PM Royalties Report: Beyond the Obvious, Part II

by: David Zurbuchen

In Part I of our royalty report we provided a brief overview of the royalty company universe as well as explained our basic valuation methodology. Below in Part II we provide a series of detailed comparative valuation charts in an attempt to highlight the relative virtues of each royalty company in comparison to its peers.

Comparative Valuation Charts

Part II begins with the valuation target chart, which provides a comprehensive picture of the potential return to shareholders across a range of metal prices assuming the market applies the same valuation standard to these companies as found in our model:

Above we can see the different mining royalty companies less Royal Gold (NASDAQ:RGLD), each with a banded target valuation range relative to each company’s current share price. These are meant to be only rough comparative guidelines given that our model assumptions attempt to be reasonable and not reflective of any purported market consensus about valuations. For example, a different discount rate would lead to significant changes in the above chart . . . but the companies would still generally rank in the same relative position. Therefore, the above chart is much better at providing an overall picture of the sector as a whole along with indicating the relative position of each company within the sector rather than telling us whether or not a particular company is overvalued. Terms such as “overvalued” are an abstraction since it must always be asked “compared to what?”.

Generally we can see that royalty companies as a whole do not seem to offer much fundamental value in our model at current metal prices, with the average company appearing to trade somewhat above the base case target price. This is reflected as a negative return at the base case (blue line). But as with any financial chart that attempts to distill a large amount of detail into a single point such as target price, there are going to be plenty of caveats. For starters, not all these companies are pure royalty companies. The most glaring example of this is Golden Predator (GPRXF.PK), which brands itself as an explorer/project generator with a large and prospective land package in the Yukon. Golden Predator also just happens to own several small royalties that help fund exploration. These royalties are valued in our model at up to 60% of the company’s enterprise value based on current metal prices. If the company were trading more at a premium for its exploration potential, we likely wouldn’t have included it within this analysis, but the fact remains that its royalty portfolio seems to justify about two-thirds of its current valuation based on our conservative model assumptions.

If you’re wondering why Virginia Mines (OTCPK:VGMNF) didn’t make the cut with its 2% variable net smelter return (NYSE:NSR) on Goldcorp’s (NYSE:GG) Eleonore project, it’s because based on current operating assumptions at Eleonore — 330,000 ounces per year for 16 years beginning in 2015 — our calculated net present value for the royalty is not substantial relative to Virginia’s enterprise value. We also did not include Sandstorm Metals & Energy (OTCPK:STTYF) in our analysis since it does not yet own any royalties.

You’ll also notice in the above chart that some companies have much wider target ranges compared to others. Just take a look at Terra Nova (NYSEARCA:TTT) versus Callinan (CCNMF.PK). The reason Terra Nova’s range is so tight is because, after factoring in their recent acquisition of Mass Financial (OTC:MFCAF), cash and securities will make up about 80% of their valuation, and you don’t get any leverage from cash in either direction. Meanwhile, Callinan shows the largest valuation range because its only royalty is a net profits interest (NPI) royalty. In the case of an NPI, the project first has to cover all its operating costs before it pays out to the royalty owner. Essentially this means that the value of the royalty ends up being much more sensitive to metal price swings than an NSR.

We consider the following chart to be the most relevant in the comparative valuation of peer companies in the mining sector. By removing overt reference to prices and potential profit/loss percentages, we create a more neutral environment for objective analysis. Ultimately, success in an extractive industry — by definition involving a dwindling asset base — requires that capital investment is first recovered through operating profits (what we call “payback”) and then capital can accrue a multiple return on that payback (what we call “leverage”). Generally speaking, the lower the payback as measured in years and the higher the leverage measured in multiples of payback, the better.

Looking at the above chart we can see that almost all the royalty companies tend to trade under 2 times Leverage. The obvious exceptions are Gold Wheaton (OTC:GLWGF), Anglo Pacific Group (OTC:AGPIF) and Terra Nova.

Zooming in on Terra Nova, its exceptional-looking 3 year Payback and 5 times Leverage can be explained by its large net cash position of about $400 million. A large net cash position has the effect of lowering enterprise value, which is the basis of both the Payback and Leverage measures. We would prefer that Terra Nova carry out a large share buyback program, but perhaps they have other plans. If a large share buyback program were to take place, both the Leverage and Payback measures would remain roughly the same and sensitivity to commodity price changes would greatly increase, giving us more reason to invest if we are bullish on the fundamentals for iron ore. On the other hand, if a special dividend were paid out to shareholders, we would see the Payback measure rise, the Leverage measure fall, and sensitivity to metal prices would remain relatively low. That’s not a scenario that we find very compelling. With its roughly $100 million investment portfolio, similar logic would apply to Anglo Pacific though the effect would be much less pronounced.

Also noteworthy in the above chart is the nearly 14 year Payback measure for Silver Wheaton (SLW). This is a huge outlier and a strong indicator that the company is trading far above its target valuation based on its current status as a market darling. The fact that Silver Wheaton does not pay any income taxes due to its corporate structure obviously helps, but we think this advantage also comes with some risk. Here’s what we wrote about Silver Wheaton’s unusual tax-sheltered status in our Silver Producer Report published this past July:

Quite frankly we were unaware that Silver Wheaton’s incorporation in Barbados and the Cayman Islands is able to almost completely avoid the tax man. Don’t believe us? Take a look at page 52 of the company’s 2009 Annual report: $118 million net income and zero taxes paid. Since the proceeds received from the sale of silver streams are recognized as deferred revenue on the books of the miners and taxed over time at a fixed rate regardless of the silver price, Silver Wheaton seems to have discovered a wonderful little tax shelter as well as a great way to unlock value from by-product silver that would otherwise have likely been hedged and thus depressed silver prices.

One consideration to keep in mind about the favorable tax structure, however, is what happens if the price of silver skyrockets such that mining companies with silver streams end up paying much lower taxes than their in-country peers who have not done similar deals. To be more specific, in an environment of elevated silver prices (our collective expectation, no?), tax jurisdictions where the mines operate are being effectively shortchanged due to the Silver Wheaton deal structure, and there might be consequences in the form of regulatory remedies or special tax assessments.

We have no idea how much longer Silver Wheaton will be able to maintain a 0% tax burden — perhaps forever — but we won’t be at all surprised if one day this distinct advantage disappears. It is important to recognize that the effect would likely be greater than a one-time 30% tax since it would also inhibit Silver Wheaton’s ability to make competitive deals on future silver streams. We note that Sandstorm Resources (SNDXF.PK) is also structured to avoid taxes. By all accounts, so far so good in tax-shelter-land, but in our opinion this is a risk that investors should keep in mind (just like investors should have kept in mind the potential changes in tax structure of Canadian income trusts).

Finally, please note the background graphic representing the gold-equivalent royalty cost per ounce for each company. This does not represent the production cost of the operations underlying the royalties but rather the imputed cost, on a converted gold-equivalent basis, related to the royalty payments themselves. For example, Silver Wheaton pays around $4.00 (plus an incremental adjustment for inflation) for each ounce of silver produced under its royalty stream agreements. We have converted this to a gold-equivalent and plotted it in the above chart. Obviously this method loses some flavor when it comes to a company like Anglo Pacific given that the conversion of coal to a gold-equivalent is a questionable practice, but relatively speaking the royalty cost measure does give an overall measure of the sensitivity that each royalty company has to changes in metal prices.

Next up we have some bubble charts that can help investors visualize the quantitative relationship between royalty companies using several different metrics at the same time.

In the above chart we see that most of the royalty companies have a royalty profit margin of over $1,000 per gold-equivalent ounce (i.e. over 70% margin at current gold prices). Royalty profit margin is simply the current metal price minus the royalty cost discussed in the preceding chart. The major exception is Callinan and as we explained earlier this is due to its income based royalty structure on Hudbay’s (NYSE:HBM) flagship 777 mine.

One can make a number of useful observations about the above chart and we invite others to be creative in doing so. For our part, we will note only a couple of examples.

Terra Nova stands out very clearly as offering the best value based on the “Discounted” Leverage metric. But again, this is largely a function of its balance sheet, and depending on the direction the company takes with its cash, its distinct outlier status may very well disappear. Beyond how it chooses to use its cash, a major outstanding question for us is the impact that the Mass Financial acquisition will have on the company’s bottom line. It would be undesirable to see wild swings in net income due to proprietary trading at Mass Financial that completely renders as irrelevant the stable cash flow from the iron ore royalty on the Wabush mine.

It is interesting to see that Anglo Pacific’s total resource appears to be about as large as Silver Wheaton, but this is actually quite deceptive since most of this is attributable to the company’s two 100% owned (not royalty-based) coal projects in Canada, Trefi and Panorama. In other words, the bulk of its resource is not attributable to royalty interests as is the case with Silver Wheaton. Among other things this means that in order for these resources to be developed, Anglo Pacific would be responsible for funding capital requirements and then covering operating costs once in production. Note that since neither of these coal projects has been the subject of an economic study, their effect on margins or other financial metrics have not been reflected in the above chart or the royalty report in general.

Although sporting a royalty profit margin somewhat lower than average, Gold Wheaton stands out as arguably the best-levered “pure” royalty company with a significant precious metals resource base. This largely confirms its placement in the first chart. Even a cursory qualitative review will reveal, however, that the company is dependent on successful operation rampup at the South African operations. If production falls behind plan, Gold Wheaton is unlikely to close the valuation gap between itself and its big-breached peers (Silver Wheaton, Franco-Nevada and Royal Gold).

The next chart evaluates the resource base and production level of each royalty company using the standard measure of enterprise value per gold-equivalent ounce. This method can be useful for high-level ranking but we believe retail investors and even brokers, institutions and other analysts place far too much reliance on such a simplistic approach that says nothing about profitability. In our view, the analytical abuse of these basic gold-equivalent measures is a symptom of the popular yet dangerous idea of ever-rising commodity prices. Still, knowing how others view the market — even if we suspect such view may be incorrect — is important because prices in the short term are dictated by consensus market thinking. As the cliche goes, the market is never wrong.

Readers are free to reach their own conclusions using the above chart. For our part, we’ll note that both Callinan and Terra Nova stand out as having the combination of lowest enterprise value to production and resource base multiples. At the same time, we’ll also note what doesn’t get shown in the above chart: of the two, only Callinan has translated these “cheap valuation” metrics into consistent and robust cash flow with a price to cash flow (P/CF) multiple of about 9x if exploration spending is ignored. This is partly due to the royalty structure itself and partly due to the quality of the underlying operations, with the remainder of the credit going to conservative financial management.

Anglo Pacific, Gold Wheaton, Franco-Nevada, and Silver Wheaton are also generating substantial cash flow from their respective royalty interests. Of the group, Anglo Pacific and Gold Wheaton offer the most attractive P/CF multiples at about 12x each compared with 24x for Franco-Nevada and 50x for Silver Wheaton. Interestingly, the P/CF ratios line up pretty well with each company’s relative position in the above chart so perhaps the enterprise value per ounce measures are more useful in this instance than typical. Please note that in our upcoming comprehensive royalty report we plan to include P/CF and other charts including those suggested by our subscribers and the royalty companies themselves.

In Part III of this report we'll examine a few more interesting comparative valuation charts and finally come to our conclusion.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Callinan Mines is an institutional client of the Metal Augmentor service.