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4 Reasons to Avoid Silver Wheaton Corp.

Silver Wheaton Corp.’s (TSX: SLW)(NYSE: SLW) share price has declined by more than 50% from the $46 peak in April 2011 when the silver price was trading around $48 and the gold price was around $1,600. The silver price is the main driver of the Silver Wheaton share price but there are other factors that may negatively influence the financial performance and share price in future.

1. Key long-term contracts signed at much higher silver and gold prices may not be profitable

The company’s business model is based on contractual arrangements to purchase, in exchange for an upfront payment, future silver and gold production of mining companies at predetermined prices.

A number of the more recent and relatively large contracts, which were signed when spot silver and gold prices were considerably higher, would now appear distinctly less profitable.

In the most recent quarter, the two main gold contracts, namely 777 and Sudbury, concluded in in 2012 and 2013, had total production costs of $1,223 and $1,241 per ounce, respectively. As the company does not hedge its production, these contracts will now be operating at a loss as the spot price of gold has fallen below the all in cost of production.

If the silver and gold prices continue to decline, the full impact of the high cost contracts on the Silver Wheaton bottom line will continue to grow as more costly production comes online. Relatively large contracts signed at much higher silver and gold prices include the Constantia and 777 projects acquired from Hudbay in 2012/13 (16% of proven silver reserves) and Salobo acquired from Vale in 2013 (61% of proven gold reserves).

2. A significant portion of the interest bill is capitalised

Accounting principles allow companies to “capitalise” interest payable on loans taken against assets that will only produce revenue in future periods. The interest is effectively added to the cost basis of the asset and does not appear in the income statement and as such has a positive impact on the current period net profit.

In the case of Silver Wheaton, interest to the amount of $6.8 million was capitalised in the first half of 2014, which was 80% of the total interest bill. This was in addition to the $19 million interest that was capitalised in 2012-13. This interest will come back in future in the form of higher cost of sales when production from the specific contracts against which the loans were taken, is received.

Although the capitalised interest will not add meaningfully to cost of the specific projects, investors have to keep in mind that this practise tends to overstate current profitability of the company.

3. The company has a zero tax bill which may change in future

Silver Wheaton currently provides no tax in the income statement – in fact it had a tax recovery in the most recent six-month period. The company states that the tax position is a result of the incorporation and operation of main subsidiaries in the Cayman Islands and Barbados where low corporate income tax rates prevail.

The company does, however, state that the Canadian Revenue Agency is currently undertaking an audit of the company’s international transactions covering the 2005 to 2010 taxation years. Although the tax position may remain unchanged in future, it is a risk that investors have to keep in mind.

4. The share price is still relatively high compared to the silver price

The Silver Wheaton share price, although more volatile, should not deviate too much from the movement in precious metal prices. The relative performance of Silver Wheaton to the silver price reached an all-time high in August and although the gap has narrowed sharply over the past few weeks, the current negative sentiment may drive this correction further.

Investors should demand a considerable risk premium when investing into this company

The financial performance of the company is highly dependent on the level of the silver price and to a lesser extent, the gold price. While it may be almost impossible to predict the direction of precious metal prices, some operational matters add an additional level of risk to Silver Wheaton. Investors may get a better entry point at a lower price in future.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Deon Vernooy, CFA has no position in any stocks mentioned. The Motley Fool owns shares of Silver Wheaton. Silver Wheaton is a recommendation of Stock Advisor Canada.

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