditions, and resulted in rapid dilution of the share capital.  Also, the company enjoys no analyst coverage at this time, and does not have a budget for a full time investor relations department.   The company also suffered while their corporate website was offline.  All of these factors have combined to discourage investment in the company, limiting the market value. 

As a measure to protect shareholders and ensure consistent reporting standards among listed companies, Canadian securities regulators have imposed a set of requirements for reporting companies documented under National Instrument 43-101.  This set of regulations prohibits communication of data for estimates of reserves, resources and forward-looking performance discussion, when the information has not be verified by qualified geologists and engineers at arms length to the issuer.  A process has been ongoing for a number of months to bring the company into compliance, and the engineering consultants that have been contracted to complete the task could issue the final report shortly.  In the absence of a thorough, documented report on the asset value and operational outlook for the company, investors have responded with indifference to purchasing shares of ECU. 

In the immediate future it is likely that ECU Silver will be reporting recurring earnings from operations and demonstrating strong growth on a quarter over quarter basis.  Most of the issues that have been discounted into the share price have now been resolved and it appears that the company has turned the corner, achieving traction in corporate revenues and a stronger balance sheet.  Additional financial resources will allow for further capital investment to generate conditions for even more robust growth in future quarters.  The corporate website was recently restored online, and new material is being added to update it on a regular basis. 

While the junior mining sector appears to be out of favour, and the company appears to be priced at a maximum discount in the market, it now appears that ECU Silver is at the beginning of a prolonged episode of growth and profitable operations.  This set of circumstances would appear to be the ideal time to establish a position in the company. 

When operating near the current maximum capacity for the milling and recovery operations, the company is capable of generating profits of over $225,000 USD per month.  Assuming the company is able to maintain this production rate and that metals prices continue in the same range, a forward price to earnings multiple of 20 would generate a market capitalization for ECU of $65 Million CDN, or a target price of 42 cents per share, representing a gain of 61% above current prices. 

Management have stated that they plan to aggressively direct surplus revenues toward capital improvements at the mine and recovery plant that will yield immediate growth in production and revenues.  If they are able to achieve this objective, ECU could report earnings of $5-10 Million USD in 2006, with a resulting expectation of improved market performance amounting to several hundred percent from the current levels.   

It should also be emphasized that there are only a very small group of junior mining firms that have been able to report recurring earnings, and thus ECU Silver should be considered among the top performing corporations.  Management deserves commendations for their accomplishments.  Given their success in building value for shareholders with such limited resources in the past, the potential is strong that they will be able to continue this success now that the company has become cash flow positive.  The ability to generate cash flow from operations also suggests that the company will no longer be dependant on raising working capital through equity placements in the market. 

No discussion on investment performance in the junior mining sector can be considered complete however without adding the disclaimer that this sector is subject to extreme volatility and market risk, and should only be considered appropriate for risk tolerant investors.  There is no guarantee that commodity prices for metals will remain firm or that future circumstances will continue to support profitable operating conditions for the company.  A degree of risk and uncertainty also affects the assumptions that can be made on the grade and tonnage of mineral resources contained on the properties controlled by the company. 

In full consideration of these risks however, on balance with the potential for upside appreciation, ECU Silver represents an attractive opportunity at the current value for investors seeking exposure in the junior mining sector.  Management has successfully implemented a complex strategy under difficult circumstances, and ECU is now positioned to benefit from these accomplishments.  They have clearly demonstrated that the system of narrow veins near the surface of the property can be mined profitably.  There are abundant exploration targets to continue to expand the development, and the promise that a much larger ore body is within reach to the deeper levels of the mines.   The problems that have adversely affected the company during the last few years are likely to be resolved within a matter of weeks, and as the expected development continues at their properties, ECU offers the potential to outperform the sector for many years.  If in fact the sector is in the early stages of a long term bull market, then ECU Silver looks like one company that investors will not be able to get enough of in the years ahead.

Disclaimer:  I have made my research and opinions available to the public as a resource to provide investors and the public with basic information.  My comments and opinions should not be interpreted as a recommendation or investment advice, which I am not qualified to provide.   While I have made every effort to maintain accuracy in the information I provide, it is possible that there are some errors or omissions in my coverage and the accuracy cannot be guaranteed.  It remains the responsibility of each individual investor to confirm if the subject of my analysis is appropriate for their investment objectives, and to conduct their own research and due diligence, and retain the services of a qualified advisor on to provide this service on their behalf.  I accept no responsibility for the performance of the companies that I feature in my coverage.  Junior mining and exploration companies are a risky market sector and investment in these companies can result in loss of capital.  Past performance is no guarantee of future success.  From time to time I may purchase stocks in the companies I feature in my reports, and I may sell some or all of my holdings.  I will disclose personal ownership in those companies that I refer to at the time of my first coverage, or after follow up reports.  I do not accept compensation from companies as payment to provide positive coverage or opinions.