Never knowingly undersold

WPM’s Q317 results were characterised by improvements in production relative to the previous quarter, but a 24.2% under-sale of silver relative to production (which was attributed to Penasquito, Zinkgruvan, Yauliyacu and Antamina) and a 13.9% under-sale of gold (which was attributed to Sudbury and Salobo). As a result, revenues were US$16.9m below our expectations for the quarter, although this was largely offset by a US$12.1m positive variance in the cost of sales. Note that, during the course of a year, WPM almost invariably experiences a period of inventory build, which is then, typically, ‘flushed through’ in the final quarter of the year. Otherwise, production was below our expectations at San Dimas, Constancia and Sudbury, but was more than offset by being above our expectations at Penasquito, Antamina, Salobo and Other Gold. Once again, gold sales exceeded silver sales, in this case in the ratio 52:48 (cf 46:54 in Q217).

Salobo was reported to have operated above nameplate capacity during the quarter, while Penasquito and Antamina both benefited from higher grades, combined with higher recoveries at Penasquito and higher throughput at Antamina. According to Goldcorp (the operator), throughput at Penasquito is expected to increase once again in Q417, as a result of improved mill efficiencies, while the Chile Colorado pit will now contribute to mill feed ahead of schedule in CY18. In the longer term, the Pyrite Leach Project at Penasquito (which will add c 1Moz gold and 44Moz silver over the current life of the mine, by recovering 40% Au and 48% Ag currently reporting to the tailings) is reported to be 40% complete and is expected to commence commissioning three months ahead of schedule, in Q418.

In the same period, Constancia was affected by the continued processing of lower-grade ore (albeit as anticipated by Hudbay), while Sudbury experienced the inevitable effects of its transition to a single furnace flow sheet in Q417. Notwithstanding the fact that production was slightly lower than our expectations, Vale (the operator) reports that the transition has proceeded smoothly, with the newly designed furnace already exceeding its nameplate capacity, with the result that it achieved record quarterly copper concentrate production. In the meantime, San Dimas continued to be adversely affected by persistent issues relating to underground equipment reliability, which has restricted development rates and underground stoping activities. Despite its tribulations however (see our note, entitled Still shining, published on 30 August 2017), WPM pronounced itself encouraged by Primero’s ability to reduce general and administrative costs and to sell non-core assets. Also, it noted that Primero has “received a number of proposals from interested parties regarding a potential acquisition of the San Dimas operation.”

Finally, WPM agreed a renegotiation of the terms of its Minto gold stream with Capstone, such that the production payment per ounce of gold delivered to WPM will increase over the current fixed price in periods in which the market price of copper is below US$2.50/lb (note that the market price of three-month copper is currently US$3.08/lb, or US$6,808/t). In return for this accommodation, WPM has received C$8m in Capstone shares. It has also advanced a subordinated secured convertible debt loan up to C$20m at an interest rate of 10% per annum over a seven-year term to Desert Star in order to assist it in developing Kutcho (over which it has concluded an “early deposit” agreement).

Overall, WPM has maintained its production guidance for FY17 at 28Moz Ag and 340koz Au, compared with Edison’s forecast of 28.5Moz Ag and 343koz Au. We perceive that there is risk to our estimates from San Dimas, but regard this as being offset by upside risk at Penasquito. Otherwise, we have also increased our Q417 silver price forecast from US$16.71/oz to US$16.91/oz and our gold price forecast from US$1,247/oz to US$1,272/oz. In the aftermath of these revisions, our updated basic EPS estimate for FY17 is 62c, which compares to an average consensus estimate (source: Bloomberg, 9 November 2017) of 60.2c, within a range of 57-64c (cf an average of 59.5c within a range of 51-67c in August).

Sales of silver and gold recorded 24.2% and 13.9% under-sales relative to production in Q317, compared to long-term average under-sale rates of 11.0% and 9.5%, respectively.

As at 30 September, payable ounces attributable to Wheaton Precious produced but not yet delivered amounted to 5.3Moz silver and 57,200oz gold (cf 4.2Moz silver and 52,900oz gold in June, 3.9Moz silver and 51,500oz gold in March, 3.2Moz silver and 61,700oz gold in December and 3.8Moz silver and 63,300oz gold in September 2016). This ‘inventory’ equates to 2.23 months and 2.00 months of forecast FY17 silver and gold production, respectively (cf 1.81 months and 1.92 months in Q217, 1.73 months and 1.85 months in Q117, 1.25 months and 2.1 months of forecast FY16 production as at end-December, and 1.5 months and 2.3 months as at end-September), or 2.15 months on a silver equivalent basis (cf 1.88 months as at end-June and 1.8 months as at end-March, 1.6 months as at end-December and 1.9 months as at end-September) – slightly above WPM’s target level of two months.

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, more usual use of the term in the mining industry itself, 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 an operation’s metallurgical recoveries.

Excluding FY04 (part year), WPM’s shares have historically traded on an average P/E multiple of 27.1x current year basic underlying EPS – ie excluding impairments (cf 33.9x Edison or 35.3x consensus FY17e, currently – see Exhibit 5).

Applying this multiple to our long-term EPS forecast of US$1.41 in FY20 (at Edison’s average long-term precious metals prices of US$23.98/oz Ag and US$1,362/oz Au in FY20) implies a potential share value for WPM shares of US$38.25, or C$48.54 in that year.

In the meantime, from a relative perspective, it is notable that WPM is cheaper than its royalty/streaming ‘peers’ in 96% (ie 23 out of 24) of the valuation measures used in Exhibit 5 and on multiples that are cheaper than the miners themselves in at least 41% of the same valuation measures, despite being associated with materially less operational and cost risk, in particular.

Currently, we make no provision for either future expansion at Salobo or related expansion payments in our long-term forecasts. However, in the event that Salobo were to be expanded from 24Mtpa to 36Mtpa by the addition of a further 12Mtpa processing lines by 1 January 2023 – thereby attracting an estimated c US$603m incremental payment from WPM to Vale – we estimate that it would increase our estimate of WPM’s earnings by a material US$0.11/share. This, in turn, would increase our forecast value per share for the company to US$41.20, or C$52.30 at prevailing FX rates, implying an internal rate of return to investors buying WPM shares currently at C$26.72, equivalent to 28.7% pa in US dollar terms.

As at 30 September, WPM had US$69.9m in cash (ex-dividend) and US$854.0m of debt outstanding under its US$2bn revolving credit facility (which attracts an interest rate of Libor plus 120-220bp and matures in February 2022), such that it had net debt of US$784.1m overall, after US$129.1m (US$0.29/share) of cash inflows from operating activities during the quarter. Relative to the company’s equity, this level of net debt equates to a financial gearing (net debt/equity) ratio of 15.5% and a leverage (net debt/[net debt+equity]) ratio of 13.4%. It also compares with a net debt position of US$876.4m as at 30 June, US$980.2m as at 31 March, US$1,068.7m as at the end of December 2016, US$1,219.5m as at the end of September 2016 and US$1,362.7m as at the end of December 2015 and is consistent with WPM continuing to generate c US$100-150m per quarter from operating activities before financing and investing activities. Otherwise, assuming the operational performance set out in Exhibit 1, we estimate that WPM’s net debt position will decline organically, to US$759.1m by the end of FY17 (equating to gearing of 15.0% and leverage of 13.0%), and that WPM will be net debt free approximately midway through 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 by its banking covenants that:

Note that the C$191.7m letter of guarantee that WPM has posted re 50% of the disputed taxes relating to its dispute with the Canadian Revenue Agency (CRA) (see below) has been determined under a separate agreement and is therefore specifically excluded from calculations regarding WPM’s banking covenants.

There have been no further substantive developments regarding WPM’s dispute with the CRA since our update note of 15 February 2016.

WPM notes that the CRA’s position is that the transfer pricing provisions of the Income Tax Act (Canada) in relation to income earned by WPM’s foreign subsidiaries should apply “such that the income of Silver Wheaton [sic] 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 a supplier of finance and capital to overseas destinations in general (ie not just for the mining industry).

Earlier this year, WPM’s CEO, Randy Smallwood, was quoted as saying that the company is willing to settle its tax dispute with the CRA via a payment of C$5-10m “with gritted teeth”, but still believes no payment should be required. As such, the C$5-10m quoted should not be interpreted as an admission of guilt, but rather an appreciation of the costs involved in going to a full trial and also of the effect that the issue is having on WPM’s share price rating relative to its peers (see Exhibit 5).

In the meantime, Wheaton Precious is approximately halfway through the case ‘discovery process’ with the CRA, designed to provide both sides with the opportunity to arrive at an out-of-court settlement before formal proceedings commence. At the moment, this discovery process appears likely to last until the end of the year and any potential out-of-court settlement would therefore be likely to occur shortly after this date. Otherwise, however, the company has stated that it is willing to go to trial if a ‘principled’ settlement is not possible (which would be likely to be towards the middle of 2018).