Silver Wheaton: The Silver Miners' Investment Banker

Jun.18.12 | About: Silver Wheaton (SLW)

Silver Wheaton Corp. (NYSE:SLW) is a unique entity in the silver mining industry. That's because while they derive all of their earnings and revenue from the sale of silver they operate zero mines and therefore have none of the overhead, currency risk or exposure to the rise and fall of energy prices that normal mining companies have.

This is simply because Silver Wheaton is not a mining company at all but rather an investment banker; filling a much needed role in the very risky business of precious metals mining. For those unfamiliar with this gem of a company a few words of review are needed. Silver Wheaton's model is very straightforward. They provide a company looking for the capital to finance the production or expansion of a primary silver mine upfront the same way a bank would. But as opposed to paying back the loan from profits, the company grants Silver Wheaton the right to buy a certain amount of the mine's production annually at a fixed price.

Bear Market Roots

Silver Wheaton is a natural outgrowth of the precious metals bull market after the 20 plus year precious metals bear market. By the time of the mid-1990's there were very few primary silver producers left as silver had become unprofitable to mine. Gold production costs were nearly as bad. The bull market in U.S. treasury bonds (NYSEARCA:TLT) and equities (NYSEARCA:SPY) that culminated in the dot com bubble and Y2K had driven precious metals mining practically extinct.

Those that did it hedged forward their production which produced a synthetic short against the rise in the price of the metals. Worse than that, the economics were so poor the only financing for new exploration that was available by the predatory Canadian banks was recourse in nature; meaning that in order to get the loan the mining company had to assume any losses the lender incurred on the project.

And since once the ink on the contract was dry the lending bank immediately took out an offsetting short against the company they just lent the money to the miners were caught between a rock and a hard place. If they didn't make money they went out of business and the bank repossessed the property. If they did find gold then once they went into production and their stock price began to rise, the short would kick in, and the bank would demand payment either in the form of equity in the company or money, which would keep investors away and the company constantly cash-strapped, production hedged forward into falling prices and the entire sector depressed, even after metal prices began to rise in 1999.

The ETF Nightmare

This underperformance by the mining industry versus the metals themselves and the creation of the two ETFs, the SPDR Gold Trust (NYSEARCA:GLD) and the iShares Silver Trust ETF (NYSEARCA:SLV) have kept retail investors interested in gold and silver away from the mining companies. Derivative losses from recourse financing are still showing up on quarterly reports around the industry 12 years after the precious metals market began.

One could make a very credible argument that the effects of this financing scheme have driven GLD and SLV to their enormous AUMs, $67 and $9 billion, respectively. Over the past 5 years the Market Vectors Gold Miners ETF (NYSEARCA:GDX) has underperformed GLD, or gold, by 6.5 times. It has underperformed SLV by only 5.1 times. Mining companies are supposed to be a derivative of the gold price, rising exponentially versus relatively fixed extraction costs versus linear rises in the underlying commodity adjusted for the price of energy.

Breaking the Bankers' Chains

But if the meteoric rise in the price of Silver is where the market is telling investors to go because of the discrepancy in returns versus the very risky miners, then Silver Wheaton should be telling investors the same thing about silver. Over that same 5 year period Silver Wheaton has outperformed silver 147% to 112%. More impressively, however, is the change since the bottom after the fall of Lehman Bros. which sparked this 3+ year leg in the secular silver bull market.

Silver Wheaton, since the fall of 2008, has returned a nearly unfathomable 667% versus silver's 192%. And they are just getting warmed up. They typically enter into a financing agreement with a miner in exchange for future production where they provide the funding for the cap-ex in return for first rights per year to a certain number of ounces of silver at an average price of $4 per ounce, which is close to the price of extraction for most high quality silver mines. The company gets financing that is not betting actively against them and the financier gets a cut of the production.

In CY 2011, Silver Wheaton produced $558.4 million in operating income on top line revenue of $730 million for a profit margin of 76.5%. The company cost less than $29 million dollars to operate. The rest of the cost is what they paid for the silver produced by their financing agreements. Their latest earnings report instituted a dividend structure equal to 20% of the previous quarter's cash flow, for a current 1.3% yield.

They currently have 16 such purchase agreements with 13 different gold mining companies including some that are life-of-mine contracts, like the 100+ year old San Dimas mine in Mexico. They have claim to nearly 800 million ounces of proven and probable reserves of silver and 220,000 ounces of gold, with about 40% again in measured and indicated. This represents a 17% increase over 2010.

Lastly implied in their FY 2011 statement is the withholding from the market of more than 4 million ounces of silver equivalent ounces held as assets. The company 'produced' 25.4 million and sold just 21.1 million ounces. Management feels that silver prices are going higher and are holding back sales to take advantage of them. Moreover, the less silver that hits the market the less there is to fuel bearish speculation through rehypothecation of brokerage customers' assets.

Not only is this company a standout investment in the precious metals industry it is a potential trading vehicle as its beta is 1.55 versus SLV's of 0.68, if one felt it necessary to trade a bonkers market like silver. As Silver Wheaton's business matures it is easy to see its model replicated and liberating the mining industry from the banks. In a way this model is more akin to sukuk, so-called Islamic bonds, which do not charge interest but rather a fixed payout versus future profits.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.