Friday, February 26, 2010

This Silver Stock Set to Soar in 2010

We haven’t taken a gander at any silver stocks in a while now, but the metal’s price is still holding up pretty well after a nice move of 50% or so from the summer lows, and the “poor man’s gold” is getting plenty of attention as an inflation hedge, an industrial metal, and a possible basis for some hypothetical commodity-backed currency in the future.

So this is the most recent silver stock teaser to jump through the Gumshoe hoops — it’s from the StreetAuthority folks, one of their “top ten” stocks for 2010 …

“Our Top Silver Stock for 2010 Is Cashing In On Soaring Demand

“This unique stock gained +122% last year and is set to soar AGAIN in 2010…”

And they have a bit more basic info at the top of the tease:

“Profit Catalysts:

“Spurred by inflation worries and increased industrial usage, silver demand is soaring (with silver prices following suit)

“New purchasing deals will give this company millions of ounces of silver at a rock-bottom cost of only $4 an ounce — about 75% cheaper than what everyone else pays for silver

“This company’s unique business model lets the firm reap all the benefits of appreciating silver but without the costs of digging and maintaining its own mines”

OK … so we’re taking it a bit easy on a chilly and quiet Tuesday here at Stock Gumshoe Headquarters — but we can start with a basic rule for your teaser deciphering convenience: when the newsletters tease you about a unique silver stock, it’s almost always Silver Wheaton (SLW)

And yes, today is no different. Silver Wheaton does match the clues they provide, it’s in the “silver streaming” business (and is almost alone in that business), has an operating margin of 42%, projected earnings per share growth of 12%, was recently priced at $16, and went up more than 122% last year. As of December 16th it was up almost exactly 122% from the January 2 close, so perhaps that’s close enough, though for the full year SLW stock was actually up something like 128%, unless I’m doing my math wrong. Still, pretty close.

When they go into some of the details, though, it’s clear that we needn’t have any qualms about the slight variations from the teaser numbers — there’s only one Silver Wheaton. Here’s what they say about it:

“As the world’s largest silver streaming company, the firm buys future silver production from gold miners for relatively fixed prices, often below $4 an ounce. These deals are a win-win for both parties: The mine owners get upfront cash for what they consider to be a byproduct, while our favorite silver company gets mounds of silver without having to shell out a penny for mine exploration or maintenance.

“Management recently locked up an agreement that will hand over 25% of whatever silver is dug up from Goldcorp’s Penasquito mine in Mexico. That deal alone is expected to yield 7.2 million ounces of silver annually for the next 22 years. The firm has 16 other agreements in place that will generate as much as 40 million ounces by 2013.

“That increased production could send sales soaring +135% within the next four years without any increase in silver prices. Keep in mind, the company has minimal future capital expenditures, so any incremental sales growth will be converted into earnings.

“In a recent quarter, sales of just 4.3 million ounces resulted in a record-shattering cash flow of $45 million, a +70% year-over-year increase. The combination of new deals and buoyant silver will send that total soaring over the next couple years.”

And yes, that’s all Silver Wheaton — in the most recent quarter it was actually 4.6 million ounces of silver equivalent sales, netting operating cash flow of $45.4 million, but close enough, and it was roughly a 70% increase year over year (though less than a 30% increase per share — Silver Wheaton issued a lot of new shares in 2009).

Silver Wheaton is one of a small class of companies who are essentially cash investors in mining projects at all stages and who receive some sort of royalty for their investment. Firms like Royal Gold, Franco-Nevada, and International Royalty are a little bit different in that they’re more strictly royalty investors, typically buying into a mining project for a set royalty based on the cash brought in from gold (or whatever else) sales.

One often used type of this investment relationship is the net smelter return royalty, for example, whereby the royalty owner gets a set percentage of the net proceeds from the “smelter” — which really means, in effect, that they get a specific percentage of the gross sales of whatever the mineral is from whatever the site is. That means they don’t have to worry about mining costs, or about anything else other than the gross output of the mine (the confusing use of the word “net” in net smelter return means the net output of the refining process, which is effectively the gross economic output of the mine).

But Silver Wheaton is a little different than the typical royalty investors — and they don’t call themselves a royalty firm, though the effect and the stock market valuation tend to be similar. They call themselves a silver “streaming” company … here’s how they describe that:

“The company has entered into seventeen agreements where, in exchange for an upfront payment, it has the right to purchase all or a portion of the silver production, at a low fixed cost, from high-quality mines located in politically stable regions. Forecast 2009 production is 16 million ounces of silver and 17,000 ounces of gold, for total production of 17 million silver equivalent ounces. By 2013, annual production is anticipated to more than double to approximately 39 million ounces of silver and 20,000 ounces of gold, for total production of approximately 40 million silver equivalent ounces. No ongoing capital expenditures are required to generate this growth and Silver Wheaton does not sell forward its silver sales.”

So instead of investing in a mine in exchange for a royalty payment, Silver Wheaton essentially buys a call option on all (or part) of a mine’s silver output — sometimes that silver is available because the miner is focused on gold and is willing to take the chance of offloading the silver in exchange for an upfront payment, or because the miner wants to hedge against possible silver price collapse, or just because they need the money and SLW is ready to offer it. This means that SLW has a slightly different calculation to make — they have to make sure that the mine will produce enough silver to make it worthwhile, and that silver stays above their break-even price (the price they offer to the miner, currently averaged at about $4 an ounce, plus the pro-rated share of whatever they paid up front for the silver rights). So they tend to focus on large projects run by big miners, which should offer some stability.

Silver Wheaton is, of course, far from undiscovered — it’s a big company, with a market cap of almost $6 billion, and it is almost unique, so it occupies its own little niche that pretty much all commodity and precious metals investors know about. It’s also well-covered in the investing press, particularly by the newsletters, and it has long been a favorite of a few of the authors at the Motley Fool (here’s one bullish article). I also own some call options on Silver Wheaton and I’ve mentioned it many times in this space, though I don’t own the shares right now.

Silver Wheaton is likely to become the largest effective silver miner in the world, as soon as that big Penasquito production comes online, and they do it without getting their hands dirty, and with a fair degree of diversification — this might do them some good in the competition against other silver investments, particularly if South American political developments end up making investors nervous about some of the other very big silver producers like Pan American Silver (Peru exposure) or Apex or Couer d’Alene (Bolivia).

That said, this is basically a financial company, so figuring out the value relies on using the same inputs you would use if you were the one buying those silver contracts — how much silver are they going to be buying (ie, will production match the expectations at the mines where they’re “streaming” the silver), how much of a profit margin will they get above that fixed buy price (meaning, what will the spot price of silver be at the time — they don’t hedge), will they continue to make effective investments with their silver income (they’re rolling all that money into new silver streaming deals, they don’t pay a dividend).

So you have to make your own assumptions about silver prices and investor sentiment to decide how much the stock should be worth — this is neither an earnings nor a dividend play at the moment, though they are profitable and relatively inexpensive (their forward PE is about 20, lower than the other large royalty-type companies and than some of the big silver miners, but higher than Pan American Silver or Coeur d’Alene). Silver Wheaton doesn’t carry any debt to speak of, but that’s typical of the big names in this space.

Investors seem to be buying Silver Wheaton largely because they think it will be a good way to get a bit of leverage on higher silver prices with SLW’s significantly increasing silver “output” over the next several years (largely from expected Penasquito production), and without the risks inherent in relying on just one or two mines in politically unstable areas or worrying about spiking oil costs cutting into margins (they pay a fixed price for the silver regardless of mining costs). More aggressive silver investors may well find that SilverCorp Metals (SVM, big low-cost Chinese miner), Pan American Silver (PAAS), Silver Standard Resources (SSRI), or Coeur d’Alene (CDE) and the other silver-focused miners have more home run potential in a silver bull run, or that one of the scores of really junior miners could boom with a new discovery, but when I’m worried about my blood pressure SLW is usually the silver stock I look to first.

I know we’ve got a lot of silver “bugs” out there in Gumshoedom — is Silver Wheaton still among your favorites, or do you prefer something else in the sector? Let us know with a comment below. And the Street Authority gang were kind enough to tease their other top ten investments for the year in a recent ad, too, so if you’re interested in finding out about the other nine just let me know and I’ll try to follow up (I just glanced quickly at the clues, can’t be sure yet but the list probably includes BHP Billiton, Hospira, National CineMedia, and a few ETFs).

Full disclosure: As I noted above, I do own call options on SLW (I also own some silver bullion and coins), but I don’t currently own any other silver miners or other stocks mentioned in this article, though I have invested in several of them in the past. I own shares of Altius Minerals, which is a significant owner of International Royalty and is in agreement to sell their ROY shares to Royal Gold. I will not trade in any name mentioned here for at least three days.


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