Despite the U.S. Federal Reserve printing $85 billion a month and even more egregious printing in Japan, the carnage in the precious metals sector continues unabated. Shares made new lows last week, including royalty plays and former darlings Silver Wheaton (SLW), Royal Gold (RGLD) and Sandstorm (SAND).
The bullish precious metal investor ought to have a core position in the royalty and streaming companies. The fantastic business model typically sees only a modest return on initial investments. As the years advance, however, the royalty (and especially streaming) companies take increasingly higher economics from the projects.
The royalty and streaming company's benefit from:
- Avoidance of capital spending overruns
- No maintenance capital spending
- Operating cost certainty
- Upside from mine life expansions
- Leverage to the metal price
Silver Wheaton operates as a streaming company. The company has 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. Silver Wheaton is the largest royalty and streaming company.
Only eleven weeks ago shares had fallen to a new low at $28 and the suggestion was made Silver Wheaton Shares Could Face Distress. Last month management took the short term financing issue off the table. Even though Silver Wheaton is the premier precious metal play, investors have more reasons for concern as the share price is now near $20.
The valuation of Silver Wheaton using a $20 silver price deck is quite rich. If an investor supposes a production run rate of 33.5 million ounces, cash costs of $4.50 an ounce and overhead of $40 million plus interest expense, then annualized free cash flow would be $450 million. With a market cap of $7.25 billion and enterprise value (market cap plus debt) of $8.3 billion, Silver Wheaton trades higher than an 18x multiple.
Silver Wheaton's debt of $1.06 billion is over twice the cash flow. With the dividend consuming 20% of cash flow and capital commitments of $480 million, debt looks to be a permanent fixture on the balance sheet. Conservative investor modify valuations when debt is present to account for the financial risk, and Silver Wheaton shares may need to trade at a discount going forward.
The debt also limits the company's ability for additional transactions. In the past, new deals have acted as a catalyst for the share price. Expect little activity in the years ahead. Instead, the audit by the Canadian Tax Authority lingers on.
For 2013, management expects production of 33.5 million silver ounce equivalents with growth to about 53 million by 2017. Unfortunately, mining is a difficult business. Silver Wheaton operating partners have a long history of falling short of production expectations in a rising price market. With silver (SLV) and gold (GLD) prices weak among other metals, investors can assume production will fall significantly short of expectations. That's the nature of the business.
With the price of silver at $20, a $5 change will move cash flow by 33%. The leverage goes both ways. At present, Silver Wheaton cannot afford another move down in the silver price. Silver Wheaton shares are high risk and represent the silver price on steroids.