Silver Wheaton — What a difference a quarter makes

For the second quarter in succession, Silver Wheaton’s results were characterised by a mixed performance at its silver division (eg better than expected production at Antamina, but worse than expected at Penasquito), but an unequivocally positive performance at its gold division, wherein all assets outperformed our expectations. In addition, whereas Q316 results were adversely affected by an under-sale of metal relative to production and a build-up of inventory, this effect was reversed in Q416 with an over-sale (especially in the gold division) and a consequent draw down in inventory to near target levels. As a result of both the outperformance in the gold division and the inventory draw-down, SLW’s financial results materially outperformed our prior estimates during the quarter, as well as exceeding our forecasts for FY16 (albeit by a smaller margin) and SLW’s own guidance at the time of its Q316 results of 30Moz and 335,000oz of silver and gold production, respectively. A summary of SLW’s Q4 results, as calculated by Edison, relative to both Q3 and Edison’s prior expectations is as follows:

Of note in the Q416 results is the decline in general & administrative expenses, which was occasioned, for the most part, by a US$3m reversal of a prior charge relating to management performance share units (PSUs).

From an operational perspective, key features of the quarter were as follows:

Sudbury’s operator, Vale, has recently completed a study on the constituent mines in an effort to improve operating margins. In essence, the conclusion of the study was to axe marginal production, with the result that recoverable gold in the 2017-2032 mine plan is now calculated to be 20% less than previously estimated and giving rise to an impairment in the value of the stream (as calculated by Silver Wheaton) of US$71m.

Silver Wheaton has provided the market with production guidance of 28Moz of silver and 340,000oz of gold for FY17. Edison’s FY17 production forecasts vary slightly compared to Silver Wheaton’s, as follows:

As in Q316, production at San Dimas in Q4 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. In response, Primero (the mine’s operator) has begun reducing the scale and complexity of the mine, including significant decreases to the workforce. However, on 15 February, unionised employees initiated strike action, which has resulted in the complete stoppage of all mining and milling activities to date.

Silver Wheaton’s guidance (above) assumes that the strike at San Dimas will last for three months (ie approximately 1.5mths in Q1 and 1.5mths in Q2). This compares with Edison’s forecast of 4.5mths. However, investors should note that Edison’s forecast should not be taken as reflecting any unique insight or proprietary knowledge about the nature and duration of workforce strikes in Mexico, so much as a device for demonstrating the effect of the strike for an entire quarter (ie Q217 in Exhibit 5) on Silver Wheaton’s earnings.

Since Primero articulated material uncertainty surrounding its ability to continue as a going concern in its Q416 results’ Management Discussion & Analysis (MD&A), its lenders have since agreed in principle to a six month extension of the maturity of its US$75m revolving credit facility (RCF), from May to November 2017, which will ultimately provide Primero with greater flexibility to replace the RCF with a longer-dated term loan. The proposed amended credit agreement would exclude financial covenants in the amended RCF during this six month period to support the San Dimas restart plan. In the meantime, Silver Wheaton is supporting Primero by guaranteeing amounts payable under the RCF to ensure the latter’s ability to meet its financial obligations and return the San Dimas mine to profitability. Primero expects the documentation formalising this extension and the guarantee to be completed imminently. Note that since Q112, San Dimas’s production attributable to Silver Wheaton has been, on average, 1,543koz silver per quarter. The carrying value of Silver Wheaton’s streaming agreement relating to San Dimas is US$140.6m.

Sudbury will transition to a single furnace in 2017. To achieve this, Vale will take one of the existing furnaces offline in H117. It will then rebuild and enlarge it, prior to returning it to operation in H217, when the remaining furnace will be powered down. In addition, subsequent to the quarter end, Vale announced that the Stobie mine (representing c 5% of Silver Wheaton’s attributable production from Sudbury) will be placed on care and maintenance later in 2017, owing to a number of factors, including declining ore grades and, more recently, seismicity issues that have restricted production below the 3,000ft (910m) level. In mitigation however, Vale has embarked on a major exploration programme at Sudbury, which is designed to expand and extend the life of the asset, and from the success of which, Silver Wheaton would be an automatic beneficiary.

SLW is forecasting non-stock general & administrative expenses in the range of US$33-35m for the full year– ie c US$8.5m per quarter – including additional legal costs relating to SLW’s dispute with the Canadian Revenue Agency. Investors should note that our financial forecasts in Exhibits 5 and 9 exclude stock-based compensation costs.

Compared to a 9.9% average historical under-sale of silver relative to production and a 10.0% historical under-sale of gold, production and sales of both silver and gold were closely aligned in Q416 – demonstrating, among other things, the traditional ‘flush through’ effect in the final quarter:

As at 31 December, payable ounces attributable to Silver Wheaton produced but not yet delivered amounted to 3.2Moz silver and 61,700oz gold (cf 3.8Moz silver and 63,300oz gold as at end-September), equating to 1.25 months and 2.1 months of annual silver and gold production, respectively (cf 1.5 months and 2.3 months of forecast FY16 production, as at end-September), or 1.6 months in aggregate (cf 1.9 months as at end-September) – slightly below SLW’s target level of two months.

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 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 metallurgical recoveries in the plant.

Over the next five years, management estimates average annual production of approximately 29Moz of silver and 340,000oz of gold. These compare with Edison’s medium-term forecasts, as follows:

In the immediate future, silver output from Penasquito attributable to Silver Wheaton is expected to recover back to its steady-state level of 7Moz as grades improve once again with mine sequencing. From 2019 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 SLW pa.

Apart from exploration success however, the other major source of organic production growth for Silver Wheaton is Salobo (which already accounts for 72% of Silver Wheaton’s gold division’s output). The operator, Vale, is in the process of 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 Silver Wheaton from Salobo per year – albeit at the cost of an additional payment from SLW. Mill throughput at the Salobo mine is currently running at 98% of its 24Mtpa nameplate capacity. If throughput capacity is expanded within a predetermined period and depending on the grade of material processed, SLW 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.

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 with SLW’s production of 30.4Moz Ag in FY16 – ie SLW estimates that it has penetrated a mere 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 four that may be of interest to Silver Wheaton in due course and regarding which it already has strong, existing counterparty relationships:

Edison’s updated basic EPS estimate for FY17 of 60c (see Exhibit 5 for revisions) compares to an average consensus estimate of 66c within a range 38-80c (cf a consensus of 91c within a range of 64-135c in December). However, it also compares with our forecast of 57c in December in the event that silver and gold prices remained at their then levels of US$16.40/oz and US$1,172/oz, respectively. Broken down by quarter, our estimates are as follows:

Edison’s financial forecasts for Q217 are notable for the fact that they assume the continuation of the strike at San Dimas for the entire quarter (vs half of the first quarter) and therefore provide investors with an indication of the financial cost of the strike to Silver Wheaton on a quarterly basis.

Edison’s financial forecasts for FY18 are also notable for the fact that our production forecasts are at or near the bottom of the range (especially for gold), as a result of which they therefore almost exclusively demonstrate Silver Wheaton’s operational gearing to (in this case) a normalisation of the silver price relative to the gold price from its current, unprecedented level:

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 26.5x current year basic EPS (cf 45.8x Edison FY17e and 30.9x FY18e – see Exhibit 8).

Applying this multiple to our long-term EPS forecast of US$1.38 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 of US$36.66, or C$49.00, in that year.

Currently, Edison makes no provision for either future expansion at Salobo or related expansion payments in its long-term forecasts. However, in the event that Salobo were to be expanded from 24Mtpa to 48Mtpa by the addition of a further two 12Mtpa processing lines by 1 January 2021 – thereby attracting the maximum incremental payment from Silver Wheaton to Vale – we estimate that it would increase our estimate of SLW’s earnings in FY20 by a material US$0.19/share. This, in turn, would increase our forecast value per share for the company to US$41.67, implying an internal rate of return to investors buying Silver Wheaton shares currently at C$27.51, equivalent to 29.2% pa in US dollar terms over four years.

In the meantime, from a relative perspective, it is notable that SLW is cheaper than its royalty/streaming ‘peers’ on at least 83% of the valuation measures used in Exhibit 8 on an individual company basis (ie in 20 out of 24 measures) and on multiples that are cheaper than the miners themselves in at least 41% of the same valuation measures (ie 37 out of 90 measures), despite being associated with materially less operational and cost risk, in particular.

As at 31 December, SLW had US$124.3m in cash and US$1,193.0m of debt outstanding under its US$2bn revolving credit facility (RCF), such that it had net debt of US$1,068.7m overall after US$175m of (US$0.40/share) of operating cash flows and a calculated US$150.8m of net cash inflows. Relative to the company’s equity, this level of net debt equates to a financial gearing (net debt/equity) ratio of 21.6% and a leverage (net debt/[net debt+equity]) ratio of 17.8%. It also compares with a net debt position of 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 SLW generating c US$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 Exhibits 5 and 9, we estimate that SLW’s net debt position will decline organically, to US$686.5m by the end of FY17 (equating to gearing of 13.5% and leverage of 11.9%), 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 by its banking covenants that:

On 27 February, the term of the revolving term loan was extended, such that it now matures on 27 February 2022.

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 to the mining industry).

Earlier this month, Silver Wheaton’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 reflects no admission or error, 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 SLW’s share price.

In the meantime, Silver Wheaton 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. This discovery process is likely to end in July 2017. Any potential settlement therefore is likely to occur shortly after the discovery process. Otherwise, however, the company has stated that it is willing to go to trial if a ‘principled’ settlement is not possible (which is likely to be towards the middle of 2018).