Silver Wheaton — Update 30 August 2016

Gold sales reached another record in Q216, driven by the continued ramp up to 24Mtpa at Salobo, a record production performance at Sudbury (as a result of higher grades and mill recoveries at the Coleman, Copper Cliff and Totten mines), continued outperformance at Antamina (for a third consecutive quarter) and inventory drawdown (for a second consecutive quarter). While the performance of Salobo was in line with our expectations, Sudbury’s performance was almost 6,000oz ahead of them. Q2 represented a third quarter of material outperformance.

Other features of the results were a continuation of the depletion charge at the relatively high levels witnessed since Q415. This was attributed to Antamina, which has the highest unit depletion charge (US$9.94/oz) of any of SLW’s major assets – however, it is non-cash and therefore does not affect cash flows. Excluding impairments, a summary of SLW’s Q116 results compared to previous quarters plus our prior expectations is as follows:

One feature of note in Q216 was the average achieved silver price of US$17.18/oz. This compared with monthly averages of US$16.26/oz, US$16.89/oz and US$17.18/oz in April, May and June, respectively (average US$16.78/oz for the quarter), and therefore demonstrated an excellent timing/trading performance by SLW’s traders, adding almost US$3m to sales in the period.

Production at Penasquito declined 35.9% to 867oz in Q2 relative to an already depressed Q1 figure. This was a result of lower ore grades and recoveries from the upper transitional ore and low grade stockpiles as well as a 10-day shutdown for planned mill maintenance (both of which had been gazetted to the market at the time of SLW’s Q1 results). In addition, however, there was a longer than anticipated period to ramp the plant back up again to full production.

In a change to previous guidance, however, Goldcorp now expects mining activities in the pit to focus on lower grade ore in the upper sections of the Penasco pit for the next three years, while stripping is prioritised to ensure an economically optimised pit shell design. As a result, mining will not return to the heart of the deposit at the bottom of the Penasco pit (where it was concentrated in FY15, for example) until FY19.

Unrelated to the above guidance, Goldcorp has approved the PLP, which is expected to recover 40% of the gold and 48% of the silver currently reporting to the tailings by treating the zinc tailings prior to discharge to the tailings storage facility. Commercial production is expected from Q119, with the PLP adding c 100-140koz of gold and 4-6Moz of silver (of which SLW will be entitled to 25%) to Penasquito’s per-year production profile. Note that, according to Goldcorp, the project will have a minimal impact on the site water balance as the Pyrite Leach processing plant recirculates existing plant process water.

On 2 August, SLW announced that its wholly owned subsidiary, Silver Wheaton (Caymans) Ltd, had agreed to acquire from Vale an additional amount of gold equal to 25% of the life-of-mine gold production from its Salobo mine in Brazil. Note that SLW was already the owner of a stream relating to 50% of Salobo’s gold output, such that this latest acquisition takes SLW’s interest to 75%.

Consideration for the additional 25% stream is:

In addition, SLW will make ongoing payments of the lesser of US$400/oz and the prevailing market price of gold. Whereas these had been inflated at 1% per year from FY17, however (for the pre-existing 50% stream), they will now be inflated from FY19 for the entire 75% gold stream. Moreover, while deliveries for the entire 75% gold stream will still be the obligation of a wholly owned subsidiary of Vale, they will now be guaranteed by Vale and the direct holder of Salobo, Salobo Metais SA.

Considering each element in turn:

As such, the total consideration of the 25% Salobo stream acquisition may be considered to be US$818.4m (800+26.3-7.9=818.4), which compares with the US$900m that it paid in March 2015 (when the gold price averaged US$1,179/oz) for an equivalent 25% gold stream from Salobo.

Mill throughput at the Salobo mine is currently 24Mtpa. If throughput capacity is expanded within a predetermined period and depending on the grade of material processed, SLW will be required to make an additional payment to Vale regarding its 75% stream. The additional payments range in size from US$113m if throughput is expanded beyond 28Mtpa by 1 January 2036 to US$953m if throughput is expanded beyond 40Mtpa by 1 January 2021. If Salobo is expanded to 36Mtpa between 2021 and 2025, for example, the expansion payment due from SLW to Vale would range between US$514m and US$692m. These expansion payments can be shown graphically, as follows:

Note that, currently, in its long-term forecasts, we make no provision for either future expansion at Salobo or related expansion payments.

As before, the Salobo stream acquisition will add an estimated 70,000oz pa to SLW’s production profile for 10 years, followed by an estimated 60,000oz pa increase for the following 30 years of the mine’s estimated >50-year life.

In the aftermath of the Salobo (gold) stream acquisition, SLW’s updated guidance for FY16 (compared with our estimates) is as follows:

Within the context of our estimates for FY16 in particular, investors should note that there is downside risk regarding its estimates for Penasquito in particular and upside opportunity regarding our estimates for Antamina and Sudbury.

Our forecasts for SLW’s FY16 and FY17 have now been updated to include the acquisition of the incremental 25% Salobo stream as well as increased precious metals’ prices. Note that SLW still forecasts non-stock general & administrative expenses to be in the range US$31-34m for the full year, including additional legal costs relating to SLW’s dispute with the Canadian Revenue Agency:

Our EPS estimates of 24c for Q316 and 22c for Q416 compare to average consensus basic EPS estimates of 22c (within a range 16-28c) and 25c (within a range 18-36c), respectively (source: Bloomberg, 30 August 2016). They also compare to average consensus estimates of 14c and 15c, respectively, in May and 14.6c and 15.7c, respectively, in April.

Our updated FY16 EPS estimate of 70c compares to an average consensus basic EPS estimate of 72c within a range 60-89c (source: Bloomberg, 30 August 2016). By contrast, our basic EPS estimate of 123c for FY17 compares to an average consensus estimate of 98c within a range 70-139c (cf 65c, within a range 33-82c in May). If silver and gold prices remain at their current levels of US$18.70/oz and US$1,319/oz (at the time of writing), we estimate that basic EPS in FY17 will instead be 84c 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 38.0x Edison FY16e or 37.1x consensus FY16e, currently).

Applying this multiple to our long-term EPS forecast of US$1.58 per share in FY19 implies a potential share value of US$40.81, or C$53.21 in that year (cf US$37.62, or C$48.38, at the time of our last note in May).

From a relative perspective, meanwhile, it is notable that SLW is cheaper than its royalty/streaming ‘peers’ on at least 79% of valuation measures in Exhibit 6 (whether consensus or Edison forecasts are used) and on multiples that are cheaper than the gold miners themselves on at least 38% of the same valuation measures, despite being associated with materially less operational and cost risk, in particular.

As at 30 June, SLW had net debt of US$582m (cf US$1,284.2m at the end of March and US$1,362.7m at the end of December 2015).

In the aftermath of its March bought deal and the additional Salobo stream purchase, we estimate that SLW’s net debt will be US$1,144.3m by the end of FY16 and that it will be net debt free by the end of FY18, all other things being equal and contingent on its making no further major acquisitions (which is unlikely).

We estimate that net debt of US$1,144.3m as at end-2016 will equate to gearing (net debt/equity) of 23.1% and a leverage (net debt/[net debt+equity]) of 18.7%. 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 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.

SLW estimates the size of the potential market open to it to be the 70% of total silver production of c 870Moz in FY16 that is produced as a by-product of either gold or base metals’ mines – ie approximately 609Moz silver per year. This compares to SLW’s estimated production of 31.3Moz Ag in FY16 – ie SLW has penetrated only c 5.1% of its potential market.

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

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

SLW 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 investment destination for suppliers of finance and capital to overseas destinations in general (ie not just in respect of mining).

Any further developments will be communicated to investors as and when they occur. In the meantime, a study of Silver Wheaton’s share price (in US dollars) reveals that it has recouped all of its losses since the announcement of the CRA’s proposal letter on 6 July 2015, having returned 113.0% in US dollar terms during the period and having similarly outperformed the silver price by 68.7%: