Gold May Glitter; But Silver Wheaton Is About To Shine

Gold and silver prices have experienced a brutal bear market over the last two years and, while the prices of the actual metals have suffered mightily, the shares of businesses that actually perform the hard work of removing them from the ground have been decimated. In many cases, the myriad of risks involved in digging up dirt and then performing the processes required to extract the mineral content was so expensive that the lower metal prices placed the production costs of some of these companies higher than the value of the metal they produced. In many ways, the cost of producing the metal and the prices available for it in the market are completely beyond the control of the mine operator. This variability can create a very tenuous environment for investors.

However, not all businesses involved in the gold and silver industry are the same and the emotional reaction of investors to falling prices destroyed the value of excellent businesses right along with those that would not be able to survive. I love to see panic and heavy selling that is driven by panic and emotion, that is where extraordinary opportunities are born. A business that can eliminate most of the unknowns from the mining business can present that type of exceptional potential as conditions improve. I believe that is the situation that exists today in shares of Silver Wheaton (SLW, Financial).

What Makes Silver Wheaton Different?

Silver Wheaton is not your average mining business. They do not drill holes in the ground looking for mineral deposits. They do not dig holes to extract minerals from the earth. They do not even run the plants that extract the minerals from the dirt that has been extracted from the ground. No, this business is something much more special than that.

Silver Wheaton is what is referred to in the industry as a royalty streaming business. They provide needed cash to project exploration and development companies or junior miners that allow them to conduct their business and develop projects in process in exchange for the right to purchase a percentage or specified amount of the minerals extracted from an eventual mine on a property at very heavily discounted prices. In some cases they might even receive shares or options for shares in the company to whom they provide the financing.

Silver Wheaton currently owns royalty streams on mineral production from 15 operating mines and 5 projects that are still in the developmental stages. The mineral interests attributable to Silver Wheaton from these projects are summarized in the table below.

Keep in mind that the numbers in this table reflect only the amount of metal upon which Silver Wheaton has a direct claim. Also remember that “measured and indicated” resources are a much lower probability for existence than the proven and probable classes and should be assessed as such in any attempt to value the business of Silver Wheaton.

Regardless of the ultimate cost of extracting these minerals from the ground and refining them into the final metal, due to its royalty agreements with the various owners of the deposits that make up these reserves, Silver Wheaton will buy their share of the gold and silver produced at an average price of $4/oz. and the gold will cost an average of $400/oz. Even after a two-year bear market in gold and silver, Silver Wheaton is still poised to be enormously profitable because of the way they acquire the metal they will eventually own. If no value is assigned to the measured and indicated reserves and the silver and gold is priced at today’s depressed values ($20/oz. for the silver and $1,300/oz. for the gold) the net value of the metal owned by Silver Wheaton is $19.107 billion dollars and they are required to perform virtually no work to get the cash!

No Work To Get Paid? Seriously?

Silver Wheaton completed its “work” on the 19 operating mines and 5 development projects when it provided funding in exchange for a generous allocation of the future production from the mines involved. This is a business with $706.5 million in 2013 revenue and only 30 employees. Those 30 employees also generated $375.5 million in net income during the year. These numbers are nothing short of astonishing. When considering these rather remarkable results, please remain mindful of the fact that silver prices hit their lowest level in years during 2013 and many industry participants ceased operations. Silver Wheaton did not have a record year, but a $375 million profit in a horrible bear market for your product is truly something of which management can be proud.

For 2014, Silver Wheaton is expected to receive metal equal to 36 million ounces of silver. Even if prices only average $20/ounce for the year, the results for 2014 should be approximately the same as they were for 2013. However, by 2018, Silver Wheaton is expected to be entitled to metal equivalent to 48 million ounces of silver, so revenues would rise 50% from the current level even if the price of silver and gold remain at the current levels and I do not believe that will happen.

What Will Be The Catalyst To Drive The Price Higher?

The price of Silver Wheaton was driven to the bargain basement level simply because it was lumped in with the mining sector, even though it is truly a different business model. As investors begin to figure out that Silver Wheaton is a different animal with an exceptionally low cost for their silver and gold purchases, buyers for the stock will return.

Since the company pays fixed prices that are already in place for its metal, if the prices of gold and silver begin to rise, each additional dollar of price increase in the metal goes straight to the bottom line of Silver Wheaton. This results from the fact that the conduct of their core business is processing the sale of the ounces of metals they receive. A higher price for the metal does not result in any additional cost under this business model.

Furthermore, China has been quietly working with its major trading partners to begin conducting international trade in their own currencies rather than using U.S. dollars. They have also been working quite diligently to divest their currency reserves held in U.S. dollars by going around the world buying land and natural resources and paying for the transactions in U.S. dollars. If the U.S. dollar begins to lose its status as the world’s reserve currency, it will dramatically weaken the demand for the U.S. currency and a weaken of demand will result in declining value. This scenario could cause gold and silver prices to soar as the world begins to search for a new safe haven of value. Throughout recorded history, gold and silver have served as a medium of exchange in the trading of goods and services. If the U.S. dollar loses that status, it is reasonable to surmise that a large segment of the population would seek safety in those metals.

A seldom discussed aspect of silver prices is the historic relationship to the price of gold. Throughout most of history, and ounce of gold has been valued at between 20 and 30 ounces of silver. During the recent past, that ratio has been fluctuating between 50 and 70 ounces of silver to an ounce of gold.

I am a firm believer that all things eventually return to their historic norm. After all, that is why something is referred to as the “norm”. It means the normal condition or proportion. The current deviation from the norm in favor of gold creates, in my view, the probability that silver will outperform gold over time going forward as the price ration between the two metals returns to a more normal range relative to the historic relationship.

Where Is The Risk In This Stock?

The largest potential risk for Silver Wheaton would be for the prices of gold and silver to fall even further than they already have. Even though they have a fixed cost for the metal they are entitled to receive from the mines where they have a royalty interest, each dollar in the decrease of the market price for the metal is a dollar Silver Wheaton does not receive for selling it in the open market. If the price were to fall low enough, it is also possible that some of the mines from which the company receives royalties would cease to operate and the company could lose that income stream.

I perceive this as a relatively small risk compared to the prospects for higher silver and gold prices. I believe that the time will come when the world faces the fact that they have loaned money to the United States that can never be repaid without creating a hyper-inflationary event where the debt is simply printed into oblivion through the printing of almost worthless paper currency notes. I do not know when this might occur, but I have little doubt as to IF it will occur.

Final Conclusions And Actionable Analysis

Silver Wheaton’s share price has been punished to some extent because of the drop in silver and gold prices over the past two and a half years. But, I believe the drop in its share price also reflects a misunderstanding on the part of investors as to how insulated this business model is from many of the most severe risks normally associated with the mining industry. This misguided perception will fade as Silver Wheaton continues to produce exceptional operating results and the share price will rise as revenues and profits continue to increase.

I see three attractive ways to approach a new position in Silver Wheaton at this time. One or more of these approaches should fit just about any investment style imaginable. I always enjoy having choices in the way I approach a new position.

Those investors who like a more passive buy and hold approach and are more interested in long-term appreciation rather than short-term gains can simply buy these shares and hold them for the next four years. A total return of 50% to 100% would, in my estimation be a fair expectation even if the price of silver and gold remain unchanged. Should the price of those metal rise, this stock could easily double in the next 12 months.

For investors like me, who simply enjoy getting a discount on everything, selling the $24 strike price July 19, 2014 expiration put options for a premium of $0.40/share gives the seller the opportunity to be assigned the shares at $24 should they be trading below that level on July 19, 2014 when the options expire. The $24 strike price of the options represents a 3.4% discount to the current market price of $24.85/share and the $0.40 premium for selling the options represents an immediate return of 1.67% on the total capital that would be required to buy the shares if they are assigned. The premium received produces an annualize return on capital of 21.77%.

Those investors who like to generate guaranteed income with the potential for short-term gains can approach opening a new position using the buy/write technique where shares are purchased and corresponding call options are sold simultaneously. The most attractive setup I see for this approach would be to buy the shares at the current market price of $24.85/share and sell one $26 strike price call option with a July 19, 2014 expiration for each 100 shares purchased for a premium of $0.37/share. This produces an immediate return of 1.49% on the capital required to purchase the shares and offers the potential for an additional 4.63% should Silver Wheaton be trading above $26/share at the expiration date. If the shares are not assigned to the option buyer at expiration, the $0.37/share premium will have produced an annualized return of 19.42% on the capital allocated to the trade. If the stock is trading above $36 at expiration, the shares will be called away for a total profit of $1.15/share capital gain plus the $0.37/share premium received for selling the options. The $1.52/share gain against the $24.85 purchase price will have produced a 6.12% return over the 28-day life of the trade for an annualized rate of return equal to 79.78%.

Everything that glitters is not gold; it might just be Silver Wheaton about to shine.