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Silver of the Sierra Madres

Bob Moriarty
August 30, 2004

In real estate there are said to be three key elements. Location, location, and location. In my view there should be two prime considerations in junior mining: cash flow and cash flow. But most often, cash flow is the last item on management's mind.

If you think about it, junior mining usually has a pretty suckie business model. As far as I can see, for most juniors, the model consists of selling shares, drilling holes, selling shares, drilling holes. And once or twice every cycle the company does a reverse split to whittle down the number of total shares outstanding. I can't really think of many companies who have a business model that consists of making money and increasing share value for their investors. Is there really any reason to invest in junior mining stocks beyond the concept of throwing dice? Does anyone wonder why the industry is in such bad shape? After all, at the end of the day, if no one in mining intends to actually make money for their shareholders, why buy the Penny Dreadfuls in the first place?

The 1997 collapse of Bre-X helped flush out the industry. Not only the marginal operators but dozens of fairly solid companies went down the toilet as by 2000 it was quite impossible for anyone associated with mining to raise money. Everyone in the industry would like you, the investor, to believe it was all due to Bre-X but that's just not logical or possible. It has a lot to do with the failure of the basic business model.

Mining is the art and science of extracting minerals from the ground at a profit. Notice that I say, at a profit, because over the long term if a business doesn't intend to profit, investors won't be interested in funding them. That's where we were in 1999-2001 and where we will be once again if someone doesn't actually do something positive for their shareholders.

So I was somewhat caught off guard when Brad Cooke of Canarc called me early in January with what sounded like an interesting business model. Brad got involved with Endeavour Silver (EDR-V $1.34 Canadian 18 million shares $24 million market cap, $9 million cash (all figures Canadian) in early 2002. [website]. The predecessor company was known as Levelland Energy and Resources which begat Endeavour Gold Corp in August of 2002 and begat Endeavour Silver Corp in August of 2004.

After evaluating almost fifty gold and silver properties in Mexico, Endeavour announced the acquisition of the Santa Cruz silver mine and Guanacevi processing plant near Durango, Mexico in January of 2004. Rather than amassing ounces of silver in the ground and sitting on them until they hatch, Brad came up with a new and perhaps unique business model in the junior mining arena. Endeavour Silver would mine silver and process it at a profit. Wow! The very thought is mind bending: producing silver at a profit. Now that's a unique plan.

In the early 1980s at the time of the Hunt brothers silver boom, the Guanacevi silver district bragged of over 50 producing silver mines in an area which had produced over 500 million ounces of silver during the last 350 years of mining history. During the 1970s the Mexican government constructed a 1400 ton per day processing plant which served the entire area. But the combination of Bre-X and $4 silver hammered the Guanacevi district, indeed every silver mine in the world, and as of a year ago there were but three operating mines and the government sold off the plant to a group of local silver miners years ago.

Even at $4 silver, the surviving mines and plant made money but due to the structure of the original business deal, the profits were distributed to the businessmen who owned the mine and mill rather than being reinvested in the mill or mine.

While the business plan of the Mexican businessmen who owned the mine and mill clearly worked, they could see the advantage of bringing in a Canadian junior with more access to expertise and capital. And it gave them an exit strategy where they could take their money out of the deal and retire.

So in January of this year, CEO Brad Cooke of Endeavour signed a deal to pay a total of $7 million to acquire 100% of the Guanacevi processing plant and the Santa Cruz mine over a four year period. They pick up an initial 51% by paying $3 million US and spending $1 million US in exploration by January of 2005. They can pick up the remaining 49% by paying $4 million US more by January of 2008.

What exactly did Endeavour Silver get for their money? Well, in the first place, the mill alone is worth twice the total purchase price. The going rate for used plant and equipment in Mexico is about $10,000 per ton of capacity. So a 1400 ton per day capacity plant is worth $14,000,000, not in replacement value, that's higher indeed, but the least value for the equipment would be $14 million.

The plant operates today at between 10-20% capacity. It has two circuits, one a flotation circuit for the sulfide ore and also a cyanide leach facility for the oxide ore. Brad has plans for increasing total capacity beyond the current 1400 tons per day. which is doable with minimal capital expenditure.

I went down to Mexico to see Santa Cruz and the mill for myself with two of my favorite people; Ian Gordon and Rick Langer (Hi, Yo, Silver!) from Canaccord Capital in Vancouver. What I saw impressed me. Endeavour is using the exploration budget to actually drive a tunnel to a newly discovered high grade silver ore vein (550 grams per ton). Brad Cooke's deal with the mine owners gets a little complicated and for those who are interested in every sentence, I encourage you to either call Endeavour or go to their website. But basically, the money they spend for exploration and development is treated as a loan and is senior to payments to the mine owners.

In other words, once Endeavour is vested at 51%, when newly found ore is processed, they get their loan repaid before the 51-49% split is made. It's pretty much having your cake and eating it, too. The 51% interest will be vested as of a payment date of January 28, 2005. I asked Brad about the payment since if he paid now, he would be vested now. Why did he want to wait until January 28 to make the payment when he has the money in the bank anyway?

His answer was interesting because it says a lot about Endeavour and Brad Cooke. They could make the payment today and it would benefit Endeavour at the expense of the existing mine owners. Since the mine is producing today and ore is being processed and silver poured into bars, if the miners took payment today, they would lose half the value of what they are producing. Brad has rejected short term gain for Endeavour in return for long term good relations with his partners for now.

I take my own 100-year-old 20oz mold on my trips with me now, in the hope that I may one day be privvy to a pour. And this time I was in luck - and had my own 'personal pour.'

And yes, I did pay for every one of the 603 grams of silver. (As mentioned above: cash flow... cash flow... ).

click thumbnail for large photo

The mill is producing silver today from three sources. Sulfide silver ore is being shipped to the mill from the Santa Cruz workings. And ore is being processed for the other two mines in the area on a contract milling basis which is quite profitable. But in a unique twist, they are using weathered sulfide tailings to process through the cyanide circuit of the mill. These sulfide tailings left over from the flotation process many years ago have weathered and turning into an oxide ore grading about 116 grams per ton of silver and 1-2 grams of gold. So the old ore is doing double duty. It produced profit before and is producing profit again.

Endeavour Silver stands to gain in two ways from this deal. Even if there wasn't more ore to be found at the Santa Cruz mine (and there is) bringing the plant up to a much higher capacity would create the basis for a good profitable company. Combining with an aggressive exploration program in a known prolific silver district creates a high value added mining junior.

Endeavour has worked the numbers out and uses a figure of $3.50 for total mining and milling costs. Other silver producers in silver rich Mexico can produce for as little as $1.50-$2.00 an ounce. But owning 100% of the mill adds a kicker. Endeavour can generate profits in theory and not mine at all.

Obviously there are other issues on Brad's agenda which haven't been sorted out. His goal is to try to control the entire Guanacevi district. By owning the only mill, he has already created a situation in which he can control the district and it pays for others to work with him. The other mine owners cannot control the area, no matter what the price of silver. Endeavour owns the only mill.

As far as I can see, this is pretty much a no lose deal on everyone's part. Obviously the price of silver is an issue. Silver at $2 an ounce won't work. Everyone will simply shut down and wait for higher prices. But silver at $6-$7 starts to get interesting and silver at $10 gets explosive.

Brad believes that in two years they can be producing and processing 4 million ounces a year. Based on what I saw on my tour two weeks ago, that is a reasonable goal. If you work the numbers out at $6 silver with $3.50 all in cash costs and 4 million ounces a year, it looks like a cash flow of $10 million per year. With a total market cap of $24 million, cash flow of $10 million starts looking very attractive.

We own Endeavour stock from way back when the price was $1.60 Cdn. I'm not upset at seeing the stock at $1.34, it's just a sign of the insanity of the current market. It's screaming 'opportunity' for all of those actually paying attention. I'd far rather see Endeavour vest now, I think there is some lack of premium due to a perceived lack of certainty of Endeavour actually doing the deal. But they will hand over a check on January 28th of 2005 and they will vest their initial 51% interest. The money is in the bank and the ore is ready to start processing.

With all junior mining companies, you are buying management and little more. Bad management can screw up any project and good management will succeed even if they have no projects, good or not. Just look at Wheaton River three years ago with $30 million in the bank and no projects. And now they are a $2 billion company. I don't expect to see Endeavour Silver at $2 billion in a year or two but I do expect them to be a solid, profit-generating silver producer, even at today's price of silver.

I like the management, I like the project and I love a business plan based on production at a profit rather than dreams of sugar plum fairies. We are not paid to produce this report, it is neither a recommendation to buy or to sell any stock. Your investments are your responsibility. All due diligance is also your responsibility. Endeavour Silver is an advertiser and we do own shares. As such obviously we are biased :)

By the way I am leaving again tonight (Sat Aug 28th) for Northern Ireland to visit Ireland's only gold mine. So please
don't send me email. It's a short trip and I'll be back in Miami on Thurs. Sep 2nd.

August 28, 2004
Bob Moriarty
President: 321gold Inc
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