Recent Updates At Sandstorm Gold
This is the third in depth article that I'm writing on Sandstorm Gold (NYSEMKT:SAND) this year. In the first, which I wrote in February, I argued that investors were pricing in a relatively optimistic scenario regarding the company's largest streaming agreement on the Aurizona Mine operated by Luna Gold (OTCQX:LGCUF) in Brazil. Specifically Luna gold has plans to expand that mine so that it produces 300,000 ounces of gold per year long-term. But despite this intention there were no concrete numbers backing up the economic viability of such a plan. In fact I subsequently wrote an article on Luna Gold in which I argue that at the current gold price of $1,300/oz. such an expansion didn't make sense unless one assumed that it would have a low cost. The reason for this, ironically, is that so much of Luna Gold's cash-flow goes to Sandstorm Gold that it didn't make sense for the company to spend so much money with effectively half of the proceeds going to Sandstorm.
Since I wrote that article we have seen a couple of significant developments. The first is that Sandstorm Gold bought its sister company--Sandstorm Metals and Energy--at a dirt cheap valuation. This company owned royalties and streams on base metal and energy projects, and despite the fact that these projects have a lot of potential they are also high risk. Given Sandstorm Metals and Energy's precarious financial position it was trading at a substantial discount to its discounted cash-flow, and Sandstorm Gold picked this asset up at an excellent valuation, as I discuss here.
More recently the risk that I point out in my first article regarding the Aurizona expansion has surfaced. Luna Gold reported that its production is down while its costs are up thanks to lousy weather. Furthermore, both companies are concerned that Aurizona's cash-flow potential is lower than Luna Gold's management had initially expected, and shares fell nearly 20% on the news. But this concern also led both companies to the realization that I had reached a few months earlier: from Luna Gold's perspective it doesn't make sense to expand the mine considering the large stream that Sandstorm Gold owns on the project.
This led to the most recent development, which is that Sandstorm Gold took a 20 million share stake in Luna Gold (raising its stake substantially to a hair under 20%). Now for a $690 million company a $20 million stake doesn't mean much. However if you look at the press release you will find that the two companies are in talks to amend their streaming agreement. Given Luna Gold's cash-flow problems, and given Sandstorm Gold's increased stake in the company, we can conclude that this means that there is going to be a modification designed to benefit Luna Gold. But given Sandstorm's increased stake this isn't necessarily at the expense of Sandstorm shareholders: it is only at the expense of the value of the Aurizona stream.
Reevaluating the Investment Thesis
In February I concluded that the company was fairly valued to slightly overvalued, and with the stock price up 18.5% with the gold price up just 4% it probably makes sense to argue that based on my February assessment the stock is somewhat overvalued.
However we need to note a couple of things.
Valuing Royalty/Streaming Companies
The first is that royalty companies rarely trade at the value of their discounted cash-flow. Investors assume that these companies will be able to reinvest this cash-flow in order to generate additional value, and so it isn't surprising to see royalty companies trade at a substantial premium to their DCF valuations. In fact Sandstorm Gold is the least expensive royalty/streaming company on this basis, with its peers--Royal Gold (NASDAQ:RGLD) and Franco Nevada (NYSE:FNV) overvalued in this respect, although they have outperformed gold, gold stocks, and global stocks in the aggregate over the long run.
As an investor you need to ask yourself if this matters to you. Discounted cash-flow analysis is a powerful tool, but it isn't the gospel truth, and some of the best performing gold assets over the long term have been consistently over-valued on a DCF basis (e,g. Royal Gold and Randgold Resources (NASDAQ:GOLD)).
This decision has a lot to do with your assessment of management. CEO Nolan Watson has no shortage of supporters in the gold community. He has been known to take risks, and while there are some that have failed miserably (e.g. Colossus Minerals) there are others that have worked out incredibly well such as Aurizona despite the recent woes. This can be said about all of the royalty companies, making Sandstorm Gold appealing given its low valuation on a relative basis (that is, relative to its royalty/streaming peers).
Higher Risk Exchanged For Higher Reward, and Sacrificing Near-Term Cash-Flow
Second, Sandstorm Gold has been making high risk/high reward investments, which is somewhat anathema to the more traditional royalty/streaming model. For example, the Sandstorm Metals and Energy deal was incredibly accretive on a price to DCF basis. Sandstorm Gold paid $44 million for what I calculated is an asset worth $159 million. But the catch is that the largest asset in this acquisition--a stream on Entree Gold's (NYSEMKT:EGI) Lookout Mountain Project in Mongolia--has a lot of risk. This project is in the crosshairs of the Mongolian Government, but if it is built it will be one of Sandstorm Gold's largest assets even if we use a heightened discount rate in order to account for this added risk.
The other high risk asset that the company has acquired is, of course, an additional 20 million shares worth $20.4 million in Luna Gold. This certainly deviates from the royalty/streaming model. Investors need to keep in mind that royalties and streams are so appealing because they have fixed (or relatively fixed) costs, whereas mines have volatile costs. Granted, Sandstorm Gold did the Luna Gold deal in part to protect its streaming interest, but this is a new dimension of risk, and investors aren't happy (shares fell 14% last week).
At the same time, however, Luna Gold trades at a multi-year low and due to its problems it has not participated in the 2014 rise in gold stocks. While this move is warranted given the problems the company has been having there is no denying the quality of the multi-million ounce high grade gold deposit at Aurizona, and assuming that the streaming deal is restructured we can see this downtrend reverse.
Both of these investments have long-term appeal and rationale, but they lack near-term cash-flow. Furthermore the investment in Luna Gold means that the Aurizona stream will be restructured and this will hurt Sandstorm's near-term cash-flow. As a result we have seen the stock decline--it was down 14% last week and it is underperforming its royalty/streaming peers.
Investors who read my February article on Sandstorm Gold will recall that I proposed 4 valuation scenarios. In the first and second I assumed no mine expansion at Aurizona, while in the third and fourth I assumed the expansion. The difference between 1 and 2, and 3 and 4 related to the assumptions made regarding Primero Mining's (NYSE:PPP) Black Fox Project, although the difference isn't that great and the optimistic scenario for that project is more likely.
Now I feel much more comfortable assuming that we will see an Aurizona expansion, as the royalty agreement will be restructured in order to make this scenario beneficial. So the good news is at $1,250/oz. gold we can assume my most optimistic scenario, which is a valuation of $512 million. But the bad news is that Sandstorm is going to lose some of its streaming cash-flow--$241 million of this is from Aurizona, and it is reasonable to assume that the company is going to sacrifice a good 15% of this cash-flow in order to make the project more economical from Luna Gold's end. with this in mind the valuation falls to about $475 million. We also have to subtract $10 million from the Sandstorm Metals and Energy Deal bringing the total to $476 million, with $420 million leveraged to the gold price.
With the gold price having risen about 5%, or about 8% relative to Sandstorm's base that figure rises to $455 million, or about $510 million if we add the cash back in. Finally we need to add in the Sandstorm Metals and Energy assets. As I stated these add $159 million in value. But it is actually more than this with the copper price having risen about 6% and with the company's Lookout Mountain stream being its largest and being tied to the copper price making it worth about 8% more making the total $166 million. Note investors should keep in mind that I was concervative in valuing the Lookout Mountain stream given the relatively high risk of mining in Mongolia.
So the total comes to just under $680 million, which is incidentally just lower than the company's $690 million market capitalization.
As we can see from the above numbers Sandstorm Gold is "fairly valued" on a DCF basis, but at the same time we have seen that this may not be an appropriate measure for a royalty/streaming company, and if it is then we could argue that it should trade at a multiple of this, making the stock undervalued assuming you believe in management.
While I have had my doubts in the past I am less skeptical now, and I say this for two reasons. The first is that by making the Sandstorm Metals and Energy deal the company added an incredible amount of risk adjusted value. Even if these streams and royalties turn out to be duds they were so inexpensive that the risk was worth taking.
The second is that by solidifying the partnership with Luna Gold the company has secured my "optimistic" scenario for the Aurizona Project. it is making a sacrifice in doing so assuming it restructures the streaming agreement. But the difference in valuation in my optimistic vs. my pessimistic scenarios in February was about $100 million, and as we saw above the company is probably sacrificing about $35 million in streaming value in order to solidify this additional $100 million, and the company can make this up in Luna's anticipated share price appreciation once the restructuring is announced. While the deal is probably better for Luna Gold shareholders than it is for Sandstorm Gold shareholders one can see how this deal is beneficial for Sandstorm Gold.
Ultimately Sandstorm Gold is a riskier company now than it was in that it has sacrificed some of its near-term cash-flow by investing in the future of Aurizona and by buying Sandstorm Metals and Energy, which has assets that have value based on cash-flow that, in most cases, won't come for many years. But this is going to pay off for long-term shareholders, and I am much more confident in the company's management than I was. With this in mind, and given the company's relatively good valuation I think the stock should be purchased by gold bulls on weakness.
Disclosure: The author is long RGLD. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I may initiate a position in Sandstorm Gold and in Luna Gold in the near future.
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