Silver Wheaton — Update 21 October 2015

On 6 July, the Canada Revenue Agency (CRA) informed SLW that it was proposing to reassess its tax, such that C$715m (US$567m) of income in the years 2005-10 would be re-characterised as earned by the parent, rather than a foreign subsidiary, and would therefore be deemed taxable. SLW estimates that the tax associated with such a reassessment could be C$201m, equivalent to US$151m (28.2% implied marginal rate), or US$0.37/share. The CRA is also announced that it would be seeking a transfer pricing penalty of C$72m (US$54m, US$0.13/share) plus interest, which was not quantified at the time.

Silver Wheaton responded to the CRA at the time, defending its position. However, the CRA has declined to alter its stance with the result that, on 24 September, it issued notices of reassessment to SLW along the lines of its 6 July notice. It also quantified interest and ‘other penalties’ at C$81m (US$60m, US$0.15/share) to bring the total of interest, tax and penalties to C$353m (US$265m – equivalent to US$0.66/share).

Therefore, from 24 September, SLW has 90 days to file a notice of objection and to lodge an appeal with the CRA (a process which would typically last from one to two years). However, it has indicated that it is more likely that it will wait for a further 91 days after filing a notice of objection (ie approximately until the end of Q116), after which it will exercise its legal right to appeal directly to the Tax Court of Canada in order to reach a conclusion as quickly as possible via litigation. Initially, this would involve a case ‘discovery phase’, in which an assessment of the strengths and weaknesses of each side would be assessed. Typically, this phase takes six to nine months, during which a meaningful amount of cases are settled out of court. If no agreement can be reached then the case will proceed to court, likely to be approximately in early 2017.

Now that a notice of reassessment has been received, SLW is obliged to make a deposit of 50% of the disputed tax, interest and penalties (ie C$177m, US$133m, or US$0.33/share) upon filing a notice of objection. Note: any cash outlay will be accounted for as a refundable deposit.

As stated in our note of 9 July, the income the CRA is seeking to tax is earned by foreign subsidiaries from assets outside Canada. Key to the CRA’s case appears to be the assertion that services bought and contracted between SLW’s Vancouver and offshore offices were mispriced and that the profit split between the two jurisdictions was therefore distorted. Silver Wheaton is limited in what it can say publicly ahead of any legal action. However, investors should be aware of three matters relevant to this assertion:

Otherwise, it remains the case that: 1) the structure and relationship between SLW and its foreign subsidiaries is common and used by many companies both globally and within Canada; 2) any ruling against SLW could expose other multinational companies operating out of Canada to similar treatment; and 3) the CRA’s approach to the 2011-14 tax years remains unclear. In our opinion, this last point may be a risk in that the CRA may seek to similarly reassess tax during 2011-14. However, it could also be an opportunity in that its approach to these years therefore appears inconsistent compared to 2005-10.

Since the date of the CRA’s letter, a number of lawyers in the US have solicited interest among investors for a class action lawsuit on behalf of those who purchased shares of Silver Wheaton between 30 March 2011 and 6 July 2015. In broad terms, it is alleged that, during this time, SLW issued false and misleading statements to investors, failed to disclose that its financial statements contained errors concerning income tax owed from the income generated by its foreign subsidiaries, lacked adequate internal controls over its financial reporting and that, as a result, Silver Wheaton’s financial statements were false and misleading.

In our opinion, it is self-evident that the extent to which the above allegations could be true will depend upon the outcome of SLW’s litigation against the CRA. Once again, SLW is limited in what it can say publicly, other than that it believes the suits to be ‘opportunistic’ and ‘without merit’. In this respect, it is notable that SLW disclosed the fact of the CRA’s audit publicly in H112. Moreover, no class action lawsuits have been filed in Canada, but only in the US, where there are fewer and lower barriers to such actions and (often) fewer or zero initial costs. It is also notable that the class action does not appear to have garnered the support of any significant institutional shareholders, but only two small funds claiming less than US$1m in damages.

Silver Wheaton’s shares have fallen by US$3.98 since its receipt of the CRA’s original proposal letter on 6 July (the vertical line in Exhibit 1), although it is notable that the interim timespan has also coincided with a renewed period of weak precious metals prices.

However, whatever the cause, the extent of the share price decline is significantly in excess of the direct 66c per share being sought by the CRA. As such, the market, in this instance, appears to be discounting material, additional future income tax liabilities.

Since the end of the second quarter, notable announcements have been made by the operators of at least three assets with which Silver Wheaton has streaming agreements, including one revised mine plan. Summaries of these announcements are below.

The Minto deposit is spread over a series of high-grade areas interspersed with large deposits of low-grade material. The mine plan was designed for the highest-grade deposits to be mined sequentially in a series of small pits supplemented with additional ore from underground. Hitherto, the 2015 mine plan reflected the delay in receiving surface mining permits for Minto North, which contains the highest-grade open-pit reserves remaining on the property, shifting the bulk of production from Minto North into 2016. In the meantime, Minto South underground ore production, which began in late 2014, is budgeted to continue until November 2015, pausing while the mill processes Minto North ore and access is developed for the next area of underground mining. Production is expected to resume from underground in mid-2016.

However, on 5 August, Capstone announced that it had successfully received its new water use licence (WUL) for Minto, thereby completing the final stage of permitting relating to the July 2012 Phase VI pre-feasibility study (PFS) and allowing stripping at the high-grade, shallow Minto North deposit to start. Therefore, for the balance of 2015, the mill will continue to process underground and stockpiled ore, with ore from North Minto being fed into the mill from December 2015. In 2016, the mill will predominately process ore from Minto North (including a notable high-grade zone in Q216), supplemented by underground and stockpiled ore.

Despite delays surrounding the grant of a new WUL, production at Minto nevertheless continued above plan in Q2. In particular, ore from Area 118 underground continued to run significantly above model grades, while enhanced mining practices resulted in lower than expected dilution. Further unplanned production originated from the Area 2 Stage 2 pit above the water storage level, with the result that Minto is now expected to surpass its 2015 production guidance. In addition, the mine plan has been revised to allow Minto North to be mined in a staged approach to mitigate some of the WUL delay.

Penasquito achieved record gold production in Q2, with the result that output for the full year is similarly expected to be at ‘the high end’ of 2015 guidance. Output was driven by higher than expected sulphide grades and substantial mining taking place in ‘the heart of the deposit’.

Elsewhere, progress on the construction of the northern well field (NWF) has been limited owing to concerns continuing to be expressed by the local communities Remaining work has now been suspended. Goldcorp is evaluating potential mitigation strategies and contingency plans also remain in place for a fresh water supply until the NWF is fully operational.

In the meantime, the Metallurgical Enhancement Project (MEP) continues to demonstrate the potential to significantly enhance the overall economics and mine life of Penasquito. Pilot plant construction was completed in Q2 and testing started. MEP permit applications were submitted in May 2015 and the feasibility study remains on track to complete in early 2016.

On 20 August, Hellas Gold (a subsidiary of Eldorado) announced that it was to suspend all mining and development activities in Halkidiki (including the Stratoni mine) from 24 August. It added that the suspension was ‘a direct result of the revocation by Greece's Ministry of Energy of the technical studies of its projects in Halkidiki’.

However, on 5 October, Eldorado further announced that Greece's Council of State (the country's supreme court on administrative and environmental matters) has issued an injunction relief in favour of the Labour Center of Halkidiki and the labour unions representing the workers of Hellas Gold, which revokes the decisions of Greece's Ministry of Energy and Environment until it (The Council of State) issues a final ruling on the matter ‘at some point in the near future.’ As a result, Eldorado confirmed that it will immediately resume mining and construction activities in Halkidiki.

Therefore, we have adjusted our estimates to reflect approximately six weeks of lost production at Stratoni, albeit the effect is negligible – amounting to only US$1.6m, or just 0.7%, of (revised) net earnings.

A summary of our operating and financial forecasts for Silver Wheaton in Q3 and Q415 (at revised metals prices and in the light of the changes considered above) is given in the table below. In addition, investors should note that deliveries of product from both Constancia and San Dimas were disrupted in Q2 by a number of temporary factors, which have now been addressed, creating the opportunity for inventory drawdown in H2 vs H1.

Our estimate of 54c for FY15 compares to an average consensus basic EPS estimate of 53c, within the range 48-58c (excluding Edison, source: Bloomberg, 19 October 2015). Note that FY16 estimates have been similarly revised to reflect lower precious metals prices (forecast US$16.11/oz Ag and US$1,224/oz Au). In this case, our basic EPS estimate of 68c (see Exhibit 5) compares to an average consensus estimate of 61c, within the range 32-77c.

Widely considered a world-class deposit, Hudbay is currently negotiating the permitting process at Rosemont and has stated that it ‘remains committed’ to the US$1.2m development of the mine. Silver Wheaton has entered a streaming deal with Rosemont, whereby it will purchase 100% of the life-of-mine output of silver and gold at Rosemont in return for a US$230m investment (note SLW’s only material future capital commitment). Whereas this had previously been expected to begin in FY18 however, comments by Hudbay to the effect that it hopes to bring the project to ‘a construction decision’ in 2016 suggest that a more likely date for commercial production is FY19, after a two-year period of construction.

The effect of a one-year delay in the Rosemont timetable reduces our forecast of SLW’s EPS in FY19 only marginally, from US$1.68 to US$1.64.

Excluding FY04 (part year) and FY08 (during which there was an exceptional write-down), Silver Wheaton's shares have historically traded on an average P/E multiple of 25.3x current-year basic EPS (cf 25.5x currently).

Applying this multiple to our updated long-term EPS forecast of US$1.64 per share in FY19 (vs US$1.68 previously) implies a potential share value of US$41.43, or C$53.59 (cf US$42.38 or C$51.61 previously).

In the meantime, the table below shows Silver Wheaton’s current rating on a number of valuation measures relative to both a sample of its ‘peer’ royalty/streaming companies and a sample of gold miners. Using our forecasts in Exhibits 2 and 5, it is notable that Silver Wheaton trades on multiples that are cheaper than its royalty/streaming ‘peers’ in three quarters of instances considered. It also trades on multiples that are cheaper than the gold miners themselves in c 46% of instances considered, despite being associated with materially less operational and cost risks, in particular.