Wheaton Precious Metals — Still shining

Wheaton Precious Metals acquires the right to purchase streams of precious metals from producing or near-producing mines in return for a combination of a fixed upfront payment and an ongoing payment (in US$/oz). Typically, it focuses on by-product precious metals streams as this offers the greatest arbitrage opportunity between the perceived value of the stream to the producer and the perceived value of the stream to WPM. Specifically, however, it seeks to build long-term value by entering streaming agreements with large, relatively financially stable counterparties operating premium high-margin projects in the lowest quartile (and certainly the lowest half) of the cost curve.

Excluding FY04, WPM’s shares have historically traded on an average P/E multiple of 27.1x current year basic underlying EPS (cf 32.6x Edison or 34.7x consensus FY17e, currently). Applying this multiple to our long-term EPS forecast of US$1.41 in FY20 (at forecast precious metals prices of US$23.98/oz Ag and US$1,362/oz Au), implies a potential value for WPM shares of US$38.29, or C$48.00 in that year, which implies a 27.9% internal rate of return to investors buying Wheaton Precious shares currently at C$25.87 in US dollar terms over three and a half years.

As at 30 June, WPM had US$76.6m in cash (ex-dividend) and US$953.0m of debt outstanding under its US$2bn revolving credit facility (which attracts an interest rate of Libor plus 120-220bp and matures in February 2022), such that it had net debt of US$876.4m overall, after US$124.7m (US$0.28/share) of cash inflows from operating activities during the quarter. Relative to the company’s equity, this level of net debt equates to a financial gearing (net debt/equity) ratio of 19.7% and a leverage (net debt/[net debt+equity]) ratio of 16.4%. This is well within the tolerances required by WPM’s banking covenants (see page 16-17). All other things being equal and assuming no further major acquisitions (which is unlikely), we estimate that WPM’s net debt position will decline organically, to US$750.8m (after a payment of US$70m in respect of its Rosemont stream) by the end of FY17 (equating to gearing of 14.8% and leverage of 12.9%), and that it will be net debt free approximately midway through FY19.

Our slightly revised financial forecasts for FY18 are conducted at precious metals prices of US$21.54/oz Ag and US$1,220/oz Au and are high relative to the consensus average of 65.6c, within a range of 34-91c. As such, they almost exclusively demonstrate WPM’s operational gearing to a normalisation of the silver price relative to the gold price from its current, almost unprecedented Au/Ag ratio of 75.2x to a more typical 56.6x. Note that, at current spot prices (of US$17.43/oz Ag and US$1,310/oz at the time of writing), our basic EPS forecast for FY18 is 70c.

We value WPM’s San Dimas stream at US$959.9m, or US$2.17 per WPM share, on the basis of Edison’s long-term precious metals price assumptions or US$684.2m, or US$1.55 per WPM share, on the basis of the current spot price of silver. Note that these values compare to a C$2.11 per share price decline in the value of WPM’s shares since it announced its results after the market close on Thursday 10 August until the close on Tuesday 15 August, which (in addition to its falls after Q316 results in November) appears to suggest that the stock market is discounting the loss of substantially all of the San Dimas stream to WPM (ad infinitum) despite its security over the asset.

WPM’s results in Q217 were closely aligned with our prior expectations (see our report, Formerly Silver Wheaton (SLW), published on 18 May 2017) and Exhibit 1, below. Production was slightly above our expectations at three assets (Penasquito, Antamina and Other Gold) and fractionally below our expectations at San Dimas, Constancia, Sudbury, Salobo and Other Silver. Otherwise, there was an 11.4%, or 0.8Moz under-sale of silver relative to production (cf 19.8%, or 1.3Moz, under-sale in Q117) and a 7.9%, 6.2koz under-sale of gold relative to production (cf a 4.2%, or 3.5koz, over-sale in Q117), resulting in a temporary build-up of ounces produced but not yet delivered as at 30 June. Note that, during the course of a year, WPM almost invariably experiences a period of inventory build, which is then, typically, ‘flushed through’ in the final quarter of the year. While revenues were 7.7% below our expectations for the quarter, therefore, this was almost exactly offset by a 10.6% reduction in the total cost of sales, such that earnings from operations were just 3.2%, or US$2.8m, below our published estimate, at US$82.9m. In addition, management formally changed its dividend policy, from 20% of average cash generated by operating activities to 30%, which thus allowed it to declare a relatively generous third quarter dividend of 10c/share compared with our prior expectation of 6c/share. Silver sales exceeded gold sales, in this case in the ratio 54:46, for the first time since Q316.

Salobo was affected by conveyor belt and plant repairs during February, as well as by lower grades. Compared to Q216, however, Salobo, Penasquito and Antamina all benefited from processing higher-grade ore in Q217, albeit Antamina’s performance was tempered by a lower silver recovery. Constancia was affected by the processing of lower-grade ore, as anticipated by Hudbay, while Sudbury experienced the inevitable effects of its regular three-week scheduled maintenance for all surface operations in June as well as its Furnace #2 rebuild, which took it offline for the entirety of Q2, prior to the smelter complex transitioning to a single furnace flow sheet in Q417. Developments at San Dimas are the subject of a separate section below.

San Dimas produced 973koz silver attributable to WPM in Q217, compared to 623koz in Q1 and our prior expectation of 1,086koz, after the conclusion of a two-month strike in April. Operations resumed on 18 April and a phased restart of the mine began on 22 April. Subsequently, a 13-day suspension of milling activities in mid-June followed the failure of an anchor block affixed to one of eight cables supporting the tailing suspension bridge. However, mining operations continued uninterrupted during that time with ore being stockpiled at the mill site. Full plant operations resumed on 24 June and the ore stockpile was fully processed in mid-July.

Since mid-July, Primero (the operator) has reported a material deterioration in employer-employee relations to the point that it believes that labour disruptions may continue to adversely affect operations at the mine into the future.

In the aftermath of the strike, Primero’s production guidance for FY17 was 4.5-5.5Moz Ag. It is maintaining this guidance, but is now erring towards the lower end of that range. This compared to WPM’s guidance at the time of its FY16 results in March (see our update note published on 29 March 2017) of 4.0Moz after an assumed three-month strike (vs two months actual) and our current, relatively conservative, expectation of 4.4Moz, which assumes a return to the average quarterly production rate of 1.5Moz per quarter only in Q417.

As such, we are forecasting that the San Dimas stream will account for 16.0% of total production attributable to WPM in FY17 and 8.5% of silver equivalent production.

In the longer term, however, Primero has opined that, despite investment, exploration at San Dimas has failed to identify any replacement for the depleting Roberta and Robertita veins and that, in the absence of suitable alternatives (or changes to the operating environment), mining rates above 1,800tpd may not be sustainable (vs nameplate capacity of 2,500tpd) – in which case it may not be able to comply with its financial obligations to lenders and its mine life may therefore become significantly shorter as a result of its consequent inability to invest in exploration and development. As a result, it has also indicated that there is material uncertainty regarding its ability to continue as a going concern and suggested that revisions to the silver purchase agreement between it and WPM may be appropriate and/or necessary.

Further, in February 2016, Primero announced that its Mexican subsidiary had received a legal claim from the Mexican tax authorities, Servicio de Administración Tributaria (SAT), seeking to nullify the Advance Pricing Agreement issued by SAT in 2012, which confirmed Primero’s ability to pay taxes in Mexico on the sale of silver at actual prices realised by its Mexican subsidiary in connection with silver sales under Primero’s silver purchase agreement (SPA) with WPM for the tax years 2010-14. In the event that SAT is retroactively successful in nullifying the deal, it may seek to audit and reassess Primero’s Mexican subsidiary in respect of sales of silver in connection with the Primero SPA for the tax years 2010-14 and tax Primero on such sales at higher than realised prices, as opposed to the actual prices realised under the Primero SPA. Self-evidently, this could have a material adverse effect on Primero’s results of operations, financial condition and cash flows. Primero has indicated that it has notified the government of Mexico that the measures taken against it by the SAT breach several provisions of Chapter 11 of the North American Free Trade Agreement (NAFTA) and that it has the option to commence international arbitration proceedings pursuant to Article 1119 of the NAFTA.

In the short term, in the event that Primero is not able to continue to operate as a going concern, it may (i) be unable to deliver some or all of the silver ounces due from San Dimas to WPM according to its SPA, (ii) otherwise default in its obligations under the SPA, (iii) cease operations at San Dimas if it is uneconomic to continue to operate the mine and/or (iv) become insolvent.

While WPM is open to the possibility of a renegotiation of the terms of the San Dimas stream with Primero (eg to include gold as well as silver), in contrast to Primero, its position is that San Dimas is an asset that has been producing for over 150 years and that judicious budgeting and appropriately targeted exploration investment should have been able to extend the mine’s life into the foreseeable future and, as such, there is no need to revise the silver purchase agreement. From a legal perspective, it regards itself as having security over the integrity of its stream in the form of San Dimas’s assets (although it would not wish to operate the mine itself) and therefore regards Primero’s financial tribulations as both “healthy” and “manageable” from the perspective of a free market economy philosophy. In the meantime, Primero has initiated a strategic review process. It is also known to have received a number of proposals from interested parties regarding the potential acquisition of San Dimas.

The San Dimas mine consists of three underground gold-silver operations, using primarily mechanised cut-and-fill and long-hole stoping mining methods, located in Mexico’s San Dimas district, on the border of the Durango and Sinaloa states. With over 100 epithermal bonanza-type mineralised gold-silver veins, the San Dimas gold-silver deposit is one of the most significant precious metal deposits in Mexico. The veins vary in width from <1cm to over 15m, but typically average c 2m, and in strike from a few metres to more than 2km. It was first mined in 1757, with historical production from the district since then being estimated at 11Moz gold and 582Moz silver, affirming it as a world class epithermal mining district.

Goldcorp acquired San Dimas in 2002 for US$75m and, on 15 October 2004, entered into a silver purchase agreement with WPM, whereby the latter would purchase 100% of the silver produced by Goldcorp’s Luismin mining operations (primarily the San Dimas and Los Filos mines) for a period of 25 years, for an upfront payment of C$46m in cash and 108m WPM shares, and an ongoing payment equal to the lesser of US$3.90/oz silver (subject to an annual inflationary price adjustment) and the then prevailing market price of silver. On 30 March, the two parties amended the Luismin silver purchase agreement, eliminating any capital expenditure contributions previously required to be paid by WPM, in consideration of which it issued 18m further shares to Goldcorp and a US$20m one-year, non-interest bearing promissory note, which was paid in full on 29 March 2007.

In August 2010, Primero (formerly known as Mala Noche Resources) acquired San Dimas from Goldcorp for US$510m in cash (US$216m), scrip (31.2m shares valued at US$184m), a US$60m convertible and a US$50m five-year note, leaving Goldcorp with a 36% share of the company. As part of the acquisition, WPM also agreed to an amended silver purchase agreement such that the term of the agreement was extended to the life of mine, in return for which Primero would deliver to WPM the first 6Moz of payable silver produced at San Dimas per annum plus 50% of any excess.

In Q116, output at San Dimas fell by 60.2%, quarter-on-quarter, to 0.9Moz attributable silver (vs 2.3Moz in Q415) as Primero reported that it had implemented new safety standards at the mine. As a result, mill throughput was limited to 1,639tpd. This recovered to above 2,500tpd in April. However the addition of ground support resulted in a modified mine plan for the remainder of 2016, with the company targeting higher-grade stopes at lower tonnages, with the result that a long-planned mill expansion to 3,000tpd was deferred. After recovering to something close to normal operating conditions in Q216, production at San Dimas was affected by high unplanned worker absences and a failure to achieve mine plans in Q316, which resulted in reduced development rates and also a number of delayed ventilation improvement projects. This, in turn, limited access to certain high-grade areas of the mine and caused Primero to revise its silver production guidance to 5.5-6.0Moz for FY16 and coincided with a US$6.04 decline in the share price of WPM in the two days immediately following the announcement of the latter’s Q316 results after the market close on 9 November:

Primero’s production guidance of 5.5-6.0Moz for FY16 implied output of 1.7Moz of silver during the Christmas quarter. In fact, production was 1.4Moz in Q4, after which workers called their two-month strike in mid-February (see page 4, above).

San Dimas was the fourth largest unique contributor to WPM’s sales in Q217 and, arguably, should have been the third largest under normal circumstances. Prior to Q217, we forecast that San Dimas could sustainably produce 6.8Moz silver per annum attributable to WPM, which equates to 24.1% of our forecast for WPM’s silver production in FY18, 15.5% of its silver equivalent (AgE) production, or 14.0% of AgE production at the currently prevailing spot price of silver. While its contribution to WPM is therefore not immaterial, in the historical context, it is worth bearing in mind that the San Dimas stream was specifically put into WPM by Goldcorp in 2004 and WPM floated as a means of showcasing the streaming business model, and that otherwise WPM would not, in the ordinary course of business, expose itself to such a material stream from an asset with such a junior operator (note: Primero’s market capitalisation at the time of writing is C$22m at a share price of C$0.115/share).

On the basis of our production forecast of 6.8Moz of silver attributable to WPM per annum from San Dimas, the cash-flows associated with its stream would be those shown in Exhibit 4 (at both long-term and spot silver prices).

Discounted at Edison’s standard 10% discount rate for mining companies, these cash-flows are valued at US$959.9m, or US$2.17 per WPM share, on the basis of Edison’s long-term silver price assumptions or US$684.2m, or US$1.55 per WPM share, on the basis of the current spot price of silver (US$17.43/oz at the time of writing). Note that these values compare to a C$2.11 per share price decline since WPM announced its results after the market close on Thursday 10 August until the close on Tuesday 15 August (as well as the US$6.04/share price decline at the time of WPM’s Q316 results), which appears to suggest that the stock market is discounting the loss of the entire San Dimas stream to WPM despite its security over the asset.

Stated alternatively, we estimate that the entire San Dimas stream is worth US$0.11 in EPS to WPM in FY17. Note that, pending further developments, we are currently forecasting a full and normal contribution from San Dimas in FY18.

On 30 March, Wheaton Precious and certain of its subsidiaries provided a guarantee to the providers of Primero’s revolving credit facility (capped at a maximum of US$81.5m plus interest, fees and expenses) until November, when the RCF falls due. WPM regards this as sufficient time for Primero to work through its strategic review process and therefore expects a resolution to the situation either before, or in, November. In the meantime, US$35m in consideration of Primero’s sale of its Black Fox mine will be offset against the RCF. Primero is also unable to redraw on the RCF. In return, Primero will pay a fee to Wheaton Precious of 5%, which will be recognised as a guarantee fee and allocated to ‘other income’.

Sales of silver and gold recorded 11.4% and 7.9% under-sales relative to production, in Q217, compared to long-term average under-sale rates of 10.4% and 9.3%, respectively.

As at 30 June, payable ounces attributable to Wheaton Precious produced but not yet delivered amounted to 4.2Moz silver and 52,900oz gold (cf 3.9Moz silver and 51,500oz gold in March, 3.2Moz silver and 61,700oz gold in December and 3.8Moz silver and 63,300oz gold in September). This ‘inventory’ equates to 1.81 months and 1.92 months of forecast FY17 silver and gold production, respectively (cf 1.73 months and 1.85 months in Q117, 1.25 months and 2.1 months of forecast FY16 production as at end-December, and 1.5 months and 2.3 months as at end-September), or 1.88 months on a silver equivalent basis (cf 1.8 months as at end-March, 1.6 months as at end-December and 1.9 months as at end-September) – slightly below WPM’s target level of two months.

Note that, for these purposes, the use of the term ‘inventory’ reflects ounces produced by WPM’s operating counterparties at the mines over which it has streaming agreements, but which have not yet been delivered to WPM. It in no way reflects the other, more usual use of the term in the mining industry itself, where it is typically used to refer to metal in circuit (among other things), and may therefore (under certain circumstances) be considered to be a consequence of an operation’s metallurgical recoveries.

Penasquito – According to Goldcorp, the Pyrite Leach Project (PLP) achieved construction progress of 14% and engineering progress of 94% by the end of the quarter. Concrete works remain underway, and mechanical works installation has commenced and is ramping up. Major procurement activities are now nearing completion, while material and equipment is arriving and major works contractors have mobilised to site. As such, the PLP remains on track for completion by the end of 2018 and is expected to result in additional production of 4-6Moz Ag per annum, of which WPM’s share is 25% (see Exhibit 9). In addition, a carbon pre-flotation facility (dubbed the Carbon Pre-Flotation Project, or CPP) is also now being incorporated into the project, which is designed to allow Penasquito to process ore that was previously considered uneconomic (including ‘significant amounts’ already in stockpiles). CPP earthworks are now reported to be substantially complete and concrete works underway, while the mechanical works contractor has mobilised and will ramp up from Q317.

Rosemont – Hudbay has now completed an updated feasibility study for its Rosemont project in Arizona, according to which the mine will be a traditional open pit, truck and shovel operation with an expected 19-year mine life. Hitherto, Hudbay has indicated that a precondition for its development of Rosemont is a copper price of US$3.00/lb (cf US$3.08/lb at the time of writing). As per its announcement of 7 June, the US Forest Service (in the form of the Coronado National Forest Supervisor) has now issued the final Record of Decision for Rosemont, which is one of two key federal permits for the project to progress, along with the Section 404 Water Permit from the US Army Corps of Engineers.

On the same day as its Q2 results, WPM also announced that it had entered into a non-binding agreement with Desert Star regarding an “early deposit” arrangement over the Kutcho project in British Columbia. Under the terms of the agreement, WPM will advance US$65m to Desert Star in return for the right to purchase 100% of the silver and gold production from Kutcho at 20% of the spot price of the two metals until 51,000oz Au and 5.6Moz Ag have been delivered, at which point the stream will decrease to a 66.67% share for a term of the life of the mine. Of the US$65m, US$7m will be advanced to Desert Star on an “early deposit” basis, in order to fund a definitive feasibility study (DFS), environmental study & impact assessment and other related documents. Following these and receipt of permits and the onset of construction, WPM may then elect to either advance the balance to Desert Star or terminate the agreement, in which case it will be entitled to the return of the US$7m less US$1m payable on certain triggering events. Conversely, WPM will be required to make an additional payment of up to US$20m in the event that processing throughput is increased to 4,500tpd or more within five years of attaining commercial production. WPM has also agreed to participate in up to 14% of a Desert Star equity financing to a maximum of C$4.0m, where such funds are to be used for the acquisition of the Kutcho project.

The Kutcho property is located approximately 100km due east of Dease Lake in the Liard mining division of northern British Columbia. The site is located at an elevation of approximately 1,500m, has an average annual temperature of -1°C and experiences 50cm of precipitation annually, half of which is snow. The site is currently accessible via a 900m gravel airstrip located 10km from the deposit and a 100km long seasonal road from Dease Lake that is only suitable for off-road vehicles during the summer months.

The Kutcho property contains three main mineralised zones: Main, Esso and Sumac. Only the Main and Esso deposits have been used in the mine planning and economics of the PFS, the Sumac deposit being excluded owing to its resources being at an inferred level of confidence only. Esso and Main are c 1.5km apart.

The Esso deposit is located approximately 420m below surface and extends vertically for about 200m. The Main deposit has a strike length of about 1.5km while Esso has a strike length of about 600m. The deposits vary in thickness from 3-20m and have dips ranging from 30-70°. The Main deposit extends from surface to about 250m in depth.

In June 2017, a pre-feasibility study (PFS) was prepared for Desert Star by JDS Energy & Mining of Vancouver. According to the PFS, the deposits are planned to be mined predominantly by underground methods via two separate portals to the two deposits. The underground mine is envisioned to produce at an average annual rate of c 0.9Mtpa for 12 years. A small starter open pit will extract about 0.4Mt of ore from the Main deposit to provide preliminary mill feed material and non-potentially acid-generating construction material. Planned underground mining methods are sublevel, long-hole stoping for steeper dipping zones, and mechanised cut-and-fill for shallower dipping areas. Both methods will use paste backfill. Ore will be trucked from underground to the process plant, which is adjacent to the Main portal. The processing plant will operate year-round at an average rate of 2,500tpd. The processing plant will consist of primary crushing, semi-autogenous grinding, a ball mill, sequential copper and zinc flotation, concentrate de-watering, tailings disposal and back-fill production. Copper rougher product will be re-ground prior to cleaning. About one half of the total tailings will be placed underground and 1.0Mt in the mined-out open pit. Approximately 178kt Cu, 253kt Zn, 5,576koz Ag and 51koz Au will be recovered from the deposits over the mine life from an average head grade of 2.01% Cu, 3.19% Zn, 0.37g/t Au and 34.6g/t Ag. In order of economic value, payable metals found in the deposits are copper, zinc, silver and gold.

Ordinarily, we would assume that a DFS would take a year from a PFS, financing would take a further year and construction two years, such that we would anticipate Kutcho entering production in approximately 2022. Thereafter, we would expect the following cash flows to accrue to WPM over the course of the mine’s initial 12-year life:

When set against initial advances of US$7m in FY17 and US$58m in FY20, these cash flows yield a net present value of US$4.7m, when discounted at Edison’s standard mining discount rate of 10%, and imply an internal rate of return to WPM of 11.7% in US dollar terms from FY17 to FY33 (assuming that the agreement is allowed to run its course and is not terminated).

Wheaton Precious Metals acquires the right to purchase streams of precious metals from producing or near-producing mines in return for a combination of a fixed upfront payment (in US dollars, typically in either cash or WPM shares) and an agreed upon ongoing payment (in US$/oz). Typically, it focuses on by-product precious metals streams as this offers the greatest arbitrage opportunity between the perceived value of the stream to the producer in the equity market and the perceived value of the stream to WPM. Specifically, however, it seeks to build long-term value by entering streaming agreements with large, relatively financially stable counterparties operating premium, high-margin projects in the lowest quartile (and certainly the lowest half) of the cost curve. As well as providing comfort regarding the sustainability of the underlying operation, this strategy also helps to mitigate geopolitical and operating risks. In addition, it provides a degree of flexibility if projects are not developed according to plan (eg as evidenced by WPM’s ability to successfully renegotiate a series of amendments with Barrick regarding the latter’s Pascua-Lama project). Unlike a number of its peers, WPM has restricted itself solely to precious metals streaming agreements and does not participate in the base metal and oil and gas markets. This strategy has the beneficial side effect that it also exposes WPM to the traditional premium multiples afforded to precious metal companies compared to base metal ones. Notwithstanding its silver heritage, however, WPM describes itself as “agnostic” in terms of its preference for either silver or gold streams, which formed the basis of its decision to change its name from Silver Wheaton to Wheaton Precious Metals earlier this year.

Latterly, WPM has engaged in a number of “early deposit” contracts whereby it has contracted to buy gold and silver streams from the Cotabambas and Toroparu mines in South America and the Kutcho mine in British Columbia, thereby effectively becoming a relatively low-cost financing component of these projects at a time when the availability of both debt and equity financing to junior mining companies is uncertain and their associated costs relatively high.

While royalty companies compete with WPM to some extent in the provision of capital to the mining industry, there are notable differences between the two business plans. Royalties are typically linked to tenement areas, for example, and also typically relate to a mine’s primary output, whereas streaming arrangements are governed by a commercial agreement between two companies (albeit often relating to a single mine) and typically relate to a mine’s secondary, or by-product, output. A summary of the unique features of WPM’s streaming business plan and how it distinguishes itself from other investment opportunities in the mining industry is provided below.

Compared to exchange traded funds (ETFs), WPM:

Compared to mining companies, WPM:

Compared to royalty companies, WPM:

A key advantage for WPM compared to potential competitors is its size, scale and valuation, which allows it to raise equity on a non-dilutive basis to fund new streams, or even to issue counterparties with equity in consideration of new streams.

WPM has five cornerstone assets (San Dimas, Penasquito, Antamina, Constancia and Salobo). The following is an analysis of the financial returns generated as a result of the application of WPM’s investment criteria to one of its cornerstone assets – Penasquito.

A gold-silver-lead-zinc mine, located in Mexico and operated by Goldcorp, Penasquito has consistently been regarded as one of WPM’s key cornerstone assets. The stream relating to this asset was acquired late in 2007 for US$485m plus US$3.56m in costs and US$15.761m in capitalised interest. The first silver-bearing lead and zinc concentrate was delivered from the mine in 2009 after production at its first 50,000tpd sulphide process line was ramped up on schedule and on budget. During the ramp-up period, metal recoveries, concentrate grades and concentrate quality were within expected ranges. At the same time, construction of a second 50,000tpd sulphide process line was progressing towards planned completion in Q310. After exceeding ramp-up expectations, Penasquito became WPM’s second largest contributor of silver production in 2010 and, after further expansions, it finally surpassed San Dimas to become WPM’s largest contributor of silver production in 2012, by which time it held the title of Mexico’s largest precious metals mine, one of the world’s largest and lowest-cost gold-silver mines and one of Goldcorp’s most significant cash flow generators. After adjusting the mine’s production schedule to reflect a targeted mill throughput rate of 110,000tpd, rising to in excess of 115,000tpd beyond 2015, Penasquito is now forecast to yield average annual production attributable to WPM of c 7Moz Ag per year plus an additional 4-6Moz pa (of which 25% will be attributable to WPM) once the Pyrite Leach Project is commissioned in FY19.

Compared to an initial investment of US$504.3m, Penasquito has yielded the following historical and forecast cash flows to WPM:

On an undiscounted basis, therefore, Penasquito paid back WPM’s initial investment in 2014. When discounted at Edison’s standard mining discount rate of 10%, the mine has already returned US$410.7m to WPM (as at end FY16) in 2007 money terms and is also worth a residual US$821.3m in 2017 money terms. Applying a 10% discount/hurdle rate, payback is indicated in H119 in 2007 money terms.

By contrast, applying a 10% discount/hurdle rate over the entire stream of income yields an ultimate value of US$759.0m, which is directly comparable to the stream’s acquisition cost of US$504.3m in 2007 money terms. Stated alternatively, the stream will provide WPM with an internal rate of return of 15.2% from the point of acquisition in 2007 to 2026. In addition, there is substantial underground potential beneath the current open pits, providing excellent opportunities for further exploration growth and expanded and/or extended silver production.

As at Q216, WPM has agreements over more than 20 major metals streams, summarised in Exhibit 9 below.

WPM is effectively exposed to two different types of market within the mining industry – that of ‘balance sheet repair’ and that of ‘development’. Over the course of the past three years, the majority of new business offered to WPM has been of the former type. In this respect, WPM estimates the size of the potential market open to it to be at least the 70% of the c 870Moz of silver production in FY16 that was produced as a by-product of either gold or base metals mines (ie approximately 609Moz silver per annum). This compares with WPM’s production in FY16 of 30.4Moz Ag – ie WPM estimates that, to date, it has penetrated less than c 5.0% of its potential market.

Recently, however, WPM has observed a shift in the type of business that is being brought to it, from ‘balance sheet repair’ towards ‘development’ (eg Kutcho). Typically, these opportunities are smaller than ‘balance sheet repair’ type opportunities (eg in the range US$100-400m), but more numerous (WPM estimates that it has seen 150 such opportunities over the course of the past three to four years, of which it has concluded deals over three).

Official management guidance is for silver production of 28Moz and gold production of 340,000oz in FY17. This compares with our (marginally) updated forecasts of 27.8Moz silver and 330,500oz gold, respectively, ie our forecasts are relatively conservative. Over the next five years (including 2017), WPM is estimating average annual silver production of approximately 29Moz and gold production of 340,000oz.

WPM continues to expect non-stock general and administrative expenses in the range of US$33-35m for the full year – ie c US$8.5m per quarter – including additional legal costs relating to its dispute with the Canadian Revenue Agency. Investors should note that our financial forecasts in Exhibits 10 and 13 specifically exclude stock-based compensation costs.

In light of the above factors, our revised quarterly operational and financial forecasts for WPM for the remainder of FY17 are as follows:

Compared with our previous forecast for FY17, production is unchanged, the silver price has been revised down fractionally for Q317 and the gold price up fractionally. In the aftermath of these revisions, our updated basic EPS estimate of 63c for FY17 remains unchanged. It compares to an average consensus estimate (source: Bloomberg, 30 August 2017) of 59.5c within a range of 51-67c. Note that our FY17 basic EPS estimate rises to 66c in the event that precious metals’ prices remain at current levels (viz US$17.43/oz Ag and US$1,310/oz Au).

Excluding FY04 (part year), WPM’s shares have historically traded on an average P/E multiple of 27.1x current year basic underlying EPS – ie excluding impairments (cf 32.6x Edison or 34.7x consensus FY17e, currently – see Exhibit 12).

Applying this multiple to our long-term EPS forecast of US$1.41 in FY20 (at Edison’s average long-term precious metals prices of US$23.98/oz Ag and US$1,362/oz Au in FY20) implies a potential share value for WPM shares of US$38.29, or C$48.00 in that year (cf US$37.52, or C$51.25, at the time of our last note in May 2017).

In the meantime, from a relative perspective, it is notable that WPM is cheaper than its royalty/streaming ‘peers’ in 100% of the valuation measures used in Exhibit 12 and on multiples that are cheaper than the miners themselves in at least 44% of the same valuation measures, despite being associated with materially less operational and cost risk, in particular.

Currently, we make no provision for either future expansion at Salobo or related expansion payments in our long-term forecasts. However, in the event that Salobo were to be expanded from 24Mtpa to 48Mtpa by the addition of a further two 12Mtpa processing lines by 1 January 2021 – thereby attracting the maximum incremental payment from WPM to Vale – we estimate that it would increase our estimate of WPM’s earnings in FY20 by a material US$0.22/share. This, in turn, would increase our forecast value per share for the company to US$44.21, or C$55.42 at prevailing FX rates (compared with US$43.31, C$59.16 previously), implying an internal rate of return to investors buying WPM shares currently at C$25.87, equivalent to 32.0% pa in US dollar terms over three and a half years.

Please see separate section on pages 4-7 for financial and valuation sensitivities specifically relating to the San Dimas mine.

As at 30 June, WPM had US$76.6m in cash (ex-dividend) and US$953.0m of debt outstanding under its US$2bn revolving credit facility (which attracts an interest rate of Libor plus 120-220bp and matures in February 2017), such that it had net debt of US$876.4m overall, after US$124.7m (US$0.28/share) of cash inflows from operating activities during the quarter. Relative to the company’s equity, this level of net debt equates to a financial gearing (net debt/equity) ratio of 19.7% and a leverage (net debt/[net debt+equity]) ratio of 16.4%. It also compares with a net debt position of US$980.2m as at 31 March, US$1,068.7m as at the end of December 2016, US$1,219.5m as at the end of September 2016 and US$1,362.7m as at the end of December 2015 and is consistent with WPM continuing to generate c US$100-150m per quarter from operating activities before financing and investing activities. Otherwise, assuming the operational performance set out in Exhibit 10, we estimate that WPM’s net debt position will decline organically, to US$750.8m by the end of FY17 (equating to gearing of 14.8% and leverage of 12.9%), and that WPM will be net debt free approximately midway through FY19, all other things being equal and contingent on its making no further major acquisitions (which is unlikely). Self-evidently, such a level of debt is well within the tolerances required by its banking covenants that:

Note that the C$191.7m letter of guarantee that WPM has posted re 50% of the disputed taxes relating to its dispute with the Canadian Revenue Agency (CRA) (see below) has been determined under a separate agreement and is therefore specifically excluded from calculations regarding WPM’s banking covenants.

There have been no further substantive developments regarding WPM’s dispute with the CRA since our update note of 15 February 2016.

WPM notes that the CRA’s position is that the transfer pricing provisions of the Income Tax Act (Canada) in relation to income earned by WPM’s foreign subsidiaries should apply “such that the income of Silver Wheaton [sic] subject to tax in Canada should be increased by an amount equal to substantially all of the income earned outside of Canada by the company’s foreign subsidiaries for the 2005-2010 taxation years”. Should this interpretation be upheld, we would expect it to have potentially profound consequences for Canada’s status as a supplier of finance and capital to overseas destinations in general (ie not just to the mining industry).

Earlier this year, WPM’s CEO, Randy Smallwood, was quoted as saying that the company is willing to settle its tax dispute with the CRA via a payment of C$5-10m “with gritted teeth”, but still believes no payment should be required. As such, the C$5-10m quoted reflects no admission or error, but rather an appreciation of the costs involved in going to a full trial and also of the effect that the issue is having on WPM’s share price rating relative to its peers (see Exhibit 12).

In the meantime, Wheaton Precious is approximately halfway through the case ‘discovery process’ with the CRA, designed to provide both sides with the opportunity to arrive at an out-of-court settlement before formal proceedings commence. This discovery process is likely to last until the end of the year and any potential out-of-court settlement would therefore be likely to occur shortly after this date. Otherwise, however, the company has stated that it is willing to go to trial if a ‘principled’ settlement is not possible (which is likely to be towards the middle of 2018).