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.

This allowed, say, a base metal mining company to raise capital without giving up any of its major product. Then, royalty companies starting providing funding to help M&A activity. The next major development came when the large royalties companies could provide capital to large mining companies with strained balance sheets. Again, this was often to base metals mining companies who gave up royalties or streams on their by-product gold and silver without having to sell any of their mines.

This was clearly very popular and much needed in the years from the peak in 2012 to the lows at the end of 2015, but as commodity prices have recovered, mining companies feel less need for it. Similarly, royalty companies could offer attractive financing alternatives to equity to smaller companies when the market was depressed, and equity financing meant excessive dilution.  As stock prices recover, this also becomes less attractive.

Something new, of which we shall see more, is the syndication of deals. Although common in many other forms of investing (real estate, private equity, and so on), it has not happened in the royalty space until recently. Generally, companies have been averse to syndicating deals to their competitors. 

Now Franco has tested the waters with a small syndication with CK Hutchison, a Hong Kong conglomerate, admitting that the deal was intended to test the concept and agreements that would be required. I suspect we shall see more syndications going forward, where the size is too great for one company or where the royalty company can reduce its risk.

It is clear that as the competition has increased the returns have declined, often with stated returns at prevailing metals prices in the low single digits.  Company such as Franco, however, explain that they are prepared to acquire a royalty or stream on a long-life asset in a solid jurisdiction at very modest nominal returns if they believe there is upside in the asset, from mine expansion over the years, or new discoveries on the land, for example.

Four major players

The royalty sector is dominated by the big three, Franco-Nevada, now a $14.5 billion behemoth, followed by Wheaton Precious Metals (the former Silver Wheaton), at $9.7 billion market cap; and third Royal Gold, at $5.6 billion. Osisko, a newer challenger, at $1.9 billion, aims to join the big league as it grows aggressively. After that comes Sandstorm, at $940 million, with several junior plays, some specifically set up (spun off from exploration companies) with just one or two royalties, and others aiming to build a diversified royalty company. there are also several hybrid exploration companies aiming to morph over time in royalty companies.

Top buys

I do not intend here to discuss all the royalty companies, but will focus on the larger ones  In a subsequent article, I shall look at a few of the junior royalty companies.

Franco:  The Blue Chip Royalty

Franco-Nevada (FNV, NY, 78.19) is the oldest and largest of the gold royalty companies, as well as the blue chip of the group. It is the most diversified of the royalty companies, with 340 assets in its portfolio, of which 47 are current generating revenue. Starting later this year is the Cobre Panama copper mine of which Franco receive a significant portion of the by-product gold. This has been Franco’s largest-ever investment (over $1 billion invested) and it is its largest asset (representing 15% of its NAV). Behind that, two other assets represent about 10% each.

Franco is the most diversified by commodity as well, including 17% in oil and gas. Apart from being sound cash-flow generating assets, they also serve as a partial hedge on the metals, since energy is the largest cost input component for mines. In all, however, 89% of last year’s revenue came from precious metals, of which almost 70% came from gold,

On most company criteria, Franco comes out on the top. It has the best balance sheet (with $630 million of working capital, available liquidity of $1.6 billion and no debt), and subjectively the best and most experienced management. It is positioning itself as the “go-to” investment for generalists who want exposure to gold and resources, and its market cap allows makes it attractive to almost any-sized institution.

As with the rest of the group, it would be difficult to describe Franco as a “Graham-and-Dodd” value investment, trading as it does at 71 x estimated earnings, and over 3 x book.  But the strong balance sheet, the growth history and the growth pipeline go a long way to justifying the rich valuation.  This would be my first choice for anyone looking to invest in the royalty space.

Wheaton: An innovator with a tax problem

Wheaton Precious Metals (WPM, NY, 21.90) receives about half of cash flow each from gold and silver, with more recent deals being gold; hence, the name change. There are three reasons that Wheaton’s stock has underperformed of late. First, the company has been seemingly quiet on the deal front, with the last transaction in early 2016.  Second, is the dispute with the Canadian tax authorities. And third, is the relatively weak balance sheet. 

Given Wheaton’s balance sheet and given that deal flow tends to go in waves, depending partly on commodity prices and stock prices, I am not particularly concerned about the lack of any M&A for nearly two years. Its pipeline is strong, with expansions at two of its large streams (Salabo and Pensaquito), plus the restart of another mine this year. In addition, progress by Barrick towards a limited underground mine at Pascua Lama, which would obviate the environmental objections, will generate strong cash flow for Wheaton (and Royal Gold, incidentally, which has a separate royalty on the asset).

Canada Revenue is seeking $267 million back taxes over Wheaton’s offshore structures. The dispute is now before the courts. So far, the dispute is only over Wheaton’s earliest offshore deals, prior to 2010. If Wheaton loses, the Revenue would then audit very carefully all offshore deals post 2010.  Many observers believe that Wheaton has tightened its process in recent years and would not be subject to back taxes on all of its offshore deals. Absent a settlement, the case may not be ruled on until next year. If Wheaton were to lose completely, but Revenue did not challenge more recent structures, this would be a blow but far from fatal, and is already discounted in the share price. Wheaton has been an innovator, not only with structuring foreign deals offshore but also with streams, two very significant factors in the sector now, and innovators often become targets.

As for the balance sheet, Wheaton has just $70 million in cash and $784 million in debt.  It has $1 billion available on its revolver.

Resolution of the Canadian tax dispute as well as a sharp move in silver—Wheaton is more sensitive to the silver price than its peers—could see the stock move sharply higher.

Royal’s Major Asset Causes More headaches

Royal Gold (RGLD, Nasdaq, 85.56) has a diversified asset base beyond Mt Milligan, which represents some 27% of its NAV.  As other assets in its pipeline come on stream, this number will go down, eventually to about 20%, a more comfortable level.

Last year, New Gold’s Rainy River started operations, its 40^th cash-flowing operation, while this year two major assets start producing by the end of this year, Barrick’s Cortez Crossroads and the Penasquito leach operation. Beyond that, Royal would benefit from operations at Pascua.

With healthy cash flow and a strong pipeline, Royal is committed to bringing down its debt, currently about $540 million against $88 million cash.  Liquidity remains strong, however, with about $900 million available. Though Royal has not ruled out any new acquisition, it has said that debt reduction is its top priority. All cash flow is going to dividends and debt; it even raised its dividend last quarter to $1 per share. It has one of the purest profiles, with (even after the copper stream, see below) 87% of its cash flow coming from precious metals, of which 77% is from gold.

The Mt Milligan mine, on which it holds its largest streams, has been an ongoing cause of concerns. In 2016, operator Thompson Creek was in danger of closing the mine due to corporate financial problems, but it was bought by stronger Centerra Gold. Royal agreed to restructure its  high gold stream, into separate gold and copper streams. It has not all been plain sailing since then, however, with lower production than estimated last year, even before the suspension of milling operations at the end of the year over lack of water. This was only a temporary issue, with part of the mill expected to resume operations by the end of this month, and then fully back by Spring ice break-up.

The market overreacted to the suspension of milling, partly not appreciating it was only a temporary processing issue, but also (in my opinion) out of nervousness with an asset which has given Royal shareholders a serious of headaches since the first investment was made.   This overreaction, however, presents a good buying opportunity for investors.  Royal arguably has the strongest short-term potential as Mt. Milligan resumes full operations, Rainy River ramps up, and new operations come on towards the end of the year.

Osisko: Rapid Growth with innovative program

Osisko Gold (OR, NY, 11.91) is the newest of the large royalty companies, formed in aftermath of the sale of the Canadian Malartic mine it has found and built; in selling the mine, Osisko kept a very attractive 5% royalty.  Shortly after, it acquired Virginia Mines and its attractive sliding-scale royalty on the Eleonore deposit it had found and subsequently sold to Goldcorp (and now in production). Osisko, thus, has two of the best gold royalties around, high interests in two long-life mines in Quebec, one of the top mining jurisdictions in the world.

A recent $1.1 billion purchase of a package of royalties, streams and other interests has solidified Osisko’s position as fourth largest royalty company. The assets include a royalty on a new Canadian diamond mine, another high-margin, long-life asset

It has 130 royalties and streams of which 16 are currently generating cash flow and another 13 are in development. So Osisko has a strong built-in growth profile from these assets over the next five years.

Where Osisko differs from the other large companies is its so–called “accelerator program”, whereby it takes major stakes in select exploration companies, often lending its expertise in both exploration and mine-building, in exchange for shares and royalties, as well as the rights to acquire royalties on future production. The program has so far proved successful purely as an investment, with the company realizing over $70 million from the share portfolio, which has a current market value of about $410 million.  Beyond that, however, it is helping the juniors advance projects which in the years ahead will generate cash flow.

Osisko took on debt to make the Orion acquisition. It currently has C$462 million in debt (most of which is a convertible debenture taken on to acquire the Orion assets) against about C$400 million in cash (as well as over $400 million in shareholdings). So the balance sheet is strong, and the company is well supported by the Quebec public pension funds which have supported the company with equity and debt when required.

Given its shorter history, smaller size, and less deep portfolio, Osisko trades at a discount to the big three on most metrics.  But given its strong growth history, as well as its strong balance sheet and aggressive management with very strong growth potential, it is a good buy here.

How they stack up

Over the past year, Franco and Royal are each up around 25%, while Wheaton and Osisko have lagged, each up around 8%. While we would continue to buy both Franco and Royal, it is time for the other two to catch up, though Wheaton will likely continue to lag until the tax issue is put to bed, one way or the other. 

Valuation Metrics of Large Royalty companies

 

                                                FNV                RGLD                        WPM              OR

 

Price to cash flow                   29x                  19x                  18x                  25x

 

p/e                                           72x                  48x                  35x                  49x

 

yield                                        1.2%                1.2%                1.7%                1.4%

 

price to book                           3.1x                 2.4x                 1.9x                 1.2%

 

debt-to-assets                                      0                      19x                  19x                  3.2%

 

ROE                                        3.1%                4.5%                4.1%                3.4%

 

Yellow highlights indicate the cheapest of each metric

Over the past year, Franco and Royal are each up around 25%, while Wheaton and Osisko have lagged, each up around 8%. While we would continue to buy both Franco and Royal, it is time for the other two to catch up, though Wheaton will likely continue to lag until the tax issue is put to bed, one way or the other.