Silver Selling for $1 per Ounce

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While the excruciating losses on Wall Street may require some adaptation, we Fools can't change who we are as investors. When fundamentals fly out the window and valuations become temporarily moot, the only thing an instinctive value-hound can do is dig even deeper for the most disjointed and infallible values out there.

Let's dig where digging's the thing.

Even within a sea of drowning value stocks, Silver Wheaton (NYSE: SLW) stands out like a lighthouse. Thanks to its unique, fixed-cost business model, a dive into these numbers is a lot more fun than the math-wary Fool might think.

As both Agnico-Eagle Mines (NYSE: AEM) and Coeur d'Alene Mines (NYSE: CDE) can attest, transforming a mine from prospect to producer is often a messy process involving unanticipated delays and cost overruns. Silver Wheaton, meanwhile, has pre-paid $1.22 billion to acquire its portfolio of silver streams, and will enjoy an essentially fixed cash cost of $3.90 per ounce for the life of those purchase agreements.

On the strength of core assets like Goldcorp's (NYSE: GG) Luismin and Penasquito mines, Silver Wheaton's total share of silver assets in the ground amounts to:

• 382.3 million ounces of proven and probable reserves (highest certainty).
• 230.4 million ounces of measured and indicated resource (reasonable certainty).
• 447.5 million ounces of inferred resource (lowest certainty).

$1 per ounce of silver?
In a perfect world, we could declare that all 1.06 billion of those silver ounces will find their way out of the ground, and determine that the company's $1.07 billion enterprise value indicates a rough market value of $1 per ounce of silver. That's some bargain all right, but those inferred resources are just preliminary estimates that must be verified through exploration before we can rely upon their accuracy.

The most conservative approach would have us count only the proven and probable reserves, as I did in this comparative analysis of gold miners like Yamana Gold (NYSE: AUY) and Newmont Mining (NYSE: NEM). Employing that formula, Silver Wheaton sports an alluring enterprise-to-reserves ratio of 0.28.

For this company, though, where six silver streams are already delivering silver and two more are expected by year's end, I believe the extremely high ratio of producing assets to development-stage assets makes the use of the first two categories combined a reasonably conservative basis for valuation calculations. For our purposes, then, we'll assume that over the long haul Silver Wheaton will acquire at least 613 million ounces of silver.

On that basis, we can calculate the company's fixed all-in cost of production as $5.89 per ounce. By contrast, major competitor Pan American Silver (Nasdaq: PAAS) reported an all-in cost of $9.53 for the third quarter, which is unnerving, considering that silver ended yesterday just above $10 per ounce. While I remain steadfast in my assertion that silver prices will rebound sharply before long, the added buffer for Silver Wheaton is a welcome moat during deep price corrections like the one we're experiencing now.

Speaking of deep corrections, Silver Wheaton shares have fallen an incredible 86% from their March high of $19.54, to close at $2.82 yesterday. With 251.5 million shares outstanding, long-term value investors can think of each Silver Wheaton share as roughly equivalent to 2.44 ounces of silver in the ground. It turns out investors really are paying just over $1 per ounce of silver in the ground.

Fun with the 2009 outlook and beyond
Silver Wheaton has targeted silver production of about 16 million ounces for 2009. With the production cost fixed at $3.90, cash flow from operations in 2009 would be roughly $98 million at $10 per ounce of silver. If silver stages a recovery to an average of $15 for 2009, the company will rake in about $178 million, or more than one-half the company's entire long-term debt of $351 million.

Judging by the forward P/E ratio of 10.7, it looks like analysts are anticipating silver prices of about $9 per ounce. Hogwash! I view $15 silver as far more likely, which would yield a forward P/E of about 4.9. If silver were to recapture the $20 mark and remain there or higher, then Fools could be picking up one sweet bargain at about 3.4 times forward earnings. No matter how you slice it, I believe the real story is a long-term saga of higher silver prices, making the notion of 2.44 ounces of silver per share the Foolish takeaway on the fundamental value of Silver Wheaton shares.

Further Foolishness:

• Gold mining has been no easier.
• Silver Wheaton had a rough summer.
• All metal miners are in the doghouse.