Silver Wheaton Still Looks Like A Quality Option

| About: Silver Wheaton (SLW)


Silver production wasn't fantastic in the second quarter, but Silver Wheaton's diverse portfolio and ample liquidity offer multiple avenues to long-term growth.

Silver Wheaton's low operating costs offer some protection in a weak silver market, and management will likely distribute future cash flows if it cannot find adequate new investment opportunities.

A fair value range of $26 to $28 seems reasonable for a company with Silver Wheaton's quality, but softer silver prices would definitely be a headwind to performance.

Investors have plenty of options for investing in silver, including silver miners like Fortuna Silver Mines (NYSE:FSM), Pan American Silver (NASDAQ:PAAS), and Coeur Mining (NYSE:CDE), bullion ETFs (as well as mining ETFs), physical bullion, numismatic silver, and so on. Amidst those options, I think streaming specialist Silver Wheaton (NYSE:SLW) remains a strong candidate, given its low fixed cost structure, attractive balance sheet/liquidity, and disciplined approach. Although weaker silver prices and producer missteps are both threats, weaker prices would at least potentially create more streaming opportunities to generate long-term value.

Differences That Matter

Silver Wheaton is by no means an under-covered name, but for those who are new to the story here is a brief rundown. Silver Wheaton has effectively positioned itself as a funding option for mining companies that need to raise capital to develop their mines. In exchange for an upfront payment and below-market pricing on an ongoing basis, Silver Wheaton gets a percentage of the output of the mine for an agreed upon length of time (10 years or more, and sometimes the life of the mine).

Importantly, Silver Wheaton doesn't seek out situations where silver output is the primary goal of the mine. A significant percentage of mined silver is produced as a byproduct of mining other metals (base metals like copper or zinc, precious metals like gold), and this is typically what Silver Wheaton targets. Internal rates of return on these streams do vary (generally ranging from the high single digits into the teens and sometimes higher), but they're still often a good deal for the operating partner as cost of capital for mining operations can easily exceed the mid-teens in tight times.

Silver Wheaton has no legal ownership of the mines, nor can it exercise any operating control. So while the company is basically immune to cost overruns and operating inefficiencies (to the extent that they do not impair production), they also get no upside from excellence in mining cost controls or other operating measurables. To control risk, Silver Wheaton looks for high-quality assets that are at least partly immunized from poor management ("too good to screw up") and on the better half (if not the best quartile) of the cost curve. Silver Wheaton prefers mines with longer lives and expansion potential, as well as those located in mining-friendly jurisdictions (a large percentage of the company's NAV comes from mines in Mexico).

Low Costs With Growth Potential

The second quarter wasn't a banner quarter for Silver Wheaton, as production shortfalls at the San Dimas mine played a role in a 1% yoy and 8% qoq decline in silver production and a 3%/7% decline in silver-equivalent ounces. Silver-equivalent sales rose 4% yoy and fell 8%, while realized prices (silver-equivalent) fell 14% and 3% to $19.83/oz. On a positive note, cash costs for Silver Wheaton remain quite low, falling 1%/rising 3% to $4.72/oz - a cost base that allows the company to continue to generate cash flow despite weaker silver prices.

Higher silver prices would be a boon to Silver Wheaton, but there are definitely opportunities for production/sale ounces growth. Primero Mining has announced its intention to expand the San Dimas mine from 2,500tpd to 3,000tpd and the company's threshold (the amount of silver that Silver Wheaton gets before a 50/50 split) increases to 6Moz/year, all while grades should be improving. Silver Wheaton is also leveraged to ongoing growth at Vale's (NYSE:VALE) Salobo facility, where Line #1 continues to ramp up and Line #2 recently started, as well as production growth at Sudbury. Constancia, a large Peruvian copper mine being developed by Hudbay Minerals (NYSE:HBM), is also on target for concentrate shipments to begin in 2015 and Silver Wheaton has actually double-dipped here - following an initial agreement for silver streaming with a subsequent gold streaming agreement.

Longer term, Goldcorp (NYSE:GG) is looking into options that could increase silver production at the important Pensaquito mine (which contributes around 20% of company NAV). It is also still possible that Barrick Gold (NYSE:ABX) will find a path forward with the Pascua-Lama mine, particularly after progress in negotiations with indigenous groups in Chile, but significant objections remain from environmental groups and Silver Wheaton may end up getting its money back in 2017 instead of the silver streams.

When it was all said and done, management reiterated its target for 48Moz (silver-equivalent) production in 2018, including 250Koz of gold. With annualized second quarter production of 33.5Moz Ag-equivalent, there's certainly a need for growth projects to come on line as expected, as well as for the company to pursue additional deals. Silver Wheaton has more than $1 billion in liquidity and could generate more than $350M in free cash flow in 2014 and close to $600M in 2015. I would also note that weak silver prices could possibly facilitate those growth goals - Silver Wheaton becomes more valuable as a source of funding when prices are weak, and the company has generally signed more deals when spot prices have been below long-term sell-side silver price estimates (as they are now).

Estimating The Opportunity

Silver Wheaton should have a full pipeline of potential deals, and the company's prioritization of silver relative to Franco-Nevada (NYSE:FNV) and Royal Gold (NASDAQ:RGLD) suggests less competition. I do wonder, though, if Silver Wheaton will see more competition from private equity - since royalty and streaming agreements do not require mine operating expertise, it would seem like the sort of area where private equity would get more involved.

There are also risks present in its project portfolio. Silver Wheaton doesn't get involved in day-to-day operations, but there need to be day-to-day operations for Silver Wheaton to get its streams. Mercator Minerals (OTC:MLKKF) declared bankruptcy when the Intergeo merger fell apart and Silver Wheaton may never see any silver from its Mineral Park mine. Elsewhere, the company restructured its agreement with Alexco (NYSEMKT:AXU) for the Keno Hill project, a rare move in the royalty/streaming world.

As for the value, I don't think it is any surprise that higher silver prices increase the value of Silver Wheaton shares. With long-term silver prices in the low $20s, I calculate a net asset value of about $20/share. That may not look impressive relative to today's price, but it's worth remembering that streaming/royalty companies like Silver Wheaton, Franco-Nevada, and Royal Gold routinely trade at premiums to NAV estimates (20% to 60% in the case of Silver Wheaton, or 1.2x to 1.6x NAV). Along similar lines, Silver Wheaton's current 18x 12-month EBITDA multiple may seem quite rich, but the company has little operating risk, solid diversification, and a very good growth profile (not to mention low taxes by virtue of an operating subsidiary located in the Caymans).

The Bottom Line

While I'd like to have the chance to buy Silver Wheaton at or below 1.2x my NAV estimate, I have no expectation of getting that chance unless things get really ugly in the silver market. As it is, I don't think 1.3x to 1.4x is unreasonable, and that would suggest fair value up to $28/share. As a way to play silver, then, I continue to like Silver Wheaton - it doesn't have to be kept in a vault, it's easy to buy and sell, it pays a dividend, and it has multiple avenues to reinvest its cash flow and grow for years to come.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.