Wheaton Precious Metals — Palladium ex machina

On 16 July, WPM announced it had entered into an agreement with Sibanye (largely the former South African assets of Gold Fields of South Africa and Gengold plus Stillwater in the US) to acquire 100% of the gold production plus a percentage of its palladium production from the Stillwater and East Boulder mines (together called ‘Stillwater’) in Montana for an upfront cash consideration of US$500m. Salient features of the agreement are as follows:

Stillwater is the US’s only platinum group metal (PGM) mine and the largest primary producer of PGMs outside South Africa (predominantly Amplats, Implats and Northam) and Russia (predominantly Norilsk). Located in Montana in the front range of the Beartooth Mountains at elevations exceeding 1,500m above mean sea level, its operations comprise two underground PGM mines (Stillwater and East Boulder), the Blitz project and the Columbus metallurgical complex.

The Stillwater and East Boulder mines have been in operation since 1986 and 2002, respectively, producing from the J-M Reef, which is the world’s highest grade PGM deposit. Each mine has its own milling and concentrator infrastructure on site. In the meantime, the Blitz project – which is part of the Stillwater mine – started ore production in 2017 and is expected to ramp up to full production in 2021. Finally, the Columbus metallurgical complex is a state-of-the-art processing plant to smelt and part-refine mine concentrates to produce a PGM-rich filter cake that is shipped to a third-party for final refining.

Stillwater reserves and resources, attributable to WPM are as follows:

Declared current reserves are sufficient to support mining activities at Stillwater until 2041, but this could be significantly increased if inferred resources are upgraded. Since 2001, the average conversion of resources to reserves has been c 95% at Boulder East and c 87% at Stillwater (the lower conversion being on account of its higher cut-off grade). Note that the Blitz project is expected to have a higher conversion rate than the Stillwater mine as it will similarly utilise a lower cut-off grade owing to an efficient infrastructure set up. In addition, there is significant exploration potential both regionally and at depth below current reserves and resources, including over 12km of undeveloped mineralisation associated with the J-M reef between the two currently producing mines.

As is typical for WPM in entering a new streaming agreement (albeit with a major mining company), there is a completion test relating to the completion of the Blitz project, including the completion of underground development, critical surface infrastructure and concentrator production output.

Expected production in H218 is forecast to be c 5.4koz gold and 10.4koz palladium. In the following 10 years, production is forecast to average c 14.5koz gold and 29.0koz palladium per year. We forecast that Stillwater will have delivered 375koz palladium to WPM by the end of FY31, such that WPM’s share of production halves, from 4.5% to 2.25%, and it will then receive c 14.7koz palladium per year thereafter until a further 175koz have been delivered (after a further 12 years, approximately), at which point its share of production will reduce, once again, to 1.00% for the rest of the life of the mine. Payable rates for gold and palladium have been fixed at 99.0% and 99.6%, respectively, with the result that we forecast the following production, sales and pre-tax cash flows attributable to WPM over the next 13.5 years (in real, FY18, dollar terms) at the current spot price of palladium of US$914/oz at the time of writing:

Within the context of an initial, upfront payment of US$500m in FY18, these cash flows imply a real internal rate of return to WPM of 4.3% in FY18 US dollar terms from FY18 to FY41.

On the basis of these forecasts, we also estimate that the balance of Wheaton’s upfront payment will have declined to nil by the end of FY31. At that point, therefore, it will also be liable to make ongoing payments of 22% of the spot prices of gold and palladium (cf 18% previously).

With due deference to the different detailed terms of each transaction, at the top line, the above gold and palladium stream is therefore approximately equivalent to a gold stream of c 34koz pa, falling to c 24koz pa after FY31, or a silver stream of c 1.9Moz pa, falling to c 1.4Moz after FY13. As such, it may be compared to recent deals concluded by WPM of a similar size, as follows:

Investors should note that, whereas WPM makes ongoing payments of US$400/oz at Salobo at the current time, which equates to approximately 33% of the price of gold at the time of writing, its ongoing payments to Stillwater are approximately half this level at 18% of the spot prices of gold and palladium. Although the Stillwater stream is thus approximately half the size of the Salobo streams in terms of revenue therefore, its ongoing payments are also approximately just over half as large.

Compared to our prior forecasts, we estimate that the Stillwater transaction will add an average of 1.9Moz (or c 4.2%) of silver equivalent to WPM’s production profile over the four years from FY19-22 (inclusive):

On an underlying basis (ie before any changes in precious metal price assumptions – see below), we expect the Stillwater palladium stream acquisition to add 4.0c (or c 5.0%) to WPM’s basic EPS per year (simple average) over the 10 years of production from FY21 to FY30 inclusive:

WPM is a pure precious metals streaming company. 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 870Moz in FY17 that is produced as a by-product of either gold or base metal mines (ie approximately 305Moz silver per year cf WPM’s production of 28.5Moz Ag in FY17). Inevitably, WPM’s investible universe would 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 that WPM’s marketplace is far from saturated or mature.

As a consequence, WPM reports that it is busy on the corporate development front. It has the potential for perhaps one more transaction over the next year with a value up to US$600m and/or up to six deals with a value in the range US$100-300m, and thus fully financeable via the c US$0.78bn we have estimated to be available to WPM under its revolving credit facility as at end Q318.

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

The main source of potential organic production growth for WPM is Salobo (which accounted for 77% of WPM’s gold division’s output in Q118). 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 carries out and the decision that it makes, any expansion could add as much as 100% to gold output attributable to WPM from Salobo per year – albeit at the cost of an additional payment from WPM. Mill throughput at the Salobo mine was reported to be running at 98% of its 24Mtpa nameplate capacity in Q118. 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 (effectively) c US$900m if throughput were to be expanded beyond 40Mtpa by 2022. If Salobo were to be expanded from 24Mtpa to 36Mtpa by the addition of a further 12Mtpa processing line by 1 January 2023, for example – thereby attracting an estimated c US$603m incremental payment from WPM to Vale – we estimate it would increase our estimate of WPM’s earnings by a material c US$0.11 per share from the date of the expansion.

One further, major project moving closer to fruition is the Rosemont copper project in Arizona, after Coronado National Forest Supervisor Kerwin Dewberry signed the final Record of Decision (ROD) for the Rosemont copper project earlier this month. The ROD outlines the supervisor’s decision to select the Barrel Alternative and approve the mine plan of operations once amended, and to amend the 1986 Coronado National Forest Plan by creating a new management area around the mine site. This advance follows a preliminary green light provided by the US Forest Service when the latter announced the release of a draft record of decision earlier this year, saying that the project, as it now stands, meets current law which, in turn, allowed other federal agencies to proceed with permitting requests. The proposed mine, which is owned by Hudbay Minerals, is located near a number of large porphyry-type producing copper mines and is expected to be one of the largest 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, or c 3.9Moz silver equivalent pa, and we estimate it will contribute an average c US$0.11 per share to WPM’s basic EPS in its first 10 years of operations for an upfront payment of US$230m (equivalent to US$0.52/sh) spread over three years.

Nickel, palladium and platinum all occur in the same (transition) group in the periodic table of the elements. As a result, they exhibit similar chemical characteristics and are often associated with one another in mineral deposits, albeit platinum and palladium have crustal abundances that classify them as precious metals. Historically, therefore, palladium has typically been mined as a by-product of either nickel (in Russia) or platinum (in South Africa). Both platinum and palladium are effective in hydrocarbon scrubbing and are used in industry as auto-catalysts. Whereas platinum is particularly effective in scrubbing diesel engine emissions, palladium is more effective in scrubbing petrol/gasoline engine emissions. As a result, since the start of the VW (diesel) emissions scandal in September 2016, the palladium price has outperformed the platinum price by 62.7%, as a series of government announcements around the world have been perceived to favour petrol/gasoline-based engines gaining market share at the expense of diesel-based engines.

While there is no need for PGMs in pure electric vehicles, hybrids and plug-in hybrids both use them and are likely to drive demand for palladium in conjunction with tightening emissions targets around the world that are typically met, in the first instance, by higher loadings of palladium per vehicle in auto-catalysts. Thus, while the internal combustion engine (ICE) may be destined to lose market share to electric vehicles over the coming years, as far as palladium demand is concerned, this is anticipated to be at least offset by an increasing overall market for cars (driven by growth in China and India, in particular) coupled with a greater intensity of use in the palladium using ICE and hybrid segment of the market.

In addition to including the Stillwater stream, we have adjusted our forecasts to reflect recent falls in the prices of both gold and silver for the remainder of the year.

This revised FY18 forecast compares to our observation in our note in June (see Kobold ex machina) that if gold and silver prices remain at US$1,278/oz and US$16.47/oz for the rest of the year, it would reduce our EPS forecast by 3c, to US$0.60/share. As it stands, our forecast of basic EPS of US$0.57/sh compares with a consensus forecast of US$0.58/sh (source: Bloomberg 18 July), within a range of US$0.48-0.63 per share.

In the meantime, our FY19 EPS forecast remains based on assumed precious metals prices of US$22.21/oz Ag and US$1,263/oz Au (see 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, (almost) unprecedented, level of 79.1x.

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 38.6x Edison or 37.6x Bloomberg consensus FY18e, currently – see Exhibit 10).

Applying this multiple to our updated EPS forecast in the wake of the Stillwater transaction of US$1.26 in FY21 (cf US$1.24 in FY20 previously) implies a potential share value for WPM of US$34.68, or C$45.71 in that year (cf US$34.11, or C$45.14 in FY20 previously). Note that this valuation excludes the value of 20.9m shares in First Majestic currently held by WPM, with an immediate value of C$188.6m, or US$0.32 per WPM share.

In the meantime, from a relative perspective, it is notable that WPM is cheaper than its royalty/streaming ‘peers’ in 91% (22 out of 24) of the valuation measures used in Exhibit 10 and on multiples that are cheaper than the miners themselves in at least 35% (32 out of 90) of the same valuation measures (effectively irrespective of whether Edison or consensus forecasts are used), despite being associated with materially less operational and cost risk (as WPM’s costs are contractually predetermined).

WPM’s initial, upfront cash payment of US$500m in consideration of the Stillwater stream purchase will be paid using amounts drawn from its US$2bn revolving credit facility.

As at 31 March 2018, WPM had US$115.6m in cash (before a dividend of US$39.9m payable on or about 7 June) and US$663.0m of debt outstanding under its US$2bn revolving credit facility (which attracts an interest rate of Libor plus 120–220bp and matures in February 2023), such that it had net debt of US$547.4m overall, after US$125.3m (US$0.28/share) of cash inflows from operating activities during the quarter. Relative to the company’s Q1 balance sheet equity of US$4,925.5m, this level of net debt equated to a financial gearing (net debt/equity) ratio of 12.7% and a leverage (net debt/[net debt+equity]) ratio of 10.0%. It also compared with a net debt position of US$671.5m as at 31 December 2017 and is consistent with WPM generating c US$100–150m per quarter from operating activities before financing and investing activities.

In the aftermath of the Stillwater palladium stream acquisition, we now estimate that WPM’s net debt position will be US$1,270.9m by the end of FY18 (cf US$756.3m previously), which will equate to gearing of 25.5% (cf 15.1% previously) and leverage of 20.3% (cf 13.1% previously), and that WPM will be net debt free in late-2020 (cf mid-2020 previously), all other things being equal and contingent on its making no further major acquisitions (which is unlikely, in our view). 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 regarding 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.