Wheaton Precious Metals — Q218 results in line with expectations

WPM’s production, sales and costs were all very close to our prior expectations in Q218. In addition, there was a close correlation between production and sales, with the result that financial results (excluding a US$246m exceptional gain relating to the revised terms of the San Dimas stream) were also very close to our expectations:

From an operational perspective, key features of the quarter were stronger production performances than expected by Edison at Salobo, Antamina (notwithstanding mine sequencing) and San Dimas’s gold stream, offset by slightly weaker performances at Sudbury (partly as a result of the unscheduled maintenance shutdown at the Coleman mine from November 2017 to April 2018), Penasquito (as a result of the transition from Phase 5D of the Penasco pit to Phase 6D), 777 and Minto (partially on account of another quarter of lower grades owing to rescheduled mine sequencing as part of an extended mine plan).

In the meantime, construction of 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 that currently report to the tailings) is now reported to have been completed (vs 86% at end Q118, 62% at the end of FY17 and 40% at the end of Q317). As a consequence, commissioning has been accelerated into the current (third) quarter – two quarters ahead of the original timeframe – with the result that the operator, Goldcorp, has modified the production plan for the third quarter with lower than planned mill throughput and low mill head grades, exclusively from the surface stockpile, to accommodate the commissioning of the new circuit. However, any production shortfall in Q3 is anticipated to be recouped in Q4 when the mine will re-sequence to higher grades and mill tonnage following the commissioning.

On 10 May, First Majestic (FR, C$9.25) announced that it had concluded its deal to buy Primero Mining (the then operator of the San Dimas mine in Mexico, over which WPM held a silver purchase agreement). As part of the terms of the (friendly) takeover, WPM agreed to terminate the existing silver purchase agreement (SPA) and then to enter into a PMPA with the new operator.

In our note, Majestic, published in February 2018, we calculated a net present value of the cash flows to WPM from San Dimas for the period FY18–33 of US$252.9m under the terms of the new PMPA at our long-term precious metals prices and customary 10% discount rate for mining companies (or US$346.9m at a 5% discount rate to reflect the lower risk attached to streaming cash flows compared to mining cash flows). This compared to a carrying value of the San Dimas stream of US$132.9m as at 31 March 2018. In conjunction with the FR shares issued to WPM under the terms of the transaction (20.9m at C$7.34/share for an aggregate value of C$153.5m, or US$120.2m, on 10 May), this suggested an exceptional profit for WPM of US$240.2m on closing the transaction, which compares to an actual gain recorded in WPM’s Q2 accounts of US$245.7m.

WPM is continuing to forecast 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 (CRA). Investors should note that our financial forecasts in Exhibits 5 and 9 exclude stock-based compensation costs.

Production and sales of both gold and silver were closely correlated in Q118, with only a 2.0% under-sale of silver (cf a long-term average of 10.7%) largely offset by a 2.2% over-sale of gold (cf a long-term average of 9.3%) relative to production:

As at 30 June, payable ounces attributable to WPM produced but not yet delivered amounted to 4.3Moz silver and 75,600oz gold (cf 4.8Moz silver and 84,400oz gold reported in March). This ‘inventory’ equates to 2.12 months and 2.59 months of forecast FY18 silver and gold production, respectively (cf 2.48 months and 2.88 months in Q417) and compares with WPM’s target level of two months of annualised production for silver, and two to three months of annualised gold production.

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 may therefore (under certain circumstances) be considered to be a consequence of metallurgical recoveries in the plant.

WPM has reconfirmed its estimated attributable production forecast for 2018 of c 355koz of gold, 22.5Moz of silver and 10,400oz of palladium. Estimated average annual attributable production over the next five years is anticipated to be approximately 385,000oz of gold, 25.0Moz of silver, 27,000oz of palladium and (from FY21) 2.1Mlbs of cobalt per annum. These compare with our expectations, as follows:

In the immediate future, silver output from Penasquito attributable to WPM 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 in FY19, which hosts significantly higher gold grades than those mined hitherto and of which WPM will now be entitled to an increased portion.

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 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 fact 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 up to six deals with a value in the range US$100-300m, and thus fully financeable via the c US$0.73bn 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 75% of WPM’s gold division’s output in Q218). 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 100% of its 24Mtpa nameplate capacity in Q218. 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 forecast 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 in June. 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 ROD 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/share) spread over three years.

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.

Our forecast of basic EPS of US$0.54/share compares with a consensus forecast of US$0.58/share (source: Bloomberg 15 August), within a range of US$0.52–0.68 per share.

In the meantime, our FY19 EPS forecast (see Exhibit 9) 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 81.5x at the time of writing (see Exhibit 6, below). Within this context, our US$0.82 basic EPS forecast compares with a consensus of US$0.70 (source: Bloomberg 15 August), within a range of US$0.49–0.86.

On 17 July, WPM acquired 7.1m shares of Adventus, for a 9.99% equity interest in the company, in a private placement transaction, for a total consideration of C$6.0m. Concurrently, it also acquired a right of first refusal on any new streaming or royalty transactions on precious metals on Adventus’s existing properties in Ecuador and a right of first offer on any subsequently acquired properties in Ecuador.

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 33.5x Edison or 34.5x Bloomberg consensus FY18e, currently – see Exhibit 8).

Applying this multiple to our updated EPS forecast of US$1.20 in FY21 (cf US$1.26 in FY21 previously) implies a potential share value for WPM of US$33.00, or C$43.25 in that year (cf US$34.68, or C$45.71 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$153.5m, or US$0.27 per WPM share (priced as at 15 August).

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 8 and on multiples that are cheaper than the miners themselves in at least 37% (34 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).

As at 30 June 2018, WPM had US$92.7m in cash (before a dividend of c US$39.9m payable on or about 13 September) and US$956.5m 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$863.8m overall, after US$135.2m (US$0.31/share) of cash inflows from operating activities during the quarter. Relative to the company’s Q2 balance sheet equity of US$5,234.6m, this level of net debt equated to a financial gearing (net debt/equity) ratio of 16.5% and a leverage (net debt/[net debt+equity]) ratio of 14.2%. It also compared with a net debt position of US$547.4m as at 31 March 2018 and is consistent with WPM generating c US$100–150m per quarter from operating activities before financing and investing activities and dividend payments.

In the aftermath of the Stillwater palladium stream acquisition, we now estimate that WPM’s net debt position will be US$1,268.1m by the end of FY18 (cf US$1,270.9m previously), which will equate to gearing of 25.4% (cf 25.5% previously) and leverage of 20.3% (cf 20.3% previously), and that WPM will be net debt free in early-2021 (cf late-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.

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 be interpreted not 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 8).

In the meantime, WPM remains in 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 Tax Court of Canada has now scheduled the trial for mid-September 2019 for a two-month period.