Seeking Alpha
Long/short equity, special situations, event-driven, growth
Profile| Send Message|
( followers)  

With gold and silver producers facing the heat of declining precious-metal prices, Silver Wheaton's (NYSE:SLW) metal-streaming business offers an alternative investment opportunity. The company makes an upfront payment to its partner mining company, which in turn provides a percentage of its metal production at a price much lower than the market price for an agreed time period.

The upfront payment provided by Silver Wheaton offers better financial flexibility to mining companies as they can fund their capital expenditures, or capex, without raising additional debt or offering equity. In November, Silver Wheaton modified its agreement with HudBay Minerals (NYSE:HBM), wherein, Silver Wheaton will provide HudBay with $135 million in total for 50% of gold produced from the Constancia project during the life of mine. This gold-purchase agreement is in addition to the existing agreement in which Silver Wheaton will receive 100% silver produced during the life of the HudBay 777 and Constancia mines.

HudBay will deliver gold to Silver Wheaton at a price of $400 per ounce or the prevailing market price, whichever is lower, subject to an inflationary adjustment of 1% beginning in the fourth year. The payment of $135 million will help HudBay develop the Constancia project without raising interest-bearing or dilutive capital. However, HudBay is entitled to the upfront payment only after it incurs $1.35 billion in capex on the Constancia project. Silver Wheaton expects an attributable annual gold production of 35,000 ounces in the first five years from the Constancia project. After the initial five years, the company expects 18,000 ounces in annual gold production over the life of mine. The life of mine is expected to be 16 years, and full production is anticipated to begin in the second quarter of 2015.

Constancia project's gold cash flows

Assuming Silver Wheaton makes the upfront payment in 2014 as the company's production forecasts, Silver Wheaton's cash flows for expected life of Constancia mine, keeping the average realized gold price of $1200 per ounce as constant, are estimated below. These cash flows are discounted at the rate of 7%, which is the mid-point of the standard 6% to 8% for precious-metal projects.

Year

Gold

production

(in ounces)

Cash outflow

(in $ million)

Cash inflow

(in $ million)

Net cash flow

(in $ million)

Present value factor

Discounted

net cash flow

Cumulative discounted net cash flow

1

Nil

135

Nil

(135)

0.9346

(126.17)

(126.17)

2

35000

14

42

28

0.8734

24.45

(101.72)

3

35000

14

42

28

0.8163

22.85

(78.87)

4

35000

14

42

28

0.7629

21.36

(57.51)

5

35000

14.14

42

27.86

0.713

19.86

(37.65)

6

35000

14.28

42

27.72

0.6663

18.47

(19.18)

7

18000

7.42

21.6

14.18

0.6227

8.83

(10.35)

8

18000

7.49

21.6

14.11

0.582

8.25

(2.1)

9

18000

7.57

21.6

14.03

0.5439

7.63

5.53

10

18000

7.64

21.6

13.96

0.5083

7.10

12.63

11

18000

7.72

21.6

13.88

0.4751

6.59

19.22

12

18000

7.8

21.6

13.8

0.444

6.12

25.34

13

18000

7.87

21.6

13.73

0.415

5.7

31.04

14

18000

7.95

21.6

13.65

0.3878

5.3

36.34

15

18000

8.03

21.6

13.57

0.3624

4.92

41.26

16

18000

8.11

21.6

13.49

0.3387

4.57

45.83

17

18000

8.2

21.6

13.4

0.3166

4.24

50.07

The above project's internal rate of return, or IRR, is 14%, and the net present value, or NPV, is $50 million at an assumed discount rate of 7%. However, with further exploration Silver Wheaton's share of gold production may increase in the future. Also, gold prices will not remain constant at $1,200 per ounce. Even though the above calculations are based solely on company forecasts and assumptions, it gives an idea of how the company benefits from its purchase agreements.

After making an upfront payment, Silver Wheaton does not incur any capex on project development and exploration activities. Once the project's production begins, the company receives a percent of production that it is entitled to, at a much lower price than the market price. The company then sells the precious metals at prevailing prices, which provide regular cash flows. The company uses these cash flows to fund higher NPV projects that increase its overall value. As a result, the company has posted impressive financial results in the past, and I expect its good performance to continue in the future.

Financial history: An added advantage

Silver Wheaton operates at attractive profitability largely due to lower operating costs. Moreover, the company operates through its Cayman Islands subsidiary, Silver Wheaton Caymans, and is therefore not required to pay taxes. As a result, the company has posted impressive profit margins.

Year

2010

2011

2012

9M 2013

Net profit margin

68%

75%

69%

52%

The company's profitability has been affected this year, primarily due to depressed metal prices. However, it posted a net profit margin above 50%. Further, the company's investment in various projects helped grow revenue at a compounded annual growth rate, or CAGR, of 50% from 2008 to 2012. The cash-flow history, too, has been impressive as operating cash flows have grown at a CAGR of 59% from $111 million in 2008 to $719 million in 2012.

Earlier this year, Silver Wheaton's $1.9 billion gold agreement with Vale (NYSE:VALE) increased the company's total debt from $22 million in 2012 to $1.14 billion at the end of second quarter of 2013. However, the company reduced its debt by $143 million in the third quarter, bringing it down to $1.04 billion. With new projects added to Silver Wheaton's portfolio, I expect the company to generate substantial cash flows, helping it to reduce debt and function with increased financial flexibility.

Conclusion

Silver Wheaton's metal-streaming business provides a better investment compared to that for metal miners. The company's definite agreements with metal companies help generate stable cash flows, which in turn can be used to enter into profitable projects. I recommend buying this stock.

Source: Silver Wheaton: A Better Option Than Metal Miners?