E Gold Royalty Companies Are Attractive Despite High Valuations

Although royalties have been significant to the oil and gas (and other) businesses for many decades, they are relatively new to the gold and metals sector, particularly in the public market. The royalty model is straightforward, though there are many twists:  in return for an up-front investment, the royalty company receives a percentage of gold production from the mine on an ongoing basis.

Types of Royalty

There are many modifications to the basic model.  On the investment side, payments can be staged depending on, say, certain development hurdles (for example, Franco’s large investment in First Quantum’s Cobre Panama mine). On the revenue side, some royalties are a percentage of profits though more now are a percentage of the production. Some royalties can be bought back by the operating company, at a profit. Some royalties have caps on the amount of the metal that can be delivered; some are backstopped by other production by the same company; some have advance payments, before production starts. We need not be concerned in detail about all these modifications.

One major adaptation of the basis royalty was a stream, whereby the company not only makes an upfront payment but also a certain payment per ounce of gold or silver delivered (perhaps around $400 or $4). For the royalty company it means that a significant part of the payment is only paid upon delivery, reducing the risk of loss.  Similarly, for the mine it means that at least it receives something for the production should be production exceed expectations, for example.

The more significant differences between royalties and streams affect titling and taxation. Royalties are typically recorded against the property itself, whereas streams are against the mining company. If a mine is sold, the stream would go with the sale, but if a company were to stop mining, perhaps go bankrupt and walk away from the property, a new company would not assume the stream liability. Clear advantage to royalties. But as regards royalties, taxation is more burdensome. For example, the IRS regards royalty income as passive income, whereas stream income is regarded as active. A company with too much royalty income, therefore, can be regarded as a Passive Foreign Investment Company” (“PFIC”) with onerous taxation consequences.

Benefits of royalty model

The main benefits of the royalty and stream model over mining (and hereinafter I shall include streams when I refer to “royalties” unless it is clear by the context) is that the royalty company is not responsible for ongoing costs at the mine, nor for things that go wrong. At the same time, royalty companies maintain much of the leverage that can come from mining. This leverage comes not only in exposure to higher metals prices, but also from expansion or new discoveries at mine site.  In addition, higher metals prices mean that long-held royalties on exploration ground can start to generate revenue if the deposit is now put into production, and this without any additional investment from the royalty company. Royalty companies like to say “the first dollar in is the last dollar in”. 

In addition, fixed costs of running the business are low and margins high, so royalty companies are more able to withstand downturns in the market.  Franco’s margin, for example, was $978 per ounce last year; and the costs have actually increased in recent years since it had done more streams, with their fixed cost per ounce. It is also a very scalable business; Franco’s G&A for example has not increased significantly even as the company’s revenue has grown significantly.

Thus, they are lower risk than mining companies, and have more upside than bullion or ETFs.

Just as royalties themselves can have differentiating features, so too the companies can and do differ. Some stick to gold (as far as possible) whereas others are more diversified, including into oil and gas. Some are more concentrated than others; 27% of Royal Gold’s NAV is attributable to a single mine whereas Franco’s largest single royalty represents 15% of the mine. Some stick to more safe jurisdictions while others are prepared to venture into more risky areas.   ome generate their own royalties while others acquire them.  Certainly, having diversification in the income stream—not only in the number of mines and geography, but also by metal (including the primary metal mined) and mining company operating the mines—is important.  So too is diversification in producing, developmental and exploration assets, which ensures a solid pipeline of future cash-flowing assets.

Drawbacks to the companies and stocks

While many acknowledge the benefits that royalty companies have, critics point to three main disadvantages:  first, they assert, royalty companies do not have the leverage of mining companies; second, the sector is too competitive and as the gold price moves up, the companies run out of things to buy; and third, the stocks are expensive (we’ll discuss that later).

Though in theory one might think that mining companies have more leverage than royalty companies, this does not work out in practice, not for the stocks.  The chart shows the  performance in the first half of last year (when gold moved from under $1200 to $1350) of the stocks of the two largest gold royalty companies, Franco-Nevada and Royal Gold, against the GDX index. (Since the GDX includes Franco and Royal, the difference against only mining companies would be even greater.)

New Royalty Models

Royalty companies have been very good at adapting the model themselves, obviating the second criticism above. At first, they bought only existing royalties, typically royalties retained by the underlying land owners when a mining company bought the land. This is how Franco acquired its royalty on Barrick’s great Goldstrike Mine in Nevada which formed the basis of both companies. Then they started creating royalties to fund development or exploration, offering an alternative to dilutive equity financing. Then came the major expansion of the model when companies helped fund development of base metals mines for royalties on the by-product gold or silver. Many of these transactions were done as streams, pioneered by Silver Wheaton.

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Disclosure: I or my family hold positions in Franco, Royal and Osisko.  In addition, clients of Adrian Day Asset Management hold positions in these three and in Wheaton Precious ...

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