Paper money being debased in a low-interest-rate world has conservative investors searching for yield and preservation of purchasing power. Shares of Franco-Nevada (FNV) are a long-term investment with a high degree of safety, robust growth, and the opportunity to benefit from government money printing.
Gold mining shares (GDX) are fraught with risk. Mine walls collapse and managements overpromise. Mine development and operating costs continue to escalate ever higher, while governments often seek to nationalize resources or dramatically increase mining taxes. Gold ETFs (GLD) have negative carrying costs to store the metal.
Pierre Lassonde and Seymour Schulich co-founded Franco-Nevada Mining Corporation in 1982. They began by participating in a series of exploration play dry holes. In 1985 Franco-Nevada began the royalty business and bought a small gold royalty in Nevada. Soon Barrick Gold purchased the property, increased production and made the Goldstrike gold discovery. Franco-Nevada parlayed this royalty success into an aggressive program to buy more gold royalties. In 2002, Franco-Nevada merged with Newmont Mining (NEM) and in December 2007 Newmont spun out Franco-Nevada into an IPO.
Over a 20-year period, the original Franco-Nevada provided shareholders with a stunning 36% annualized rate of return. A $1,000 investment in the 1983 IPO grew into $1.25 million in Newmont shares to begin 2004. At investment conferences, Franco-Nevada management jests about falling only slightly short of that stellar mark over the over the last five years. Repeating the success of the old Franco-Nevada may not be possible. The Goldstrike find was a company maker and had a disproportionately large effect on the very small old Franco-Nevada. However, the old Franco-Nevada operated in an environment of a secular gold bear market while the new Franco-Nevada has the tailwind of the current gold bull market. Today's Franco-Nevada begins with the head start of a deep portfolio of exploration assets acting as perpetual call options. Today's tight equity and credit markets are competitive advantages and volatility creates opportunities.
Franco-Nevada management's attitude considers safety first. In financial conservatism they do not believe in debt; they believe in the need to have cash on hand for when the opportunities to make investments occur. The patience to negotiate new deals from a position of strength allows for strong returns.
Another factor of safety is to be the low cost producer. Franco-Nevada is a royalty and streaming company. Royalties are taken off the top of production from mine operators. Streams are the right to purchase mine production at a low preset price. Franco-Nevada has little exposure to always increasing mine operating costs. In commodity businesses, the low-cost producers dominate the economic returns. Royalty companies are the low-cost industry participant.
Franco-Nevada has limited political exposure with strong title on its asset base. Contracts are written with tenure and the rule of law of Western courts. When the royalties are on private lands, Franco-Nevada writes the royalty into the land title. These royalties rank ahead of debt holders and survive operator bankruptcy. Franco-Nevada never has had a legal dispute because of clean arrangements.
Franco-Nevada has full exposure to the gold bull market. Revenue from Franco-Nevada's royalties rise and fall with the gold price and the production of the underlining assets. Some royalties increase to higher rates as the price of gold increases. Royalty streams provide operating leverage by allowing the operator to deduct a fixed amount, typically $400 per ounce with small inflationary adjustments, to the revenue due Franco-Nevada. Franco-Nevada exposure to operating costs is very small, with few of their interests being profit-based.
Today's tight credit and debt markets give Franco-Nevada a strong position in negotiating new royalties. Junior exploration and production companies are in need of regular financing. When one of these many companies would like to explore their property further or expand their production facilities, capital is needed and difficult to obtain. Banks and bond investors demand onerous terms in today's marketplace. Depressed stock prices for these same companies make equity financing unacceptably dilutive. This dynamic creates opportunity for Franco-Nevada.
Franco-Nevada writes these royalties with an exceptionally long view. Consider a royalty Franco-Nevada wrote in February 2012 with Lake Shore Gold Corp (LSG) on its Timmins West Complex. Based on current production, Franco-Nevada could expect this royalty to provide annual revenue approaching 10% of the purchase price, a meager risk-adjusted return. However, Timmins West is undergoing a production expansion which will increase the return. Centrally important to Franco-Nevada's long-term orientation is the large land position this new royalty covers with promising resource growth potential. Future gold discoveries and associated production accrue to Franco-Nevada's benefit at no additional cost. This perpetual exploration free call option is the incentive for Franco-Nevada enter the deal.
The perpetual explorations free call options embedded into Franco-Nevada's portfolio makes the company different and superior to competitors. Silver Wheaton (SLW) simply takes on too much financial risk. Royal Gold (RGLD) is a mundane financing company. Sandstorm Gold (SAND) is a young company venturing into risky Mongolia.
Franco-Nevada has interests in 136 exploration assets and looks forward over multiple decades and resource cycles. When making investments, management is comfortable to get its money back and to make a low initial rate of return in order to have significant exploration upside. This exploration upside is how the company came to have Tasiast and Detour in the pipeline. Franco-Nevada is not a cold investment company merely calculating discount rates. Franco-Nevada pays today for growth years and decades into the future.
Tasiast and Detour as two examples:
- The Tasiast gold mine royalty is a 2% revenue based royalty and on Franco-Nevada's books as a $3 million asset. While Franco-Nevada has owned this royalty, the asset has changed owners several times. One previous owner did large amounts of exploration and deep drilling, proving up a world class resource. Current owner Kinross (KGC) has aggressively advanced exploration and feasibility work for multibillion-dollar expansion. Tasiat production shall dramatically increase in the years ahead, potentially provided Franco-Nevada with tens of millions of dollars in free cash flow annually. Most exciting is the potential for Tasiast to be a gold district far larger than what Kinross has on its books.
- Another property to highlight is the 2% royalty on the Detour Gold project. Detour is building Canada's largest gold mine and expects production with production having begun in 2013. Future plans are to increase production to 650 thousand ounces a year. Detour is similar to Tasiast in size, and the royalty also covers additional ground.
Franco-Nevada management has demonstrated over the last three decades the large share of wealth creation from the resource sector comes from new discoveries. Grassroots exploration, building mines, and operating mines are difficult businesses. Franco-Nevada has all the benefits of new discoveries without the myriad of associated costs. They are explorationists at heart.
Interest in 28 advanced stage assets have the potential to generate revenue within five years. Highlighted already were the two most promising in Tasiast and Detour. The rest as a group have the potential to generate more profit than Tasiast and Detour combined and are detailed in the asset handbook. Mining is a difficult business and some projects will not get permitted, financed or perform as well as projected. The diverse asset base provides Franco-Nevada insulation from being exposed heavily to the inevitable challenges of the operating business. These advanced stage assets provide approximately 50% growth to Franco-Nevada over the next five years. Most importantly, the growth is already purchased and does not require any financing from Franco-Nevada.
Often in the resource industry, operating companies boast of future growth, growth built upon heavy capex spending. A powerful aspect of Franco-Nevada's business model is the first dollar invested is the last dollar invested. After the investment payback, all the revenue comes in as free cash flow. Continued significant Franco-Nevada growth over the long term requires no further capital spending.
Anticipate Franco-Nevada's investment universe to broaden. CEO David Harquail at a investment conference last year:
We've actually become dominantly 90% plus precious metals and so we're agnostic. We're now actually bidding, as you saw with Lumina, on copper royalties and we're looking at iron ore and other larger copper royalties, potash and coal royalties because we believe the royalty model works in all commodities. The key thing is having that optionality for upside on those properties, and so we now have what we believe is one of the largest investment universes open to us.
The current annual dividend yield is 1.50% and is paid monthly at a rate of $0.06 per share. The new Franco-Nevada initiated the dividend six months after becoming public in May 2008, and has raised the dividend at the annual shareholders meeting every year since. The dividend increases have been by 16.67% in 2009, 7.1% in 2010, 60% in 2011, and twice in 2012 by 25% and 20% in 2012. The board of director's intent is to annually increase the dividend, keep the dividend at about 20% of free cash flow, and maintain the dividend during cyclical downturns.
Current Chairman Pierre Lassonde led the old Franco-Nevada and current CEO David Harquail was on that management team too. The company operates with 20 employees and has annual G&A overhead of $16 million. The Toronto-based company reports results in U.S. dollars while 60% of the shareholder base resides in the U.S. Currently, Franco-Nevada receives 15% of its revenue from the platinum group metals.
Two potential catalysts to move the stock are possible. First, the precious metals complex has suffered and may rebound. Second, Franco-Nevada last year obtained a large stream on the Cobre Panama project from Inmet Mining, and Inmet is busy fighting off a hostile bid by First Quantum. A resolution should provide clarity. The business and shares of Franco-Nevada have an incredibly bright long-term future. Safety remains a company core value, the exploration upside is substantial while meaningful growth is real without any capital spending requirements. Expect Franco-Nevada to continue to make additional transactions on a regular basis. The possibility of currency debasement and a rising gold price multiplies the upside.