Wheaton Precious Metals — Q3 results and update

Despite relatively conservative precious metals price assumptions, underlying earnings for Q3 were within US$2.0m, or 2.7%, of our prior forecasts. Both Wheaton’s gold and silver divisions outperformed our production expectations. However, a 1.6Moz under-sale of silver relative to production resulted in an ‘inventory’ build and a deferment of sales, albeit this was almost exactly offset by a similar reduction in associated costs, such that earnings from operations were within 1.0% and US$1.0m of our forecasts. The only other significant departure from our expectations was a 14.5% quarter-on-quarter increase in the general & administrative charge, albeit US$4.8m of the US$1.8m increase could be attributed to the differences in accrued costs associated with the company’s performance share units, without which the charge would have been almost exactly in line with Edison’s expectations and WPM’s pro-rata guidance of non-stock general and administrative expenses in the range US$36–38m for FY19 as a whole. As a result, underlying EPS was reported to be 16c (in line with consensus) compared with our forecast of 17c (which assumed no inventory and no stock-based general & administrative effects). A full analysis of WPM’s underlying Q3 results relative to our prior forecasts and Q119 results is provided in the table below:

Once again, Salobo reported an exceptionally strong quarter, with lower grades and recovery offset by higher throughput, such that production records were set for both gold and copper in July, albeit 10,551oz of production remained unsold at the end of the quarter. In addition, Vale also noted that the 50% capacity expansion at Salobo (which is scheduled to start up in H122) is 27% complete, including the completion of the concrete foundations for the mill and primary crusher bases and the arrival to site of the first loads related to the long-distance conveyor belt. Otherwise, positive production performances relative to our expectations were also recorded at Constancia, San Dimas and Antamina – although in each of these cases (with the exception of San Dimas) there was an under-sale of product with respect to production. Conversely, production and sales at Penasquito were negatively affected by the illegal blockage that began there on 15 September and finished on 8 October and which Newmont (the operator) estimated cost Wheaton c 0.4Moz in attributable production. Production and sales at Sudbury were negatively affected by its traditional maintenance shutdowns in Q3.

After converging to close to their long-term rates (92.2% for gold and 88.8% for silver) in Q219, sales relative to production diverged once again in Q319, with silver sales, in particular, amounting to just 73.6% of production, principally as a result of the disruption to operations at Penasquito during the quarter:

As at 30 September, payable ounces attributable to WPM produced but not yet delivered amounted to 4.2Moz silver and 85,468oz gold (vs a reported 3.3Moz silver and 80,740oz gold in June). This ‘inventory’ equates to 2.31 months and 2.60 months of forecast FY19 silver and gold production, respectively, and compares with WPM’s target level of two months of annualised production for silver, and two to three months of annualised gold and palladium 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 be considered to be a consequence of metallurgical recoveries in the plant.

WPM has adjusted its production guidance for FY19 to 390,000oz of gold (cf 385,000oz previously), 21.0Moz of silver (cf 22.5Moz previously) and 22,000oz of palladium (unchanged). For the five-year period ending in FY23, the company has maintained its average annual gold equivalent production at 750,000oz pa. This compares with Edison’s (updated) longer-term forecasts, as follows:

Note that the major differences between Edison’s gold equivalent production forecasts and Wheaton’s may be explained by the ratio of the gold price to the silver price. Whereas Wheaton assumes an 81.25x ratio (based on a gold price of US$1,300/oz and a silver price of US$16.00/oz), the current ratio is closer to 87.2x and Edison assumes that the ratio will revert to closer its long-term average of 57x from FY20 onwards. In addition, Edison is also expecting a production contribution from Salobo III in FY23. However, in the light of recent events (see ‘Rosemont’, below), it has removed any contribution from Rosemont until there is more clarity regarding the legal situation.

In the medium term, 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 and grades improve once again at the main Penasco pit with mine sequencing. 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 by recovering 48% of the silver that previously reported to tailings. Production of palladium and gold at that Stillwater mine is also anticipated to increase as the Blitz project ramps up to full capacity in FY21. In the meantime, 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). In lieu of this however, WPM is entitled to receive an additional 2,005oz gold per quarter during FY19 and FY20 relative to its precious metals purchase agreement.

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 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.

Wheaton’s contract with Barrick provides for a completion test that, if unfulfilled by 30 June 2020, results in WPM’s 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 the current time it is, to all intents and purposes, impossible for Pascua-Lama to pass a completion test on 30 June 2020, as a result of which Edison had presumed that WPM would be the recipient of c US$273.4m 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. As a result, we have now removed this repayment item from our capital expenditure forecasts for FY20 (see ‘Financials’ on page 10).

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 was produced as a by-product of either gold or base metal mines (ie approximately 305Moz pa silver vs WPM’s production of 28.5Moz Ag in FY17). 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 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, thus fully financeable via the c US$1.14bn available to WPM in cash and under its US$2bn revolving credit facility as at end-Q319.

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:

One further, major project that had been moving closer to development is the Rosemont copper project in Arizona, after its operator, Hudbay, announced that it had received both a Section 404 Water Permit from the US Army Corps of Engineers and its 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 the year, which ‘should enable first production by the end of 2022’. In the meantime, it commenced an early works programme to run concurrently with financing activities (including a potential joint venture partner) for the remainder of the year.

On 31 July however, the US District Court for the District of Arizona issued a ruling in the lawsuits challenging the US Forest Service’s issuance of the Final Record of Decision effectively halting construction of the mine, 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 on the environment. Hudbay also pointed out that various agencies had accepted that the company could operate the mine in compliance with environmental laws. In conclusion, it said that it will appeal the ruling to the Ninth Circuit Court of Appeals. Nevertheless, in the light of the uncertainty about the timing and development of the project we have, for the moment at least, removed it from all of our forecasts.

The proposed Rosemont development is located near a number of large porphyry-type producing copper mines and is expected to 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 and we estimate it could contribute an average c US$0.12 per share to WPM’s basic EPS in its first eight years of operations from FY22–29 for an upfront payment of US$230m (equivalent to US$0.51/share) in two instalments of US$50m and US$180m (of which neither has yet been paid).

In addition to our short-term FY19 forecast adjustments, we have also adjusted our longer-term gold and silver price assumptions to those set out in our recent report, Portents of economic weakness: Gold – doves in the ascendant, as follows:

WPM has reduced its guidance for non-stock general and administrative expenses for FY19, from US$36–38m to US$33-36m, or US$8.25–9.0m per quarter (vs a comparable forecast of US$34–36m, or US$8.5–9.0m per quarter, for FY18), including all employee-related expenses, charitable contributions, etc. Investors should note, however, that stock-based compensation costs are excluded from our financial forecasts in Exhibits 6 and 9 owing to their inherently unpredictable nature.

Taking into account the aforementioned considerations, plus the improved precious metal pricing environment so far in H219, our updated forecasts for WPM for FY19, by quarter, are now as shown in Exhibit 6. In addition to our Q419 and FY19 forecasts, we have also taken the opportunity to show contingency forecasts for FY20, based on gold and silver prices remaining at current levels of US$1,462/oz and US$16.75/oz, respectively (note that these contrast with our formal base case forecasts in Exhibit 9, which are based on our higher long-term gold and silver prices shown in Exhibit 5). While we believe that our higher, longer-term gold price forecast for FY20 remains eminently achievable, current indications are that it will take some time longer for the silver price, in particular, to revert to its longer-term c 57x price multiple relationship with gold.

Our basic EPS forecast of US$0.57/share (the same as previously) for FY19 is in line with a consensus forecast of US$0.57/share (source: Refinitiv, 15 November 2019) within a range of US$0.49–0.62 per share.

Our US$1.30 basic EPS forecast for FY20 (see Exhibit 9) compares with a consensus of US$0.83 (source: Refinitiv, 15 November), within a range of US$0.52–1.30. As noted previously, this estimate is predicated on an average gold price during the year of US$1,635/oz and an average silver price of US$26.74/oz, which, in the latter case, is 59.6% above the current spot price. One of the central assumptions behind our silver price forecast is that it will, at some point, revert to the long-term correlation that it has exhibited with gold since the latter was demonetised in 1971. In the event that both metals remain at current levels however (US$16.75/oz and US$1,462/oz at the time of writing), we forecast that WPM will instead earn US$0.80 per share in FY20 (as shown in Exhibit 6).

Excluding FY04 (part-year), WPM’s shares have historically traded on an average P/E multiple of 28.5x current year basic underlying EPS, excluding impairments (vs 46.8x Edison or 46.2x Refinitiv consensus FY19e, currently – see Exhibit 8).

Applying this 28.5x multiple to our updated EPS forecast of US$1.15 in FY21 (cf US$1.20 in FY20 previously) implies a potential value per share for WPM of US$32.78, or C$43.37 in that year (vs US$34.11, or C$45.37 previously). Note that, given the wide range surrounding our FY20e EPS forecasts, we have elected to roll the basis of our valuation forward by one year to FY21 cf FY20, previously. In addition, this valuation excludes the value of 20.2m shares in First Majestic currently held by WPM, with an immediate value (15 November) of C$288.2m, or US$0.49 per WPM share.

In the meantime, from a relative perspective, it is notable that WPM is cheaper than its royalty/streaming ‘peers’ in at least 70% (17 out of 24) of the valuation measures used in Exhibit 8 and on multiples that are cheaper even than the miners themselves in at least 34% (27 out of 78) of the same valuation measures, despite being associated with materially less operational and cost risk (since WPM’s costs are contractually predetermined).

As at 30 September 2019, WPM had US$151.6m in cash (cf US$87.2m at the end of Q219) and US$1,017.1m of debt outstanding (cf US$1,100.0m at end-Q219), 99.6% of which is under its US$2bn revolving credit facility (which attracts an interest rate of Libor plus 120–220bp and matures in February 2024), such that it had net debt of US$865.5m (cf US$1,012.8m at end-Q2) overall, after US$142.3m (US$0.32/share) of pre-financing cash inflows during the quarter. Relative to the company’s Q3 balance sheet equity of US$5,201.4m (cf US$5,111.9m at end-Q2), this level of net debt equates to a financial gearing (net debt/equity) ratio of 16.6% (cf 19.8% at end-Q2) and a leverage (net debt/[net debt+equity]) ratio of 14.2% (cf 16.5% at end-Q2). It also compares with a net debt position of US$1,057.7m as at end-March, US$1,188.2m as at end-December and US$1,261.1m as at end-September 2018. 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 late in H121 (cf FY20 previously when we assumed the return of c US$273.4m from Barrick relating to the Pascua-Lama stream – see page 5).