Silver Wheaton — Update 2 November 2016

Silver Wheaton’s Q316 results are scheduled for release after the market close on Wednesday 9 November. Our forecasts for SLW’s Q316, Q416 and FY16 have been adjusted to account for actual precious metals prices that were marginally higher in Q3 than previously predicted (eg US$19.60/oz vs US$19.44/oz Ag and US$1,335/oz vs US$1,333/oz Au), but are lower, to date, so far in Q4.

Financial results for Q316 will include a full quarter’s contribution as a result of SLW’s acquisition of an incremental 25% Salobo stream for the first time (taking its interest to 75%). Our revised EPS estimates of 23c for Q316 and 19c for Q416 compare to average consensus basic EPS estimates of 21c (within a range of 17-24c) and 23c (within a range of 18-27c), respectively (source: Bloomberg, 28 October 2016). Our updated FY16 EPS estimate of 67c compares to an average consensus basic EPS estimate of 69c within a (narrowing) range of 64-83c (source: Bloomberg, 28 October 2016).

In addition, we have adjusted our FY17 forecasts to reflect our updated annual precious metals price forecasts, as set out in our report Gold and other metals: Normalisation augurs well for exploration, published in October 2016. In the wake of this adjustment, our basic EPS estimate for FY17 of 106c compares to an average consensus estimate of 100c within a (widening) range of 68-141c. If silver and gold prices remain at the current levels of US$17.59/oz and US$1,266/oz, respectively, at the time of writing, we estimate that basic EPS in FY17 will instead be 73c per share (all other things being equal).

Production at Penasquito declined 35.9% in Q2, to 867koz, as a result of lower throughput (on account of ore hardness), lower ore grades, lower recoveries from the upper transitional ore and the processing of low-grade stockpiles, as well as a 10-day shutdown for planned mill maintenance. There was then a longer than anticipated period to ramp the plant back up again to full production. On 26 October, Goldcorp reported Q3 silver production from Penasquito of 5,242koz, implying production attributable to Silver Wheaton of 1,310.5koz. As a result, Edison forecasts that production from Penasquito attributable to Silver Wheaton will recover in Q3 and Q416, but only towards the lower end of the prior range (below).

Subsequently, protestors began a blockade of Penasquito on 26 September. After stating that the blockade would not affect production and cost guidance for FY16, Goldcorp initiated a controlled shutdown of the mine on 3 October. The exercise included a contingency plan to restart mining and processing immediately a resolution with the protestors was concluded and this was then put into effect on 8 October.

Towards the end of Q316, mining at Penasquito shifted from the lower-grade upper transitional ore into higher-grade ore in the lower portion of the pit. As a result, Goldcorp expects the (gold) grade of ore at Penasquito to continue to improve during Q416 as the mine progresses deeper into the high-grade zone in the current phase. We also expect tonnes milled to increase on account of a reduction in planned maintenance.

In common with other businesses (both mining and otherwise), Silver Wheaton is engaged in a continual process to minimise stocks – as evidenced by the declining trend in the under-sale of silver relative to production in recent years (see Exhibit 3 below).

While desirable, however, a permanently declining trend in the context of a rising production profile is likely to prove well-nigh impossible to achieve. Notwithstanding occasional over-sale purges, the degree of average silver under-sale since Q112 has been 10%. Should this level of under-sale recur in Q316, we estimate that it could reduce earnings by approximately 15.0%, as shown in the column entitled Q316e (Ag under-sale) in Exhibit 1.

Note that the volatility in gold sales relative to production is much greater than that for silver:

Investors should note that Edison’s financial forecasts in Exhibit 1 specifically exclude stock-based compensation costs. SLW still forecasts non-stock general & administrative expenses to be in the range of US$31-34m for the full year – ie US$7.75-8.50m per quarter – including additional legal costs relating to SLW’s dispute with the Canadian Revenue Agency. However, while Silver Wheaton’s share price has comfortably outperformed the majority of its peers during Q3, its 14.3% appreciation (in US dollar terms) is nevertheless still markedly more conservative than during Q1 and Q2 when it returned 34.6% and 43.2%, respectively (giving rise to the larger G&A expenses recorded for those periods in Exhibit 1 once stock-based compensation costs were included).

As a result, Edison regards the risk of an underlying G&A expense overrun as being small. Nevertheless, it self-evidently does exist.

Goldcorp’s board granted approval for the Pyrite Leach Project (PLP) at Penasquito on 27 July. Based on a feasibility study completed in December 2015, the PLP is expected to provide annual incremental production of 100-140koz of gold pa and approximately 4-6Moz of silver – of which 25% will be attributable to Silver Wheaton – for an expected capital investment of approximately US$420m (NB None of which is attributable to Silver Wheaton).

At the time of writing, the project contractor is currently mobilising on site to begin the construction of permanent facilities, while simultaneously preparing bid packages for long lead time equipment, with a view to completing construction in H218, whereupon precious metals production is forecast to commence in CY19.

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 34.9x Edison FY16e or 33.7x consensus FY16e, currently – see Exhibit 7).

Applying this multiple to our long-term EPS forecast of US$1.32 in FY20, at Edison’s revised long-term precious metals prices (US$23.98/oz Ag and US$1,362/oz Au in FY20 vs US$26.57/oz Ag and US$1,483/oz in FY19, previously), implies a potential share value of US$34.22, or C$45.85 in that year.

From a relative perspective, meanwhile, it is notable that SLW is cheaper than its royalty/streaming ‘peers’ on 75% of valuation measures in Exhibit 7 (79.2% if consensus forecasts are used) and on multiples that are cheaper than the gold miners themselves on 46.3% of the same valuation measures (whether consensus or Edison estimates are used), despite being associated with materially less operational and cost risk, in particular.

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 31.0Moz Ag in FY16, ie SLW estimates that it has penetrated only c 5.1% of its potential market.

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 Silver Wheaton in due course and regarding which it already has strong, existing counterparty relationships:

SLW had net debt of US$582m as at the end of June 2016 (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 incremental 25% Salobo stream acquisition (see our note Going for gold, published on 30 August 2016) and assuming the operational performance set out in Exhibit 1, we estimate that SLW’s net debt will be US$1,159.6m by the end of FY16 (equating to gearing of 23.4% and leverage of 19.0%), and that it will be net debt free early in FY19, all other things being equal and contingent on its making no further major acquisitions (which is unlikely). Self-evidently, such a level of debt is well within the tolerances required of its banking covenants that:

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

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 mining).