Analysts have gravely understated the value of the royalty and streaming companies by not understanding terminal value and by ignoring the rising price of gold.
A thorough analysis of competition, risk, and management of precious metals royalty and streaming.
Mining companies are capital-intensive commodity businesses and therefore are horrible investments. Precious metals royalty and streaming are nearly risk-free, and have enormous upside potential.
The Mafia of the Gold Mining Industry
The dominant players in the industry include: Silver Wheaton, Franco Nevada, Royal Gold, Sandstorm Gold.
A Brief Explanation of the Business
- The precious metals royalty/streaming company issues common shares, and the small management team receives cash.
- They receive many phone calls/offers; they don't have to proactively make outgoing offers. They look at 300 prospects a year, and choose to do two or three deals.
- Criteria for the streams include: Great asset with exploration upside, low cost quartile, and great management team.
- The royalty/streaming company provides cash to an operator in exchange for a streaming contract imposed on the asset. The contract stipulates that the operator must pay the royalty/streaming company a certain portion of the precious metal ounces produced over the life of the mine.
- The streaming company has fixed ongoing costs. However, the company is still exposed to cost pressures and other risks of the underlying operator, because the royalty/stream payments are dependent on production levels.
Royalty/Streaming Companies Provide Three Opportunities:
- Exposure to the commodity, i.e. precious metals.
- The interest rate and production/exploration upside can provide a return, even if the precious metal is shorted as a hedge.
- Value arbitrage. Silver is often a by-product, not the core asset. Lead, zinc, nickel, copper, or other base metal mines generally do not want exposure to silver, and trade at lower P/Es than pure silver companies. The silver stream trades at a higher P/E when extracted from the base metal mine, and hence, instantaneous value is created. The fundamental reason pure gold/silver companies trade at higher P/E ratios is that the risk-free rate used can be close to zero considering that many investors hold physical gold/silver with no yield.
Financing the Various Phases of Mining:
First, a company must find a deposit through exploration. Once a discovery is made, the property must be developed; feasibility, permitting, and mine construction. Then, finally, production occurs.
The royalty/streaming companies can provide financing along every phase, namely; exploration, mine construction, and streams can be purchased on producing mines.
Exploration stage: The royalty/streaming companies can spend small amounts of money on exploration ventures with the opportunity for enormous returns. This method allows the royalty/streaming companies to take advantage of their very long-term perspective. Bank debt is not a viable option, because it is short-term in nature. Bonds are not particularly suitable, because ongoing interest payments are impractical for junior companies with no earnings. Most junior exploration companies are funded by equity. Equity investors must have a diversified portfolio of junior explorers, and always face the risk of bankruptcy or dilution. A company may run out of cash before making a major discovery, and be forced to shut down or dilute existing shareholders. Streaming/royalty companies can provide diversification, and because the royalty/stream is on the land, bankruptcy risk is non-existent; the project will be completed sooner or later if it is a quality asset.
Funding for mine construction: This allows the royalty/streaming company to bypass the many years of cumbersome exploration and permitting. After all the regulatory headaches are taken care of, the royalty/streaming company steps in to provide funding, and receives the gold shortly after.
Value arbitrage from producing mines: This method allows for instant value creation. Large commodity producers are not interested in their precious metal by-products. By separating the base metal from the precious metal, each part is able to trade at a higher valuation than the sum.
Outstanding Performance Under Worst-Case Scenario:
2012 and 2013 were years of rapidly rising costs for miners and crashing precious metal (and other commodity) prices.
- The royalty/streaming companies are trading at near all-time highs, while many regular miners are trading near all-time lows.
- The royalty/streaming companies have increased their dividends, while many operators have reduced or halted dividend payments.
Since their creation, the royalty/streaming companies have outperformed nearly every precious metals mining company. (When comparing past performance, one must keep survivorship bias in mind.) The price performance of many mining companies has been flat or down over the decade. During the same period, presumably a weak mining environment, the royalty/streaming companies have had outstanding performance.
The royalty/streaming companies have proven that they are able to outperform the gold/silver ETFs; their premium relative to the price of gold/silver ETFs has expanded over time.
The stock prices of royalty/streaming companies have gone up, despite leveraged exposure to precious metal prices, in a declining market, and heavy exposure to mining conditions, in a rising cost environment.
The only difference between a royalty and a stream is that the latter includes fixed ongoing payments for each ounce of precious metal purchased.
The stream's fixed ongoing payments are usually as low as $400 per ounce of gold and $4 per ounce of silver.
When most investors learn about these low cash costs, they typically think that the mining companies try to bargain the fixed ongoing payment upwards.
… But actually, it's the opposite. When the mining companies look at a spreadsheet, they quickly realize that they can receive more money to build their mine (the upfront payment) if they reduce the ongoing payments.
The streaming companies have been able to force up the fixed ongoing payments, which illustrates their strong bargaining power.
Fixed Costs and Indirect Cost Exposure
Royalty/streaming companies have fixed costs, and are therefore not directly affected by cost increases. However, because costs affect the miners adversely, the royalty/streaming companies are indirectly negatively impacted by rising costs.
Royalty/stream payments are made from the operator's revenue, and are thus not directly impacted by rising costs. For the operator, falling costs allow for margin expansion and rising costs force margins to shrink. In contrast, changes in costs do not affect the profit margins of the royalty/streaming companies. This is a clear advantage for the royalty/streaming companies, because inflationary pressures are relentless. Mining is a labor-intensive industry, and labor costs have a tendency to rise persistently, especially due to union pressures.
If costs rise for the operator, then production is likely to decline and ramp-ups/exploration upside become restricted. This greatly reduces the value of the royalty/stream, even when margins are unaffected.
In the event that there is an issue with the mine, the royalty/streaming company suffers a delay in production, whereas the operator must;
- Continue paying employees.
- Suffer equipment maintenance costs.
- Pay the cost of fixing the issue.
- If necessary, dilute shareholders at precisely the wrong time.
Rising costs may create cash flow problems for the operator increasing bankruptcy risk but, on the other hand, it also creates an opportunity for the royalty/streaming companies to provide more financing.
The main risk for the royalty/streaming companies is the possibility that the mine shuts down. There is no recourse for the royalty/streaming company. Of course, if the mine restarts production, regardless of how long it takes, the royalty/streaming company remains entitled to receive payment.
To avoid this problem, the management invests only in high-quality assets. Mines that are in low cost quartiles are unlikely to stop producing, irrespective of low commodity prices.
Once a mine shuts down, it is very difficult to start it up again. The company would rather continue to operate unprofitably, than shut down for various reasons:
- The management loses their salaries.
- The operator may lose its permits.
- The equipment rusts without costly ongoing maintenance.
- Employees that are laid off must be re-hired.
The Price of Gold, and Rigid-Minded Analysts:
When calculating the value of royalties/streams, analysts erroneously use flat gold/silver prices, and then they use ridiculously low discount rates to justify the seemingly high valuation.
Analysts are right to use a low risk premium because of the extremely low risk involved with the royalty/streaming model, but the discount rate typically used is clearly reverse-engineered to justify the market valuation.
It only makes sense to use flat gold prices for regular mining companies, whose costs rise with inflation. Using flat gold prices and flat costs is equivalent to making equal inflation adjustments for both prices and costs, which leaves the margins constant over time. Gold prices must rise faster than mining costs; otherwise, gold mining companies cannot capture any benefit from inflation. In contrast, the royalty/streaming companies have fixed costs, and hence, the value of royalties mimics the gold price. If an adjustment is made to include rising precious metal prices, i.e. a 5% average compounded annual increase, then the value of the stream increases dramatically.
Over time, gold prices will naturally rise at a rate equal to money supply growth, because the supply of gold is virtually fixed. One can easily calculate a conservative compounded annual growth rate of roughly 5%: (Current price of gold) = (1975 price of gold)*(1+r)^38
Discount Rate: Inflation
The supply of precious metal is virtually fixed, unlike the supply of consumer goods, which grows over time.
If average annual money supply growth is 5%, then the price of precious metals (virtually fixed in supply) will rise at 5% per year on average over time.
If average annual money supply growth is 5% and the supply of consumer goods increases at an average rate of 2% per year, then consumer price inflation will be 3% annually.
The royalty/streaming companies have continuous annual revenue growth of 5%, and they can discount inflation at 3%. Given these figures, holding precious metals provides a 2% real yield per annum.
Risk premium: The business model is very low-risk. As long as the asset is high-quality and commodity prices are at reasonable levels, then the only risk is a delay in production. Thus, the risk premium can be low.
Discount Rate: Infinitely Valuable?
The price of royalty/streaming companies could arguably be infinite if they have the ability to endlessly provide any degree of alpha to the price of gold or silver.
Many individuals hold gold/silver with zero yield (negative yield if storage costs are taken into consideration), suggesting that the discount rate on precious metals should be zero. If royalty/streaming companies can receive any positive yield on their precious metal-denominated loans, then these returns can be discounted at a discount rate of zero. Assuming the funds can be continually re-invested forever into the future, an infinite stream of earnings can be summed to arrive at the price of royalty/streaming companies.
On the other hand, from the perspective of income return or per share earnings, the performance of streaming/royalty companies may not necessarily be that good.
Royalty vs. Stream
The only difference between a stream and a royalty is that a stream includes fixed ongoing payments for each ounce of precious metal purchased.
Streams have a powerful advantage over royalties. Inflation can only reduce future dollar-denominated liabilities. The upfront fixed payment cannot be affected, no matter how much inflation is created afterwards. The stream's ongoing fixed per ounce payments can be wiped out through inflation.
Another advantage of a stream, compared to a royalty, is that there is less disincentive to mine, because the streaming company pays part of the cost. The royalty/stream company must ensure it does not take too much of the profits of the miner.
There is no liquidity risk with a royalty or a stream. The stream's ongoing payments never pose a liquidity problem, because the ongoing payments always coincide with the royalty/stream precious metal payments. The fixed ongoing per ounce cost is just a technicality. (If ever the price of gold/silver goes below the fixed ongoing per ounce cost, the contract stipulates that in that case the market price is paid.)
Streams Benefit from Inflation Through Margin Expansion
If a royalty company provides ten million dollars in exchange for 11,000 ounces of gold (at $1000/ounce) one year later, then regardless of the level of money printing, the real return on the inflation-hedged investment is 10%.
An inflation hedge is neutral in the sense that it defends you against inflation, but it does not allow you to benefit from inflation. The beauty of a stream, compared to a royalty, is that fixed currency-denominated payments are made in the future.
Example: A streaming company gives ten million dollars in exchange for 11000 ounces of gold ($1500/ounce), plus an ongoing payment of $500/ounce at the end of one year. Analysts would get a cash margin of $1000 in both cases (the previous royalty example). However, if there is hyperinflation, the $500 ongoing payment would effectively disappear, leaving the company with a $1500 cash margin.
The stream, unlike a royalty, allows the holder to benefit from inflation by having the ongoing cash payment slowly decrease in real terms. The gold price will rise based solely on an increase in the supply of money, thereby increasing stream revenue proportionately, while the ongoing payments remain the same.
The benefit can be calculated by factoring in a rising gold price (5%) into the spreadsheet.
The royalty/streaming companies have very few employees, the majority of which are managers. Silver Wheaton has about 30 employees, Franco-Nevada has about 20, and Royal Gold has about 21 employees. Sandstorm Gold and Sandstorm Metals & Energy have a combined 16 employees. Given that there are only a handful of employees, rising administrative costs will not harm the business, and any slack can be identified and removed promptly.
Management has a lot of control over the business. Management can be patient and not engage in deals if precious metal prices are too high, or if it is not satisfied with the return.
Additionally, the company can:
- Buy royalties to acquire a right of first refusal.
- Engage in share repurchases.
- Return cash to shareholders through a dividend.
- Acquire existing royalty/streaming companies.
"Go for a business that any idiot can run - because sooner or later, any idiot is probably going to run it." - Peter Lynch
The managements of all four dominant players have already done a wonderful job at acquiring a valuable portfolio of royalties and streams... they are now useless. Any additional deals are likely to be less profitable than the ones that management has already made (based on diminishing marginal returns, i.e. management will pick the low-hanging fruit first.) Only accretive deals, i.e. deals with higher rates of return than the existing average, will make the company more valuable on a per share basis.
Royalty/streaming companies do not necessarily need management. If the cost of management is one percent of market capitalization (or, say, ten percent of earnings) per year, then the market cap should rise by ten percent (assuming the earnings are discounted at 10%) the day the management is fired.
Of course, if management is fired, then terminal value will vanish.
A Potential Problem
Management benefits, through an increase in compensation, from having a very large company. The management could be tempted to issue common shares to engage in non-accretive deals which would dilute shareholders. The managers can make it seem like they are finding projects with high rates of return by choosing deals with greater risks.
The managements of the dominant companies have been very shareholder-friendly, and there is no evidence to suggest that this will change.
Silver Wheaton did not engage in a deal for roughly 2 years (2010-2012) during a period of very high spot silver prices.
Silver Wheaton's Vale deal is an example of shareholder-friendly behavior and long-term thinking. Many analysts were disappointed with the Salobo deal because of a supposedly low IRR, not recognizing its risk-free nature and high potential for production upside.
Simply discounting the existing royalty/stream payments to the present does NOT provide a full representation of the royalty/streaming company's value. Once the royalties/streams mature, the funds can be re-invested. If management can make new loans at a rate superior to that of a risk-free sovereign bond, then this alpha must be discounted to the present and added to the value of the company.
Assume the management can re-invest the proceeds from any royalties/streams that mature at a risk-free rate of 5% (this number is conservative considering it includes the lending rate, the rising price of gold, and exploration/production upside). If a long-term government bond is trading at 4%, then the alpha produced by management is 1% per year forever into the future. The 1%, if discounted at the long-term government bond rate, is worth 25% at the maturity date of the original royalties/streams. This 25% needs to be further discounted to the present, at the risk-free rate. If on average, the royalties/streams mature in 15 years, then the present value of the 25% outperformance is worth 13.88% (25%/(1.04^15)).
If management cannot continuously reinvest the company's funds at superior returns, then their existence is not justified and they should immediately be fired. (Management can also justify its existence by finding accretive deals, but this is limited.)
Competition: Worst-Case Scenario:
Royalty/streaming companies are essentially financing companies, and thus, they compete with other royalty/streaming companies, debt (including bank debt), and equity.
The worst-case scenario for the royalty/streaming companies, with respect to competition, is that they halt operations and fire management. The companies can simply stop doing deals, hold their existing portfolios, and return excess cash to investors.
Of course, this will wipe out terminal value, but this is somewhat offset by eliminating management.
Fortunately, the worst-case scenario is an unlikely outcome.
Competition: Royalty/Streaming Companies
The companies that have chosen to avoid the actual mining of gold have prospered.
- Prospect generators: Virginia Mines, Reservoir Minerals, Abitibi Royalties, Solitario Exploration & Royalty. The prospect generators represent potential competitors that may begin to compete.
- Small competitors: Altius Minerals, Callinan Royalties, Anglo Pacific Group.
The business model of the royalty/streaming companies is to consider and analyze various mines, determine which are the most lucrative, and then pay an appropriate price for the royalty/stream. Acquiring royalties/streams is essentially identical to acquiring companies, especially other royalty companies. The dominant players have the ability to examine the existing royalty/streaming companies and acquire the best ones, e.g. International Royalty Corporation, Premier Royalties, Gold Wheaton, etc.
Industry consolidation reduces competition and reinforces the niches of each of the major players.
Silver Wheaton dominates the silver streaming space; the other players are reluctant to compete for silver deals too fiercely. Sandstorm has explicitly stated that it will not compete with Gold Wheaton (when GLW still existed as a separate entity) or Silver Wheaton. Silver Wheaton, for the most part, stays within its niche by engaging in very large silver streams (not royalties). Royal Gold and Franco-Nevada purchase many royalties on exploration projects. Franco-Nevada's assets consist of roughly 20% oil & gas.
Due to Sandstorm's small size, it will surely encounter less competition. Only large deals move the needle for the larger players, and therefore, management cannot get bogged down by the small deals that Sandstorm is interested in. Additionally, royalty/streaming companies serve as a second set of eyes and reinforce the legitimacy and quality of the project. Small companies benefit disproportionately from this, because the market sees that the royalty/streaming company checks off on the quality of the asset.
Unlike debt, stream financing is patient capital. There are no covenants that the miner can trip over. Royalty/streaming companies are partners of the mining companies; their interests are aligned. Sandstorm's management is interested in ultimately being a one-stop financing entity for mining companies. Based on the specific mine, Sandstorm can determine how the capital structure (comprised of equity, debt, and stream financing) should be formed. This allows royalty/streaming companies to build a brand and to build relationships with the mining companies, further strengthening their market position.
Niches: Various Phases of Mining
Various phases of mining include:
- Mine construction; and
Royalties/streams can be purchased in each category. Analyzing the value of royalties/streams requires a different skill set for every different mining phase. This creates an opportunity for the royalty/streaming companies to build a niche.
Buying royalties on exploration projects: This requires being able to figure out whether an asset is viable, whether a major discovery will be made, and/or whether a mine will be built and in how much time.
Funding for mine construction: It is necessary to analyze the specific operator, unlike the exploration method, where quality of the asset is the only consideration. The operator must be strong financially. The operator's management must be highly experienced. Exploration/production upside is relevant, but ensuring that the mine is built without encountering too many technical (and legal) problems is paramount. Given that large producers have access to equity and debt markets, this category involves dealing with small mining companies.
Value arbitrage: This method involves transactions with large producers (generally financially sound and highly experienced). Assessing production/exploration upside and determining if the costs are sufficiently low is essential.
As the industry expands from its current state of infancy, there may be a lot of room for growth and room for new streaming companies for many years. The combined market capitalization of the dominant players is less than $25 billion.
Additionally, many competitors may focus their efforts away from the precious metals space, on the much undeveloped base metal and energy royalty/streaming industry, e.g. Altius Minerals, Sandstorm Metals & Energy.
The commodity royalty/streaming industry can easily be 5% of the global mining industry (roughly 2 trillion), which suggests an industry size of at least $100 billion.
Competition: Barriers to Entry
Barriers to entry are surprisingly high:
- Nolan Watson, an expert in the field (considering his experience at SLW) and a workaholic, had a difficult time starting up Sandstorm. Potential investors were reluctant to invest. The model seemed too good to be true, and they felt they had to be missing something.
- The royalty/streaming companies consider hundreds of deals, and only do a few per year. The capability of management is crucial, but it is difficult to prove their skill and establish credibility without a long-term track record; the outcome of exploration projects is not known for years, even decades.
- Many companies that try to enter the space run out of cash. They do not get into cash flowing positions, and so, they end up being bought out or merged.
- The stream contracts must ensure that the tax structure, accounting structure, and legal framework are all properly aligned. Some start-up streaming companies have had trouble doing this.
- David Harquail claims that the hit rate for "true value creation events", such as Goldstrike, Detour, Tasiast, and other major discoveries that FNV holds a royalties on is 1 in 20. A new royalty company will not be sufficiently diversified to ensure great returns. The deals are very large, and becoming larger, and thus, large amounts of capital are required to create a diversified royalty/streaming company.
Debt finance and the mining companies' incentives are not aligned.
Banks are heavily regulated, and hence, inefficient. They are not legally allowed to engage in royalty/stream finance. It is notoriously difficult for junior mining companies putting their first or second asset into production to acquire bank finance. It may take three to six months or longer to acquire the funds. In contrast, royalties and streams can be arranged extremely quickly. The due diligence that is done on the mining companies is costly, and even then, there is no commitment from the banks that they will lend. Even if the bank does lend, there are extremely onerous covenants. Banks may force miners to hedge their production as a condition for a loan. The covenants often force the company to raise equity (diluting shareholders). If the tight covenants are breached and the bank gets nervous, it can seize assets or demand that more collateral is put up for the loan.
Bonds bring risk of default. Interest payments can be difficult to make during turbulent times. Additionally, unexpected production delays can make principal repayment difficult even when the company is fundamentally solvent. The companies can't roll over their debt or issue equity at precisely the wrong time; when there are low gold prices and high costs. Nearly every mine has unforeseen challenges that create short-term liquidity problems and make it easy to trip over debt covenants.
Bondholders and banks are not as patient as royalty/streaming companies, and serve as a source of stress for mining companies.
The main competition for royalty/streaming companies is the equity market. Equity shares in the upside and the downside potential of a project, and is just as patient as royalty/stream capital.
Ideally, the royalty/streams can be used to complement equity. This way, the royalty/streams can receive large returns and have the equity holders bear the risk.
The ability to do royalty/stream deals is somewhat countercyclical;
- During a mining and precious metal bull market, there is plenty of financing available through equity. This restricts the royalty/streaming company's ability to do deals. Regardless, the companies will perform well, because precious metal prices and mining conditions will presumably be favorable. Note that this is a natural constraint on the management's ability to complete large deals at the height of the market.
- During a mining and precious metal bear market, financing will dry up and opportunities will be available for the royalty/streaming companies.
Streams Are MORE Dilutive Than Equity
The typical argument is that if the share price is below NAV (book value), then equity dilution will be especially burdensome. It is a fallacy to believe that streams are less dilutive than equity. Mining company share prices are low when mining conditions are weak, which suggests that in such an environment, the terms of a stream will be favorable to the royalty/streaming company (and thus, highly dilutive to shareholders).
Royalty/streams receive all the upside if the mining company does well, and have less downside if the company performs poorly.
If stream finance is used;
- And the company has positive earnings, then the stream will receive payment, thereby diluting shareholders.
- And the company has negative earnings, but does have revenue, then the stream will receive payment, thereby diluting shareholders.
If equity finance is used;
- And the company has positive earnings, then new equity will dilute shareholders.
- And the company has negative earnings, then the new equity will help to dilute the losses for the previous shareholders.
If the mine shuts down or bankruptcy occurs, then the shareholders likely get wiped out, and streamholders will either be treated like subordinated debt holders or simply have to wait for another operator to come along.
Shareholder vs. Streamholder
Too Good to Be True?
The business model seems to not make any sense. Why would the royalty/streaming companies issue equity and then transfer the money to mining companies? Why wouldn't the mining companies just issue equity?
Is there a fundamental/economic reason for the existence of royalties and streams?
The royalty/stream has the unique capability of being placed, or concentrated, on one specific mine, compared to equity, which applies to the entire company's earnings.
Why would an operator choose a royalty/stream instead of equity? One reason, previously mentioned, is value arbitrage. The mining company can kill two birds with one stone; raise funds and divest itself of a non-core asset. This method allows the mining company to raise funds by concentrating its sale on one specific part (the stream) of the mine.
If an equity investor wants to invest in a specific mine of a mining company that owns many mines, he cannot do so without taking on the rest of the company's assets. By allowing investors to invest in the mines of which they are most optimistic, the cost of capital is reduced. Additionally, if the value of one specific mine has not declined as much as other lower-quality assets, all held by the same mining company, then the mining company can benefit by issuing a royalty/stream on the asset that is not selling at a distressed price.
There may be financial risk, such as a high debt load. The underlying asset might be great, but prospective shareholders might be reluctant to invest because of bankruptcy risk. Even if the expected return for shareholders is high, the volatility of earnings can make bankruptcy a possibility. Attempting to roll over the debt and take on more debt can be very difficult under distressed conditions. Streams are like debt in that they are less exposed in the case of bankruptcy, but are patient like equity.
When a royalty/stream is imposed on the land, it reduces the value of the land. If the mining company sells the land after applying a royalty/stream, it will receive less. This reduces the cushion for bondholders. Bond covenants can be circumvented, assuming there are no provisions about royalties/streams. Bondholders are effectively being robbed to benefit the shareholders and the stream/royalty holder.
High Lending Rates
Sandstorm generally prices its deals using a 5%-10% discount rate, conservative commodity prices, and then considers whether there is enough production and exploration upside potential.
As evidenced by many deals, Sandstorm applies an annual 10% charge in a formulaic manner to repurchase agreements that are offered. Most stream deals do not include a repurchase option and, typically, only up to 50% of the stream can be bought back by the mining company. The mining company would not have negotiated for the buy-back option were it not favorable, suggesting that the 10% annual rate of return is the minimum that Sandstorm is expecting.
The use of a systematic approach suggests that the performance can be repeated and does not rely solely on management's ability.
A Business with Little-to-No Debt, Yet a High Capacity for Debt
Royalty/streaming companies have the capacity to hold a large amount of debt for several reasons:
- A very liquid business-
The royalty/streaming companies often hold large cash stocks, they are constantly issuing equity, and free cash flow is continuously generated from the royalties/streams.
- Stable earnings-
Unlike some operators, a royalty/streaming company is diversified across many different mines in different geopolitical environments. Royalty/streaming companies have a lower risk profile, because they are not directly affected by cost increases, and additionally, they are not fully exposed to technical problems with the mine.
- Continuously growing earnings-
A high debt load can be sustained as long as the company keeps growing (i.e. as long as there is continuously more cash inflow than outflow.)
The royalty/streaming business model requires that royalties/streams are continuously purchased. Therefore, an increasing amount of cash continuously flows into the business, while any increase in debt lags behind.
The debt, relative to equity, declines as the company grows on an absolute (and per share) basis. However, as long as the company expects to grow in the future, it can maintain its high debt-to-equity ratio on an ongoing basis, with very little risk.
The precious metals stream/royalty industry is still in its infancy, and has a lot more growth ahead of it. The low-risk financial leverage can magnify performance.
- Royalties/streams yield higher rates than debt-
There are several reasons for this:
- Royalties/streams are unsecured (debt is secured), and therefore, should naturally provide higher return.
- Royalties/streams have principal payments embedded in the return.
- Debt is not inflation-hedged like precious metals royalties/streams.
The ability to borrow at low rates and lend at higher rates allows virtually an unlimited amount of debt to be sustainable.
Potential to Become a Ponzi Scheme
No one ever really knows whether a dividend is real, i.e. whether it is justified by earnings, or whether equity is being distributed back to shareholders.
Consider a scenario where the royalty/streaming companies started paying a 20% dividend yield. The dividend would be received by the existing shareholders at the expense of the newer shareholders. New shares are continuously being issued for new royalties and streams, and therefore, there are always newer shareholders arriving to fund the previous shareholders. The royalties/streams often last decades, and therefore, there is no way to know whether they are profitable or not for a long time.
The only thing that would put a stop to this virtuous cycle is if investors stopped believing that the real return on investment is 20%, and realized that it was all just a Ponzi scheme.
Of course, any company can do this, but because royalty/streaming companies constantly issue shares, it would be far more difficult to identify.
Risk Mitigation Through a Base Metal Put
The beauty of the royalty/streaming model is that it is insulated from nearly every risk. However, there is one important risk that must be considered.
Often, the royalties/streams are placed on base metal mines. If base metal prices were to collapse, many of the base metal mines would become uneconomic and, thus, by-product precious metal production would correspondingly decrease.
Additionally, base metal credits are used to offset cash costs of precious metal mining. Therefore, if base metal prices fall, cash costs will rise for precious metal mines, resulting in lower production and lower royalty/stream proceeds.
Fortunately, this risk can be hedged out using a base metal (e.g. copper) way out-of-the-money put.
When to Buy?
If the spread between the price of Silver Wheaton is high, on a historical basis, relative to the price of physical silver, then it may be best to wait for the premium to diminish or, even better, turn into a discount.
Silver Wheaton represents a stream of future silver, and therefore, optimism about future silver prices is reflected heavily in the share price. And vice versa, under pessimistic conditions, it is likely that the price of Silver Wheaton will be low relative to physical silver.
Disclosure: The author is long SLW, SAND. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.