What Is So Compelling About Royalty Companies?

gold streamingOver the past decade, the prices of precious metals have performed incredibly well.  However the companies that mine these metals have not had the same good fortune.  These companies suffer from a variety of issues, although the most pressing is rising production costs. It doesn’t matter that the gold price is up roughly $1,000/oz. over the past twelve years, as for most gold miners the cost of producing is up around the same amount.  And as these companies face regulatory burdens and rising taxes, it becomes increasingly difficult to pick winning mining stocks.  As a result, many investors have turned to other ways to profit from rising precious metals’ prices.

One of the standout alternatives is royalty or streaming companies.  These companies have a business model that nearly eliminates the threat of rising costs for investors.  Royalty and streaming companies make agreements with mining companies whereby they pay these mining companies for the right to a certain amount of production—usually a percentage—on a given project.  While there are various ways to structure a royalty or streaming agreement, they almost always have no cost, fixed costs, or costs that vary in a way that is not punitive to the royalty or streaming company.

To say that this business model is categorically better than mining is an oversimplification. But if we look at the historical performances of royalty and streaming companies, we have a small group of stocks that have outperformed the gold price, the silver price, mining stocks, and global stocks in general, and all by a wide margin.  Buying the three well-established royalty and streaming companies –Franco Nevada Corporation (FNV), Royal Gold (RGLD), and Silver Wheaton (SLW)—at virtually any time except near a market top has resulted in strong, double-digit or triple-digit gains.

We can see this strong performance by looking at a couple of charts.  The first shows Royal Gold (blue) compared with the SPDR Gold Trust (GLD) (gold) and the S&P 500 (red) since the inception of the SPDR Gold Trust.  As you can see, you would have made over a 300% return in Royal Gold, versus a 171% return in gold and a 69% return in the S&P 500.

We can see a similar outperformance in Silver Wheaton shares since the inception of the iShares Silver Trust (SLV) in 2006.  While the S&P 500 (yellow) outperformed silver (red) by a small margin, Silver Wheaton (blue) blew them both out of the water by tripling in value.

Finally let’s look at Franco Nevada, which only began trading publicly towards the end of 2007.  Since then, Franco Nevada (blue) shares have returned more than 300% while Gold (red) has returned 56% and the S&P 500 (yellow) returned just 33%.

So why are the royalty/streaming companies able to outperform by such a wide margin?  There are three general attributes of the business model that I believe offer significant competitive advantage:

1) Fixed Costs:  An NSR royalty agreement—the most common type of royalty agreement—entitles the owner of the royalty to a percentage of the revenues off the top of a particular mining operation.  A streaming agreement entitles the owner of the stream to buy a certain amount of gold or silver from the mining company at an agreed upon price.  It can either be fixed, as is the case with Royal Gold’s large streaming agreement on Thompson Creek’s (TC) Mt. Milligan Project, which entitles Royal Gold to the right to buy 52.25% of the gold produced there for $435/oz.; or it can be variable such as the streaming agreement between Royal Gold and Rubicon Minerals (RBY), which entitles the former company to the right to buy 6.3% of the gold produced at Rubicon Minerals’ Phoenix Project at 25% of the spot price of gold, guaranteeing Royal Gold’s profitability.

In addition to volatile production costs, mining companies have to deal with a plethora of other costs. Whereas royalty and streaming companies have to make just one payment or a series of payments that is agreed upon once the deal is signed, mining companies have to finance permitting, exploration, mine construction, mine closure, mine repair, and taxes.  Royalty companies just collect money as it comes in.

2) Exploration Upside at No Additional Cost:  Let’s say that a royalty company buys a royalty on a gold project after the owner of this project estimates that it has 1 million ounces of gold.  The size of the initial payment is going to be based on this 1 million ounce estimate.  But if subsequent drilling encounters significantly more gold on the property, the royalty extends to these new discoveries!

Some of the larger royalty companies have dozens of these agreements.  While there is no guarantee that these mining companies will find more gold, the royalty companies have such broad exposure that chances are a few of these royalty agreements will wind up being big winners.

As investors tend of focus their analysis on cash-flow models, it can be hard to incorporate this type of upside potential.  Analyzing the cash-flow potential for gold that hasn’t been discovered yet is kind of like analyzing the cash-flow potential from lottery tickets.  We can try to ascribe some sort of probability to exploration success and use this to come up with a conservative model, but it will almost certainly be wrong.

Lastly, when a mining company determines its mine plan and generates a resource estimate, it does so with a certain gold price assumption in mind.  This leads it to pick a cut-off grade for its ore, meaning that it is only interested in mining ore that has a minimal amount of gold. The rest is considered to be waste.  But some waste becomes mineable ore if the gold price rises because gold that wasn’t economical to exploit at $1,300/oz, might be economical to exploit at $2,000/oz.  While this benefits mining companies, keep in mind that this lower grade ore costs more to process, and the royalty companies, which have fixed costs, benefit to an ever greater extent than the miners.

3) Mitigated Downside Risk: Having fixed costs means that streaming companies do not face margin compression as costs rise and overruns take place. In addition, the streaming companies usually include language in their contracts whereby they do not have to continue making payments or receive funds back if certain parameters are not met.  So, while a mining company could lost a significant amount of value if a mine is shut down, the streaming or royalty company can mitigate this risk through contract terms.

The diversification of projects also limits their risk, whereas a mining company typically has all of their eggs in just a few baskets. When a large mine is shut down, it could spell doom for a particular miner. For a well diversified streaming/royalty company, it is not likely to have as large of an impact.

Additional Benefits: Streaming companies also tend to have extremely strong balance sheets with a lot of cash and little debt. In the case of Franco Nevada, they have no debt. These companies also tend to be exceptionally well managed.  If you look at the quality of some of the deals that have been made by the royalty and streaming companies over the years, you’ll find that these management teams are extremely prescient in their ability to pick winning mining teams and winning properties. While Sandstorm Gold has made some questionable calls over the past few years, these growing pains have not derailed the success of the company.  On the other hand, Franco Nevada’s $2 million investment in the Detour Lake Project owned by Detour Gold (TSE: DGC), is now expected to generate over $1 billion in cash-flow for the company. This is the type of unexpected upside potential that can net a royalty company such a huge ROI.

Not only have these companies made outstanding royalty and streaming deals, but they have managed their capital exceptionally well.  Royal Gold, for example, issued stock right at the top of the market when the shares traded at over $100 each.  A little more than a year later, the shares were bottoming 60% lower as the gold price fell and this left the company with plenty of capital to make new deals.

Royalty/streaming companies tend to hold up better than mining stocks when precious metals prices declines. But this doesn’t mean you should throw away the invaluable advice to buy low and sell high.  If you buy at the right time you can find tremendous bargains.  For instance, I recommended Royal Gold shares at the beginning of the year and pointed out that they traded at just a slight premium to the value of the company’s discounted cash-flow.  Since then, the shares are up 65% while the gold price is up just 6%.  This means that if you pick your moment, you can buy these stocks when they are cheap.

Given these points, it is no wonder that royalty and streaming companies have performed so well.  The one drawback, if any, is that a lot of investors have figured this out and choose royalty and streaming companies as their preferred way to get exposure to precious metals.  As a result, these companies are overvalued relative to their discounted cash-flow.  They also trade with unusually high price-to-earnings multiples.

Ultimately, royalty and streaming companies offer a unique way to get low-risk exposure to precious metal prices with substantial leverage to the upside and mitigated downside risk. These companies are a cornerstone to any high quality precious metals portfolio.

By | 2017-03-23T14:06:19+00:00 August 26th, 2014|Gold & Silver Commentary|
Ben is an independent investor that writes in order to clarify his own ideas and refine his investment strategies. Ben's investment philosophy is guided by two major themes: long term secular trends and deep value.