Silver Wheaton — Update 14 February 2016

A summary of our forecasts for SLW at the time of its Q315 results is shown in the table below. Since then, SLW has provided broad production forecasts of 28Moz for silver and 230koz for gold for FY15, which are 3.1% below and 2.9% above our previous forecasts (respectively). In addition, various of SLW’s counterparties have announced production results for Q415 (see page 3), while the silver price averaged US$14.75/oz during the quarter and the gold price US$1,104/oz, compared with our previous forecasts of US$14.87/oz and US$1,112/oz, respectively. Notwithstanding the inclusion of Antamina in the gold stream for the first time in Q4 (see our update note published on 11 November 2015), investors should note the particularly strong implied performance of SLW’s gold assets during the quarter. In addition, while parity is broadly assumed between sales and production, the fourth quarter is traditionally the one in which sales may be ‘flushed through’ by operators and inventories reduced.

Record attributable production was recorded at both Salobo and Penasquito in Q315 and record sales at San Dimas, although this was ostensibly offset by under-sales at Salobo, Yauliyacu and SLW’s ‘other’ silver assets. In the meantime, gold production was lower at Sudbury (owing to planned maintenance shutdowns), but higher than expected at both Constancia and Minto.

Production at Penasquito reached a record as substantial mining took place in the heart of the deposit and despite the suspension of construction of the Northern Well Field project owing to an illegal blockade by a local community. Penasquito continues to seek an equitable resolution of the matter with the community, while taking steps to enforce its contractual rights. In addition, it is also advancing alternatives to complete the project, without crossing through the affected community lands. The operator, Goldcorp, is confident that there will be a resolution of the matter in time to meet the future water needs of the mine. In the meantime, the Metallurgical Enhancement Project feasibility study remains on schedule to be completed in early 2016. Elsewhere, stripping at Minto North is on schedule and high-grade ore is expected to be delivered to the mill in Q216. Finally, Salobo’s operator, Vale, has been aiming to achieve capacity utilisation at the mine of 100% in Q415.

Our estimate of 53c for FY15 compares to an average consensus basic EPS estimate of 51.6c, within the range 39-56c (source: Bloomberg, 12 February 2016). By contrast, our basic EPS estimate of 80c for FY16 compares to an average consensus estimate of 55.3c (vs 65.3c on 11 November 2015), within the range 24-78c (excluding Edison). Note that our FY16 estimates are based on precious metals price forecasts of US$16.11/oz Ag and US$1,224/oz Au (vs spot prices of US$15.79/oz and US$1,239/oz at the time of writing).

A number of SLW’s counterparties have made statements so far in 2016 regarding the performance of their operations during Q415, which are summarised below.

During the fourth quarter of 2015, Hudbay reported that Constancia produced 6,560oz Au (SLW interest 50%) and 636,514oz Ag (SLW interest 100%) and sold 7,888oz Au and 511,148oz Ag. Shipments of copper concentrate from the mine to the port in Matarani increased with improved trucking capacity, resulting in a significant drawdown of inventory to normal working levels, with all excess copper concentrate having been sold by the year end. As a result, approximate concentrate inventory levels in Peru (including the mine site and port inventories) decreased from 74,000 dry metric tonnes (dmt) at the end of Q3 (including 65,000dmt at the mine) to a normal working level of approximately 28,000dmt at the end of Q4, including 11,000dmt at the mine.

Constancia’s production in Q116 is expected to be affected by the planned replacement of the trunnions on both the SAG and ball mills in one of the two grinding circuits. The trunnions were damaged due to a lubrication failure during the commissioning period and are expected to be replaced over a six- to eight-week period in the first quarter of 2016, during which time the second grinding circuit should continue to operate normally. Nevertheless, output of precious metals is expected to increase to 50-65koz in FY16 (at an Au:Ag ratio of 70:1), compared with our forecast of 54.2koz on the same basis, ie Constancia is ramping up very much in line with expectations.

Production of gold from Hudbay’s operations in Manitoba (comprising the 777, Lalor and Reed mines, in which SLW has an interest only in the 777 stream) was 20,184oz and consistent with output levels for the previous three quarters, although there was also evidence of additional inventory drawdown in the form of sales of 23,996oz. Precious metals output from Manitoba is forecast to increase from 92,973oz AuE in FY15 to within the range 95-115koz AuE, although no detail between the three mines was provided in terms of a production breakdown. Nevertheless, according to Hudbay Minerals, the 777 mine “is expected to benefit from improved equipment reliability resulting from its fleet renewal program”.

Primero produced 2.32Moz Ag from San Dimas in Q415, resulting in annual production of 8.30Moz Ag and consistent with production attributable to SLW of 1.9725Moz (Edison calculation), with the mine exceeding expectations as a result of higher throughput related to the ongoing expansion of the mill to 3,000tpd and increased availability of the high-grade Jessica vein. Average throughput in FY15 increased by 10% to a record 2,721tpd (vs a nameplate capacity of 2,500tpd). The focus of operations in FY16 will be the completion of the mill expansion to 3,000tpd, while “continuing to identify productivity opportunities while also ensuring… a transformational shift in attitude at the mine towards a safety culture committed to a workplace free of accidents”.

During Q4, Stratoni produced 11,734t of lead/zinc concentrate out of a total for the year of 40,232t (ie Q4 outperformed the average of the previous three quarters). There was additional evidence of inventory drawdown in the form of 14,007t of sales during the same period (ex-46,502t for the full year). During 2016, Stratoni is expected to process 220,000t of ore at grades of 6.2% lead, 10.0% zinc and 163g/t silver (ie 1.2Moz of contained silver, implying 968koz production at an 84% metallurgical recovery rate). Sustaining capital costs for the year are expected to total US$10.0m, including underground equipment rebuilds and replacement, and environmental infrastructure.

Eldorado is conducting its annual impairment review and “preliminary analysis” is reported to indicate an impairment expense of approximately US$1.2-1.6bn (after-tax) primarily related to its Greek assets (of which a portion could, obviously, pertain to Stratoni and, thereby, SLW, albeit in non-cash terms).

A pocket of high-grade underground ore in excess of 3% copper in close proximity to existing development was opportunistically mined and processed at Minto, which resulted in above average production of silver of 52,849oz. In the meantime, stripping of the Minto North pit was reported to be proceeding well and the lower-grade ore was reached (as expected) in December. Gold output during Q4 was steady at 4,320oz.

Production in the fourth quarter at Cozamin amounted to 399,834oz Ag, which was 6.6% higher than our previous forecast of 375,000oz.

Investors should be aware that both Goldcorp and Vale – major SLW counterparties – are scheduled to provide their own investors with operational and financial results updates on 25 February.

On 27 January, SLW announced the terms of a proposed Early Deposit Precious Metals Stream with Panoro Minerals. Under the terms of the agreement, SLW will purchase 100% of the silver and 25% of the gold from Panoro’s Cotabambas project in Peru (up to a cumulative total of 90Moz AgE sold) for an initial payment of US$140m and ongoing payments of US$5.90/oz Ag and US$450/oz Au (inflating at 1% pa from the fourth year of production). Once 90Moz of silver equivalent has been delivered, the stream will reduce to 66.67% of silver produced and 16.67% gold.

Once certain conditions have been met, SLW will advance US$14m to Panoro, spread over up to nine years, to fund corporate expenses relating to the project. Provisions also exist to accelerate these payments via SLW matching, up to certain limits, any additional third-party financing of Cotabambas, such that up to US$7m could be made available by SLW in the first two years of the agreement. Following the delivery of a bankable/definitive feasibility study, environmental study and impact assessment and other related documents and the receipt of permits and commencement of construction, SLW may then advance the remaining deposit or elect to terminate the agreement. If it elects to terminate, SLW will be entitled to the return of a portion of the US$14m paid less US$2m payable on certain triggering events occurring. If it does not terminate, the balance of the US$140m becomes payable in instalments during construction. Until 1 January 2020, Panoro also has a one-time option to repurchase 50% of the precious metals stream in the event of a change in control for an amount based on a calculated rate of return to SLW.

Thus far, Panoro’s board of directors and SLW have both approved the term sheet. However, the final conclusion of the deal is subject to the negotiation and completion of definitive documentation.

Cotabambas is at a relatively early stage of development, with Panoro (PML.CN, share price C$0.13, market capitalisation C$29m) having produced an updated preliminary economic assessment (PEA) for the project in September 2015. A brief summary of the project (at US$3.00/lb Cu, US$1,250/oz gold and US$18.50/oz Ag) is as follows:

The following table is based on production data provided in Panoro’s NI 43-101 Technical Report on the updated preliminary economic assessment for Cotabambas for the first 10 years of the mine’s life (the remaining years being omitted only on account of space). Given that the project is currently at the PEA stage of development, we (tentatively) estimate that it will be the best part of 10 years before it enters production, being approximately four years before the required bankable/definitive feasibility study, environmental study, environmental impact assessment and other related documents are produced (plus the receipt of permits) plus a further one to two years for financing and then approximately three years of construction before production begins. Note that this time frame would seem to be borne out by the estimate that SLW will advance US$14m to Panoro, spread over up to nine years. As such, we assume the first year of production of the project to be 2025, although clearly this timing could vary as the project develops.

Note that at no point does the cumulative production from the stream approach the 90Moz AgE limit that would trigger a lower SLW interest in the stream.

The analysis in the above table is conducted at our real price forecasts for gold and silver in 2015 money terms. Assuming a US$140m investment to generate the cash flow shown above (ie just 10 years), the internal rate of return of the stream is 32.7%. Over the full life of the project it is 34.4%. However, whereas the cash flows above are depicted in 2015 money terms, the associated US$140m will be in money-of-the-day terms. That is to say, the real value of US$14m in the next nine years plus US$126m thereafter is actually less than US$140m in 2015 money terms and, as such, the above analysis can be regarded as conservative.

Analysing the stream in terms of multiples, it can be seen that SLW is potentially paying approximately 3.1x average annual cash flows for the Cotabambas stream (vs 9.5x for Antamina, with the proviso that Antamina is already in production, etc).

Finally, if the current spot prices for copper, gold (US$1,239/oz at the time of writing) and silver (US$15.79/oz) are substituted for our forecasts, the life-of-mine annual average cash flow of the streams falls from US$45.6m to US$28.1m and the IRR of the stream to 22.8% (with the same proviso that this is conservative on the basis of the 2015 money terms’ value of US$140m in 10 years’ time).

On 19 January, SLW confirmed that it had filed a Notice of Appeal with the Tax Court of Canada against the Canada Revenue Agency (CRA) on 8 January (as expected), in relation to the latter’s notice of reassessment for the 2005-10 tax years of 24 September. In doing so, SLW has exercised its right to pursue a resolution of the dispute through a judicial court process rather than via the CRA’s internal appeals process. Once a court date has been set (which is likely to be in Q217 and gazetted to that effect in Q216), the case will enter a ‘discovery phase’, during which an assessment of the strengths and weaknesses of each side’s case will be considered. Typically, this phase takes six to nine months, during which a meaningful amount of cases are settled out of court. If no agreement can be reached, the case will proceed to court.

Subsequent to filing the Notice of Appeal, SLW received further correspondence from the CRA advising that it will now be commencing an audit of the company’s international transactions for the 2011-13 taxation years (which is only to be expected under the circumstances). Thus far, it is important to note that the correspondence received is not a formal proposal or notice of reassessment. However, SLW estimates that were the CRA to take a position in respect of the 2011-13 taxation years similar to the one it took for the 2005-10 tax years, it would assert that an additional US$310m in taxes is payable in Canada. Taxation years subsequent to 2013 also remain open to audit by the CRA.

An updated summary of SLW’s situation with respect to the CRA is therefore as shown in Exhibit 3 below.

In per share terms, the equivalent table is as follows:

These numbers compare to the US$5.83 decline in the price of SLW’s shares since the announcement of the CRA’s reassessment notice on 6 July 2015. However, as stated consistently, SLW believes that it has always complied with Canadian tax law and intends to “vigorously defend” its position.

As stated in previous notes, the income the CRA is seeking to tax is earned by foreign subsidiaries from assets outside Canada. Key to the CRA’s case appears to be the assertion that services bought and contracted between SLW’s Vancouver and offshore offices were mispriced and that the profit split between the two jurisdictions was therefore distorted. SLW is limited in what it can say publicly ahead of its legal action. However, investors should be aware of three matters relevant to this assertion:

Otherwise, it remains the case that the structure and relationship between SLW and its foreign subsidiaries is common and used by many companies both globally and in Canada, and any ruling against SLW could expose other multinational companies operating out of Canada to similar treatment.

Excluding FY04 (part year) and FY08 (during which there was an exceptional write-down), SLW’s shares have historically traded on an average P/E multiple of 25.9x current year basic EPS (cf 19.1x Edison FY16 currently or 27.5x consensus FY16).

Applying this multiple to our (unchanged) long-term EPS forecast of US$1.84 per share in FY19 implies a potential share value of US$47.51, or C$66.09 (cf US$46.36 or C$61.59 previously).

In the meantime, the table below shows SLW’s current rating on a number of valuation measures relative to both a sample of its ‘peer’ royalty/streaming companies and a sample of gold miners. Using our forecasts in Exhibits 1 and 7, it is notable that SLW trades on multiples that are cheaper than its royalty/streaming ‘peers’ in 71% of instances considered (63% using consensus forecasts). It also trades on multiples that are cheaper than the gold miners themselves in c 57% of instances considered (52% using consensus forecasts), despite being associated with materially less operational and cost risk, in particular.

Note the inclusion of Randgold Resources for the first time in the above table, to provide a European benchmark valuation with which to compare SLW.

At 30 September, SLW had US$566.5m of net debt on its balance sheet (vs US$643.1m at end-June – consistent with its performance of generating c US$100m from operating activities per quarter). During Q4, it announced its US$900m Antamina stream acquisition; it has also repurchased 645,389 of its own shares under its share repurchase programme at an average price of US$11.86 and therefore an implied consideration of US$7.7m. Note: SLW has TSX approval to repurchase up to 20,229,671 common shares (representing 5% of the total outstanding common shares at 11 September 2015) under an enhanced normal course issuer bid, according to which its broker may also purchase shares for the same purpose over 12 months until 22 September 2016 (although potential future repurchases are excluded from our forecasts on the basis of the uncertainty surrounding the size, price and timing of any such repurchases).

In addition, in the aftermath of receiving a notice of reassessment from the CRA, SLW became obliged to make a deposit of 50% of the disputed tax, interest and penalties relating to 2005-10 (ie C$177m, US$133m, or US$0.33/share) on filing a notice of objection. Consistent with SLW’s intention to treat this deposit as refundable, we have therefore assumed this to be a ‘receivable’ for accounting purposes.

In the aftermath of its Q415 investments, we forecast that SLW will have net debt on its balance sheet of US$1,483m at end-December 2015 (vs US$1,345.0m previously – the difference being almost exclusively attributable to the effect on cash of the deposit relating to the CRA dispute), equating to a gearing (net debt/equity) ratio of 32.8% and a leverage (net debt/[net debt+equity]) ratio of 24.7%. Nevertheless, such a level of debt is well within the tolerances required of its banking covenants that:

Note that the interest rate associated with SLW’s revolving debt facility is Libor plus 120-220bp.