The carnage in the precious metal sector has accelerated. The safe haven is supposed to be the royalty and streaming companies, including Franco-Nevada (NYSE:FNV), Royal Gold (NASDAQ:RGLD) and Silver Wheaton (NYSE:SLW).
Silver Wheaton operates a simple and fantastic business model as a streaming company. The company has many agreements which, in exchange for an upfront payment, it has the right to purchase silver and gold production from 19 operating mines and four development projects. Benefits of the business model include:
- Avoidance of capital spending overruns
- No maintenance capital spending
- Operating cost certainty
- Growth already purchased
- Upside from mine life expansions
- Revenue turning into true free cash flow
- Leverage to the price of silver
With Silver Wheaton a premier precious metal play, the title of this essay may appear outrageous. Silver Wheaton investors, unfortunately, have seen this movie before. In the financial crisis of 2008, shares traded under $3 per share for a short time. The company was caught borrowing short against long-term assets. When the silver price collapsed to single digits, Silver Wheaton was only two quarters away from breaking debt covenants and declaring bankruptcy. Both debt and equity markets were closed to the company.
Silver Wheaton has again borrowed short and lent long.
CEO Randy Smallwood characterizes the stream acquisition environment as "exciting." However, the large stream purchase from February assumes higher gold prices in the net present value calculation. Further, the largest deal in company history was financed with bank debt. When Silver Wheaton announced the Vale (NYSE:VALE) deal, I immediately sold my shares.
The debt structure consists of a 5-year $1 billion revolver and $1.5 billion 1-year bridge loan. Post the Vale transaction, $1.09 billion is outstanding on the bridge loan. At this time Silver Wheaton is not facing undo risk.
If two events occur, however, Silver Wheaton shares would quickly become distressed. The first event would be significant further stream acquisitions, something management clearly states the intent to accomplish. The second event would be a meaningful fall in the price of silver.
Silver Wheaton intends to "quickly repay the drawn debt facilities entered into for the Vale transaction." The ability to do so is dependent upon a robust silver price, and the price has been falling.
Additionally, Silver Wheaton disclosed in 2012 that the Canadian Revenue Agency (the Canadian version of the IRS) is auditing the company's 2005-10 international earnings. While I expect the event to not be material, resolution still has not occurred and unfavorable headlines promoted by bears are possible.
Leverage cuts both ways. Investors are well aware that Silver Wheaton is leveraged to the silver price. Unfortunately, Silver Wheaton is now financially levered as well. Certainly this means the valuation must be lower. While the stability of the company is not in immediate danger, investors need to know the risk is real. Be sure the sharks are watching again.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.