Why Silver Wheaton Can't Be Beaten

Over the past year, shares of precious-metals maven Silver Wheaton  (NYSE: SLW  )  have fallen nearly 40%. Yet at least one analyst still thinks the company's a top pick. Here's why that contrarian opinion may actually be correct.

A sterling business model
Though it's in the silver business, Silver Wheaton is not a miner, but a streamer. It opts to exercise its right to buy silver at fixed, pre-negotiated contracts from downstream silver producers and sell it to upstream buyers. Therefore, unlike mining companies, this company's business model does not include extraction at all. That means it has no costly capital outlays, delays or times-to-market. As a result, it boasts the lowest costs-per-ounce among its competitors, no matter how it's measured. 

At all-in-sustaining-cash-costs per ounce of only $9.57, it handily beats closest competitors First Majestic Silver (NYSE: AG  ) at $13.61 and Pan American Silver  (NASDAQ: PAAS  ) at $17.69 in this efficiency metric. 

Exactly a year back, Silver Wheaton's stock was trading at $40. Since then, its price has driften downward, with a much sharper fall since February to around $25. Even so, the Forbes Energy Stock Channel rates SLW as an analysts' top pick. 

The outlook for silver
To determine whether Forbes made the right call, we should first see where the underlying metal's headed. Here's what CPM Group commodity analyst Erica Rannestad said in late October:

We're seeing a slowdown in industrial demand, particularly in the electronics demand sectors . . . [and] a slowdown in growth which is a bit of a shift in that source of demand because it's been growing at a pretty strong rate over the past couple of decades. . . . The slowdown is a combination of two factors, first slowdown in economic growth which will contribute to a reduction in industrial activity . . .

Bingo! Silver is now even more of an industrial metal than a precious metal, so the state of the overall economy, particularly in consumer goods and electronics, drives the price of silver. For these and other reasons, Rannestad and CPM are "expecting a consolidation in prices through 2016."

Trading at around $23, from a high of $34 in late November 2012, the price of silver has already slumped by 33 % within 12 months. As such, Rannestad's outlook is even more of a downer. 

Despite this grim prognosis, some folks are extremely optimistic. At the annual Silver Summit on On Oct. 24 and 25, the prevailing belief seemed to be that silver was valued at $40: The conference's organizers charged "$40 per person or 1 Oz. of silver at the door"(!)

Whither Wheaton?
Given Silver Wheaton's business model, the question boils down to the contracts and options that Silver Wheaton holds with its downstream counterparties. Will stagnating -- perhaps sinking -- silver take Silver Wheaton underwater?

First, let's quickly look at some key statistics. The jaw-dropping stats for this company in a (supposedly) sickly sector include net and operating margins that exceed 60 %. Revenue per share (trailing 12 months) and diluted EPS are $2.32 and $1.41, respectively.

Those are acceptable numbers, and more importantly, the relatively narrow difference between per-share revenue and earnings reveals a company unencumbered by massive debt. Other key indicators, such as the P/E ratios, are also in the right ballpark. But take a look at this: Year over year, quarterly revenue shrank 17.1 %, and quarterly earnings dropped 49.7 %. 

We know part of the reason behind that negative growth: Silver's swoon. For the other part of the reason, turn to the quarterly income statements. Quarterly performance, both year-over-year and quarter-over-quarter, has been affected not only by declining revenue, but also by a surge in operating expenses. Those expenses rose 38.3 % sequentially and 64.4 % year over year. This is a problem.

Spiking costs are part of the game for traditional miners who explore, excavate and extract. However, with its pure streaming business model, Silver Wheaton's apparently out-of-control expenses are cause for concern, especially when the company itself says that its "unique business model ... [reduces] many of the downside risks faced by traditional mining companies." 

The ace in the hole
What about Silver Wheaton's downstream counterparty agreements? The company is sitting on proven reserves of many millions of ounces in numerous mines that are geographically hedged, plus as many probable reserves. The company provides copious data in its "Reserves and Resources" chart, which offers a different perspective on the company's assets with its counterparties, notably with Goldcorp (NYSE: GG  ) and Capstone Mining Corp. (TSX: CS  ) . The range and breadth of these assets is very impressive. 

As such, if the price of silver declines and demand drops, then where Silver Wheaton holds rights instead of obligations, it can choose to exercise its rights to buy silver only in the appropriate quantities, and only from those producers with lower costs.

For these reasons, despite CPM and Rannestad's bleak outlook for silver, Forbes's Energy Stock Channel's gung-ho outlook on Silver Wheaton is not irrational, and the two opinions are not in conflict.

Still, the company's increase in operating expense should worry investors. Silver Wheaton is set for a conference-call and webcast on 12th November to announce its third-quarter results. If operating expenses have increased again without a very good explanation, all bets are off. But if that line item is back under control, you might want to consider making a small bet on this company, given its adaptable and resilient business model.


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