Wheaton Precious Metals — Formerly Silver Wheaton (SLW)

Wheaton Precious’s results in Q117 were closely aligned with our prior expectations (see our report, Silver Wheaton – What a difference a quarter makes, published on 29 March 2017) with the single exception of the fact that there was a 19.8% (or 1.3Moz) under-sale of silver relative to production, resulting in a temporary inventory build as at 31 March. Note that, during the course of a year, WPM almost invariably experiences one quarter of inventory build, which is then, typically, ‘flushed through’ in the final quarter. While revenues were therefore 7.8% below our expectation for the quarter, this was almost exactly offset by a similar reduction in costs, such that net earnings were only 0.3% (or US$0.2m) below our published estimate, at US$61.2m. Moreover, management declared a relatively generous second quarter dividend of 7c/share cf our prior expectation of 6c/share. For the second quarter in succession, gold sales exceeded silver sales, (in this case) in the ratio 54:46.

From an operational perspective, there were notable production outperformances by both Wheaton Precious’s ‘other’ gold and silver assets relative to our expectations, as well as Sudbury, where higher grades and recovery more than offset lower throughput. By contrast, Salobo was affected by conveyor belt and plant repairs during February, as well as by lower grades, while the effects of industrial action had an impact on San Dimas (although operations returned to normal on 18 April, after the quarter’s end).

Compared to a 10.4% average historical under-sale of silver relative to production and a 9.3% historical under-sale of gold, sales of silver in Q117 recorded a 19.8% under-sale, while sales of silver recorded a 4.2% over-sale:

As at 31 March, payable ounces attributable to Wheaton Precious produced but not yet delivered amounted to 3.9Moz silver and 51,500oz gold (cf 3.2Moz silver and 61,700oz gold as at end-December and 3.8Moz silver and 63,300oz gold as at end-September). This ‘inventory’ equates to 1.73 months and 1.85 months of forecast FY17 silver and gold production, respectively (cf 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 1.8 months on a silver equivalent basis (cf 1.6 months as at end-December and 1.9 months as at end-September) – still 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 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.

Production for the remainder of FY17 will be affected by a number of factors, including:

Penasquito – Goldcorp reports that higher grade ore is expected to be mined in Q217 as further mining occurs in Phase 5. After that, mill feed is expected to consist of lower grade ore and stockpiled material for the remainder of the year. However, this will coincide with increased productivity as a result of a number of initiatives including improved pit conditions (on account of large and wide cut-backs), a continued focus on balancing truck haulage with available shovels and the optimisation of drill-and-blast activities. Finally, pre-stripping of the Chile Colorado pit is reported to have commenced ahead of schedule with the first two benches being mined and ore anticipated to be produced from CY18.

San Dimas – operations at San Dimas resumed on 18 April after strike action and a phased restart of the mine is currently underway. In the aftermath of the strike, Primero’s production guidance for FY17 is now 4.5-5.5Moz Ag. This compares with Wheaton Precious’s guidance at the time of its FY16 results in March (see our note published on 29 March 2017) of 4.0Moz after a three-month strike (vs two months actual) and our current, relatively conservative, expectation of 4.3Moz.

Sudbury – production of gold from Sudbury will be affected after Vale took its second furnace offline in mid-March for a three-month rebuild and expansion ahead of its return to production in Q4, when Sudbury transitions to a single-furnace operation. In addition, Sudbury is scheduled to incur its regular (every 18 months) three-week, surface plant shut-down in Q2.

On 30 March, Wheaton Precious and certain of its subsidiaries provided a guarantee to the lenders under Primero’s (the operator of San Dimas) existing revolving credit facility (capped at a maximum of US$81.5m plus interest, fees and expenses), in respect of which Primero will pay a fee to Wheaton Precious of 5% in connection with the guarantee. For the purposes of the following financial forecasts, we assume that this will be recognised as a guarantee fee, allocated to ‘Other Income’.

Also in March, WPM amended its silver purchase agreement with Alexco, to make the production payment a function of the silver head grade and spot price in the month in which it is produced. In addition, the area covered by the stream has been expanded to include properties currently owned by Alexco as well as properties acquired by Alexco in the future within a one kilometre radius of its existing holdings in the Keno Hill Silver District. As consideration of the amendments, on 10 April, Alexco issued 3m shares to Wheaton Precious with a fair value of US$5m. For the purposes of the following financial forecasts once again, we assume that this will be reflected as a reduction to the carrying cost of the stream in Q2. NB There is also likely to be a reduction in the depletion rate applied to the Keno Hill silver stream in WPM’s income statement.

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

Note that our FY17 forecasts of 27.3Moz Ag and 333,852oz Au produced compare with WPM’s (reiterated) guidance for the full year of 28Moz Ag and 340,000oz Au.

Our updated basic EPS estimate of 63c for FY17 (see Exhibit 3 for revisions) represents a 3cps upgrade relative to our previous forecasts (see our note published on 29 March 2017), but is notable for the fact that it is achieved despite expectations of lower average precious metals’ prices for the year. It also compares to an average consensus estimate (source: Bloomberg, 18 May 2017) of 64.3c within a (rising) range of 58-74c (cf a consensus of 62.4 within a range 42-74c on 8 May, immediately prior to WPM’s results).

Edison’s slightly revised financial forecasts for FY18 are high relative to the consensus average of 78c, within a range of 49-97c, which is noteworthy for the fact that our production forecasts are at or near the bottom of the range of expectations (especially for gold). As such, they therefore almost exclusively demonstrate Wheaton Precious’s operational gearing to (in this case) 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.

Excluding FY04 (part year) and FY08 (when there was an exceptional write-down), WPM’s shares have historically traded on an average P/E multiple of 26.5x current year basic EPS (cf 33.8x Edison FY17e and 23.7x Edison FY18e – see Exhibit 5).

Applying this multiple to our long-term EPS forecast (upgraded to reflect revised Keno Hill mine plan and terms) 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$37.52, or C$51.25, in that year.

Currently, Edison makes no provision for either future expansion at Salobo or related expansion payments in its 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 Wheaton Precious 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$43.31 (C$59.16 at prevailing forex rates), implying an internal rate of return to investors buying Wheaton Precious shares currently at C$29.08, equivalent to 29.7% pa in US dollar terms over four years.

In the meantime, from a relative perspective, it is notable that WPM is cheaper than its royalty/streaming ‘peers’ on at least 91% of the valuation measures used in Exhibit 5 on an individual company basis (ie in 22 out of 24 measures) and on multiples that are lower than the miners themselves in at least 50% of the same valuation measures (ie 45 out of 90 measures), despite being associated with materially less operational and cost risk, in particular.

As at 31 March, WPM had US$83.8m in cash (ex-dividend) and US$1,064m of debt outstanding under its US$2bn revolving credit facility, such that it had net debt of US$980.2m overall, after US$119.9m of cash inflows (US$0.27/share) 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$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. Most recently, these investing activities involved the acquisition of an additional 25% of the gold output from the Salobo mine in Brazil for an immediate cash payment of US$800m, announced in August 2016 (see our note Going for gold, published on 30 August). Otherwise, assuming the operational performance set out in Exhibits 3 and 6, we estimate that WPM’s net debt position will decline organically, to US$702.0m by the end of FY17 (equating to gearing of 13.8% and leverage of 12.1%), and that WPM will be net debt free in early 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:

On 27 February 2017, the term of the revolving term loan was extended, such that it now matures on 27 February 2022.

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. In the meantime, WPM’s revolving debt facility attracts an interest rate of Libor plus 120-220bp.

Penasquito – Goldcorp reports that earthwork activities are now complete at the Pyrite Leach project, that concrete works are underway and that mechanical works installation will commence in Q217. A carbon pre-flotation facility is also now being incorporated into the project, which is designed to allow Penasquito to process ore that was previously considered to be uneconomic (including ‘significant amounts’ already reported to be in stockpiles).

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$2.50/lb at the time of writing). Nevertheless, it has stated that it expects the Record of Decision from the Coronado National Forest Supervisor (one of two key federal permits outstanding) to be signed in June 2017. The other outstanding permit is the Section 404 Water Permit from the US Army Corps of Engineers.

Although the nature of the streams that it is in negotiations to buy has changed from ‘balance sheet repair’ to ‘development’ opportunities broadly within the range US$100-400m, WPM estimates the size of the potential market open to it to be the 70% of 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 year). This compares with WPM’s production in FY16 of 30.4Moz Ag – ie WPM estimates that, to date, it has penetrated only c 5.0% of its potential market.

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, Wheaton Precious’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 5).

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 end in July 2017. Any potential settlement therefore is 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).