Silver Wheaton: A Hidden Gem

One of the most dynamic companies I have ever come across is a hidden gem. Silver Wheaton (SLW) should be a core position in everyone's portfolio for the following reasons.

The first reason is obviously valuation - I mean this is the stock market after all. It recently acquired Silverstone, increasing previous guidance of 14m/oz to 18m/oz. The company will then reach 25m oz in 2010, 29m/oz in 2011 and 33m/oz by 2012.

But isn't mining a very risky business? Yes mining does come with its share of risks, but that's the thing. Silver Wheaton does no mining. It is purely a royalty company, which is now comprised of 12 streams around the world. For those who don't know, a royalty company pays money up-front to miners in need of financing in return for a contractual percent of the future product. So yes, Silver Wheaton has been a very risky company in the past, and has come close to being unable to service its debt. But that is all in the past now - the company had $220m in debt just 6 months ago and has reduced that to just under $150m, which excludes the debt repaid so far this quarter, most likely in the neighborhood of $40-75m.

WAIT, HOW DOES THIS WORK? Well it is rather simple, and anyone capable of doing elementary math can calculate a rough estimate of operating income. Silver Wheaton pays on average $4/oz for each oz of silver produced from its streams (technically $3.93 for 2009 and subject to a maximum increase of 1% per annum). Silver, which is currently trading at $14/oz as I write this, would provide $10 of operating income per ounce. I expect silver to skyrocket over the next 3-5 years, which essentially makes SLW a pure play on this precious metal. The company has 5 people in the entire company (remember no actual mining takes place), whose combined salaries don't even make it to the financial statements due to the insignificance of that amount.

WHAT ABOUT TAXES? Though a Canadian based company, Silver Wheaton was allowed by regulators to be headquartered in the Caymans. I think we all know that means NO Income Tax! That's right, unless the tax laws change, SLW will only pay capital gains tax on investments. So putting this all together, GROSS REVENUE- INTEREST EXPENSE = NET INCOME = FREE CASH FLOW. For those unfamiliar with the meaning of the latter, free cash flow is the true measure of earnings for investors. What about net income? Well yes, net income is the true measure of earnings for the company, but in order for the business to continue operating, a significant portion of that must be reinvested into such things as inventory, plant, property, equipment, and cash (in order to ensure that viability, should the company hit hard times). SLW will likely continue to make additional purchases should the opportunity present itself, but it can continue operations for over 20 years even without doing so. It gets better - as mines develop, they often lead to additional reserves, thus either increasing annual production for SLW or an extended royalty life (depending on the conditions of the contract).

WHY SILVER? Chances are you have stumbled upon this because you believe there will be substantial Inflation in the near future. Gold and Silver have historically been inflation hedges throughout history. They are and have always been recognized as international currencies (although not recognized by the government). This has to do with the history behind them, as they have been used for over 5,000 years. Gold has been for larger purchases and silver for the small denomination every day purchases. As silver prices rise, the contracted purchase price can only increase 1% per year of the previous year’s purchase price. This means inflation is a positive because net margins increase!

IS THAT THE ONLY REASON? Not by a long shot. Silver is being used more and more in technology (Silver will play a substantial role in the future of batteries, not to mention other technological equipment) and as we all know, it is important for industrial production. The majority is mined as a byproduct from base metals (which have come to a halt due to the recession). In other words, the supply has drastically fallen without the market taking notice. A clear buy signal is flashing as there is currently more gold above ground than silver, yet the industrial demands for silver will rebound in the near future, and when they do, you'd better watch out.

Even if inflation were to be low to moderate in the future, Silver is still compelling as it is used heavily in solar panels. The “Green” craze the world seems to be in, will cause the demand to increase even if all these alternative energy theories turn out to be nothing but hogwash. But what has really caught my eye in my research is the fact the next generation of batteries, both those used for everyday electronics and the much larger ones, will contain substantially more silver than the current lithium Ion batteries.The next generation batteries currently referred to as Silver-Zinc or ZMP have many advantages over the current standard. Most importantly is the fact that they can keep their charge and maintain that amount of energy throughout the life of the battery. They last 40% longer than lithium-ion batteries and are 95% are recyclable which will garner the attention of the "green crowd". There have been talks of this battery rolling out as soon as the fall of this year. As laptops, cellphones and other semi-conductor equipment switch over the demand will increase much faster than the supply every could.

Looking at the big picture, BRIC countries in addition to the next generation of emerging countries drive the demand for silver and therefore the price for a prolonged period of time coupled with the future of silver, and its uses should send the long term price of silver to the mid-20's or higher.

So how much could it be worth? Call me crazy but I think the intrinsic value of SLW is in the range of $40-$50. No I'm not the type to make such a bold call, but those are my conservative estimates. Avoiding any dragged out calculation, let's just project 2012 profit. Assuming we experience the inflation of the late 70's (which is very conservative), silver will trade between $30-40/oz if the money supply had not changed. But to make it simple, we will assume it only increased 2- to 3-fold. 65 is a good number. So $65-$5 = $60 profit per ounce. SLW will produce approximately 32-35M oz. So $60*$30M = $1.8 billion. If the company has a current market cap of around $2.4 billion and should make at least a billion dollars (to be conservative) over the next decade, then wow! Of course I expect $65/oz to be the peak as was $50/oz in the 70’s. More important is the long term silver price, which I think will be at least $20/oz, likely in the $22-$28/oz range.

Below is a published DCF valuation using conservative inputs. It is open for editing as I published via Google docs. A 5-8% discount rate is appropriate in my opinion because it is a royalty company with a diverse portfolio of silver streams, whereas if it did actual mining, 13-18% would be appropriate.

View SLW's valuation here.

Disclosure: Long Silver Wheaton