By Ben Kramer-Miller, From Seeking Alpha

Disclosure: I am/we are long SLW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Summary
Silver Wheaton is down as investors are concerned that its previously untaxed off-shore income will now be taxed.

The risk today is the same as what is was previously; the perceived risk is up because the CRA is finally acting as many have suspected it would for years.
CRA action has been priced in and was again discounted last week.
Investors overreacted and are heavily discounting a high-quality, low-risk precious metals streamer that is worth holding long-term.

Silver Wheaton (NYSE:SLW) is a stock that I have highlighted in the past, most recently in an article emphasizing the importance of investing in precious metals companies that have low operating costs. In that article I mention one risk at the end–parenthetically–namely that the company–which operates most of its operations out of the Cayman Islands–could be forced to pay Canadian corporate income tax on income that was preciously tax-free.

Sure enough we just learned that the CRA is cracking down on Silver Wheaton. The company announced that it was informed by the CRA that it could be liable for taxes on income previously thought to be shielded from the CRA given that it was income from a non-Canadian asset (e.g. income from its San Dimas stream) earned by a non-Canadian subsidiary of a Canadian company. Silver Wheaton contests that such income isn’t taxable under Canadian law.

Regardless this announcement means that Silver Wheaton could be on the hook for ~C$200 million in back taxes. Frankly that’s not a big deal–its about US$0.40/share or ~3% of the market capitalization. What is material to shareholders is that Silver Wheaton’s non-Canadian income earned by its non-Canadian subsidiary could be taxable in the future, and that means that Silver Wheaton could be on the hook for Canada’s 15% corporate income tax on most of its income. On a DCF basis that would make the stock worth ~15% less.

The stock fell hard on this news, and we have seen continued weakness in the days after the announcement. The situation wasn’t helped by general weakness in precious metals, but investors have clearly been biased towards the bearish side of the Silver Wheaton trade of late.

Traders Overreacted: Buy the Dip

Despite this I think the opportunity continues to be enticing as I stated in the above-cited article: Silver Wheaton owns extremely high quality streams on mines that are core assets for major mining companies. Note that the company’s major three assets–Penasquito, Salobo and San Dimas–are all Latin American assets that are subject to the new tax. These streams are leveraged to precious metals prices while they are on assets whose owners are devoting a lot of time and capital to develop, and Silver Wheaton would reap the benefits without any additional capital outlay (Salobo is an exception to this last point).

I further noted that Silver Wheaton trades at a discount to its peers, and attributed this in part to fears that the CRA would come after Silver Wheaton. This possibility has been on investors’ and analysts’ minds for years now and there have even been research notes (e.g. here) suggesting that the potential change in Silver Wheaton’s tax situation was a sufficient enough reason to be concerned.

In my mind the situation is largely the same today as it was on July 5th–the day before the announcement. All that has been confirmed thus far is something that could have been readily predicted–a government sees a corporation generating tremendous tax-free profits and is trying to get its piece of the pie.

Furthermore, we’re only a week closer to an actual tax payment by Silver Wheaton. Silver Wheaton is not going to just start paying taxes now that it has received a letter. This could be a legal battle that lasts for years, and it is a battle that Silver Wheaton may very well win.

Finally, since the main issue is Silver Wheaton’s future tax liability as opposed to the overdue taxes the company could just pay the $0.40/share and spin-off its Cayman subsidiary–worth ~18% more untaxed as opposed to taxed. The “Spin-co” would be the bulk of the company.

The Bottom Line

Silver Wheaton has done a tremendous job creating value over the long-run, having outperformed the broad stock markets and precious metals during its time as a publicly traded company. While some of this success can be attributed to its tax-favored status we’ve seen that back taxes due are a mere 3% of the company’s valuation. As CEO Randy Smallwood told Bloomberg: “Tax does not decide if we win or lose. This is not a big enough issue that it has that much impact on our business model.”

The company is worth less, and deals will appear to be inherently less attractive on an after-tax NPV-estimate basis, but the business model that has allowed Silver Wheaton to generate outsized returns is still intact.

The fact remains that the streaming business offers investors a way to generate high-margin cash-flow with low, fixed operating costs. Silver Wheaton consistently generates incredibly high margins–despite a >60% fall in silver prices–and its management has invested in quality assets that have generated tremendous cash-flow for investors. You can see the company’s OCF and OCF per share growth on the following chart.

SLW Chart

SLW data by YCharts

Continued weakness in precious metals and recent weakness at Goldcorp’s Penasquito Project could put pressure on cash-flows in the near-term, but long-term the company will likely grow its cash-flow. Note that even with the >60% collapse in silver prices since the 2011 peak that the company’s OCF and OCFPS have fallen by less than half.

With this in mind the recent pullback in Silver Wheaton offers investors an opportunity. I’m not sure that the low is in, and the potential for further weakness in precious metals markets could put additional pressure on Silver Wheaton shares. But at this point in time I think the risk outweighs the reward. The company is expected to grow its output as Vale (NYSE:VALE) increases its throughput at Salobo. Meanwhile we are seeing Primero Mining (NYSE:PPP) expand output at San Dimas. Other, lesser, growth opportunities exist as well, so that in all the company expects to increase its attributable production slowly yet consistently over the next few years. The possibilities for additional discoveries and opportunities for production growth by any one of Silver Wheaton’s partners is another benefit that I cannot stress enough since Silver Wheaton doesn’t have to pay for it.

Maybe the company is on the hook for some taxes that investors hoped it could avoid. Nothing has really changed since the CRA sent its letter except that maybe the odds that Silver Wheaton will have to pay is slightly higher. If it is investors have certainly discounted it considering the price action of the week of July 6th-10th. And that was after they had already discounted years in advance. So I think investors are making a mountain out of a molehill.

The bottom line is that we have a great company that is facing a lot of negativity. The negative fact of the matter has been around for a while but the perception is new. This perception is probably here to stay for a while, but it has presented investors with a tremendous opportunity to own a world-class streaming company at a discounted valuation.

For more on this story go to: http://seekingalpha.com/article/3319855-the-tax-man-cometh-for-silver-wheaton

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