Silver Wheaton — Update 6 December 2016

Silver Wheaton’s Q316 results were characterised by exceptionally strong production from its gold assets, supported by record quarterly output at Salobo and Minto and a strong performance at the 777 mine. Production from SLW’s silver assets was in line with our expectations, with another quarter of outperformance from Antamina being offset by a subpar result at San Dimas (see page 3, below); although production from Penasquito was affected by the factors set out in our report, Q3 results scheduled for 9 November, published on 2 November, it was nevertheless ahead of our expectations and ahead of the pro rata outcome that would otherwise have been inferred from Goldcorp’s Q3 results.

The other principal feature of the results was a 20.0% under-sale of silver relative to production (towards the upper end of the historical range) and a 22.1% under-sale of gold, which resulted in a return of inventory to more normal levels of circa two months of production versus circa one month as at the end of Q216. Exhibit 1 provides a summary of SLW’s Q3 results relative to both the previous quarter (Q216) and also our prior expectations, as well as our updated forecasts for Q4 in the light of recent precious metals price weakness.

Our revised EPS estimate of 17c for Q4 compares to an average consensus basic EPS estimate of 20c (vs 21c immediately before SLW’s Q3 results), within a range of 16-24c (source: Bloomberg, 2 December 2016). Our updated FY16 EPS estimate of 60c compares to an average consensus basic EPS estimate of 64c within a range of 60-70c.

Production at San Dimas in Q316 was affected by high unplanned worker absences and a failure to achieve mine plans, which resulted in reduced development rates and also a number of delayed ventilation improvement projects. This, in turn, limited access to certain high-grade areas of the mine. As a result of these tribulations, Primero (the mine’s operator) estimates that silver production in FY16 will now be 5.5-6.0Moz. Given that San Dimas has produced 3.8Moz of silver in the first three quarters of the year, achieving output of 5.5Moz would require the production of 1.7Moz of silver in Q4, which, while possible (San Dimas last produced in excess of this number in Q415), may prove challenging under the circumstances and during the Christmas quarter. Our forecast for production at San Dimas in Q416 is therefore 1.4Moz.

Note that since Q112, San Dimas’s production attributable to Silver Wheaton has been, on average, 1,543koz silver per quarter.

Edison’s forecasts assume parity between production and sales in Q416, compared to an average historical under-sale of 10.4% for silver in the period Q112-Q316 and 10.6% for gold (see below):

Payable ounces attributable to Silver Wheaton produced but not yet delivered amounted to 3.8Moz silver and 63,300oz gold as at end-September 2016, equating to 1.5 months and 2.3 months of forecast FY16 production, respectively, or 1.9 months in aggregate – close to SLW’s target level of two months. Combined with broadly flat production expectations for Q416, this alone should militate against a material change in Q4 inventory. In addition, the fourth quarter, immediately before the calendar and (often) financial year ends, is traditionally the one in which operating companies typically try to ‘flush’ inventory through the sales pipeline.

Note that, for these purposes, the use of the term ‘inventory’ reflects ounces produced by SLW’s operating counterparties at the mines over which it has streaming agreements, but which have not yet been delivered to SLW. It in no way reflects the other use of the term in mining companies themselves, where it is typically used to refer to metal in circuit (among other things), and may therefore (under certain circumstances) be considered to be a consequence of metallurgical recoveries in the plant.

Silver Wheaton acquires the right to purchase streams of precious metals from producing or near-producing mines in return for a combination of a fixed upfront payment (in US dollars, typically in either cash or SLW shares) and an ongoing payment (in US$/oz). Typically, it focuses on by-product precious metals streams as this offers the greatest arbitrage opportunity between the perceived value of the stream to the producer in the equity market and the perceived value of the stream to Silver Wheaton. Specifically, however, it seeks to build long-term value by entering streaming agreements with large, relatively financially stable counterparties operating premium high-margin projects in the lowest quartile (and certainly the lowest half) of the cost curve. As well as providing comfort regarding the sustainability of the underlying operation, this strategy also helps to mitigate geopolitical and operating risks. In addition, it provides a degree of flexibility if projects are not developed according to plan (eg as evidenced by SLW’s ability to successfully negotiate a series of amendments with Barrick regarding the latter’s Pascua-Lama project). Unlike a number of its peers, Silver Wheaton has restricted itself solely to precious metals streaming agreements and does not participate in the base metal and oil & gas markets. This strategy has the beneficial side effect that it also exposes SLW to the traditional premium multiples afforded to precious metal companies compared to base metal ones. Notwithstanding its silver heritage, however, SLW describes itself as ‘agnostic’ in terms of its preference for either silver or gold streams.

Latterly, Silver Wheaton has engaged in two ‘early deposit’ contracts whereby it has contracted to buy gold and silver streams from the Cotabambas and Toroparu mines in South America, thereby effectively becoming a relatively low-cost financing component of these projects at a time when the availability of both debt and equity financing is uncertain and their associated costs therefore relatively high.

While royalty companies compete with Silver Wheaton to some extent in the provision of capital to the mining industry, there are notable differences between the two business plans. Royalties are typically linked to tenement areas, for example, and also typically relate to a mine’s primary output, whereas streaming arrangements are governed by a commercial agreement between two companies (albeit typically relating to a single mine) and relate to a mine’s secondary, or by-product, output. A summary of the unique features of Silver Wheaton’s streaming business plan and how it distinguishes itself from other investment opportunities in the mining industry is provided below.

Compared to exchange traded funds (ETFs), Silver Wheaton:

Compared to mining companies, Silver Wheaton:

Compared to royalty companies, Silver Wheaton:

A key advantage for Silver Wheaton compared to potential competitors is its size, scale and valuation, which allows it to raise equity on a non-dilutive basis to fund new streams, or even to issue counterparties with equity in consideration of new streams.

Silver Wheaton has four cornerstone assets (San Dimas, Penasquito, Antamina and Salobo). The following is an analysis of the financial returns generated as a result of the application of SLW’s investment criteria to one of its cornerstone assets – Penasquito.

A gold-silver-lead-zinc mine, located in Mexico and operated by Goldcorp, Penasquito has consistently been regarded as one of Silver Wheaton’s key cornerstone assets. The stream relating to this asset was acquired late in 2007 for US$485m plus US$3.56m in costs and US$15.761m in capitalised interest. The first silver-bearing lead and zinc concentrate was delivered from the mine in 2009 after production at its first 50,000tpd sulphide process line was ramped up on schedule and on budget. During the ramp-up period, metal recoveries, concentrate grades and concentrate quality were within expected ranges. At the same time, construction of a second 50,000tpd sulphide process line was progressing towards planned completion in Q310. After exceeding ramp-up expectations, Penasquito became Silver Wheaton’s second largest contributor of silver production in 2010 and, after further expansions, it finally surpassed San Dimas to become Silver Wheaton’s largest contributor of silver production in 2012, by which time it held the title of Mexico’s largest precious metals mine, one of the world’s largest and lowest-cost gold-silver mines and one of Goldcorp’s most significant cash flow generators. After adjusting the mine’s production schedule to reflect a targeted mill throughput rate of 110,000tpd, rising to in excess of 115,000tpd beyond 2015, Penasquito is now forecast to yield average annual production attributable to Silver Wheaton of 7Moz Ag per year over the next two years, plus an additional 4-6Moz pa (of which 25% will be attributable to SLW) once the Pyrite Leach Project is commissioned in FY19.

Compared to an initial investment of US$504.3m, Penasquito has yielded the following historical and forecast cash flows to Silver Wheaton:

On an undiscounted basis therefore, Penasquito paid back Silver Wheaton’s initial investment in 2014. When discounted at Edison’s standard mining discount rate of 10%, the mine has already returned US$412.3m to Silver Wheaton (as at end FY16e) in 2007 money terms and is also worth a residual US$878.0m in 2017 money terms. Applying a 10% discount/hurdle rate, pay back is indicated in late 2018/early 2019 in 2007 money terms.

By contrast, applying a 10% discount/hurdle rate over the entire stream of income yields an ultimate value of US$784.6m, which is directly comparable to the stream’s acquisition cost of US$504.3m in 2007 money terms. Stated alternatively, the stream will provide Silver Wheaton with an internal rate of return of 15.6% from the point of acquisition in 2007 to 2026. In addition, there is substantial underground potential beneath the current open pits, providing excellent opportunities for further exploration growth and expanded and/or extended silver production.

As at Q316, Silver Wheaton has agreements over more than 20 major metals streams, summarised in Exhibit 5 below.

Official management guidance for FY16 is for gold production of 335,000oz (vs 305,000oz previously) owing to better than expected results in the first nine months of the year and expected production from Salobo and Sudbury in Q4. By contrast, attributable silver production for 2016 is now expected to be 30Moz (vs 32Moz previously) as a result of lower than expected results from Penasquito and San Dimas, partly offset by better than expected results from Antamina. On a silver-equivalent basis, however, it remains unchanged, at 55Moz (based on average LBMA gold and silver prices of US$1,260/oz and US$17.12/oz, respectively, for the first nine months of calendar 2016).

Over the next five years (including 2016), management estimates average annual production of approximately 330,000oz of gold and 31Moz of silver.

These compare with our medium-term forecasts, as follows:

SLW now forecasts non-stock general & administrative expenses in the range of US$31-32m for the full year (cf US$31-34m previously) – ie c US$8m per quarter – including additional legal costs relating to SLW’s dispute with the Canadian Revenue Agency. Investors should note that our financial forecasts in Exhibit 1 specifically exclude stock-based compensation costs.

In the first three quarters of the year, silver production attributable to Silver Wheaton was 22.8Moz (the equivalent of 7.6Moz per quarter, on average). For SLW to meet its guidance of 30.0Moz in FY16, production in Q416 would have to be 7.2Moz during the three-month period. While our estimate of production attributable to Silver Wheaton from San Dimas is conservative for Q416 in the order of 0.3Moz (see page 3), we are somewhat optimistic in our estimate of 3.0Moz of output from its ‘other’ assets cf an average of 2.7Moz in the first three quarters of the year. Again, while we recognise that 3.0Moz is optimistic, we believe it is achievable if all of the assets perform in tandem. Self-evidently, an optimistic estimate in the order of 0.3Moz of production from SLW’s ‘other’ assets approximately offsets a pessimistic estimate in the same order relating to San Dimas.

Edison has adjusted its 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 105c compares to an average consensus estimate of 91c within a range of 64-135c. Note that, if silver and gold prices remain at the current levels of US$16.40/oz and US$1,172/oz, respectively, at the time of writing, we estimate that basic EPS in FY17 will instead be 57c 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 30.2x Edison FY16e or 28.3x consensus FY16e, currently – see Exhibit 8).

Applying this multiple to our long-term EPS forecast of US$1.28 in FY20, at Edison’s revised long-term precious metals prices (US$23.98/oz Ag and US$1,362/oz Au in FY20), implies a potential share value of US$33.09, or C$44.03, in that year.

In the meantime, from a relative perspective, it is notable that SLW is cheaper than its royalty/streaming ‘peers’ in at least 87% of the valuation measures used in Exhibit 8 and on multiples that are cheaper than the gold miners themselves in at least 48% of the same valuation measures, 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 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 30.7Moz Ag in FY16, ie SLW estimates that it has penetrated only c 5.0% of its potential market.

While it is difficult/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$1,219.5m as at the end of September 2016 after US$161.6m of cash inflows from operations (equivalent to 36.7c/share). This compares with US$582m as at the end of June 2016, US$1,284.2m as at the end of March and US$1,362.7m as at the end of December 2015 and is consistent with SLW generating c US$100-150m per quarter from operating activities before financing and investing activities. Most recently, these investing activities involved the acquisition of an additional 25% of the gold output from the Salobo mine in Brazil for an immediate cash payment of US$800m, announced in August (see our note Going for gold, published on 30 August 2016). Otherwise, assuming the operational performance set out in Exhibit 1, we estimate that SLW’s net debt will be US$1,092.6m by the end of FY16 (equating to gearing of 22.1% and leverage of 18.1%), and that SLW will be substantially net debt free early in FY19, all other things being equal and contingent on it 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 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 (see below) has been determined under a separate agreement and is therefore specifically excluded from calculations regarding SLW’s banking covenants. In the meantime, 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 update note of 15 February 2016.

SLW notes that 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 for the mining industry).

Otherwise, any further developments will be communicated to investors as and when they occur.