Silver Wheaton (SLW) announced yesterday that it has entered into a binding term sheet to acquire Vale's (VALE) gold production from two mines located in Brazil and Canada. We think this deal fits well with Silver Wheaton's specialty in helping fund exploration for gold and silver and then splitting the production proceeds based on a fixed purchase price agreement.
The company will pay Vale $1.9 billion in cash, plus 10 million Silver Wheaton warrants with a strike price of $65 and a term of 10 years. Of the $1.9 billion, $1.33 billion will be paid for 25% of the gold output from the Salobo mine in Brazil and $570 million for 70% of the gold output from the Sudbury mine in Canada. In addition, Silver Wheaton will pay the lesser of $400 or market price for each ounce of gold produced, subject to a 1% inflation related adjustment after 2016 for Salobo. This deal will be valid for 20 years and production will accrue retroactively to Silver Wheaton as of Jan. 1, 2013, even as the term sheet remains subject to negotiations and approval by Vale’s board of directors.
In addition to Silver Wheaton making use of its $550 million cash reserves, the deal is being financed by Scotiabank and BMO Capital Markets. These institutions will provide Silver Wheaton with a $1 billion revolving credit facility and also a $1.5 billion bridge financing facility to facilitate upfront payments to Vale.
Business Model: Strength Is Also the Weakness
Silver Wheaton signs long-term purchase agreements with mining companies that produce silver or gold as a by-product. It provides funds for capital expenditure upfront when a project is being developed and obtains the right to buy precious metals produced at low, fixed prices. It does not pay for any ongoing capital or exploration costs at the mines. Thus, the company's costs are one-time and fixed. This greatly reduces its business risk. The silver or gold obtained at a fixed price is sold at market rates, which exposes it to the daily volatility of these metals' prices. Its gains increase when the market prices of silver and gold go up. Prices of precious metals have been generally high for some time and are expected to be so in the near future. This makes Silver Wheaton a likely winner.
However, this business model also makes it hugely dependent on gold and silver prices for earnings growth. Even a slight change in prices translates into a major variance in EBITDA, so earnings can be quite volatile.
What It Means for the Company's Business
Prior to the deal, Silver Wheaton had a cash chest of $550 million, which it was looking to deploy. The deal with Vale will add an average of 110 thousand ounces of gold per year over the next 20 years (5.9 million silver equivalent ounces). It will cause the share of gold in Silver Wheaton's revenues to rise from an average 12% to a peak value of 25% over the next five years.
Silver Wheaton now forecasts 33.5 million ounces of silver equivalent production (including 145,000 ounces of gold) in 2013. In 2017, it forecasts 53 million ounces of silver equivalent production (including 180,000 ounces of gold). You can check the impact of the new silver stream on Silver Wheaton's Trefis price estimate in the following graph and modify it using your own expectations and check the impact it will have on the company's valuation.
In our opinion, the deal fixes the price of gold at a relatively lower figure, considering the huge jump in the cost of production over the last few years. Going forward, we think it will rise further owing to higher costs associated with labor, energy, and regulatory compliance. Silver Wheaton, however, will be insulated from these owing to its fixed-price contracts.
Also given the popularity of gold as a hedge and given the belief that it will preserve its value despite volatile and unpredictable currency markets, Silver Wheaton is well positioned if the price of gold continues to rise in the coming years.
We recently revised our price estimate for the company to $38 after the latest earnings numbers.
Disclosure: No positions.