First and Last Word on Metals and Mining

Introduction

Maybe you already find the royalty model to be an attractive method to gain exposure to mining and metal prices? Or perhaps you have heard about royalty companies but don’t have enough information to decide if one or more of them belongs in your portfolio? Either way, it is important to understand the underlying value of a royalty company based on the current market environment and the future production outlook. Unfortunately up until now, there has been no comprehensive source of royalty company valuations available to the public, leaving most retail and many institutional investors in the dark.

We at Metal Augmentor have had the same problem — but since we specialize in fundamental analysis and market research in metals and mining — we have come up with a solution. Using our proprietary database of exploration, development and production stage companies, we have individually analyzed well over one hundred royalties and prepared the following report covering the vast majority of them that are held by public companies deriving a significant portion of their valuation therefrom. For good measure, we have even thrown in the odd coal royalty. To the best of our knowledge, few others have completed such an arduous analysis and none have released their findings for public dissemination.

We believe this summary report and the subsequent comprehensive versions — to be available only to subscribers of the Metal Augmentor service — will be very useful to many investors since this will be the first time royalty companies have been valued at current metal prices on the basis of cash flows and earnings generated from each individual royalty calculated on a stand-alone basis. Consider Franco-Nevada (TSX: FNV; Pink Sheets: FNNVF) with its 50+ different royalties: faced with the sheer amount of data, even large brokerage firms tend to generate price targets using aggregate cash flow assumptions and estimates of top-level financial metrics. We don’t blame them given the time and effort required to complete a comprehensive analysis, but we also wouldn’t trust our own money to what amounts to a sophisticated wag.

Investors familiar with the royalty majors will notice right away that we are missing data in this report for Franco-Nevada’s closest competitor, Royal Gold (NYSE: RGLD; TSX: RGL). This is because we are still validating all of Royal Gold’s royalties, a process that has proven to be very time consuming. We expect to complete the validation by early January and will be releasing a comprehensive version of this royalty company report to subscribers at such time.

What is a Royalty Company?

A royalty is a payment to a property interest holder by the majority owner or operator usually based on the amount of mine production (e.g. flat rate royalty of $10/tonne), the value of production (e.g. 2% of sales less certain costs — see Net Smelter Return), or the net revenue/profit generated from production (e.g. 5% of net profits). There is also the fixed price metals purchase royalty stream, which accrues to the royalty holder based on the difference between the current metal price and a fixed purchase price, such as the “silver streams” innovated by Silver Wheaton (NYSE/TSX: SLW).

Royalties based on the amount of production have no direct correlation to changes in commodity prices other than the possibility that production rates could increase in reaction to higher commodity prices and vice versa. Fixed price metals purchase royalty streams and royalties based on the value of production will exhibit a high degree of correlation with movements in commodity prices. Finally, royalties based on the profits generated from production are expected to leverage changes in commodity prices and therefore such royalties can be the most profitable (and risky).

Arguably, the main attraction to investors in royalty companies is that they generally have no responsibility for contributing funds to a project for any future purpose, including operating and capital costs, after an initial cash payment or transaction. Thus, an unexpired royalty essentially represents a fully carried asset with zero future cost. This results in low-risk exposure to mining operations, whether it be a development-stage project or long-established mine, especially during the bust period of the boom-bust cycle in mining when purported cash cows become cash vacuums that suck up money and can create massive share dilution for operators. While a royalty might not generate any revenue during such downturns, it also won’t impose costs or commitments to make cash payments in most cases.

On the other hand, most royalties do not shelter the royalty company from the ultimate risk of temporary or permanent shutdown of operations and they provide little relief from the bankruptcy of the mining company or operating subsidiary. In other words, royalties and royalty companies do not offer much shelter from, or recourse against, the tail-end risk of the mining business: failure. Consider the following disclosure in Silver Wheaton’s financial statements:

Except in limited circumstances, the Company will not be entitled to any material compensation if such operations
do not meet their forecast silver or gold production targets in any specified period or if the operations shut down
or discontinue on a temporary or permanent basis.

For the above reason, it is not enough to simply look at royalty companies from a quantitative perspective; one should also understand the quality of the operations underlying the royalty portfolio. Future editions of our royalty report, available only to subscribers, will include analysis of several qualitative factors (such as weighted average operating margin, production grade, etc.) in our ongoing effort to provide the most comprehensive analysis of the metals and mining sector. In future editions of our royalty company report, we will also consider covering oil and gas royalties in addition to the one-off coal royalty that we have included thus far.

As of now, however, we have identified 11 companies that can be classified primarily as metals and mining royalty companies. This 11 company universe boasts a combined market capitalization of about $23 billion. Silver Wheaton is the sun within this solar system given its nearly $14 billion market cap (the next closest competitor by size is Franco-Nevada, with a market capitalization of around $4 billion). But whereas Silver Wheaton might now be considered a red giant, it wasn’t long ago that it looked like a white dwarf. Believe it or not, back in late 2008 during the worst of the financial crisis, Silver Wheaton was trading for under $4 with a market capitalization less than $1 billion. So in case anyone thought royalty companies were immune from extreme volatility, think again.

Let’s now take a look at how the entire universe of metals and mining royalty companies have performed over the past 12 months:

We can see from the above chart that the royalty companies have generally risen along with gold and commodities this year, though there is quite a bit of variability and several of the companies have been poor performers. Silver Wheaton stands out as a top performer, helped in large part by the 60%+ rise in silver, the growth profile of its portfolio, and its ascension as a market darling. The similarly-impressive rise in Callinan Mines (TSX-V: CAA; Pink Sheets: CCNMF) can be explained by its levered net profits royalty structure on Hudbay Minerals’ (NYSE/TSX: HBM) flagship 777 mine. [Note: Callinan is an Institutional client of Metal Augmentor.]

The one apparent loser in the group is Terra Nova Royalty (NYSE: TTT), though this can largely be explained by its corporate restructuring. This restructuring involved splitting up what was formerly KHD Humboldt Wedag International Ltd. into a mineral royalty company (Terra Nova Royalty) and an industrial plant technology, equipment and service company (KHD Humboldt — Pink Sheets: KHDHF). So far a total of 25.7 million shares have been spun out to Terra Nova shareholders worth about $230 million, largely explaining Terra’s falling share price over the past 12 months. One last dividend is expected to occur on December 31, 2010. If we adjust for all the dividends paid thus far, Terra Nova has traded roughly flat during 2010, joining a small group of other under-performers in the royalty space.

Among this group of under-performers is Royal Gold, a company that seems to have a love-hate relationship with the market. One possible reason Royal Gold has been flat in recent times amid the huge rally in gold stocks is that its showcase Voisey’s Bay royalty (International Royalty Corp acquisition) has been besmirched by a lengthy strike. Moreover, investors do not appear to know how to value the company (hint: forget P/E ratios) — particularly given the number of royalties on large development-stage projects — and this is something we aim to change with our upcoming comprehensive royalty report. We note also that Royal Gold held up extremely well during the 2008 meltdown, which is a sign that the market views its royalty portfolio as a stable, high-quality asset that has nonetheless failed to be inspirational so far.

Generally we are not surprised to see a low degree of leverage to higher (and lower) commodity prices since most of the royalty companies own royalty interests on projects that are not yet in production and will only stand a chance of producing cash flow after further exploration and/or development spending. If commodity prices fall, so too will exploration and development budgets as project economics become less favorable and financing becomes harder to obtain. But if prices move higher then healthy amounts of spending should eventually lead to new discoveries and the development of new mines, triggering new royalty streams and increasing expected cash flows for the royalty companies going forward. In addition, the market is expected to re-value a royalty upwards at the start of commercial production just as the market tends to re-value mining companies themselves at the start of commercial production.

Methodology

Our valuation method is based on a fairly standard discounted cash flow analysis of each royalty interest, using a conservative discount rate of 8 percent. In determining valuation targets, the share structure of each company is adjusted to account for in-the-money warrant and option exercises. Financial metrics take into account liquid assets and debt in arriving at enterprise value.

In calculating attributable resources, the royalty interest percentage is applied to the total resource of each project. For example, consider a 2% net smelter return on a 1 million ounce gold deposit. The attributable resources would be calculated to be 20,000 ounces. We then adjust contained resources according to assumed metallurgical recovery rates. In the case of the 1 million ounce gold deposit, if it is estimated that only 80% of the gold will be recovered in processing the ore, then the attributable resource works out to 16,000 ounces. This does not always work out smoothly due to the complexity of some royalty interest arrangements, but generally our figures will reflect each company’s level of exposure to the produced metals or commodities.

To determine estimated total cash flow, we simply apply the royalty percentage interest to the expected production rate of each project in 2010, 2011, and the terminal period (defined as 2012 through the end of the mine life), adjust for any operating costs associated with the royalty, multiply by the current metal price of each produced metal or commodity, sum these amounts together, subtract out any future capital costs that the company may be subject to (rare for royalties), and then adjust for the company’s estimated depreciation, amortization, and tax charges. When calculating valuation range targets, we adjust for the base, best, and worst case metal price scenario assumptions using a price band at +30/-30% of the current level.

Comparative Valuation Charts

Our report begins with the valuation target chart, which provides a comprehensive picture of the potential return to shareholders across a range of metal prices assuming the market applies the same valuation standard to these companies as found in our model:

Above we can see the different mining royalty companies less Royal Gold, each with a banded target valuation range relative to each company’s current share price. These are meant to be only rough comparative guidelines given that our model assumptions attempt to be reasonable and not reflective of any purported market consensus about valuations. For example, a different discount rate would lead to significant changes in the above chart . . . but the companies would still generally rank in the same relative position. Therefore, the above chart is much better at providing an overall picture of the sector as a whole along with indicating the relative position of each company within the sector rather than telling us whether or not a particular company is overvalued. Terms such as “overvalued” are an abstraction since it must always be asked “compared to what?”.

Generally we can see that royalty companies as a whole do not seem to offer much fundamental value in our model at current metal prices, with the average company appearing to trade somewhat above the base case target price. This is reflected as a negative return at the base case (blue line). But as with any financial chart that attempts to distill a large amount of detail into a single point such as target price, there are going to be plenty of caveats. For starters, not all these companies are pure royalty companies. The most glaring example of this is Golden Predator (TSX: GPD; Pink Sheets: GPRXF), which brands itself as an explorer/project generator with a large and prospective land package in the Yukon. Golden Predator also just happens to own several small royalties that help fund exploration. These royalties are valued in our model at up to 60% of the company’s enterprise value based on current metal prices. If the company were trading more at a premium for its exploration potential, we likely wouldn’t have included it within this analysis, but the fact remains that its royalty portfolio seems to justify about two-thirds of its current valuation based on our conservative model assumptions.

If you’re wondering why Virginia Mines (TSX: VGQ; Pink Sheets: VGMNF) didn’t make the cut with its 2% variable net smelter return (NSR) on Goldcorp’s (NYSE: GG; TSX: G) Eleonore project, it’s because based on current operating assumptions at Eleonore — 330,000 ounces per year for 16 years beginning in 2015 — our calculated net present value for the royalty is not substantial relative to Virginia’s enterprise value. We also did not include Sandstorm Metals & Energy (TSX-V: SND; Pink Sheets: STTYF) in our analysis since it does not yet own any royalties.

You’ll also notice in the above chart that some companies have much wider target ranges compared to others. Just take a look at Terra Nova versus Callinan. The reason Terra Nova’s range is so tight is because, after factoring in their recent acquisition of Mass Financial (Pink Sheets: MFCAF), cash and securities will make up about 80% of their valuation, and you don’t get any leverage from cash in either direction. Meanwhile, Callinan shows the largest valuation range because its only royalty is a net profits interest (NPI) royalty. In the case of an NPI, the project first has to cover all its operating costs before it pays out to the royalty owner. Essentially this means that the value of the royalty ends up being much more sensitive to metal price swings than an NSR.

We consider the following chart to be the most relevant in the comparative valuation of peer companies in the mining sector. By removing overt reference to prices and potential profit/loss percentages, we create a more neutral environment for objective analysis. Ultimately, success in an extractive industry — by definition involving a dwindling asset base — requires that capital investment is first recovered through operating profits (what we call “payback”) and then capital can accrue a multiple return on that payback (what we call “leverage”). Generally speaking, the lower the payback as measured in years and the higher the leverage measured in multiples of payback, the better.

Looking at the above chart we can see that almost all the royalty companies tend to trade under 2 times Leverage. The obvious exceptions are Gold Wheaton (TSX: GLW; Pink Sheets: GLWGF), Anglo Pacific Group (TSX: APY; LSE: APF; Pink Sheets: AGPIF) and Terra Nova.

Zooming in on Terra Nova, its exceptional-looking 3 year Payback and 5 times Leverage can be explained by its large net cash position of about $400 million. A large net cash position has the effect of lowering enterprise value, which is the basis of both the Payback and Leverage measures. We would prefer that Terra Nova carry out a large share buyback program, but perhaps they have other plans. If a large share buyback program were to take place, both the Leverage and Payback measures would remain roughly the same and sensitivity to commodity price changes would greatly increase, giving us more reason to invest if we are bullish on the fundamentals for iron ore. On the other hand, if a special dividend were paid out to shareholders, we would see the Payback measure rise, the Leverage measure fall, and sensitivity to metal prices would remain relatively low. That’s not a scenario that we find very compelling. With its roughly $100 million investment portfolio, similar logic would apply to Anglo Pacific though the effect would be much less pronounced.

Also noteworthy in the above chart is the nearly 14 year Payback measure for Silver Wheaton. This is a huge outlier and a strong indicator that the company is trading far above its target valuation based on its current status as a market darling. The fact that Silver Wheaton does not pay any income taxes due to its corporate structure obviously helps, but we think this advantage also comes with some risk. Here’s what we wrote about Silver Wheaton’s unusual tax-sheltered status in our Silver Producer Report published this past July:

Quite frankly we were unaware that Silver Wheaton’s incorporation in Barbados and the Cayman Islands is able to almost completely avoid the tax man. Don’t believe us? Take a look at page 52 of the company’s 2009 Annual report: $118 million net income and zero taxes paid. Since the proceeds received from the sale of silver streams are recognized as deferred revenue on the books of the miners and taxed over time at a fixed rate regardless of the silver price, Silver Wheaton seems to have discovered a wonderful little tax shelter as well as a great way to unlock value from by-product silver that would otherwise have likely been hedged and thus depressed silver prices.

One consideration to keep in mind about the favorable tax structure, however, is what happens if the price of silver skyrockets such that mining companies with silver streams end up paying much lower taxes than their in-country peers who have not done similar deals. To be more specific, in an environment of elevated silver prices (our collective expectation, no?), tax jurisdictions where the mines operate are being effectively shortchanged due to the Silver Wheaton deal structure, and there might be consequences in the form of regulatory remedies or special tax assessments.

We have no idea how much longer Silver Wheaton will be able to maintain a 0% tax burden — perhaps forever — but we won’t be at all surprised if one day this distinct advantage disappears. It is important to recognize that the effect would likely be greater than a one-time 30% tax since it would also inhibit Silver Wheaton’s ability to make competitive deals on future silver streams. We note that Sandstorm Resources (TSX-V: SSL; Pink Sheets: SNDXF) is also structured to avoid taxes. By all accounts, so far so good in tax-shelter-land, but in our opinion this is a risk that investors should keep in mind (just like investors should have kept in mind the potential changes in tax structure of Canadian income trusts).

Finally, please note the background graphic representing the gold-equivalent royalty cost per ounce for each company. This does not represent the production cost of the operations underlying the royalties but rather the imputed cost, on a converted gold-equivalent basis, related to the royalty payments themselves. For example, Silver Wheaton pays around $4.00 (plus an incremental adjustment for inflation) for each ounce of silver produced under its royalty stream agreements. We have converted this to a gold-equivalent and plotted it in the above chart. Obviously this method loses some flavor when it comes to a company like Anglo Pacific given that the conversion of coal to a gold-equivalent is a questionable practice, but relatively speaking the royalty cost measure does give an overall measure of the sensitivity that each royalty company has to changes in metal prices.

Next up we have some bubble charts that can help investors visualize the quantitative relationship between royalty companies using several different metrics at the same time.

In the above chart we see that most of the royalty companies have a royalty profit margin of over $1,000 per gold-equivalent ounce (i.e. over 70% margin at current gold prices). Royalty profit margin is simply the current metal price minus the royalty cost discussed in the preceding chart. The major exception is Callinan and as we explained earlier this is due to its income based royalty structure on Hudbay’s flagship 777 mine.

One can make a number of useful observations about the above chart and we invite others to be creative in doing so. For our part, we will note only a couple of examples.

Terra Nova stands out very clearly as offering the best value based on the “Discounted” Leverage metric. But again, this is largely a function of its balance sheet, and depending on the direction the company takes with its cash, its distinct outlier status may very well disappear. Beyond how it chooses to use its cash, a major outstanding question for us is the impact that the Mass Financial acquisition will have on the company’s bottom line. It would be undesirable to see wild swings in net income due to proprietary trading at Mass Financial that completely renders as irrelevant the stable cash flow from the iron ore royalty on the Wabush mine.

It is interesting to see that Anglo Pacific’s total resource appears to be about as large as Silver Wheaton, but this is actually quite deceptive since most of this is attributable to the company’s two 100% owned (not royalty-based) coal projects in Canada, Trefi and Panorama. In other words, the bulk of its resource is not attributable to royalty interests as is the case with Silver Wheaton. Among other things this means that in order for these resources to be developed, Anglo Pacific would be responsible for funding capital requirements and then covering operating costs once in production. Note that since neither of these coal projects has been the subject of an economic study, their effect on margins or other financial metrics have not been reflected in the above chart or the royalty report in general.

Although sporting a royalty profit margin somewhat lower than average, Gold Wheaton stands out as arguably the best-levered “pure” royalty company with a significant precious metals resource base. This largely confirms its placement in the first chart. Even a cursory qualitative review will reveal, however, that the company is dependent on successful operation rampup at the South African operations. If production falls behind plan, Gold Wheaton is unlikely to close the valuation gap between itself and its big-breached peers (Silver Wheaton, Franco-Nevada and Royal Gold).

The next chart evaluates the resource base and production level of each royalty company using the standard measure of enterprise value per gold-equivalent ounce. This method can be useful for high-level ranking but we believe retail investors and even brokers, institutions and other analysts place far too much reliance on such a simplistic approach that says nothing about profitability. In our view, the analytical abuse of these basic gold-equivalent measures is a symptom of the popular yet dangerous idea of ever-rising commodity prices. Still, knowing how others view the market — even if we suspect such view may be incorrect — is important because prices in the short term are dictated by consensus market thinking. As the cliche goes, the market is never wrong.

Readers are free to reach their own conclusions using the above chart. For our part, we’ll note that both Callinan and Terra Nova stand out as having the combination of lowest enterprise value to production and resource base multiples. At the same time, we’ll also note what doesn’t get shown in the above chart: of the two, only Callinan has translated these “cheap valuation” metrics into consistent and robust cash flow with a price to cash flow (P/CF) multiple of about 9x if exploration spending is ignored. This is partly due to the royalty structure itself and partly due to the quality of the underlying operations, with the remainder of the credit going to conservative financial management.

Anglo Pacific, Gold Wheaton, Franco-Nevada, and Silver Wheaton are also generating substantial cash flow from their respective royalty interests. Of the group, Anglo Pacific and Gold Wheaton offer the most attractive P/CF multiples at about 12x each compared with 24x for Franco-Nevada and 50x for Silver Wheaton. Interestingly, the P/CF ratios line up pretty well with each company’s relative position in the above chart so perhaps the enterprise value per ounce measures are more useful in this instance than typical. Please note that in our upcoming comprehensive royalty report we plan to include P/CF and other charts including those suggested by our subscribers and the royalty companies themselves.

The next chart is another one you would probably never see if we hadn’t built a royalty model. Although there isn’t much to it, the comparative format does provide some insight and in particular we look forward to adding Royal Gold and other companies in the future. In the case of our Silver Producer Report, a similar chart helped First Majestic Silver (TSX: FR; Pink Sheets: FRMSF) validate that it was the “purest” silver producer, and this in part resulted in a sector-leading price performance by First Majestic during the current historic run by silver. [Note: First Majestic is an Institutional client of Metal Augmentor.]

The above chart gives investors a good overview of the commodities to which each company is exposed. Surprise, surprise: Silver Wheaton is all about silver. For exposure to the iron ore market, look no further than Terra Nova. If coal’s what you’re looking for in your Christmas stocking this year, take a look at Anglo Pacific.

Beyond the obvious, however, there are some subtleties as well. Examples: For those seeking exposure to copper via the royalty model, Callinan’s your man. Although primarily a gold vehicle, Franco-Nevada offers exposure to a variety of commodities. Platinum and palladium bugs should consider Gold Wheaton; while it may look like it is primarily exposed to gold, this is largely contingent upon the successful ramp up of production at First Uranium’s (TSX: FIU; Pink Sheets: FURAF) perennially-problematic Ezulwini and MWS mining operations. For the time being, however, Gold Wheaton generates a substantial percentage of its royalty revenues from platinum and palladium produced by Quadra FNX’s (TSX: QUX; Pink Sheets: QADMF) Sudbury operations.

Those interested in more-or-less pure gold exposure to near-term production might consider Sandstorm Resources. The companies that remain — Golden Predator, Bullion Monarch (OTCBB: BULM), and Golden Arrow (TSX-V: GRG; Pink Sheets: GARWF) — also offer more-or-less pure gold exposure in terms of their royalties with each one also having a peripheral attraction as an exploration company. As mentioned earlier, Golden Predator has an extensive and promising land package in the Yukon where it has already drilled a number of promising holes. Bullion Monarch has its interesting, albeit very early stage, Enshale subsidiary focused on oil shale. And Golden Arrow recently optioned 2 of its projects to Vale (NYSE: VALE) on attractive terms.

The following chart shows the number of producing or development-stage royalties in each company’s portfolio.

Although Silver Wheaton “only” owns 19 producing or advanced stage royalty interests compared to about 50 for Franco-Nevada (and a lot as well for soon-to-be-added Royal Gold), several of Silver Wheaton’s royalties are absolute monsters. For example, our model values its royalty streams on silver production at Barrick’s (NYSE: ABX) Pascua-Lama development project and Goldcorp’s Penasquito mine at about $2 billion each! As we mentioned earlier, however, quantity isn’t everything and so we are looking forward to providing future qualitative analysis that will help place big numbers like these $2 billion examples into clearer context.

The next chart provides a comparative scale of the production profile covered by the royalty portfolio of each company.

The chart makes it perfectly clear why Silver Wheaton commands the highest market capitalization among royalty producers and also why it is the market darling among royalty companies. However, this impressive production growth profile doesn’t negate the fact that Silver Wheaton is trading well above its target valuation. It also says little about the quality of the operations subject to the company’s royalties.

Although many of the above production profiles appear wimpy on a gold-equivalent basis, and especially in comparison to Silver Wheaton, remember that most of these companies have minimal production costs associated with their production (see the secondary axis on the “Payback and Leverage” chart shown earlier) such that 25,000 ounces of gold for a royalty company might end up being equivalent in “value” to say 50,000 or even 100,000 ounces for the typical mining company that must pay the capital and operating costs association with production.

The penultimate chart in this inaugural royalty company report summarizes information about mine lives at projects subject to the companies’ royalties.

One use of the above chart would be to identify when, in anticipation of potential cash flow, a company’s combined projects will enter commercial production on a weighted average basis. Mining companies often get a re-rating from the market when they enter production so the assumption is that royalty companies would as well. Golden Predator is the outlier here, with its Weighted Average Production Start-Up of about 2013. In other words, it currently isn’t generating much cash flow from its royalty interest, but will potentially see a big jump beginning in about 2-3 years. This means the company’s growth curve still lies ahead and therefore so does the price appreciation potential. Several other companies also have growth ahead and once again Silver Wheaton looks pretty darn good. The roughly 25 year Weighted Average Mine Life of Anglo Pacific’s royalty portfolio is also noteworthy.

The final chart shows something that investors often forget about: overhead expenses.

Typically the larger the company, the smaller its Overhead Dilution rate, and this rule generally holds true in the above chart. A few noteworthy exceptions are Callinan and Sandstorm Resources. We mentioned earlier that Callinan has managed to produce consistent and meaningful cash flow from operations, and most of this is “free” cash flow in large part due to low overhead expenses. Despite being about four times the size of Callinan, here you can see that Terra Nova’s overhead dilution rate is about 2 times greater. This goes a long way in explaining why Terra Nova has thus far been unable to produce meaningful free cash flow. The greater than 10% dilution rate at Golden Predator means that a significant portion of royalty revenues will go to cover overhead if expenses continue to remain at the same level. Combined with its aggressive exploration spending, shareholders should not expect Golden Predator’s royalties to generate free cash flows or dividends (but they will perhaps provide a substantial contribution to the exploration budget, reducing the need to issue new shares).

Conclusion

The universe of metals and mining royalty companies is quite varied and up until now it may have been difficult for many investors to evaluate the financial metrics of any one of them, much less all of them on a comparative basis. We hope this report has helped clarify how these companies compare against one another on a number of fundamental valuation metrics. Although companies like Silver Wheaton currently trade above their target valuations, this may not always be the case. On the other hand, a rich valuation is not necessarily a bad thing because often it means that management has been very successful in delivering value to shareholders. Ideally, though, we want to identify situations before the delivery happens.

The real beauty of our model is that it is fully dynamic and can be updated at the push of a button, which allows the pinpointing of value opportunities in almost real time. We constantly add companies and monitor our model for subscribers not only to identify opportunities in the royalty area but also silver producers, gold producers (an update on gold producers will be released very shortly) as well as other sectors (copper producers, gold developers, etc.). Our complete model including all royalty and other data is available to subscribers of our Metal Augmentor Institutional service. Current Institutional subscribers include Callinan among the royalty companies and several others in the gold and silver space.

Alright, time for some final thoughts.

  • On the opposite end of the valuation scale from Silver Wheaton, Terra Nova looks interesting but uncertainty surrounding the exact royalty agreement at its Wabush mine and the recombination with Mass Financial makes it a sensible idea to remain on the sidelines for the time being.
  • In their individual ways, Bullion Monarch, Callinan, Golden Arrow, Golden Predator and Sandstorm Resources all appear to offer value to investors interested in royalties or the royalty model.
  • Sandstorm Resources is the only “pure” gold royalty company and it is also aggressively seeking new royalties.
  • Callinan is spinning off its exploration business and will focus its future efforts on royalty generation.
  • Golden Predator in our view has an attractive exploration portfolio in the Yukon where several projects have seen drilling that suggests the tenor of gold mineralization could support a mine if sufficient tonnage can be delineated.
  • Gold Wheaton seems to offer decent fundamental value at the present time and could be a dark horse that eventually gets market respect approaching the status of its namesake sibling, although a U.S. exchange listing would be helpful as would the addition of new royalties and improvement at the South African operations.
  • We favor one of the companies above the others in the short term and we plan soon to profile it separately for subscribers of the Metal Augmentor service.

Disclaimer: From time to time we have and may own shares in several of the companies mentioned in this analysis but at the publication we held no material position. No compensation has been received from any of the companies mentioned except Callinan Mines and First Majestic Silver which are institutional clients of the Metal Augmentor service. This is not investment advice; should you seek investment advice we recommend you discuss the company with a licensed investment advisor or broker.

About Zurbo

David likes to eat. He has looked at more technical reports than just about any sane person. He can train Excel spreadsheets to bring his slippers and play fetch.
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23 Responses to Royalty Company ReportComment RSS Feed

  1. Bart

    Scratch Gold Wheaton off.

  2. @Bart
    Wow, that sure was quick!

  3. thefroggydude
  4. forwill

    Regarding Gold Wheation…Weird! On the same damn day…go figure! Another awesome job fellas. The inclusion of Anglo Pacific was a great idea too.

  5. Painful day for Gold Wheaton warrant holders, down over 50% on the news: http://barchart.com/quotes/futures/GLW-WT.TO

    To make matters worse, most everyone else is celebrating the “good news”.

    Illustrates one of the major risks of owning a significantly out of the money warrant on a smaller company that has the potential to interest the less volatile/levered majors.

  6. Dave

    @zurbo
    When you read about warrant repricing does that apply to non-trading ones only?
    If not, then presumably the GLW.WT holders will make a fuss, maybe they will get repriced?
    Is there an opportunity here?

  7. @Dave
    I don’t recall any examples where trading warrants have been repriced, but it would be very interesting if anyone knew of any historical precedent. If there were past examples of repricing we would be much more inclined to evaluate the potential speculative opportunity further.

  8. Peter Wright

    What about Tanzanian Royalty Exploration? Jim Sinclair’s company.

    I bought this very cheaply a couple of years ago and it is up 150% since then. I know that they have been finding some good surface gold. And I know how rich Tanzania and other African countries are, having spent 20 odd years there.

  9. Peter Wright

    By the way, this is an excellent report. I’m really grateful that you took the time to put this together.

  10. @Peter Wright
    Hello Peter, Welcome aboard, your future comments will appear immediately and will not be held for moderation. Thanks for the compliments, it sure was hard work (most of the review and entry by zurbo, who as a result now is no doubt one of the world’s foremost royalty experts). We don’t view TRE as a royalty company because they don’t have any producing royalties or any properties in development where the royalty has significant value (at least 40% of the company’s market cap, which is how our report defines a “royalty company”).

  11. Kev

    Have you disclosed the royalty company(ies) you prefer or was it gold wheaton?

  12. @Kev
    Thanks for the comment Kev. In the future all your comments will appear immediately after posting. Although it was certainly in the running, Gold Wheaton was not the royalty company we favored above all others. The holidays combined with various other projects have largely occupied our time these past few weeks, but we promise to work hard to get something formal written up on our favorite pick soon. This is a public post so I must remain hush hush about specifics. Thank you for your patience.

  13. L Anderson

    Hi – I’m overweight perhaps in Royal Gold. Despite holding over a year, I’m only up 2% which is pretty darn poor return vs holding the metal. About when will you finish the pending RGLD analysis and update the royalty company analysis… I’ve been waiting for that to decide what to do with RGLD vs other names I’m tracking. I’m also pretty heavy SLW and up about 28% on that.

    A loyal founding subscriber,
    LA

  14. @L Anderson
    With website redesign and other tasks we have not been able to validate the Royal Gold model yet but you shouldn’t expect anything different from most of the other royalty plays — no fundamental value support at current levels and poor leverage to metal prices. I would consider traditional royalty companies at this point as defensive plays. Hopefully we’ll have the revised report in a couple of weeks.

  15. Dave

    Terraco (TEN) and the complex Spring Valley Royalty option. Just wondering if you’ve looked at the value of the option Terraco have on this Barrick / Midway mine-to-be that is on-strike with Terraco’s Moonlight project. The details canbe found at http://johnston-sequoia.blogspot.co.uk/2011/12/terraco-gold-announces-acquisition-of.html (this guy must be a fan of the Berrys judging by his portfolio).

    New drill results today prompted favourable comment and proclaimed bidding by the Berrys (they are advisers and own shares already, at a big loss I presume). They reckon the royalty is worth much more than the company. But it is somewhat confusing/ too good to be true, perhaps because there is some history missing.
    Terraco is now $19m vs 60ish not so long ago (so says SH). Although somewhat variable today.

    [re tagging, I see that last time I must have typed too fast for the filtered list to appear, much better]

    • Dave

      @Dave

      PS: and in March there was some kind of extension to the royalty purchase.

    • @Dave

      I’m expecting a call back from Midway to clarify some questions I have on the royalty after having done some research this morning and a review will be forthcoming assuming I can get everything straightened out to a sufficient degree. I’ll probably also have to call up Terraco and clarify certain aspects of the “second royalty transaction” you alluded to. The main inquiry being how much of the project is encumbered by what in both cases would amount to a max 2.5% NSR for Terraco.

      But going with the following assumptions:

      1) the combined royalties apply to the entire mineable resource,
      2) 4M ounces are recovered over 10 years, i.e. 400,000 ounces per year
      3) production begins 2017 (4 years)
      4) 5% discount rate

      …we arrive at an NPV of $78.6 million. It is no coincidence that Johnston-Sequoia Capital Corp. made reference to the royalty being worth $80 million using NPV model, since we in fact tried to model the production level that would arrive at such a figure. We’ve also adjusted for the royalty (at least the more substantial one, transaction 1) does not kick in until 500,000 ounces are produced, as well as the net $7.5 million cost to Terraco ($12.5 million less $5 million)

      I don’t think it’s worth arguing about the accuracy of that NPV, better just to wait until we get a scoping study on the project (planned for Q4 2012 I believe). For now what’s interesting is looking at the relative value provided by this project to Terraco vs Midway.

      I’m calculating that the royalty as contemplated above would be worth about $0.50/share to Terraco on a fully diluted basis (current price $0.14).

      Meanwhile, the value of the Spring Valley project to Midway Gold assuming $800/oz cash costs and $300M capital cost is about $3.00/share (current price $1.45).

      Thus it appears there’s 2-3x more leverage to Spring Valley success by owning Terraco, but at the same time Midway arguably boasts a much lower risk profile and more immediate share price drivers since Spring Valley is #3 in its project pipeline.

    • @Dave

      Just got off the phone with Midway Gold. No clear idea of how much the royalty applies to, but guessed at 50% of the total. Was told that the NSR in question (referred to as the Paul Schmidt Agreement in the technical report) would not apply to any resource expansion to the north or south (see map given in December 6, 2011 news release: http://www.midwaygold.com/s/NewsReleases.asp?ReportID=494746).

      Here’s the zinger: if the royalty only applies to 50% of the current resource and given same assumptions as above (which are already probably very optimistic in terms of production) then the royalty is worth an estimated $35 million or about $0.22 per Terraco share on a fully diluted basis which is significantly less upside from success at Spring Valley than offered by owning Midway Gold (again, using these same assumptions).

      Failed to mention that I was generally skeptical of the deal laid out in Terraco’s December 21, 2011 news release: http://www.terracogold.com/s/NewsReleases.asp?ReportID=497960&_Type=News-Releases&_Title=Terraco-Gold-Announces-Acquisition-of-Royalty-Option-on-Spring-Valley-Gold-
      … in the sense that the Terraco royalty could be worth $80 million. It just seems too good to be true for Terraco. As I understand it some unknown third party is not only paying Terraco $5 million, but also giving them a 5 year option to acquire half of the royalty at the same pro-rated cost as paid by the 3rd party.

      In exchange all the 3rd party gets a smaller royalty on Terraco’s less advanced Almaden and Moonlight projects as well as 1M warrants at $0.35!? Just doesn’t seem accretive. Then again if you’re a royalty aggregator perhaps the added diversification is worth it, but I think if you’re bullish on Spring Valley then Midway is currently the better investment vehicle.

    • Dave

      @Zurbo

      Hi re “No clear idea of how much the royalty applies to, but guessed at 50% of the total.” – not sure what you mean here, are you saying that neither Medway nor Terraco would/could tell you what was an agreed final % in the contract, or that this 50% is based on how much expansion, and thus resource, is in the excluded north and south zone, and is an unknown figure?

      Yesterday the Berrys had it as “Few people realize that the company controls a very sizeable royalty asset – worth, at present value we believe, over $80 million. This asset is very, very liquid.”, in December (before the March addition that is) they stated “Well it is ½ of 5/7th of 7% of gold production at Spring Valley. And the option is good for 5 years. Stay tuned. We will calculate some estimates for various prices of gold. (Our calculations will be approximate with several conservative assumptions).”

      Anyway, sounds like not worth pursuing, unless Terraco drops again? Many thanks for the insights though, hope it was worth a look at least!

    • @Dave

      Early last week I spoke with Todd Hilditch, CEO Terraco, and received a fair amount of clarification. Sorry it has taken so long to come back to the topic.

      It’s doubtful that no one has a clear idea of how much the royalty applies to. I suspect Barrick as the operator has a pretty clear idea, but there would be no reason for them to reveal that type of information not to mention the resource envelope is still growing. Todd thought Midway’s 50% figure was probably too low for what would be their 2.5% Paul Schmidt NSR royalty (red area in image below), but because the resource does appear more robust to the North where this royalty doesn’t apply (green) I’d surmise coverage at say less than 80 percent.

      Spring Valley ownership map

      However, notice that Terraco owns a 0.5% NSR to the North in addition to a right of first refusal to obtain a further 0.5% from Paul Schmidt at a price yet to be determined. The point being that even if the resource to the North is more robust and continues to grow as seems to be the case, Terraco still participates just to the tune of say 1% instead of 2.5%.

      Furthermore, you can see that Terraco’s Moonlight project sits not too far north of Spring Valley, which means extension and intensification of the mineralization in that direction is very positive.

      In a June 2012 research report from Stifel Nicolaus initiating coverage of Midway Gold, it put forth the following key assumptions for a Spring Valley mining operation:

      – Start Date: 2018
      – Mine Life: 17 years
      – Initial Capital: $500M
      – Sustaining Capital: $180M
      – Total Cash Costs $779
      – Avg Annual Production (after 75% recovery assumption): 264,700 ounces

      If we assume a blended royalty of 1.5% for Terraco while using $1600 gold and a 5% discount rate, I calculate the value of Terraco’s royalty package at roughly $16M or about $0.10 per share. So nowhere near $80 million I’m afraid, but still decent enough. In comparison, for Midway I calculate that the project’s worth about $0.85 per share when discounted at a higher 8 percent while using the same $1600 gold price.

      The strategic investor that Terraco has partnered with remains anonymous, but they’re supposedly a big enough player in the industry that Todd was really anxious they come out of their shell sooner than later in order that Terraco might get more credit for the partnership.

      My question of what’s in it for this strategic investor was also answered when Todd explained that it’s hard to come by this type of royalty and Terraco had some sort of exclusive on it with Paul Schmidt. But because Terraco didn’t have the funds they gave this unnamed investor the opportunity they never would have had, thus explaining the relatively favorable deal terms.

    • Dave

      @Zurbo

      Many thanks, another piece of vapour-gold evaporates away! Good to know that there was some reason for the somewhat surprisingly good looking terms (even if I didn’t understand them) though.

    • Dave

      @Dave
      ps: [I was in the middle of editing the post but the edit box disappeared as I was typing, don't think I clicked anything, does the 5min window expire even f you are in the middle of an edit?]

      .. I’ve always been suspicious of the Berrys’ valuation acumen, they seem to like over-priced stocks.I do have one hope for them in a medical stock Senesco SNT (US) who have just released favourable phase 1/2 results, albeit very early stage and with a small cohort tested with low-dose for toxicity assessment, but who have shown some actual improvement. Early days, and not helped by a capital structure change earlier in the week which created a bunch of new shares (they claim they reduced the fd count, but the numbers haven’t made sense yet) and brought the price right back down.
      The Berrys followed up this latest result bemoaning that it and two other recent favourable NRs of late had left the price languishing, completely failing to make it clear that the third news piece was still pre-market and that there had been this capital adjustment (I think they completely missed it). Not that they reply to my emails though. Oddly they also commented on the NR before it was findable on the news service Senesco use, although it did appear before the market opened.
      [And they certainly didn't spot the AMY disaster before it happened (rising costs)]

    • @Dave

      We’ll look into the edit window expiring in a hard 5 minutes but I would say there is a good reason to do it that way since the edit is really only supposed to be for catching some obvious/embarrassing typo or other silly boo-boo and not re-writing the comment.

      Regarding Terraco and the Spring Valley royalty, I would just add that it does have decent value but of course it is not worth $80 million when properly adjusted (NPV, etc.). It is still quite an attractive asset for what it is and provides a very decent backstop to the company valuation at the current share price but in the end it is probably the Almaden/Idaho project that will ultimately drive valuation (and to a lesser extent their other properties). On that project, the key is their approach to mining and processing because the deposit is high in mercury and has other challenges. It will take a different, creative approach to move it forward. Certainly Terraco having done the Spring Valley royalty would indicate these guys are capable of that.

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