Wheaton Precious Metals — Serene start

In terms of aggregate production, WPM’s silver streams outperformed our expectations in Q118, while its gold streams performed closely in line. However, after demonstrating the traditional ‘flush through’ effect in the last quarter of FY17 whereby there was a close correlation between production and sales, sales of silver and gold in Q118 reverted to close to their long-term trends, with a 14.6% under-sale of silver (cf a long-term average of 10.5%) and a 12.2% under-sale of gold (cf a long-term average of 9.2%) relative to production. As a result, sales were 9.1% below our expectations, although this was largely offset by the total cost of sales being 12.3% lower, such that earnings from operations were just 4.6% lower. Otherwise, the main feature of the results, from a financial perspective, was a US$2.8m negative variance in ‘Other expenses’, which predominantly reflected a loss on fair value adjustment of the Kutcho convertible note held by WPM. A full analysis of WPM’s Q1 results relative to both Q417 and our prior expectations is provided in the table below.

Note that, if the loss on fair value adjustment of the Kutcho convertible note held by WPM is excluded from the above income statement, adjusted net earnings are US$69.9m and EPS 16 cents, which is a variance relative to our prior expectation of only 9.2%.

From an operational perspective, key features of the quarter were stronger production performances than expected by Edison at San Dimas and Antamina (both silver streams), offset by weaker performances at Sudbury, Constancia and WPM’s other gold streams (partially on account of another quarter of lower grades at Minto owing to rescheduled mine sequencing as part of an extended mine plan). Antamina too experienced lower grades (albeit in line with expectations, given pit sequencing), while Salobo and Penasquito experienced higher grades, in mitigation of planned shutdowns. Finally, extended unscheduled maintenance at the Coleman mine since November 2017 resulted in lower throughput at Sudbury, although Vale reports that the mine has been returned to production since April.

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 86% complete (vs 62% at the end of FY17 and 40% at the end of Q317). The carbon pre-flotation component of the project, in particular, is reported to have commenced wet commissioning during April and the balance of the project is still expected to commence commissioning three months ahead of schedule, in Q418.

On 12 January, First Majestic (FR, C$9.25) announced that it was to buy Primero Mining (the operator of the San Dimas mine in Mexico, over which WPM holds a silver purchase agreement). As a part of the terms of the (friendly) takeover, WPM agreed to terminate the existing silver purchase agreement (SPA) and then to enter into a precious metals purchase agreement (PMPA) with the new operator on the following terms:

Under the First Majestic PMPA, San Dimas is expected to contribute, on average, approximately 40-50koz of gold production (equivalent to 2.80-3.15Moz Ag at an Au:Ag ratio of 70:1) annually to WPM over the next five years (company estimate). In addition to the new stream, First Majestic will also issue to WPM 20.9m FR common shares with a value at the time of writing of C$193.5m (US$151.5m, or US$0.34/share). In addition, at the time of closing, WPM agreed to release the guarantee previously provided by Goldcorp under the existing SPA in consideration of a payment of US$10m from the latter and also to extinguish the US$0.50/oz penalty for each ounce less than 215Moz delivered by 2031.

Pursuant to its announcement in January, on 10 May, First Majestic announced that it had closed the acquisition of Primero and hence we have adjusted our forecasts for Q218 on this basis (cf an assumption that the transaction would close on 31 March previously).

In our note, Majestic, published in February 2018, we calculated a net present value of the cash flows to WPM from San Dimas for the period FY18–33 of US$252.9m at our long-term precious metals prices and customary 10% discount rate for mining companies (or US$346.9m at a 5% discount rate to reflect the lower risk attached to streaming cash flows compared to mining cash flows). This compares with a carrying value of the San Dimas stream of US$132.9m as at 31 March 2018 and, in conjunction with the FR shares to be issued to WPM under the terms of the transaction, suggests an exceptional profit for WPM in the order of US$271.5–365.5m (US$0.61–0.83 per share), pre-tax in Q218. Note, however that, owing to their exceptionality, these gains are excluded from our forecasts in Exhibits 6 and 10.

As per Hudbay’s news release, dated 26 March 2018, although negotiations to secure surface rights over Pampacancha continue to progress and it has been granted access to the land to carry out early-works activities, it anticipates that mining of this high-grade satellite deposit will now commence in 2019 (being a one-year delay cf prior expectations), in which case WPM will be entitled to an increased portion of gold from Hudbay. In 2019, the net value of the increased portion of gold is estimated to be US$7.0m to Wheaton (ie equivalent to c 7,609oz of gold at current prices).

WPM is continuing to forecast non-stock general and administrative expenses in the range of US$34–36m for the full year, ie c US$8.5–9.0m per quarter, including all employee-related expenses, charitable contributions and additional legal costs relating to WPM’s dispute with the Canadian Revenue Agency (CRA). Investors should note that our financial forecasts in Exhibits 6 and 10 exclude stock-based compensation costs.

After demonstrating the traditional ‘flush through’ effect at the end of Q417, sales of silver and gold reverted to close to their long-term trends in Q118, with a 14.6% under-sale of silver (cf a long-term average of 10.5%) and a 12.2% under-sale of gold (cf a long-term average of 9.2%) relative to production.

As at 31 March, payable ounces attributable to WPM produced but not yet delivered amounted to 4.8Moz silver and 84,400oz gold (cf 4.5Moz silver and 79,500oz gold reported in December). This ‘inventory’ equates to 2.48 months and 2.88 months of forecast FY18 silver and gold production, respectively (cf 1.89 months and 2.68 months in Q417), or 2.69 months on a silver-equivalent basis (cf 2.31 months as at end-December) and compares with WPM’s target level of two months of annualised production for silver, and two to three months for gold.

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 (under certain circumstances) be considered to be a consequence of metallurgical recoveries in the plant.

WPM has maintained its production guidance of 22.5Moz of silver and 355,000oz of gold for FY18, which compares with our updated FY18 forecasts as follows:

Note that the principal reason for the change in our forecasts (apart from incorporating Q1 actual numbers) is the updated assumption that San Dimas will contribute another half quarter’s worth of silver production from 1 April to 10 May (after contributing an ahead-of-expectation 1.6Moz Ag in Q118), before the new precious metals’ purchase agreement with First Majestic comes into force, which will convert San Dimas into a gold stream for WPM (hence there will only be 2.5 quarters’ worth of gold contribution from San Dimas, cf three quarters’ worth assumed previously).

Over the next five years, including FY18, management continues to estimate average annual production of approximately 25Moz of silver and 370,000oz of gold (cf 28.5Moz of silver and 355,000oz of gold in FY17 – the difference being substantially accounted for by the First Majestic takeover of Primero and the termination of the existing San Dimas silver purchase agreement in favour of a new precious metals purchase agreement). This compares with our current expectations, which are, on average, 6.6% more conservative than guidance vs 7.2% previously (simple average):

In the immediate future, 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 ahead of schedule in CY18 and grades improve once again with mine sequencing. From Q418 onwards, 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. At the same time, mining at Constancia will start at the Pampacancha pit in FY19, which hosts significantly higher gold grades than those mined hitherto and of which WPM will now be entitled to an increased portion.

WPM is a pure precious metals streaming company. As such, it is interested in gold, silver and platinum potential streams. 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 silver per year cf WPM’s production of 28.5Moz Ag in FY17). Inevitably, WPM’s investible universe would 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, with 6–8 potential deals that could close within the next 12 months, each with a value in the US$100–600m range.

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

The other major source of organic production growth for WPM is Salobo (which accounted for 77% of WPM’s gold division’s output in Q118). The operator, Vale, is studying expansion scenarios and is deploying four drill rigs to test the deposit at depth. Given the open-ended nature of the deposit and depending on the work that Vale does and the decision that it makes, any expansion could add as much as 100% to gold output attributable to WPM from Salobo per year – albeit at the cost of an additional payment from WPM. Mill throughput at the Salobo mine was reported to be running at 98% of its 24Mtpa nameplate capacity in Q118. If throughput capacity is expanded within a predetermined period and depending on the grade of material processed, WPM will be required to make an additional payment to Vale regarding its 75% gold 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.

In the event that Salobo were to be expanded from 24Mtpa to 36Mtpa by the addition of a further 12Mtpa processing line by 1 January 2023, for example – 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 c US$0.11 per share from the date of the expansion.

We have honed our silver price for FY18 to US$16.63/oz in Q2, followed by US$16.67/oz thereafter, to reflect recent movements in the spot market. Our gold price forecast remains unchanged at US$1,320/oz for the remainder of the year.

In the aftermath of these changes, our updated basic EPS forecast for FY18 remains unchanged, at US$0.63/sh, cf an average consensus estimate (source: Bloomberg, 14 May) of 61c within a range of 53–66c (cf a consensus of 61.8c, within a range of 49–77c, in March). Broken down by quarter, our estimates are as follows:

Note that, as a result of the conversion of the San Dimas stream from a silver one to (effectively) a gold one, we expect WPM to become a majority gold streaming company from Q218 onwards on an annual basis (albeit there will inevitably be some quarterly fluctuations depending on the balance of production, sales, etc).

In the meantime, our FY19 EPS forecast (see Exhibit 10) has been made on the basis of assumed precious metals prices of US$22.21/oz Ag and US$1,263/oz Au (see our report, Mining overview, Unlocking the price to NPV discount, published in November 2017) – as much to demonstrate WPM’s operational gearing to a normalisation of the gold:silver ratio from its current, (almost) unprecedented, level of 79.1x:

On 25 April, WPM made a strategic investment of US$1.0m by participating in a private placement undertaken by Tradewind, a financial technology company that uses blockchain to streamline digital gold trading. Tradewind has built a technology platform for digitising the trading, settlement and ownership of precious metals. Its platform combines exchange technology with Vaultchain™ Gold (Tradewind’s blockchain technology tailored for precious metals), which can be applied to WPM’s trading arm.

WPM has an early deposit agreement with the Kutcho Copper Corporation (formerly Desert Star, market cap C$23.9m) whereby it will advance to US$65m in instalments (upon achieving a predetermined set of milestones) in return for the right to purchase 100% of the silver and gold production from the Kutcho project in British Columbia at 20% of the spot price of the metals over the life of the mine. In the meantime, on 14 December, WPM acquired 6,153,846 shares and half-warrants in Kutcho for a total consideration of C$4m (US$3m) to give it a 12.88% equity stake in the company. Additionally, it advanced Kutcho US$16m (C$20m) in exchange for a subordinated secured convertible term debt loan agreement receivable, bearing interest at a rate of 10% pa (NB which was responsible for the unrealised US$1.8m fair value loss included in US$2.8m of ‘Other expenses’ in Exhibit 1).

Excluding FY04 (part-year), WPM’s shares have historically traded on a contemporary average P/E multiple of 27.6x current year basic underlying EPS, ie excluding impairments (cf 34.8x Edison or 36.0x Bloomberg consensus FY18e, currently – see Exhibit 9).

Applying this multiple to our EPS forecast of US$1.27 in FY20 (cf US$1.28 previously as a result of a recent increase in the US dollar LIBOR rate and therefore the rate of interest that we apply to WPM’s net debt) implies a potential share value for WPM shares of US$35.07, or C$44.78 (cf US$35.13, or C$45.93 previously) in that year (excluding the US$0.34/share value of its equity interest in First Majestic).

In the meantime, from a relative perspective, it is notable that WPM is cheaper than its royalty/streaming ‘peers’ in 100% (24 out of 24) of the valuation measures used in Exhibit 9 and on multiples that are cheaper than the miners themselves in 40% (36 out of 90) of the same valuation measures, despite being associated with materially less operational and cost risk (as WPM’s costs over time are contractually predetermined).

As at 31 March 2018, WPM had US$115.6m in cash (before a dividend of US$39.9m payable on or about 7 June) and US$663.0m 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$547.4m overall, after US$125.3m (US$0.28/share) of cash inflows from operating activities during the quarter. Relative to the company’s Q1 balance sheet equity of US$4,925.5m, this level of net debt equated to a financial gearing (net debt/equity) ratio of 12.7% and a leverage (net debt/[net debt+equity]) ratio of 10.0%. It also compares with a net debt position of US$671.5m as at 31 December 2017, and is consistent with WPM continuing to sustainably generate c US$100–150m per quarter from operating activities before financing and investing activities. Otherwise, assuming the operational performance set out in Exhibit 6, we estimate that WPM’s net debt position will have declined organically, to US$366.3m by the end of FY18 (equating to gearing of 7.3% and leverage of 6.8%), and that WPM will be net-debt-free late in FY19, all other things being equal and contingent on its making no further major acquisitions (which is unlikely, in our view). 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 regarding 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 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).

In 2017, 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 be interpreted not 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 9).

In the meantime, WPM remains in 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. If a ‘principled’ settlement cannot be reached, however, the Tax Court of Canada has now scheduled the trial for mid-September 2019 for a two-month period.