Investors in Sandstorm Gold (SAND), the aggressive gold-streaming company, have been in shock over the precipitous drop in the share price over the past 30 days. In that time period, the price of gold has dropped 6%, but SAND has lost 30% of its value. This is in addition to a 20% plunge from its high of $15 only last fall.
On February 19, 2013, Sandstorm Gold announced its full year 2012 results and conducted a conference call. Shareholders were not soothed, as the stock fell 8% on five times the normal trading volume that day alone. This article is to explain our view on the reasons for the recent weakness in this stock, and if this is an omen of worse things to come or a great buying opportunity.
For those not familiar with Sandstorm Gold, it became a public company in 2010, and it focuses on completing gold purchase agreements with junior gold mining companies that have advanced stage development projects or operating mines. SAND provides alternative cash financing to gold mining companies in search of capital, and in exchange receives the right to purchase a percentage of the gold produced for the life of the mine at a fixed price per ounce. Usually the price is between $350 and $500 an ounce.
We first became attracted to SAND in 2011, when it literally traded in the penny stock category. We mostly liked the business model and the fact that the CEO, Nolan Watson, had been the CFO of the highly successful silver-streaming company, Silver Wheaton Corp (SLW). Other SLW execs are also helping adapt the SLW streaming model to Sandstorm. After a reverse split and steady growth, our investment reached $15, but now has fallen back to $9.25 today.
The Anatomy of the Plunge
Four events seemed to be at the root of the sudden plunge in SAND share value from its high in the fall of 2012.
On November 9, 2012 theStreet.com ran an article advising to "buy SAND off any weakness." Then on November 14, in Jim Cramer's Lighting Round, theStreet.com announced that it was time to sell SAND. The stock immediately dropped to $11 per share.
At the end of January 2013, SAND announced the acquisition of a majority equity stake in Premier Royalty (BPVIF.PK), a smaller competitor in the gold streaming business. This involved issuance of warrants, and the cost and dilution appeared unjustified to some investors.
SAND re-rallied to $13, but gradual deterioration in the spot price of gold and the announcement of a $100 million credit facility left SAND at $ 12 per share on February 14, 2013. The next day, SAND announced investment in an agreement with Entree Gold (EGI) for interests in the Heruga and Hugo North Extension properties in Mongolia. The bottom dropped out of the SAND stock, which closed last week just below $11 per share. We were surprised with this deal as most of the company's acquisitions had been in jurisdictions in the Americas, and most of the cash flow to SAND from these developmental mines is about a decade away.
Finally, the stock fell back into single digits with the annual report on February 19, 2013. The impetus was probably less growth in revenue and ounces sold during the final quarter than expected and guidance for only a modest production increase in 2013. Also the nature of the recent deals for Premier and Entree became more clear, and those indicated a change in the direction of the company from pure streaming to an equity investor.
The Good, Bad and Ugly of Acquisitions
Part of the concern about SAND taking equity positions in place of pure streaming is that those investments involve participating in the risks of mining that the streaming model typically avoids. The streaming company does not worry much about capex over-runs or rising production costs, but the equity position includes those risks.
The Premier Royalty deal actually appears to us to be a positive arrangement. As CEO Watson explained in the conference call, SAND has outgrown the small deals with junior miners, and the development staff has been inundated by potential deals that may be profitable, but are no longer big enough. These can be filtered and passed through to the Premier analysts, creating new opportunities for growth in that company's streaming portfolio. The equity position gives SAND an opportunity to participate in the success of Premier, free the SAND staff to follow up on more significant deals and eliminate a competitor in the gold streaming market. Since Premier is also a streaming company, the capex and cost worries do not apply.
The Entree acquisition is more perplexing to us. Mongolia is considered a risky jurisdiction and in the third quarter conference call Watson indicated that they were looking to grow primarily in familiar countries, mostly in the Americas. We were not totally surprised by the fact that the company was taking a position in such a long-term arrangement with no appreciable payout in the near term. In Our Mid-Year Precious Metals Update we were concerned about this:
"Lately, Sandstorm has been investing in more exploration phase projects, which gives us pause for the short-term.
We agree that a royalty company needs to plan years ahead to maintain a production stream as older mines play out. We also think that the management has proven that it knows where the good deals are. Our concern for the short-term is that the earnings from these latest project investments will take years to hit the bottom line. In the meantime, the market is likely to evaluate the stock as fully-priced, on the basis of PE..."
We should mention that the price of SAND stock when we made that comment was actually a little lower than it is today, so traders following our advice may have missed a short-term trading opportunity.
From a stockholder point of view, the latest acquisitions seem to indicate a change in management strategy that was not anticipated. Stockholders do not like surprises that are not clearly positive, and the confidence in management is strained by costly, long-term deals with no immediate gratification. Even though the company may receive a billion dollars in cash flow in the long run, there is an ugly sense of betrayal.
The Problem with Gold Technicals
It has not helped SAND that the above events occurred as the spot price of gold dropped through the long term trend line.
The fundamentals for gold have not changed drastically, but we frankly expected that the listless action during the past couple weeks was due to the Chinese New Year break. However, when normal trading resumed, the price of gold dropped further, penetrating the five year trend line. It is entirely possible that the price of gold could retrace 40% of the long-term gain over the past five years. That would place the support of the gold price at 1420, about 10% lower than the spot price today.
The three major factors we must consider in determining how to play Sandstorm Gold after its precipitous drop in share price are:
1. The direction of the price of gold
2. If the latest acquisitions are good for the company
3. Has management changed its direction or lost the "golden touch"
We are very concerned that we could see a 10% drop in the price of gold in the next few months. The sequester fight is a politically-charged event that could create some short-term anxiety that normally is good for gold, but the investing public seems jaded by such politically created crises. The scary technicals and lack of strong upside impetus makes us bearish short-term on gold. Having said that, we do think that the increasing cost of production and the eventual bump in inflation, coupled with new global worries, will contribute to a resumption in the long-term uptrend after any near-term retracement.
We do think that the Premier Royalty acquisition will prove to be a smart move. Short-term, the weakness in the gold price will probably affect all gold stocks. Even though SAND has had a terrible month, this week alone many of the junior miners that are partners of SAND have dropped more than 3% in value. One that we follow as a benchmark for Canadian miners, Aurico (AUQ) has dropped 9% in three trading days. The equity investment in Premier will likely be a short-term drag on the next earnings report, unless gold rebounds in the next month.
We see the Entree deal as an insurance policy against SAND resources playing out in the next decade. It is noteworthy that SAND wrote into the agreement some partial protection against the political risk of the deal by requiring reductions in commitment according to reductions in production. The deal represents only about 5% of the market capitalization, so we are on board with this acquisition as a one-time divergence from the typical Sandstorm deal.
Finally, we have not lost faith in the management of SAND. According to the conference call, Watson indicated that the Entree deal was not an indication of future arrangements. SAND has plenty of financing options to make additional streaming acquisitions. Although we are a little uncomfortable with the boldness of the latest actions, we cannot say that we have been disappointed with the results of the Sandstorm deals to date.
For investors, we consider the current price of the Sandstorm stock reasonable for a long-term holding. Short-term, we are less optimistic. Although the worst is probably over in this price plunge, we doubt that investor confidence will flood back into SAND in the short-term. Traders may want to take a wait-and-see attitude. Long-term investors should consider this an opportunity.
As for us, our strategy is to sell SAND 7.50 puts. For example, we get $250 for 10 contracts, and that ties up $750 of our margin limit. The result is one of two outcomes. The puts expire in June with a 33% gain in four months on our margin, or the we have to buy the stock at an attractive $7.25 cost basis. Either way, we think we win.
Speculators may want to take a hard look at Premier Royalty, as that may be the ultimate winner in this latest drama.
Disclosure: I am long SAND.
Additional disclosure: We do not know the circumstances, risk tolerance or investment objectives of our readers. There is no guarantee that any investment mentioned in this article will be profitable or appropriate for readers.