Wheaton Precious Metals — Starting as it means to continue

Wheaton’s results in Q119 were closely aligned with our prior expectations (see Exhibit 1), with the exception of the fact that a large oversale of gold relative to production (resulting from a drawdown in inventory – see ‘Ounces produced but not yet delivered – aka inventory’ on page 3) broadly offset a large under-sale of silver, resulting in a US$5.4m positive variance in revenues during the quarter relative to our expectations. This was then augmented by a US$2.2m positive variance in depletion, but offset by a US$7.3m negative variance in general and administrative expenses (albeit including stock-based compensation, which Edison declines to attempt to forecast) to result in net earnings that were within 3.5% of our prior forecast for the quarter. A full analysis of WPM’s Q1 results relative to our prior forecasts is provided in the table below:

The 22.9% oversale of gold relative to production was largely the consequence of a significant drawdown of ounces produced but not yet delivered at Salobo in particular and resulted in a record level of gold sales during the quarter and gold sales accounting for 66.8% of WPM’s total sales (almost exactly the reverse of the situation as recently as Q415 when silver sales were dominant).

From an operational perspective, the star performer within WPM’s portfolio of streams was once again Salobo, at which production (although lower than the previous quarter) continued at high levels, despite a lower throughput and grade, which was offset by higher recoveries. WPM’s other assets performed broadly in line with our expectations, with the exception of Penasquito, Constancia and Stillwater. Penasquito continued to be affected by the higher than expected ore hardness that has compromised mill performance since Q318, albeit this has now become the focus of management efforts to remedy. Nevertheless, the newly commissioned Pyrite Leach Project was operated successfully throughout the quarter. In the meantime, production was lower than our expectations at Constancia, owing to delays in mining the Pampacancha satellite deposit (in lieu of which WPM is entitled to receive an additional 2,005oz gold per quarter during FY19 and FY20 relative to its precious metals purchase agreement). Over the remainder the year, Sibanye-Stillwater has also indicated that it will commit additional resources to recover its lower Q1 production. By contrast, silver and gold grades at San Dimas were reported to be 10% and 8% higher compared to the prior quarter, owing to higher in-situ grades in the Victoria and Jessica areas of the mine, together with improvements in mine dilution controls.

Sales of gold and silver diverged further in Q119 relative to production. Whereas sales of gold increased to 122.9% of production during the three-month period (relative to a prior long-term average of 91.2% of production), silver sales fell further, to 76.5% of production (cf a prior long-term average of 89.3%),

As at 31 March, payable ounces attributable to WPM produced but not yet delivered amounted to 3.5Moz silver and 51,515oz gold (vs 3.2Moz silver and 77,074oz gold in December, 3.0Moz silver and 77,588oz gold in September, 3.4Moz silver and 70,259oz gold in June, and 4.1Moz silver and 75,153oz gold in March 2018). This ‘inventory’ equates to 1.92 months and 1.66 months of forecast FY19 silver and gold production, respectively (vs 1.59 months and 2.49 months of FY18 production in Q418), and compares with WPM’s target level of two months of annualised production for silver, and two to three months of annualised gold and palladium production.

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

WPM has maintained its production guidance for FY19 of 365,000 ounces of gold, 24.5 million ounces of silver, 22,000 ounces of palladium and 690,000 ounces of gold equivalent production. For the five-year period ending in FY23, the company estimates that average annual gold equivalent production will amount to 750,000 ounces per year. This aligns closely with both our current and prior expectations with the exception of the fact that we are also anticipating a production contribution from Rosemont (see below) from FY22 and a production contribution from Salobo III in FY23.

In the medium term, silver output from Penasquito attributable to WPM is expected to recover back to its steady-state level of 7Moz as the Chile Colorado pit contributes to mill feed and grades improve once again at the main Penasco pit with mine sequencing. It will also benefit from the development of the Pyrite Leach Project, which will add an additional 1.0–1.5Moz of silver attributable to WPM per year by recovering 48% of the silver that previously reported to tailings. In the short term however, we expect it to continue to be affected by harder than anticipated ore for at least one more quarter. In addition, on 29 April, Newmont Goldcorp announced that it is to temporarily suspend operations at Penasquito, pending resolution of an illegal blockade, which we forecast will affect production there for a one-month period during the second quarter. At the same time, mining at Constancia will not start at the Pampacancha pit (which hosts significantly higher gold grades than those mined hitherto and of which WPM will now be entitled to an increased portion) until FY20. The company also expects palladium and gold production at Stillwater to increase as the Blitz project ramps up to full capacity in FY21.

On 24 October, Vale announced the approval of the Salobo III brownfields mine expansion, intended to increase processing capacity at Salobo from 24Mtpa to 36Mtpa, with start-up scheduled for H122 and an estimated ramp-up time of 15 months. According to its agreement with Vale, , depending on the grade of the material processed, WPM will be required to make a payment to Vale in respect of this expansion, which WPM estimates will be in the range US$550–650m in FY23, in return for which it will be entitled to its full 75% attributable share of gold production. Note: this compares to its purchase of a 25% stream in August 2017 for an estimated consideration of US$820.8m (including renegotiated warrants and cost inflation terms) and the US$900m it paid in March 2015 (when the gold price averaged US$1,179/oz) for another 25% gold stream from Salobo (see our note, Silver Wheaton: Going for gold, published on 30 August 2016).

WPM is ostensibly a precious metals streaming company (plus one cobalt stream). Considering only the silver component of its investible universe, WPM estimates the size of the potential market open to it to be the lower half of the cost curve of the 70% of global silver production of c 870Moz in FY17 that is produced as a by-product of either gold or base metal mines (ie approximately 305Moz pa silver vs WPM’s production of 28.5Moz Ag in FY17). Inevitably, WPM’s investible universe may be further refined by the requirement for the operations to be located in good mining jurisdictions, with relatively low political risk. Nevertheless, such figures serve to illustrate the fact that WPM’s marketplace is far from saturated or mature.

As a consequence, WPM reports that it is busy on the corporate development front. It has the potential for up to six deals with a value in the range US$100–300m, thus fully financeable via the c US$0.94bn available to WPM in cash and under its US$2bn revolving credit facility as at end-Q119.

While it is difficult, or impossible, to predict potential future stream acquisition targets with any degree of certainty, it is perhaps possible to highlight two that may be of interest to WPM in due course for which it already has strong, existing counterparty relationships:

One further, major project rapidly moving closer to development is the Rosemont copper project in Arizona, after its operator, Hudbay, announced that it had received both a Section 404 Water Permit from the US Army Corps of Engineers and its Mine Plan of Operations (MPO) from the US Forest Service. The Section 404 permit regulates the discharge of fill material into waterways according to the Clean Water Act and is effectively the final material administrative step before the mine can be developed. Hudbay has since indicated that it expects to seek board approval to commence construction work by the end of the year, which “should enable first production by the end of 2022”. In the meantime, it has commenced an early works programme to run concurrently with financing activities (including a potential joint venture partner) during the remainder of the year. The proposed mine is located near a number of large porphyry-type producing copper mines and is expected to be one of the largest copper mines in the US, with output of c 112,000t copper in concentrate per year and accounting for c 10% of total US copper production. Total by-product production of silver and gold attributable to WPM will be c 2.7Moz Ag pa and c 16,100oz Au pa and we estimate it will contribute an average c US$0.11 per share to WPM’s basic EPS in its first nine years of operations from FY22–30 for an upfront payment of US$230m (equivalent to US$0.52/share) in two instalments (vs three previously) of US$50m and US$180m. Note that, for the purposes of our financial modelling, we have assumed that these instalments will be paid from WPM to Hudbay in FY20 and FY21, respectively, although they could fall in FY19 and FY20.

WPM has forecast non-stock general and administrative expenses for FY19 in the range US$36–38m, or US$9.0–9.5m per quarter (vs a comparable forecast of US$34–36m, or US$8.5–9.0m per quarter, for FY18), including all employee-related expenses, charitable contributions, etc. Investors should note, however, that our financial forecasts in Exhibits 5 and 8 exclude stock-based compensation costs.

Taking into account the aforementioned considerations, our updated forecasts for FY19 for WPM, by quarter, are now as shown below:

Our forecast basic EPS of US$0.50/share for FY19 compares with a consensus forecast of US$0.53/share (source: Refinitiv, 9 May 2019), within a range of US$0.46–0.69 per share.

Our US$1.17 basic EPS forecast for FY20 (see Exhibit 8) compares with a consensus of US$0.67 (source: Refinitiv, 9 May), within a range of US$0.50–1.17. However, our estimate is predicated on an average gold price during the year of US$1,482/oz and an average silver price of US$25.95/oz. These are 15.8% and 75.0% above current spot prices, respectively, but are consistent with our historical practice and, in particular, assume that silver will, at some point, revert to the long-term correlation that it has exhibited with gold since the latter was demonetised in 1971. In the event that precious metals prices remain at current levels (US$1,280/oz Au and US$14.83/oz Ag at the time of writing), we forecast that WPM will instead earn US$0.47 per share in FY20.

Excluding FY04 (part-year), WPM’s shares have historically traded on a contemporary average P/E multiple of 28.5x current year basic underlying EPS, ie excluding impairments (vs 40.9x Edison or 38.2x Refinitiv consensus FY19e, currently – see Exhibit 7).

Applying this 28.5x multiple to our updated EPS forecast of US$1.17 in FY20 (vs US$1.19 previously) implies a potential value per share for WPM of US$33.41, or C$45.03 in that year (vs US$33.97, or C$45.18 previously). Note that this valuation excludes the value of 20.9m shares in First Majestic currently held by WPM, with an immediate value of C$165.9m, or US$0.28 per WPM share (priced as at 9 May).

In the meantime, from a relative perspective, it is notable that WPM is cheaper than its royalty/streaming ‘peers’ in at least 91% (22 out of 24) of the valuation measures used in Exhibit 7 and on multiples that are cheaper even than the miners themselves in at least 42% (33 out of 78) of the same valuation measures (irrespective of whether Edison or consensus forecasts are used), despite being associated with materially less operational and cost risk (since WPM’s costs are contractually predetermined).

As at 31 March 2019, WPM had US$125.8m in cash and US$1,183.5m of debt outstanding under its US$2bn revolving credit facility (which attracts an interest rate of Libor plus 120–220bp and matures in February 2024), such that it had net debt of US$1,057.7m overall, after US$118.2m (US$0.27/share) of cash inflows from operating activities during the quarter. Relative to the company’s Q1 balance sheet equity of US$5,225.9m, this level of net debt equates to a financial gearing (net debt/equity) ratio of 20.2% and a leverage (net debt/[net debt+equity]) ratio of 16.8%. It also compares with a net debt position of US$1,188.2m as at end-December and US$1,261.1m as at end-September 2018. Self-evidently, such a level of debt is well within the tolerances required by its banking covenants that:

All other things being equal and subject to its making no further major acquisitions (which is unlikely in our view), on our current cash flow projections WPM will be net debt free early in FY21.