Silver Wheaton — Update 25 May 2016

After four successive quarters in which the production of gold and silver ounces each achieved new records, output attributable to Silver Wheaton moderated in Q116 – albeit to only the second-best ever – with good quarterly performances (again) from Antamina and Salobo offset to some extent by headwinds at San Dimas and SLW’s ‘other’ assets. In another positive development, sales of material closely approximated production, with the result that payable silver equivalent ounces produced but not yet delivered to Silver Wheaton decreased by 0.9Moz AgE (although this is anticipated to reverse later in the year as production increases once again).

Other features of the results were a continuation of the (albeit non-cash) depletion charge at the elevated levels of Q415 and a decision to change the accounting treatment of interest paid, such that all interest is now expensed and none capitalised (whereas previously the majority, relating to the Barrick silver interest in particular, was capitalised). Excluding impairments, a summary of SLW’s Q116 results, compared with the previous quarter plus our prior expectation is as follows:

Vale reported that production at Salobo in Q415 was near full capacity. Nevertheless, production increased to a record 37,871oz in Q116 and is expected to continue to improve throughout the remainder of the year as rainfall decreases. Compared to 125,624oz in FY15, Edison is forecasting production from Salobo attributable to Silver Wheaton of 148,871oz in FY16 – although this has scope to increase as and when operations engage higher grade ore faces in H216.

Antamina produced 2,021koz silver attributable to SLW in Q116 (vs 2,403koz in Q415) – its second successive quarter of outperformance relative to prior expectations – as higher grades and recoveries more than offset the impact of planned maintenance during the period. SLW has issued guidance to the market of 5.5Moz of production for FY16. This compares to Edison’s forecast of 6.146Moz. Self-evidently, four quarters of production at the levels of Q1 would imply output of 8.084Moz and could therefore add up to 2Moz to Edison’s forecast and 2.5Moz to SLW’s.

After an almost uninterrupted run of good production results, output at San Dimas fell to 0.9Moz attributable silver (vs 2.3Moz in Q415) as Primero implemented new safety standards at the mine. As a result, mill throughput was limited to 1,639tpd. This recovered to above 2,500tpd in April. However the addition of ground support has 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 the mill expansion to 3,000tpd has been deferred. As a consequence, Edison has reduced its forecast output from San Dimas for FY16 from 7.5Moz (ie effectively the same level as FY15) to 5.6Moz.

Similarly, Penasquito recorded its worst quarter since Q113, with output falling 23.4%, quarter-on-quarter, from 1,766koz to 1,352koz, owing to lower grades being mined as part of mine sequencing. As disclosed in Goldcorp’s Q116 results, these lower grades are now expected to persist throughout the remainder of the year. In addition, there will be a 10-day maintenance shutdown in Q216.

Headline production from SLW’s ‘other’ assets increased 8.1%, quarter-on-quarter, compared to Q415. However, given that this now includes production from Barrick’s mines, this suggests an underlying decline. Similarly, headline production from SLW’s ‘other’ gold assets increased 84.3%, quarter-on-quarter, from 8,043oz to 14,824oz. Again, this includes 8,275oz of production from the 777 mine, suggesting an underlying decline from the remaining assets contributing to this division. Within this context, it is notable that output from Minto declined 40.5%, from 5,237oz Au to 3,114oz, quarter-on-quarter, owing to lower grades and recoveries more than offsetting higher throughput (a pocket of high-grade underground ore in close proximity to existing development was opportunistically mined and processed at Minto in Q415). Mining rates are reported to be on schedule, as is stripping at Minto North, where low-grade ore was reached, as expected, in December and high-grade ore is expected to be delivered to the mill in Q216.

At the time of its Q415/FY15 results, SLW’s outlook for production for FY16 was 54Moz AgE, including 265koz Au. At the time, our equivalent forecast was 53.1Moz, comprising 33.5Moz Ag and 252.5koz Au. We have now adjusted this expectation to output of 49.9Moz for the full year – the majority of the decline is attributable to performance at San Dimas, followed by Penasquito. Other changes include the continuation of an elevated depletion charge, the continued expensing of interest and elevated general and administrative charges to reflect higher legal costs, relating to SLW’s dispute with the CRA (note that non-stock G&A expenses are forecast to be in the range US$31-34m for the full-year). Our revised forecasts are as follows:

Our EPS estimate of 14c for Q216 compares to an average consensus basic EPS estimate of 13c from revenue of US$204.25.0m, EBITDA of US$134.5m, operating profit of US$70.9m and net income of US$62.0m (source: Bloomberg, 11 May 2016). Consensus EPS estimates for Q316 and Q416 are 14c and 15c, respectively (vs 14.6c and 15.7c respectively in April).

Our FY16 EPS estimate of 55c compares to an average consensus basic EPS estimate of 55c within the range 37-68c (source: Bloomberg, 11 May 2016). By contrast, our basic EPS estimate of 111c for FY17 compares to an average consensus estimate of 65c, within the range 33-82c (excluding Edison), albeit this depends on higher precious metals prices (see Exhibit 2). Should silver and gold prices remain at the current levels of US$17.01/oz and US$1,265/oz (at the time of writing), we estimate that basic EPS in FY17 will instead be 61c per share (all other things being equal).

Excluding FY04 (part year) and FY08 (when 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 34.3x Edison FY16e or 33.3x consensus FY16e, currently).

Applying this multiple to our long-term EPS forecast of US$1.45 per share in FY19 implies a potential share value of US$37.62, or C$48.38. Note that this EPS estimate has declined compared to the US$1.64/sh estimate in our note of 18 April. This is almost exclusively a function of an elevated depletion charge and a higher G&A expenses (implicitly including ongoing legal expenses). Note that this EPS forecast also depends on a continued recovery in the gold price to US$1,483/oz and a rebalancing of the gold:silver ratio from an almost unprecedented 74x currently to 56x – implying a silver price of US$26.57/oz. In the event that silver and gold prices remain at current levels, our FY19 EPS forecast moderates to 69cps.

From a relative perspective, meanwhile, it is notable that SLW is cheaper than its royalty/streaming ‘peers’ on 23 out of 24 valuation measures in Exhibit 4 (ie 96% of instances considered or 83% using consensus forecasts) and on multiples that are cheaper than the gold miners themselves on 38 out of 54 valuation measures (ie 70% of instances considered or 61% using consensus forecasts), despite being associated with materially less operational and cost risk, in particular.

As at 31 March 31, SLW had US$1,284.2m of net debt on its balance sheet (vs US$1,362.7m as at end-December and US$566.5m as at end-September), which is consistent with its generating c US$100m from operating activities per quarter and paying US$900m for the Antamina stream acquisition in Q415.

In the aftermath of its March bought deal (the proceeds from which had not been received at 31 March), we estimate that SLW’s net debt will reduce to US$445.9m by the end of FY16 and that SLW will be ostensibly debt free in FY17, all other things being equal and contingent on its making no further major acquisitions (which is unlikely).

We estimate that net debt of US$445.9m as at end-2016 will equate to gearing (net debt/equity) of 9.1% and a leverage (net debt/[net debt+equity]) of 8.4%. Self-evidently, such a level of debt is well within the tolerances required of its banking covenants that:

Note that the C$191.7m letter of guarantee that SLW has posted re 50% of the disputed taxes relating to its dispute with the CRA has been done so under a separate agreement and is therefore specifically excluded from calculations regarding SLW’s banking covenants. SLW’s revolving debt facility attracts an interest rate of Libor plus 120-220bp.

There have been no further substantive developments regarding SLW’s dispute with the CRA since our last update note.

Silver Wheaton notes the CRA’s position is that the transfer pricing provisions of the Income Tax Act (Canada) in relation to income earned by SLW’s foreign subsidiaries should apply “such that the income of Silver Wheaton 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 an attractive investment destination for suppliers of finance and capital to overseas destinations.

Any further developments will be communicated to investors as and when they occur.