Silver Wheaton (SLW) is set to declare its first-quarter results May 10. Companies in the precious metals and mining sector are under intense scrutiny right now given the steep fall in gold and silver prices this year. Although Silver Wheaton is not a mining company, its business model makes it very vulnerable to volatility in the prices of precious metals. The price of silver in the first quarter was much lower on a year-over-year and sequential basis. This is likely to have a significant negative impact on its year-over-year and sequential revenue figures.
Silver Wheaton links its dividend payment to cash generated by operating activities in the previous quarter. Low silver prices imply lower cash flows and hence lower dividends, which may be putting further pressure on the company's share price. However, Silver Wheaton's share price has been tumbling not just due to falling silver prices, but also some bad news from Barrick Gold (ABX).
Work on Barrick's Pascua Lama mine has been suspended following a Chilean court order. At the very least, this is likely to delay the commencement of production from this mine beyond the anticipated date. If Silver Wheaton chooses to terminate the contract with Barrick over a failure to meet its commitments, it will have a negative impact on its expected silver stream quantity by 2017.
Silver Wheaton signs long-term purchase agreements with mining companies (typically gold and copper mining companies) that produce silver as a byproduct. The company has the right to purchase all or a portion of the silver production at a low fixed price for an upfront payment pursuant to any agreement. This gives it an edge over conventional mining companies as it does not incur any operational losses in volatile market conditions. Moreover, since the company does not own any of the mines, it does not incur any operational and capital costs associated with production. However, Silver Wheaton doesn't hedge itself against silver price movements, which leaves it vulnerable to significant adverse price movements.
Low Silver Prices Will Impact Results
While the prices of gold and silver showed a gradual decline in the first three months of the year, April was extraordinary for the precious metals market. The prices of gold and silver plunged dramatically. This phenomenon cannot be explained by a single event, but rather a combination of events occurring in tandem. Broadly, the primary factors driving prices downward are believed to be the Federal Reserve Bank's monetary policy, European economic woes, inflation data, and the slowing Chinese economy. In a previous article, we explained these factors and their impact on gold prices and mining companies. Silver prices show a high positive correlation with gold prices, even though silver has many more industrial applications than gold.
There are conflicting opinions in the market over whether the commodity super cycle has come to an end. In either case, the price outlook for most commodities is bearish for the foreseeable future.
Impact From the Pascua Lama Ruling
Silver Wheaton entered into a silver purchase agreement with Barrick in September 2009 to acquire 25% of the life-of-mine silver production from Pascua Lama. Under the agreement, Barrick provided a completion guarantee that requires it to complete work at Pascua Lama to at least 75% of design capacity by Dec. 31, 2015. If there is a production shortfall at Pascua Lama in 2014 and 2015, Silver Wheaton is entitled to compensatory silver production from Barrick’s Lagunas Norte, Pierina, and Veladero mines until Barrick satisfies the completion guarantee. If Barrick does not satisfy the guarantee, Silver Wheaton has the option of terminating the agreement. In such a case, Silver Wheaton would be returned $625 million, the upfront cash consideration it has paid to Barrick. The amount payable to Silver Wheaton will be adjusted for silver delivered to it up to the date the contract is cancelled.
A court in Chile has ordered work suspension on the Chilean side of the Pascua Lama mine, which straddles Argentina as well. Even if the project is not terminated, there may be a significant time delay before production commences. According to some analysts, production is unlikely to commence until late 2015, and this will have a significant impact on Silver Wheaton's projected silver stream by 2015.
In light of recent market conditions and the Pascua Lama ruling, we are interested in knowing if Silver Wheaton's management still has the appetite for more deals. As late as March, CEO Randy Smallwood had expressed readiness to close more deals in 2013 at the right valuation. We think that any more deals in 2013 will encounter a negative reaction from shareholders. We have a price estimate for the company of $38, which will be revised after the earnings results.
Disclosure: No positions.