Wheaton Precious Metals — A fine finish

Overall, production attributable to WPM during FY17 was 28.6Moz Ag and 355koz Au, compared with guidance of 28Moz Ag and 340koz Au and our most recent forecast of 28.5Moz Ag and 343koz Au. Results for Q4 were notable for the close correlation of production and sales, demonstrating the traditional ‘flush through’ effect in the final quarter of the year. From a financial perspective, results were better than our prior expectations for both Q417 and FY17, partly on account of an increase in gold production compared to the prior quarter, but also on account of a material increase in other income, which largely reflected fees from contract amendments and reconciliations. Excluding this item, Q4 net earnings would otherwise have been US$80.9m (assuming no taxation effect) cf our prior forecast of US$78.1m – a 3.6% positive variance. A summary of WPM’s Q4 results, as calculated by Edison, relative to both Q3 and our prior expectations is as follows:

From an operational perspective, key features of the quarter were strong production performances at Salobo and Penasquito, which both performed above our expectations, and positive sales performances from Penasquito and Sudbury. Combined, these more than offset a slightly less dynamic performance at WPM’s ‘other’ gold assets, reflecting, in particular, reduced production at Minto owing to lower grades on account of mine sequencing as part of an extended mine plan.

In the longer term, the Pyrite Leach Project at Penasquito (which will add c 1Moz gold and 44Moz silver over the current life of the mine, by recovering 40% Au and 48% Ag currently reporting to the tailings) is reported to be 62% complete (vs 40% at the end of Q317) and is expected to commence commissioning three months ahead of schedule, in Q418.

On 18 January, Barrick (the operator of Pascua-Lama) reported that it had received a revised resolution from Chile’s environmental regulator, SMA, requiring it to close its existing infrastructure on the Chilean side of the border. Barrick went on to say that the revised resolution does not affect its ongoing evaluation of an underground, block-caving operation at the mine, which would anyway require additional permitting and regulatory approvals in both Chile and Argentina and are unconnected to SMA’s decision. Nevertheless, in the light of the order to close surface facilities, Barrick has reclassified Pascua-Lama’s proven and probable mineral reserves of c 14Moz Au (based on an open-pit plan) as measured and indicated resources instead. As a result, WPM has similarly reclassified 151.7Moz of proven and probable silver reserves as measured and indicated resources, which it has interpreted as an ‘indicator of impairment’ in the sum of US$229m (from US$485m to US$256m).

Note that if the requirements of the Pascua-Lama completion test have not been satisfied by the deadline of 30 June 2020, WPM has the right to terminate its Pascua-Lama silver purchase agreement with Barrick, in which case it would be entitled to the return of its upfront cash payment of US$625m less cashflows received relative to the Lagunas Norte, Veladero and Pierina mines in the meantime – a figure that would have been US$261m as at 31 December 2017 (WPM figure) and we estimate is likely to be in the order of US$255m in 2020.

WPM has provided the market with production guidance of 22.5Moz of silver and 355,000oz of gold for FY18. Our updated FY18 production forecasts vary slightly compared to WPM’s, as follows:

On 12 January, First Majestic (FR, C$8.65) announced that it is to buy Primero Mining (the operator of the San Dimas mine in Mexico, over which WPM holds a silver purchase agreement). As a part of the terms of the (friendly) takeover, WPM has agreed to terminate the existing silver purchase agreement (SPA) and to then enter into a precious metals purchase agreement (PMPA) with the new operator on the following terms, including:

Under the First Majestic PMPA, San Dimas is expected to contribute, on average, approximately 40-50koz of gold production (equivalent to 2.80-3.15Moz Ag at an Au:Ag ratio of 70:1) annually to WPM over the next five years (company estimate). In addition to the new stream, First Majestic will also issue to WPM 20.9m FR common shares with an aggregate value at the time of the announcement of US$151m (US$168m at the time of writing).

The termination of the existing SPA and the effectiveness of the First Majestic PMPA remain subject to a number of conditions, including completion of the arrangement. In addition, at the time of closing, WPM has agreed to release the guarantee previously provided by Goldcorp under the existing SPA in consideration of a payment of US$10m from the latter. It will also extinguish the US$0.50/oz penalty for each ounce less than 215Moz delivered by 2031.

Primero has indicated that closing of the transaction is anticipated before the end of April. Note that, for the purposes of the analysis below, we have assumed that it will complete on 31 March and that Q118 of WPM’s financial year will therefore be governed by the existing SPA and that the new PMPA will then become effective thereafter.

WPM is forecasting non-stock general and administrative expenses in the range of US$34-36m for the full year, ie c US$8.5-9.0m per quarter, including all employee-related expenses, charitable contributions and additional legal costs relating to WPM’s dispute with the Canadian Revenue Agency. Investors should note that our financial forecasts in Exhibits 6 and 10 exclude stock-based compensation costs.

Compared to an erstwhile 11.0% average historical under-sale of silver relative to production and a 9.5% historical under-sale of gold, production and sales of both silver and gold were closely aligned in Q417, demonstrating, among other things, the traditional ‘flush through’ effect in the final quarter. Note that this compares to under-sales of silver and gold of 24.2% and 13.9%, respectively, in Q317.

As at 31 December, payable ounces attributable to WPM produced but not yet delivered amounted to 4.5Moz silver and 79,500oz gold (cf 5.3Moz silver and 57,200oz gold reported in September). This ‘inventory’ equates to 1.89 months and 2.68 months of FY17 silver and gold production, respectively (cf 2.23 months and 2.00 months in Q317), or 2.31 months on a silver equivalent basis (cf 2.15 months as at end-September) and compares with WPM’s target level of two months of annualised production for silver and two to three months for gold.

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 use of the term in the mining industry itself, where it is typically refers to metal in circuit (among other things), and may therefore (under certain circumstances) be considered to be a consequence of metallurgical recoveries in the plant.

Over the next five years, including FY18, management estimates average annual production of approximately 25Moz of silver and 370,000oz of gold (cf 29Moz of silver and 340,000oz of gold in March 2017 – the difference being substantially accounted for by the First Majestic takeover of Primero and the termination of the existing San Dimas silver purchase agreement in favour of a new precious metals purchase agreement). This compares with our current expectations, which are, on average, 7.2% more conservative than guidance (simple average):

In the immediate future, silver output from Penasquito attributable to Wheaton Precious is expected to recover back to its steady-state level of 7Moz as the Chile Colorado pit contributes to mill feed ahead of schedule in CY18 and grades improve once again with mine sequencing. From Q418 onwards, it will also benefit from the development of the Pyrite Leach Project, which will add an additional 1.0-1.5Moz of silver attributable to WPM per year. At the same time, mining at Constancia will start at the Pampacancha pit, which hosts significantly higher gold grades than those mined hitherto. Moreover, should the mining of Pampacancha be delayed, WPM will still be entitled to an increased portion of gold from Hudbay.

Apart from exploration success, however, the other major source of organic production growth for WPM is Salobo (which already accounts for 74-79% of WPM’s gold division’s output). The operator, Vale, is studying expansion scenarios and is deploying four drill rigs to test the deposit at depth. Given the open-ended nature of the deposit and depending on the work that Vale does and the decision that it makes, any expansion could add as much as 100% to gold output attributable to Wheaton Precious from Salobo per year – albeit at the cost of an additional payment from WPM. Mill throughput at the Salobo mine is currently reported to be running in excess of its 24Mtpa nameplate capacity. If throughput capacity is expanded within a predetermined period and depending on the grade of material processed, WPM will be required to make an additional payment to Vale regarding its 75% gold stream. The additional payments range in size from US$113m if throughput is expanded beyond 28Mtpa by 1 January 2036, to US$953m if throughput is expanded beyond 40Mtpa by 1 January 2021.

WPM estimates the size of the potential market open to it to be the 70% of global silver production of c 870Moz in FY17 that is produced as a by-product of either gold or base metals mines (ie approximately 609Moz silver per year). This compares with WPM’s production of 28.6Moz Ag in FY17 – ie WPM estimates that it has penetrated a mere c 5.0% of its potential market.

As a consequence, WPM reports that it is busy on the corporate development front, with at least six potential deals that could close within the next 12 months and US$2-3bn of deals that could close within 12-24 months, approximately equally split between ‘development and expansion’ projects and corporate ‘balance sheet repair’.

While it is difficult, or impossible, to predict potential future stream acquisition targets with any degree of certainty, it is perhaps possible to highlight four that may be of interest to WPM in due course and regarding which it already has strong, existing counterparty relationships:

We have honed our silver price for FY18 to US$16.75/oz in Q1, followed by US$16.50/oz thereafter to reflect recent movements in the spot market. Our gold price forecast remains unchanged at US$1,320/oz over all four quarters.

In the aftermath of these changes, our updated basic EPS forecast for FY18 remains ostensibly unchanged, at US$0.63/sh cf an average consensus estimate (source: Bloomberg) of 61.8c within a range 49-77c (cf a consensus of 64.5c, within a range 49-80c, in February). Broken down by quarter, our estimates are as follows:

Note that, as a result of the conversion of the San Dimas stream from a silver one to (effectively) a gold one, we expect WPM to become a majority gold streaming company from 31 March onwards on an annual basis (albeit there will inevitably be some quarterly fluctuations depending upon the balance of production, sales etc).

In the meantime, our FY19 EPS forecast was made on the basis of assumed precious metals prices of US$22.21/oz Ag and US$1,263/oz Au (see our report, Mining overview, Unlocking the price to NPV discount, published in November 2017) – as much to demonstrate WPM’s operational gearing to a normalisation of the gold:silver ratio from its current, unprecedented, level of over 80x:

WPM has an early deposit agreement with the Kutcho Copper Corporation (formerly Desert Star, market cap C$23.9m) whereby it will advance to it US$65m in instalments (upon achieving a predetermined set of milestones) in return for the right to purchase 100% of the silver and gold production from the Kutcho project in British Columbia at 20% of the spot price of the metals over the life of the mine. In the meantime, on 14 December, WPM acquired 6,153,846 shares and half warrants in Kutcho for a total consideration of C$4m (US$3m) to give it a 12.88% equity stake in the company. Additionally, it advanced Kutcho US$16m (C$20m) in exchange for a subordinated secured convertible term debt loan agreement receivable, bearing interest at a rate of 10% per annum.

As of 2 February 2018, Minto’s operator, Capstone, has agreed to sell the mine to Pembridge Resources (a UK-listed company run by David Linsley, formerly of Behre Dolbear). According to Capstone’s Q417 management discussion and analysis, at the start of 2017, it was its intention to place Minto on ‘care and maintenance’ at the end of the year. On account of the rising copper price however, it reconsidered its position and instead decided to continue operations until at least mid-2021 (cf our expectation of 2022).

Excluding FY04 (part year), WPM’s shares have historically traded on a contemporary average P/E multiple of 27.6x current year basic underlying EPS, ie excluding impairments (cf 31.2x Edison or 31.8x consensus FY18e, currently – see Exhibit 9).

Applying this multiple to our EPS forecast of US$1.28 in FY20 (cf US$1.40 previously as a result of the presumed deferment of production from Rosemont until after FY20) implies a potential share value for WPM shares of US$35.13, or C$45.93 (cf US$37.90, or C$47.18 previously) in that year (excluding the US$0.38/share value of its equity interest in First Majestic).

In the meantime, from a relative perspective, it is notable that WPM is cheaper than its royalty/streaming ‘peers’ in at least 95% (23 out of 24) of the valuation measures used in Exhibit 9 and on multiples that are cheaper than the miners themselves in at least 36% (33 out of 90) of the same valuation measures, despite being associated with materially less operational and cost risk (as WPM’s costs over time are contracturally predetermined)

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 36Mtpa by the addition of a further 12Mtpa processing line by 1 January 2023 – thereby attracting an estimated c US$603m incremental payment from WPM to Vale – we estimate that it would increase our estimate of WPM’s earnings by a material c US$0.11 (or 15.0%) per share from the date of successful expansion. This, in turn, would increase our forecast value per share for the company to US$38.82, or C$50.74 at prevailing FX rates (excluding the US$0.38/share value of its equity interest in First Majestic), implying an internal rate of return to investors buying WPM shares currently at C$25.79, equivalent to 44.8% pa in US dollar terms.

As at 31 December 2017, WPM had US$98.5m in cash (ex-dividend) and US$770.0m 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$671.5m overall, after US$165.1m (US$0.37/share) of cash inflows from operating activities during the quarter. Relative to the company’s equity, this level of net debt equated to a financial gearing (net debt/equity) ratio of 13.7% and a leverage (net debt/[net debt+equity]) ratio of 12.1%. It also compares with a net debt position of US$784.1m as at 30 September and US$1,068.7m as at the end of December 2016, and is consistent with WPM continuing to sustainably generate c US$100-150m per quarter from operating activities before financing and investing activities. Otherwise, assuming the operational performance set out in Exhibit 6, we estimate that WPM’s net debt position will have declined organically, to US$351.8m by the end of FY18 (equating to gearing of 7.0% and leverage of 6.6%), and that WPM will be net debt free early in FY20 (or in H219 if WPM’s First Majestic shares are treated as cash), 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 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 Canadian Revenue Agency (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 for the mining industry).

In 2017, 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 should not be interpreted as an admission of guilt, 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 9).

In the meantime, WPM is now nearing the end of 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. If a ‘principled’ settlement cannot be reached, however, the company has stated that it is willing to go to trial, which would be likely to be towards the middle of this year.