The Smart Silver Play: Silver Wheaton

by James Brumley | August 20, 2012 1:25 pm

There are two ways to invest in silver… the hard way, or the Silver Wheaton Corp. (NYSE:SLW[1]) way.

The hard way is taking a swing on a silver miner. Sure, it may have solid prospects, but it still has to dig the silver up and all-too-often costs greatly exceed initial estimates when getting a new mine up and running.

The Silver Wheaton way is easier, and generally speaking, more fruitful. This Canadian-based silver outfit is considered a silver ‘streaming’ name, meaning it doesn’t do any mining of its own, but rather, invests in low risk and high odds mineral mining operations in order to gain access to that mine’s by-product.

It’s not a terribly unusual role in the silver mining industry, but in terms of size, there’s no other name in the industry that holds a candle to Wheaton’s streaming operation.

More important to current or prospective investors, the growth engine is revving again.

Two weeks ago, the company signed a $750 million deal with HudBay Minerals to acquire the life of mine silver production from HudBay’s currently producing 777 Mine, located in Canada, and 100% of the life of mine silver production from its Constancia Project, located in southern Peru. It was the first deal the company has made in more than two years, though not likely the last for the foreseeable future.

CEO Randy Smallwood notes, “We think silver has reached a bottom around a base level between $25 and $30 (per ounce). We’ve seen this before. This is a cyclical business, and we expect silver prices to rise again.”

Translation: For the same reason pullback in silver prices made it a great time to ink the Hudbay deal, more deals are on the way while silver’s on the lower end of the price scale.

Smallwood isn’t looking to make more deals just for the sake of making deals, however, adding “We’re really targeting quality over quantity … We’d like to get that capital deployed over the next six to twelve months.”

That quality requirement is evident given the results from other mining operations the company’s deployed capital to.

Take the Yauliyacu (Peru) operation — a mine operated by Glencore International (LON:GLEN[2]) — as an example. Yauliyacu has been operating for well over 100 years,producing silver in a bulk concentrate that also contained lead and copper. This bulk concentrate was traditionally shipped to the nearby La Oroya smelter, but in 2009 the smelter was shut down.

Glencore continued producing the bulk concentrate for nearly a full year, but had challenges selling the bulk concentrate to other smelters, resulting in a inventory that Silver Wheaton has carried for some time now. During the second quarter of 2012, Glencore finally moved the entire bulk concentrate inventory off to another smelter, giving Silver Wheaton a very nice boost in sales for the quarter.

As it turns out though, lightning can strike twice. There are unconfirmed reports that the La Oroya smelter may be resuming operations ahead of schedule, meaning Silver Wheaton is positioned for another windfall. And, ‘positioned’ has a dual-meaning in this instance. The smelter is only about 100 miles away from the Yauliyacu mine, which should reduce inventory levels even further.

In total, Silver Wheaton has seventeen operating mines under its umbrella and four development stage projects. That count doesn’t include any deals inked following the Hudbay deal. Included in this suite of assets is Barrick Gold’s cornerstone project, Pascua Lama, which is forecast to begin production in mid-2014. Once in production, it is forecast to deliver approximately 9 million ounces of silver annually to Silver Wheaton in the first five years of operations.

So how much silver will these operations produce once they’re up and running? Following the Hudbay deal, Silver Wheaton has set a target of 48 million silver-equivalent ounces (or SEO) per year by 2016. Smallwood however has suggested that “70 million and then even 100 million is a comfortable [future] level. The silver streaming industry produces 750 million SEO per year, so 100 million for us is a tangible [forward-looking] level for us.”

For perspective, over the past six months Silver Wheaton has produced and sold more than 13 million SEO, and collected $400 million in revenue for it during a period where silver prices were lackluster. At first glance an annualized revenue rate of $800 million may not seem like much for an $11.2 billion organization. The company managed to turn $288 million of that $400 million into net income though — net margins of more than 70%.

And that’s when the attractive aspect of a silver streaming company really starts to shine. It also underscores why investors may want to mentally disconnect the presumed relationship between SLW and silver itself, including iShares Silver Trust (NYSE:SLV[3]). It is also worth noting that Silver Wheaton does all this with a very lean cost profile — administration costs are almost half that of SLV.

When asked whether or not another round of quantitative easing is needed by Silver Wheaton, Smallwood replied “It would help, but we don’t need it … our average cost for silver in Q2 was $4.06.”

The amount leaves plenty of wiggle room for other expenses, which is why margins can remain so strong even when silver prices are at relative low points. Indeed, silver prices could drop precipitously, and Silver Wheaton would remain profitable.

While Wheaton has been viewed by the media and the market as a high-growth instrument fueled by incredible net margins and rising silver prices, growth isn’t the ultimate goal here. As the company brings all of its foreseeable projects to an operational, revenue-bearing status, it will also grow its income distribution policy. Ultimately, as the company gets closer to its 100 million ounce per year production target, it will give the majority of the streaming business’ net income back to shareholders as dividends.

The company’s got the assets to keep the payouts strong for quite a while too. Smallwood adds “Currently, 25% of our projects have 20 years or more worth of mining life left. After the development of our open pit projects, almost 50% of our assets will have a mine life of 20 years or more.”

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