Silver Wheaton — Majestic

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:

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$145m 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.

Note that, for the purposes of the analysis below, we have assumed that First Majestic’s acquisition of Primero completes 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.

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 (then trading at C$4.00/share), 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 2006, 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, shares and debt, 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 only the first 3.5Moz of payable silver produced at San Dimas per annum plus 50% of any excess for four years. With the agreement of both parties, this then increased to the first 6.0Moz plus 50% of any excess from the fifth year onwards.

Between 2010, when it acquired the mine and 2014, Primero increased mill capacity from 1,500tpd to 2,500tpd and had plans to increase it further to 3,000tpd thereafter. In Q116 however, output at San Dimas fell by 60.2%, quarter-on-quarter, to 0.9Moz attributable silver (vs 2.3Moz in Q415) which Primero attributed to the implementation of new safety standards at the mine. As a result, mill throughput was said to be limited to 1,639tpd. This recovered to above 2,500tpd in April. However, the addition of ground support was reported to have 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. This implied output of 1.7Moz in Q4. In the event, only 1.4Moz was produced, after which workers called a strike in mid-February 2017.

After two months of strike action, operations at San Dimas 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 however, Primero has reported a material deterioration in employer-employee relations to the point that productivity was materially, adversely affected.

In the aftermath of the strike, Primero’s production guidance for FY17 was 4.5-5.5Moz Ag. In the first three quarters of the year, it produced 2,639koz silver attributable to WPM (an average of 880koz per quarter). In September, it revised its guidance to 4.5-5.0Moz and has maintained this range to date, albeit it is now erring towards the lower end. This compares to WPM’s guidance at the time of its FY16 results in March 2017 (see our update note published on 29 March 2017) of 4.0Moz after an assumed three-month strike (vs two months actual) and Edison’s current, relatively conservative, expectation of 4.2Moz, which assumes a return to San Dimas’s long-term average quarterly production rate of 1.5Moz per quarter in Q417 (and then again in Q118).

As such, we are forecasting that the San Dimas stream will have accounted for 14.7% of total silver production attributable to WPM in FY17 and 7.8% of silver equivalent production.

Fundamentally, Primero’s exploration at San Dimas failed to identify any replacement for the depleting Roberta and Robertita veins, with the result that mining rates above 1,800tpd (vs nameplate capacity of 2,500tpd) became increasingly difficult to maintain and Primero was in danger of failing to comply with its financial obligations to lenders and consequently cut back on exploration activities, thereby further compromising the mine’s potential future life.

In addition, 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. In response, Primero notified the Mexican government that the measures taken against it by the SAT breached 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 NAFTA. Nevertheless, at present, the dispute remains unresolved.

San Dimas was the fourth largest unique contributor to WPM’s sales in Q317 and, arguably, should have been the third largest and could have been the second largest under more normal circumstances. Prior to Q217, we forecast that San Dimas could sustainably produce 6.8Moz silver per annum attributable to WPM, which would ordinarily equate to c 24% of WPM’s silver production in a typical year, or c 15% of silver equivalent (AgE) production. While such a contribution to WPM is therefore not immaterial, in the historical context, it is worth noting 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 comparatively junior operator.

Otherwise, all terms were entered into freely by both parties and these initially left Primero in a cash flow-positive position. WPM also highlights a number of Primero's strategic decisions, such as apparently giving precedence to gold over silver exploration and pursuing corporate expansion (eg via the Black Fox acquisition) while simultaneously reining in development expenditure at San Dimas as being material contributory factors in aggravating Primero's tribulations. In any event, it was certainly not in WPM's interest to risk a corporate bankruptcy at Primero, which was part of the reason for the corporate loan guarantees provided by it to Primero last year. As a result, with multiple mines, a single union, a pre-expanded mill and the status as Durango's largest taxpayer, WPM believes there is a tangible opportunity for First Majestic to turn around the fortunes of the San Dimas complex, including the possibility of some relatively near-term success in previously relatively neglected silver exploration.

Edison’s assumption that First Majestic’s acquisition of Primero completes on 31 March 2018 means that our FY17 forecasts will be unaffected by the transaction. We have nevertheless updated our FY17 forecasts to reflect slightly different average silver and gold prices to those estimated at the time of WPM’s Q3 results after the market close on 9 November (see Exhibit 2).

WPM’s Q317 results were characterised by improvements in production relative to the previous quarter, but a 24.2% under-sale of silver relative to production (which was attributed to Penasquito, Zinkgruvan, Yauliyacu and Antamina) and a 13.9% under-sale of gold (which was attributed to Sudbury and Salobo). 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. As always, Edison’s forecasts are made on the basis that what is produced is sold and that there is therefore no inventory change between quarters over the period under review.

Overall, WPM has maintained its production guidance for FY17 at 28Moz Ag and 340koz Au, compared with Edison’s forecast of 28.5Moz Ag and 343koz Au. We perceive that there is risk to our estimates from San Dimas, but regard this as being offset by upside risk (opportunity) at Penasquito. Otherwise, we have honed our Q417 silver price forecast from US$16.91/oz to US$16.72/oz (-1.1%) and our gold price forecast from US$1,272/oz to US$1,276/oz (+0.3%).

In the aftermath of these revisions, our updated basic EPS estimate for FY17 is barely changed at 62c, which compares to a (rising) average consensus estimate (source: Bloomberg, 22 January 2018) of 60.4c, within a range of 57-66c (cf an average of 60.2c within a range of 57-64c in November and 59.5c within a range of 51-67c in August).

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).

Hitherto, Edison’s FY18 EPS forecast were made on the basis of assumed precious metals prices of US$21.54/oz Ag and US$1,220/oz Au – as much to demonstrate WPM’s operational gearing to a normalisation of the gold:silver ratio as an expression of our expectations. At the time of our Q317 results update, published on 10 November, this resulted in an initial EPS forecast of US$0.89/share for FY18, although we noted that this moderated to 67c in the event that precious metals’ prices remained at the then level of spot prices, namely US$17.12/oz and US$1,287/oz for silver and gold, respectively. We have now formally updated these forecasts further, to reflect both updated precious metals’ prices and our assumption that the First Majestic-Primero deal will close on 31 March 2018, by quarter, 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 Wheaton Precious Metals 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).

As such, Edison’s EPS forecasts for FY18 are ostensibly flat compared to FY17 and compare to a consensus estimate of 64.5c, within a range 49-80c (cf a consensus of 65.3c, within the range 42-81c, excluding Edison, at the time of WPM’s Q317 results in November 2017).

Edison has recently updated its long-term gold and silver price expectations (see Mining overview: Unlocking the price to NPV discount, published in November 2017). On the basis of our revised production and sales expectations in the light of the new First Majestic PMPA, our updated forecasts for the cash-flows derived by WPM from the San Dimas stream are as follows:

Discounted at Edison’s standard 10% discount rate for mining companies, we value the cash-flows to WPM from San Dimas for the period FY18-33 at US$252.9, or US$0.57 per WPM share, on the basis of Edison’s long-term gold price assumptions or US$238.7m, or US$0.54 per WPM share, on the basis of the current spot price of gold (US$1,320/oz at the time of writing).

Stated alternatively, we estimate that the entire San Dimas stream will henceforward contribute c US$0.04-0.08 per annum to WPM’s EPS, compared with an estimated US$0.11 in FY17 (the last full year of the existing silver purchase agreement). In recognition of this, First Majestic is also issuing WPM 20.9m FR common shares with an aggregate value of US$151m at the time of the announcement, or US$145m at the time of writing – equivalent to US$0.33 per WPM share. These values compare with an adjusted purchase price of the San Dimas stream of US$190m and a carrying value, for accounting purposes, of US$136.8m, which suggests the possibility of an exceptional profit once the FR-PMO transaction concludes.

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 35.0x Edison or 33.6x consensus FY18e, currently – see Exhibit 6).

Applying this multiple to our long-term EPS forecast of US$1.40 in FY20 (at Edison’s updated average long-term precious metals prices) implies a potential share value for WPM shares of US$37.90, or C$47.18 in that year (excluding the US$0.33/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 96% (ie 23 out of 24) of the valuation measures used in Exhibit 6 and on multiples that are cheaper than the miners themselves in at least 43% (ie 39 out of 90) of the same valuation measures, despite being associated with materially less operational and cost risk.

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 lines 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 US$0.08-0.13/share. This, in turn, would increase our forecast value per share for the company to US$41.53, or C$51.69 at prevailing FX rates (excluding the US$0.33/share value of its equity interest in First Majestic), implying an internal rate of return to investors buying WPM shares currently at C$27.33, equivalent to 41.7% pa in US dollar terms.

As at 30 September 2017, WPM had US$69.9m in cash (ex-dividend) and US$854.0m 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$784.1m overall, after US$129.1m (US$0.29/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 15.5% and a leverage (net debt/[net debt+equity]) ratio of 13.4%. It also compares with a net debt position of US$876.4m as at 30 June, 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 Exhibits 2 and 3, we estimate that WPM’s net debt position will have declined organically, to US$690.1m by the end of FY17 (equating to gearing of 13.6% and leverage of 12.0%), 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 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 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 6).

In the meantime, Wheaton Precious 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 2018.