Wheaton Precious Metals — Barely missing a beat

Although below the levels of Q1 – unsurprisingly, given the emergence of the worst manifestations to date of the coronavirus – Wheaton’s Q2 results were nevertheless materially above our expectations, as all six of its partners’ disrupted operations were returned to production, to a greater or lesser extent, during the period. As all six of the mines are primarily silver producers, this resumption of operations led to a 2.1Moz positive variance in silver production, relative to our expectations, and a 3.1Moz positive variance in sales as inventories were also drawn down. Coupled with a strong silver price, this led to a US$66.3m (or 36.5%) positive variance in total sales, partially offset by US$33.6m (or similar 37.2%) variance in the cost of sales to result in a US$32.7m (or 35.8%) positive variance in earnings from operations relative to our expectations. This, in turn, was partially offset by a US$8.2m positive (ie higher) variance in general and administrative costs – albeit the majority of this increase could be attributed to non-cash performance share unit accrual costs (see Exhibit 9) – to result in a US$25.1m positive variance in earnings before income tax and a US$0.06 (or 34.8%) positive variance in basic EPS.

A full analysis of WPM’s Q220 income statement relative to both Q120 and our prior expectations is provided in the table below:

Six of Wheaton’s partners’ mines were directly affected by shutdowns and suspensions during the period. Whereas we had previously expected zero production and sales from each of these assets for the entirety of Q220, their performance was considerably better than our (albeit somewhat conservative) expectations:

Although not directly affected by a suspension or a lockdown, Wheaton’s flagship asset, Salobo in Brazil, experienced increased absenteeism during the quarter attributable to COVID-19, which resulted in production 6,896oz Au (or 10.4%) below our prior expectations. However, this was more than made up for by a 15.9% over-sale of gold, as inventories were drawn down, to result in sales that were 2,487oz (or 3.8%) ahead of our expectation. According to Vale’s Q220 performance report, physical completion of the Salobo III mine expansion was at 54% (cf 47% at end-Q1, 40% at end-Q419 and 27% at end-Q319) and remains on schedule for start-up in H122.

Rather unusually – within the historical context – both WPM’s gold and silver divisions reported large over-sales of metal relative to production during the quarter, as inventories were drawn down. However, whereas the over-sale in gold could (effectively) be solely attributed to performance at Salobo, the material (29.6%) over-sale of silver relative to production could be attributed to all of its major silver producing assets and half of its minor ones as well.

As at 30 June, payable ounces attributable to WPM produced but not yet delivered to WPM amounted to 3.1Moz silver and 79,518oz gold (vs an albeit restated level 4.9Moz silver and a fractionally restated 88,383oz gold at end-March). This ‘inventory’ equates to 1.67 and 2.51 months of FY20 forecast silver and gold production, respectively (cf 3.17 and 2.78 months as at end-Q120, as reported) and compares with WPM’s target level of two months of silver and two to three months of gold and palladium production, respectively. As a consequence, WPM believes that there is the potential for an inventory increase of approximately 20,000oz AuE in Q320, in particular, which Edison has rationalised (for the purposes of its forecasts in Exhibits 10 and 14) as a rise in silver inventories of 685koz and a rise in gold inventories of 11,377oz to take their levels back to 2.04 months and 2.87 months, respectively.

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 typically refers to metal in circuit (among other things) and would therefore be considered to be a consequence of metallurgical recoveries in the plant.

Prior to the coronavirus pandemic, WPM provided production guidance for FY20 of 390–410koz gold, 22.0–23.5Moz silver and 23.0–24.5koz of palladium to result in gold equivalent production of c 685–725koz (based on an assumed gold price of US$1,500/oz, an assumed silver price of US$18.00/oz and an assumed palladium price of US$2,000/oz). WPM suspended its production guidance on 1 April in response to the coronavirus crisis. As its partners’ previously furloughed mines have returned to production however, it has reinstated updated guidance, as shown in the exhibit below. Its long-term production forecast remains unchanged at 750,000oz gold equivalent per annum on average between 2020 and 2024. This compares with Edison’s current and previous forecasts, as follows:

Readers should note that the major differences between Edison’s gold equivalent production forecasts and Wheaton’s can be attributed to the ratio of the gold price to the silver price. Whereas Wheaton assumes an 83.33x ratio (based on a gold price of US$1,500/oz and a silver price of US$18.00/oz), the current ratio is closer to 74.7x and Edison assumes that the ratio will revert closer to its long-term average of 61.5x from FY21. Note that, at WPM’s prices, Edison’s gold equivalent production forecast in FY20 is 678koz, rather than 669koz (which assumes a gold price of US$1,927/oz for the balance of the year and a silver price of US$25.79/oz). In addition, Edison is also expecting a production contribution from Salobo III from FY23 (albeit nothing from Rosemont).

In the medium term, First Majestic has announced plans to increase production at San Dimas by restarting mining operations at the past-producing Tayoltita mine and expects to ramp up production to add another 300tpd (12%) to throughput by the end of FY20. In addition, it intends to install a new 3,000tpd high-intensity grinding mill circuit and an autogenous grinding mill in Q221 (cf H220 previously) to further improve recoveries and reduce operating costs. Production of palladium and gold at Stillwater (operated by Sibanye-Stillwater) will similarly increase into FY21 under the influence of the Fill-the-Mill and Blitz projects.

By contrast, production is expected to remain at lower levels at Constancia, owing to delays in mining the Pampacancha satellite deposit (which hosts significantly higher gold grades than those mined hitherto). However, Hudbay reports that it has now secured the surface rights for the Pampacancha deposit and expects to begin mining ore from the satellite deposit in early FY21 (cf late FY20 previously). Nevertheless, in lieu of the delay, WPM is entitled to receive an additional 2,005oz gold per quarter from Hudbay during FY20 relative to its precious metals purchase agreement.

On 22 June, WPM announced that it had signed a non-binding term sheet with Caldas Gold to enter into a precious metals purchase agreement (PMPA) for the Marmato project in Colombia. Under the terms of the proposed PMPA, WPM will acquire 6.5% of the gold production and 100% of the silver production of Marmato until 190,000oz gold and 2.15Moz silver have been delivered, after which the stream will drop to 3.25% of gold production and 50% of silver production for the remainder of the life of the mine. Under the proposed PMPA, WPM will pay Caldas a total cash consideration of US$110m, of which US$38m will be payable upon closing and the remainder during the construction of the Marmato Deep Zone project. In addition, WPM will make ongoing delivery payments equal to approximately 20% of spot prices over the life of the mine.

The Marmato project comprises the existing producing underground gold and silver mine in the Upper Zone, including the right to mine the lower portion of the neighbouring Echandia licence area, the existing 1,200tpd processing plant and the area encompassing the Deeps Zone mineralisation, all located within the mining licence area referred to as Zona Baja. The area has been a centre for gold production for approximately 500 years and the current mine has been in operation since 1991. As at 31 July 2019, the project’s mineral resource inventory was estimated at 5.4Moz, of which 38%, or 2.0Moz, is in the measured and indicated categories. Among other things, it has excellent infrastructure, being located adjacent to the Pan American Highway with access to Medellin to the north and Manizales to the south and has access to the national electricity grid, which runs near the property.

A preliminary economic assessment (PEA) was completed on the project in 2019 and charts a path for expansion of mining operations at the Marmato Project to encompass both the existing Upper Zone operation and a new Deeps Zone operation, which sits directly below the Upper Zone vein system. Wheaton interprets the geology of the mine to be structurally controlled and believes that there is a high probability that the system coalesces into one ore body at depth, similar to other systems in the region. Wheaton’s agreement with Caldas is subject to receipt of required permits and licenses, sufficient financing having been obtained and other customary conditions. To date, Edison has not included any contribution from Caldas to its forecasts for WPM. On the basis of a PEA, filed by Caldas in February 2020 however, we have calculated the following potential cash flows to WPM based on the first 10 years of mining (out of a total of 19) as follows:

In crude terms therefore, WPM is acquiring an average annual positive cash flow of c US$15m (albeit front loaded) over 19 years for an upfront payment of US$110m. However, deeper drilling has indicated the potential for the mine to continue at depth beyond its official 19-year life and WPM envisages the potential for multiple additional drop downs once the PEA plan has been concluded.

A pre-feasibility study (PFS), which is currently in progress and expected to be completed in mid-2020, is focused on the development of the Deeps Zone mineralisation, construction of a new 4,000tpd plant and new dry stack tailings storage facilities. Mechanised mining, using an underground long-hole stoping method, is expected to commence in 2023 with an additional estimated 1.6Moz gold recovered over a 16-year mine life.

On 24 October 2018, Vale announced the approval of the Salobo III brownfields mine expansion, intended to increase processing capacity at Salobo from 24Mtpa to 36Mtpa, with start-up scheduled for H122 and an estimated ramp-up time of 15 months. According to its agreement with Vale, depending on the grade of the material processed, WPM will be required to make a payment to Vale in respect of this expansion, which WPM estimates will be in the range US$550–650m in FY23, in return for which it will be entitled to its full 75% attributable share of expanded gold production. Note: this compares to its purchase of a 25% stream in August 2016 for a consideration of US$800m (see our note, Silver Wheaton: Going for gold, published on 30 August 2016), the US$900m it paid for a similar stream in March 2015 (when the gold price averaged US$1,179/oz) and the US$1.33bn that it paid for its original 25% stream in February 2013.

According to Vale’s Q220 performance report, the Salobo III mine expansion is now 54% complete (cf 47% at the end of Q120, 40% at the end of Q419 and 27% at the end of Q319) and remains on schedule for start-up in H122.

Wheaton’s contract with Barrick provides for a completion test that, if unfulfilled by 30 June 2020, results in WPM being entitled to the return of its upfront cash consideration of US$625m less a credit for any silver delivered up to that date from three other Barrick mines (at which point it would have no further streaming interest in the mine). As a result, Edison calculates that WPM has the right to an estimated US$252.3m (the carrying value of Pascua-Lama in WPM’s accounts) repayment from Barrick in FY20. Given the long-term optionality provided by the Pascua-Lama project however, Wheaton has indicated that it is unlikely to enforce the repayment of its entitlement and that it prefers instead to maintain its streaming interest in the project.

Another major project with which WPM has a streaming agreement for attributable gold and silver production is Rosemont copper in Arizona.

The proposed Rosemont development is located near a number of large porphyry-type producing copper mines and would be one of the largest three copper mines in the US, with output of c 112,000t copper in concentrate per year and accounting for c 10% of total US copper production. Total by-product production of silver and gold attributable to WPM will be c 2.7Moz Ag pa and c 16,100oz Au pa.

Rosemont’s operator Hudbay has received both a Section 404 Water Permit from the US Army Corps of Engineers and a Mine Plan of Operations (MPO) from the US Forest Service. The Section 404 permit regulates the discharge of fill material into waterways according to the Clean Water Act and was effectively the final material administrative step before the mine could be developed. Subsequently, Hudbay indicated it would seek board approval to commence construction work by the end of CY19, which would have enabled first production ‘by the end of 2022’. In the meantime, it commenced early works to run concurrently with financing activities (including a potential joint venture partner).

On 31 July 2019 however, the US District Court for the District of Arizona issued a ruling relating to a number of lawsuits challenging the US Forest Service’s issuance of the Final Record of Decision effectively halting construction, saying that:

In its reaction to the ruling, Hudbay said that it believed that the ruling was without precedent and that the court had misinterpreted federal mining laws and Forest Service regulations as they apply to Rosemont. It pointed out that the Forest Service issued its decision in 2017 after a ‘thorough process of ten years involving 17 co-operating agencies at various levels of government, 16 hearings, over 1,000 studies, and 245 days of public comment resulting in more than 36,000 comments’ and with a long list of studies that have examined the potential effects of the proposed mine on the environment. Hudbay also pointed out that various agencies had accepted that the company could operate the mine in compliance with environmental laws. As a result, Hudbay is in the process of appealing the ruling to the Ninth Circuit Court of Appeals.

At our updated precious metals prices (see ‘Precious Metals prices’, below), Edison estimates that Rosemont could contribute an average c US$0.19 per share (12.7%) to WPM’s basic EPS in its first nine years of its official 18-year life from FY22–30 for an upfront payment of US$230m (equivalent to US$0.513/share) in two instalments of US$50m and US$180m (of which neither has yet been paid). Nevertheless, in the light of the uncertainty about the timing and development of the project we have, for the moment at least, removed any contribution from Rosemont from our forecasts.

WPM is ostensibly a precious metals streaming company (plus one cobalt stream). Considering only the silver component of its investible universe, WPM estimates the size of the potential market open to it to be the lower half of the cost curve of the 70% of global silver production of c 856Moz in CY18 (down from 894Moz in CY15) that was produced as a by-product of either gold or base metal mines (ie approximately 300Moz pa silver vs WPM’s attributable production of 22.6Moz Ag in FY19). Inevitably, WPM’s investible universe may be further refined by the requirement for the operations to be located in good mining jurisdictions, with relatively low political risk. Nevertheless, such figures serve to illustrate the fact that WPM’s marketplace is very far from being either saturated or mature.

As a consequence, WPM reports that it is busy on the corporate development front, albeit with the caveat that COVID-19 has inevitably slowed the pace of progress. Whereas potential deals in FY19 were generally reported to be with development companies in the US$100–350m range, more recent overtures are reported to have been from producing companies looking to strengthen their balance sheets with mooted transactions in the >US$1bn range, which WPM would fund, in the first instance, via the US$1,359.5m available under its revolving credit facility, plus US$131.8m in cash and (potentially) from its ATM programme (see below).

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

Otherwise, WPM also has streaming agreements with other potential producing mines, including (but not limited to) Navidad, Keno Hill (at which the operator, Alexco, has announced its intent to recommence mining operations from Q420) and Cotabambas. Note that during its most recent period in production, Keno Hill typically produced in the order of 150–200koz silver attributable to Wheaton per annum.

Gold is a traditional beneficiary of negative real interest rates (and therefore falling nominal interest rates, assuming constant inflation) and central bank balance sheet expansion either in the form of quantitative easing or otherwise. In our last note on the gold price (see A golden future, published on 11 June 2020), Edison argued that the recent, sharp increases in the total US monetary base might be expected to support a (nominal) gold price of US$1,892/oz and potentially as high as US$3,000/oz. While there is a historically strong and statistically significant correlation of 0.909 between the gold price and the total US monetary base from 1967 to 2018 however, there is very little visibility as to how, or to what extent, the total US monetary base may be expected to evolve. Currently, we know that it is expanding at a rate of approximately US$110bn per month, which equates to an expected increase in the gold price (using the historical correlation) of approximately US$500/oz per annum. Anecdotally, the total US monetary base may probably be expected to continue to increase for a time until the COVID-19 crisis has been managed and then to flatten off for a discrete period until a period of tapering is attempted by the Federal Reserve (in a similar fashion to the aftermath of the global financial crisis). However, neither the extent of any increases nor the extent of any subsequent tapering nor the timing of either is easy to judge. In consequence, Edison’s strategy now is to maintain a flat, nominal gold price of US$1,892/oz into the future from FY21. Note that this may be contrasted with our previous approach to gold price forecasts (see Portents of economic weakness: Gold – doves in the ascendant, published on 14 August 2019). Given their historical correlation, a flat nominal gold price of US$1,892/oz should support a silver price of US$30.78/oz (cf a spot price currently of US$25.79/oz and one of US$29.85/oz on 7 August 2020) – ie a gold/silver price ratio of 61.5x).

In the absence of more general deflation however, a flat, nominal gold price of US$1,892/oz is, self-evidently, a declining gold price in real terms, which is an unlikely long-term scenario, given that the gold price has historically increased by 2.0% per annum in real terms from 1914 to 2018 (see Portents of economic weakness, Gold: Doves in the ascendant). During the period 2013–18, the gold price was relatively flat, averaging US$1,270/oz. Its average price in 2018 was also US$1,271/oz and this might therefore be considered an appropriate floor price from which to grow the gold price in real terms. A second long-term gold price scenario might therefore be inflating the real price of gold from US$1,271/oz in 2018. All other things being equal, these two scenarios cross between 2025 and 2026 (see Exhibit 8) and, from that point, Edison therefore assumes that both the gold and silver prices will rise with US inflation (ie flat in real terms). These scenarios may be plotted graphically into the future, for both gold and silver, in both nominal and terms, as follows:

Consequently, and in the absence of much immediate visibility as to the evolution of the total US monetary base, Edison’s new gold price scenario for valuation purposes is for the gold price to remain at US$1,892/oz in flat nominal terms (ie declining in real terms) until the price (in real terms) crosses with the increased US$1,271/oz real 2018 price. At that point we assume that the price will flatten out in real terms (at US$1,494/oz) and rise with US inflation in nominal terms.

In the meantime, in common with Edison’s stated practice, we use prevailing prices (ie US$1,927/oz Au (cf US$1,691/oz previously), US$25.79/oz Ag (cf US$15.03/oz previously) and US$2,062/oz Pd (cf US$1,814/oz previously)) to generate our forecasts for the remainder of the current financial year.

WPM reiterated its guidance for non-stock general & administrative (G&A) expenses of US$40–43m (or US$10.0–10.75m per quarter) in FY20, compared to a range of US$33–36m in FY19 (reduced from an earlier estimate of US$36–38m), an actual FY19 outcome of US$31.6m and guidance of US$34–36m in FY18 cf an actual outcome of US$36.7m, including all employee-related expenses, charitable contributions, etc, but excluding performance share units (PSUs) and equity settled stock based compensation. It is notable, within this context, that WPM’s non-stock G&A expense for Q220 fell within this range (see Exhibit 9) and that the extent to which actual all-in G&A costs exceeded our forecasts could be entirely attributed to performance share unit accruals and a US$2.0m increase in donations, in particular.

Investors are reminded that, since April this year, stock-based compensation costs and PSUs have been included in Edison’s financial forecasts in Exhibits 10 and 14 notwithstanding their somewhat unpredictable nature. Excluding stock-based effects however, it is clear that non-stock expenses are trending towards the bottom end of Wheaton’s guided range of US$40–43m, notwithstanding higher donations.

Our updated forecasts for WPM for FY20 are as shown in Exhibit 10, below. The forecasts assume that operations will continue throughout the remainder of the year without major interruptions, which is, self-evidently, a risk. Apart from precious metals prices, the principal remaining risk to our forecasts relates to the extent to which sales differ from production and therefore, by extension, the extent to which inventory (in the form of ounces produced but not yet delivered to Wheaton) either increases or decreases during the year.

Readers should note the slightly uncharacteristic Edison assumption in Q3 that there will be an 11.4% under-sale of both gold and silver, relative to production to allow inventories to recover by an approximate 20,000oz gold equivalent, as pre-figured by WPM management. Altogether, our basic EPS forecast of US$1.209/share for FY20 (cf US$0.859/share previously) for FY20 is 23.4% above the consensus forecast of US$0.98/share (source: Refinitiv, 14 August 2020) and (now) right at the top of the range of expectations, of US$0.86–1.19 per share quoted for the period:

Our US$1.77 basic EPS forecast for FY21 (cf US$1.12 previously) compares with a consensus of US$1.20 (source: Refinitiv, 13 August 2020) within a range US$0.93–1.60 and is materially higher than the equivalent figures of US$0.88 within a range US$0.76–1.15 of mid-March (source: Refinitiv, 19 March 2020). As discussed previously, this estimate is predicated on an average gold price during the year of US$1,892/oz (cf US$1,509/oz previously) and an average silver price of US$30.78/oz (cf US$24.76/oz previously), which assumes, among other things, that the gold/silver price will revert to the long-term correlation that it has exhibited with gold since the latter was demonetised in 1971. If both metals remain at current levels however (US$25.79/oz Ag and US$1,927/oz Au at the time of writing), we would then forecast that WPM would instead earn US$1.58 per share in FY21.

Excluding FY04 (part-year), WPM’s shares have historically traded on an average P/E multiple of 29.5x current year basic underlying EPS, excluding impairments (vs 44.3x Edison or 51.7x Refinitiv consensus FY20e, currently – see Exhibit 13).

Applying this 29.5x multiple to our updated EPS forecast of US$1.77 in FY21 implies a potential value per share for WPM of US$52.05 or C$68.71 in that year (vs US$33.08, or C$46.59 previously). However, it is clearly apparent from the graph above that WPM’s current year multiple has been trading higher for some time and the last two years would suggest that a multiple in excess of 40x earnings could be sustainable – notwithstanding the fact that these years were not subject to the extraordinary trials and tribulations being experienced in FY20. In this case, applying a 42.0x earnings multiple (the average of FY18 and FY19) to our updated EPS forecast of US$1.77 in FY21 implies a potential value per share for WPM of US$74.10 or C$97.81 in that year (cf US$47.10 or C$66.32 previously) and/or for as long as precious metals prices remain at higher levels and/or the current coronavirus crisis persists. Even at such elevated levels however, a multiple of over 42.0x would still leave WPM’s shares at a noticeable discount to those of its obvious peers (ie Franco-Nevada and Royal Gold), as demonstrated in Exhibit 13.

Note that neither of these valuations include the value of 20.2m shares in First Majestic currently held by WPM, with an immediate value (13 August) of C$318.8m, or US$0.54 per WPM share.

In the meantime, from a relative perspective, it is notable that WPM has a lower relative valuation than its royalty/streaming ‘peers’ on at least 70% (17 out of 24) of the valuation measures used in Exhibit 13 if Edison estimates are adopted or 50% of the same valuation measures if consensus forecasts are adopted; among other things, this could possibly indicate the market has more conservative precious metal pricing expectations than Edison (albeit Edison’s forecasts are based on a continuation of current spot prices for the remainder of the year and only our FY21 silver price forecast is above its spot price, currently).

As at 30 June 2020, WPM had US$131.8m in cash cum-dividend (cf US$126.7m in Q120 and US$104.0m in Q419) and US$640.5m of debt outstanding (cf US$715.5m in Q120, US$874.5m in Q419 and US$1,017.1m at end-Q319) under its US$2bn revolving credit facility (which attracts an interest rate of Libor plus 120–220bp and now matures in February 2025), such that (including a modest US$3.8m in leases) it had net debt of US$512.5m (cf US$592.7m in Q120, US$774.8m in Q419 and US$865.5m in Q319) overall, after US$151.8m of cash generated by operating activities during the quarter (cf US$177.6m in Q120 and US$131.9m in Q419). Relative to the company’s balance sheet equity of US$5,238.2m, this level of net debt equates to a financial gearing (net debt/equity) ratio of 9.5% (cf 11.3% in Q120, 14.5% in Q419 and 16.6% in Q319) and a leverage (net debt/[net debt+equity]) ratio of 8.6% (cf 10.2% in Q120, 12.7% in Q419 and 14.2% in Q319). Self-evidently, such a level of debt is well within the tolerances required by its banking covenants that:

All other things being equal and subject to its making no further major acquisitions (which is unlikely in our view), on our current cash flow projections WPM will be net debt free early in FY21 (even after anticipated dividend payments).

WPM has initiated an at-the-market equity programme that allows it to issue up to US$300m of common shares from treasury to the public, from time to time, at the prevailing market price or other prices through the Toronto Stock Exchange, the New York Stock Exchange or any other marketplace on which its shares are traded. The volume and timing of distributions under the programme, if any, will be determined at the company’s sole discretion, subject to applicable regulatory limitations. WPM intends that the proceeds from the programme, if any, will be available as one potential source of funding for stream acquisitions and/or other general corporate purposes, including the repayment of indebtedness. Owing to inherent uncertainties as to price and size, for the moment, at least, Edison has excluded from its forecasts the assumption of any such issues of shares under the programme.