Has Gold Streaming Weakened Silver Wheaton?
Gold and silver prices rebounded since the beginning of this year, posting a gain of around 9% and 11% respectively. In response to this gain, Silver Wheaton's (SLW) stock price appreciated by almost 21% year-to-date. Silver Wheaton enters into purchase agreements with mining companies that produce gold or silver as by-products. Silver Wheaton pays the mining company an upfront amount in return for a fixed percentage of the miner's future production. Apart from that, Silver Wheaton also makes a delivery payment when the metal is delivered. This delivery payment is made at a fixed price that is much lower than the market price. The mining company uses the upfront payment provided by Silver Wheaton to fund capital expenditures. However, Silver Wheaton isn't required to pay any ongoing capex or exploration costs at the mine. Hence, Silver Wheaton's cost structure is more stable than that of mining companies since Silver Wheaton only incurs one-time upfront payments and fixed delivery payments.
Source: Company presentation
Silver Wheaton generates majority of its revenue from silver streaming. However, the company increased its exposure to gold in 2013 by entering into a gold purchase agreement with Vale S.A. (VALE). As a result of this gold purchase agreement, Silver Wheaton's dependence on silver has reduced. In the first nine months of 2013, the company generated 77% of its revenue through silver sales compared to 90% in 2012. Under the agreement, Silver Wheaton will receive 25% of the Salobo mine's gold production throughout its life and 70% of the Sudbury mines' gold production for a 20-year period. In addition to the upfront payment of $1.9 billion, Silver Wheaton will make ongoing payments to Vale for every ounce of gold delivered. These payments will be less than $400 per gold ounce or the prevailing market price per gold ounce.
The company expects to receive 60,000 ounces of gold per year throughout the Salobo mine's life, and the Salobo open pit mine is expected to have a life span of 29 years. Silver Wheaton will receive approximately 50,000 ounces of gold from the Sudbury mines for the next 20 years. The company's share of proven and probable gold reserves at the Salobo and Sudbury mines is over 4 million ounces. This will help Silver Wheaton generate substantial cash flows in the coming years, but it signed the gold purchase agreement when gold prices were hovering around $1,600 per ounce levels. Understandably, the decline in gold prices might affect the value of the agreement negatively. Below is an approximate calculation of what would be the cost of gold that Silver Wheaton will receive from the Salobo and Sudbury mines over the agreement period.
Attributable gold production- Salobo mine (60,000 ounces per year for 29 years) | 1.74 million ounces |
Attributable gold production- Sudbury mine (50,000 ounces per year for 20 years) | 1 million ounces |
Expected gold production over the agreement | 2.74 million ounces |
Ongoing payment ($400 per ounce of gold) | $1,096 million |
Upfront payment | $1,900 million |
Total payment | $2,996 million |
Implied cost per ounce of gold | $1,093 |
Note:
The above calculation is approximate and is based on the company's expectations of gold production from the Salobo and Sudbury mines. It doesn't include the annual inflation adjustment of 1% that will be paid on the Salobo mine's production beginning in 2016.
The implied cost of gold from the Vale agreement is below gold's current price levels. Assuming an average realized gold price of $1,300 per ounce, Silver Wheaton will generate close to $3.56 billion in revenue over the period of this agreement. However, if gold prices remain subdued, the company's profit margins could be under pressure in the coming years.
Is gold streaming shrinking the company's profit margins?
Historically, Silver Wheaton posted impressive profit margins mainly due to its low-cost silver purchase agreements. However, the company's decision to increase its exposure to gold streaming at a time when gold prices declined has affected the company's profit margins.
Parameter | 2011 | 2012 | Q1 2013 | Q2 2013 | Q3 2013 |
Contribution of gold sales to total revenue | 4.0% | 9.2% | 13.5% | 28.7% | 27.7% |
Company's net profit margin | 75.3% | 68.9% | 64.8% | 42.6% | 46.3% |
The contribution of gold sales to the company's total revenue has consistently increased over the past three years. However, the company's profit margins declined considerably during this period. Even though the Vale agreement provided some degree of diversification to Silver Wheaton, the direct relation between the increase in gold's contribution to total revenue and the fall in profit margins can't be ignored. Below, I have compared the company's cash margin for both silver and gold in the last three quarters.
Silver ($ per ounce) | Q1 2013 | Q2 2013 | Q3 2013 |
Average cash costs | 4.08 | 4.14 | 4.13 |
Average realized price | 29.89 | 23.12 | 21.22 |
Cash margin | 86.3% | 82.1% | 80.5% |
Despite the price of silver dropping 36% in 2013, Silver Wheaton posted impressive cash margins for its silver streaming business. The company has consistently posted a cash margin above 80% in the last three quarters. However, the company reported a lower cash margin for its gold streaming business as compared with silver.
Gold ($ per ounce) | Q1 2013 | Q2 2013 | Q3 2013 |
Average cash costs | 362 | 391 | 386 |
Average realized price | 1,645 | 1,417 | 1,308 |
Cash margin | 78.0% | 72.4% | 70.5% |
Conclusion
Considering gold's current price level, Silver Wheaton ended up paying a higher amount for the gold purchase agreement. However, the company still generates around 77% of its revenue from silver streaming. The company's low-cost silver purchase agreements will ensure profit margins don't drop significantly. Silver Wheaton's margins will improve if and when gold prices increase.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: Fusion Research is a team of equity analysts. This article was written by Madhu Dube, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article
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