Description

Disclaimer: This writeup represents my personal opinions only. Do your own due diligence to verify or discredit my work.

For the sake of timeliness, I’m only hitting the key points of my short SLW thesis and assume the reader can gain a basic understanding of the company and its fundamentals via their filings/website/sell-side research. Definitely read Casper719’s VIC writeup back in December 2008. I realize SLW has pulled back already but I still believe the name has some structural issues.

Investment Thesis Summary:

I believe Silver Wheaton (SLW-US, $10.5 bln market cap) is a short because, notwithstanding its great royalty-like structure (i.e. paying US$4/oz for silver and selling it at spot), the market is grossly overvaluing SLW based on misguided assumptions about:

1) SLW being able to operate income tax free forever,

2) SLW’s “franchise” value associated with being to find bigger and bigger accretive deals, and

3) as a result of reasons 1 and 2, SLW should trade at a significant premium to Net Asset Value (NAV).

In other words, these, in my opinion, misguided assumptions actually compound the magnitude of error inherent in the market's assesment of SLW's intrinsic value.

I have followed this company for 3-4 years and admit this company has a great business model in the mining space whereby it has high margins, strong FCF and no capex requirements – cashflows are basically: spot silver price less US$4/oz less G&A. However, over time this has almost become a ponzi scheme. That may be too strong of an opinion, but SLW began trading at a huge premium to NAV, and because of this premium, it could make many accretive acquisitions. And because of its offshore tax free structure (to be explained in detail below), it had to make acquisitions to grow, as repatriation of capital to Canada would trigger the payment taxes. This circular argument for higher valuation and continued growth should have to end at some point but I needed to wait for a catalyst as shorts based only on valuation only rarely work (i.e. those who shorted Netflix "early"). I originally thought that when growth slowed, and SLW could not pay a dividend (because that would trigger tax upon repatriation), that would be the catalyst for the market to rerate SLW downward. However, I was wrong as SLW initiated dividends after a tax treaty between the Cayman Islands and Canada allowed the repatriation of certain “surplus income” on a tax-free basis. This seemingly positive development could be SLW’s downfall as the treaty does not seem to make SLW exempt from Canada’s Income Tax Act anti-avoidance rules, in my view. I think, as a result, SLW attracted the attention of the Canada Revenue Agency (CRA, the equivalent of the IRS in the U.S.) and is now facing a tax audit, as disclosed in their latest annual report. Finally, an analyst apparently highlighted this risk recently (a newsletter type analyst as opposed to sell-side). Long story short (no pun intended), I think SLW’s NAV is more like $22, with another $1+ or more downside in back taxes/penalties if applicable. Realistically < $20 if one is less aggressive with the expected silver growth profile. Further, the deterioration of P/NAV multiples in the precious metals space (see gold producers) is probably another tailwind for this short recommendation.

Description and History:

Silver Wheaton is a silver streaming company. Similar to a royalty, a silver stream gives SLW the right to buy a certain amount of silver from a mine at a fixed price (mostly at US$4/oz, and SLW sells it at spot for say US$31.50/oz). In return for this arrangement, the mining company selling the stream receives an upfront payment from SLW which is typically used to fund the development of the mine to begin with. In other words, this arrangement is a form of innovative financing for mining companies, selling most of the NPV of your silver production in return for having funds to proceed with capex. The structure also allows SLW to participate in the silver production growth of a mine without the capex associated with it, as SLW is entitled to a percentage of a mine’s silver production (so long as the economics of the mine does not become poor enough for it to shut, hence no entitled production). Further, SLW exploited the apparent financial arbitrage between the P/NAV multiples the market previously gave to precious metal companies (1-3x NAV) compared to base metal companies (0.5-1.5x NAV). This gave an incentive for base metal producers trading at say 1x NAV to sell off a silver stream to SLW, when it could pay say 2x NAV for the silver production. Strictly my opinion and based on scuttlebutt, my understanding is SLW was initially an internal project of Goldcorp. With an innovative offshore setup, Goldcorp could have believed that it could reduce its near-term tax bill by setting up this structure for its own operations, and perhaps use the money to fund capex over time, and eventually have to pay tax on repatriated funds to Canada. However, with the expected P/NAV premium in a publicly traded vehicle, a rising silver price environment and the potential to grow as a result, SLW was spun off in 2004. “Entitled” silver production grew from 1.5 mln oz in 2004, to 27 mln oz today. Given its inherent relationship with Goldcorp, SLW had several marquee silver streams such as Penasquito, San Dimas, and Los Filos. As it gained critical mass, it also bought a silver stream from Barrick’s Pascua Lama project, which helps SLW have a favourable growth profile.

Why SLW Growth has to Slow:

SLW’s historical growth has been impressive given its existing silver streams with its related entity Goldcorp and additional streams acquired as a result of SLW’s growing P/NAV premium. Investors pay premiums to NAV, from a fundamental perspective, usually because of management’s ability to do accretive deals that are not yet apparent in its income statement/balance sheet. While SLW benefited from both P/NAV multiple expansion and a rising silver price environment, I contend it is increasingly difficult to find sizeable projects and acquire them at a cheap price. On P/NAV multiples generally, the precious metals space no longer commands a big premium to NAV multiple it used to command and that should at least be somewhat of a headwind for SLW.

The reasons for the multiple deterioration in the precious metals space likely has to do with:

1) increasing difficulty of miners bringing on metal production (cost inflation, lower grades, geopolitical challenges),

2) the popularity of precious metal ETFs, and

3) the significant run in gold and silver prices in the context of the past 3 to 5 years (mid-cycle or peak prices should not attract above average multiples).

SLW will have trouble doing accretive M&A deals as SLW already has streams on 3 of the 4 largest silver deposits in the world (see SLW’s latest investor presentation page 47). Given the rise in silver price, my guess is SLW would have to really pay up to get silver streams at US$4/oz. Further, from my own understanding of the remaining deposits listed in the presentation, SLW is unlikely to get silver streams with them (or at a reasonable price). For example:

1) Mt Isa – Xstrata is busy dealing with the proposed Glencore/Xstrata merger first and foremost. Second, Glencore’s own trading/financial engineering capabilities can unlock its silver production value if it needs to do so

2) Antamina – Teck Resources has a stake in this primarily copper mine. Teck themselves have an entity called Teck Gold that has the objective of crystallizing value from its precious metal resources it views as non-core

3) Grasberg – Freeport McMoran’s flagship mine represents some government royalty risk to SLW to begin with (see recent Indonesian government demands). Also, being a mega cap name in the mining space, FCX itself already has the capability of securing financing at favourable terms without SLW.

4) Fresnillo – This is Fresnilo plc’s mine. They are a primary silver producer. Silver producers would not stream their main product unless they have significant operating challenges/issues. SLW has typically gained silver streams from gold and base metal producers, not silver. Perhaps with the exception of Navidad from Pan American Silver. But that project is not permitted due to a ban on cyanide use and open pit mining in the Chubut province of Argentina (this is a risk to SLW expected growth in the future as well).

Another hint of growth slowing would be SLW’s need to make equity investments in junior mining names. Presumably, SLW has to take on more risk by injecting equity capital in speculative names in the hopes of securing silver streams later on in the future (again see investor presentation).

Tax Situation:

I am not a tax expert so I can only relay the information/opinion/scuttle I got from tax people, accounting people, companies I talk to. First off, I understand most of SLW’s income stream is in the Cayman Islands which has a 0% corporate income tax rate. In spirit, SLW’s structure is probably similar to Canadian private equity that invests in the US. I spoke with a private equity shop in Canada and they employ a structure where they establish a subsidiary in an offshore island and invest in US private equity deals. Any gains they make can be kept offshore tax free (and they have some loss carryforwards as well). They have been reinvesting that capital in the US to generate more gains, etc. From my conversation with them, they acknowledge clearly they will be taxable when they eventually repatriate that capital to Canada but will only do so when they run out of (or see a significant slow down in) ideas to generate a return on their US capital. Along with an implied holdco discount, that may be why some private equity-like asset managers in Canada trade at a discount to NAV (that is another story). Back to SLW, with this Cayman tax structure, I understand so long as no income/dividend is repatriated, SLW can remain “tax free” for the time being. Once you send income/dividend back, you have to start paying taxes. My original guess was that the market would demand SLW to make more accretive M&A deals and start paying a dividend, and when they could not, the market would realize this huge tax liability that nobody has accounted for yet (see sell-side research assumptions).

However, a recent June 2010 tax treaty between Canada and the Caymans seemingly allows the tax free payment of offshore dividends to Canada on “surplus income” or “exempt income”. Not too surprisingly, SLW as a result initiated its first dividend 1Q11. This is beyond my expertise but it seems to me that this dividend repatriation would alert the tax authorities potentially because:

Read these first:

http://www.conyersdill.com/publication-files/153_10_06_30_Canada_Signs_TIEA_with_Cayman.pdf

http://www.compasscayman.com/cfr/2012/01/11/Canada-TIEA-establishes-a-new-era-for-Cayman-captives/

1) SLW’s income is not likely “surplus income” possibly because it did not pay any taxes in the jurisdiction where the mine is located. For example, Goldcorp is paying ~25% tax on its silver income (from the exact same mine) in Mexico. If Goldcorp, through an offshore entity, then repatriated the dividend as “surplus income” then it could be Canadian tax free. *This is my non-professional interpretation only, chat with a tax specialist yourself*

2) SLW still likely trips the Canadian Income Tax act anti-avoidance rules. There are general anti avoidance rules (GAAR) in Canada which basically states that if the spirit of the transactions/structures is to avoid taxes only, then the CRA can tax you on that income. It would seem to be SLW’s offshore structure is done solely to avoid taxes as there are no silver mines or operations in the Caymans.

See Section 245 of the Canada Income tax Act: http://laws-lois.justice.gc.ca/eng/acts/I-3.3/page-391.html#docCont

See recent ruling on GAAR: http://business.financialpost.com/2011/12/16/supreme-court-of-canada-upholds-use-of-general-anti-avoidance-rule-against-li-familys-copthorne-holdings-unit/

Now all the tax discussion above is fairly theoretical, hence I could not recommend the short until there is a catalyst or evidence of the discussion being somewhat correct. However, with SLW’s latest annual report, I think the probabilities have shifted dramatically to suggest SLW’s 0% income tax assumption is unreasonable in anybody’s NAV calculation.

 In SLW’s 2011 Annual Report recently published, under “contingencies” on page 24 it states:

"Due to the size, complexity and nature of the Company’s operations, various legal and tax matters are outstanding from time to time, including an audit by the Canada Revenue Agency of the Company’s international transactions covering the 2005 to 2010 taxation years. By their nature, contingencies will only be resolved when one or more future events occur or fail to occur."

Also, on page 77, SLW shows that they would otherwise be paying a 26.5% corporate tax rate or $148 million in 201. With 356 mln diluted shares outstanding, that’s $0.41 per share. Since 2005, SLW cumulatively had $1.04 bln in pretax profits or a theoretical $276 mln tax bill. With interest (since CRA charges interest on unpaid taxes for at least 5% per annum), that’s over $300 mln or $0.85 per share, assuming no penalties. The biggest problem, however, is the market’s assumption SLW will never be taxed and a 26.5% rate would be a detrimental hit to its NAV and its subsequent ability to make accretive acquisitions.

Sell Side Might be Complacent:

The sell side is generally very constructive on SLW because it is a good story, and SLW issues shares to do acquisitions. Low “cost” of production, no capex, participation in upside (% of output), dividend payout, etc. While I agree with these points, I think the valuation and growth assumptions have been taken too far. Without naming the brokerages but I know one analyst has a ~$50 target based on a $30 per share NAV using US$50/oz near-term silver, 0% tax rate and 5% discount rate (since its “safe”). Another analyst has a ~$50 target, using a $25 NAV, US$30/oz silver assumption, 0% tax rate and a 3% discount rate. All of them already accounting for management guidance of 60-70% production growth by 2016. (from 27 mln oz to 43 mln oz per year)

Mgmt Scuttle:

In management meetings with investors, they never seem to directly address the growth and tax risks I highlighted, other than reminding investors their historical performance and great silver-streaming model. Indirectly, though, I hear their former CFO may have had concerns about this ballooning potential tax liability that could hit the company one day – this CFO has since started the sandstorm gold and sandstorm base metals + energy streaming vehicles.

My NAV

I get an NAV of $22 assuming production does grow to 42 mln ozs by 2015 (aggressive already). To avoid debates over the silver price (this short generally doesn't require geotechnical expertise or predicting silver prices), I assume spot silver prices forever (US$31.50/oz) and an 8% discount rate, and a 1X P/NAV multiple. While you may argue my discount rate is high, I would contend that silver producers currently have a similar implied discount rate (or you can say they’re trading at a meaningful discount to NAV, or both). For instance, my numbers on Pan American Silver (PAAS-US) is a $40 NAV and currently at a 50% discount to NAV (8% discount, US$31.50/oz silver). Now Pan American Silver has cost inflation issues and negative sentiment around its recent M&A deal. Interesting, the market is attributing no value to its Navidad project because of regulatory hurdles on PAA's NAV. At the same time, it is fully priced in for SLW (its silver stream on Navidad) to get to the 43 mln oz production number in 5 years. Realistically, delaying or eliminating the contribution from 2 future projects Navidad and Rosement, my NAV would be < $20.

Multiples

I favour NAV since it’s essentially an asset level DCF that better captures changes in production etc. But for those inclined, my 2012E tax free EPS is $1.90 and 2016E tax free EPS is $2.73. Assuming no income tax, SLW trades at 16x 2012 P/E and 11x 2016 P/E. Assuming 26.5% tax rate, the multiples become 21.4x 2012 P/E and 15x 2016 P/E. An oversimplified way of looking at this is it would take until 2016 before SLW trades at a market multiple of 15x P/E, if it ever had to pay tax. Even then, past 2016, there is an expected production dropoff by 2018 to 38 mln oz or less (as some mines deplete) - hence a market multiple then would be generous.

Risks

The biggest risk is obviously significant upside in the silver price (and perhaps one could hedge that out). The second biggest risk is that I have the tax situation wrong. But fundamentally, I believe even the market being aware of this risk will create a negative domino effect. Lower P/NAV multiple = harder to pursue M&A. That alone should make the market wake up to the fact that historical growth most likely cannot be duplicated simply because the biggest silver streams are either accounted for, or not for sale, and even if they are for sale, they won’t come “cheap” relative to SLW’s own valuation (i.e. hard to be accretive). Third risk is production upside to SLW’s silver streams. Sometimes, a miner’s exploration efforts and operational efficiencies enable a mine to produce more silver than anticipated, which would enhance SLW’s production profile – however, my $22 NAV already gives them full credit to get to 43 mln oz by 2016.

Catalyst

Market becoming aware of CRA tax audit and the unreasonable 0% income tax rate forever assumed.

Market becoming aware of difficulty in sustaining growth required to justify SLW's premium to NAV.