An Overview Of Callinan Royalties
Callinan Royalties (OTCQX:CCNMF) is one of the smaller companies in the metals royalty space with a valuation of just $80 million. It has a strong working capital position of $27 million and $22 million in cash/equivalents, a handful of equity and debt-based investments, and several royalty agreements. The one royalty agreement that stands out is the company's royalty on HudBay Minerals' (NYSE:HBM) 777 Project. The others have very little value and are years away from generating cash-flow.
If you compare it with its peers it trades at a discount, and at first glance this would make it compelling. After all, like its peers it has very strong profit margins, a rock solid balance sheet, and free exposure to the exploration success of its partners.
But there is one glaring red flag--its 777 royalty is a net profit interest, or NPI royalty. What does this mean?
Most royalties that investors are used to, that is, the royalties that you find in Franco Nevada's (NYSE:FNV) or Royal Gold's (NASDAQ:RGLD) portfolios are usually net smelter return royalties, or NSR royalties. A 2% NSR royalty entitles the royalty company to 2% of the revenue generated by a mine after smelting costs, which are generally minimal (about $10-$15/oz. for gold, usually). It doesn't matter if the mining company incurs higher costs for whatever reason, and the appeal of an NSR royalty is that it eliminates one of the risks associated with mining. When you buy stock in Franco Nevada you don't have to worry too much about whether or not its partners are making more or less money on its mining activities, as long as it continues to mine. The one risk is that the cost of mining rises so high that the company shuts the mine down completely.
An NPI royalty doesn't eliminate this risk, meaning that Callinan shareholders have to worry about Hudbay's production costs. Regarding Callinan's actual cash-flow this may not be a bad thing, and if costs come down it may even turn out to be good. But at the same time we, as investors, have to factor this uncertainty into our valuation model, and this means we have to use a higher discount rate than we would otherwise with a royalty.
However, despite this one setback Callinan has all of the same advantages that one would expect to find with royalty companies, and considering that investors have been acutely aware of the added risk of owning an NPI royalty as opposed to an NSR royalty I think there is an opportunity for investors who don't mind the extra risk, especially since they are being paid to take it (and I mean this literally in the sense that the company pays a 4.5% dividend).
Furthermore, as we will see in a moment the value of the company's assets exceeds its market capitalization. This is unusual for a royalty company given that investors often place a lot of value on the potential discoveries that their partners may make. The reason this exploration is so valuable for royalty companies is that it is free--their partners lay out all of the capital.
With these points in mind I think Callinan Royalties is an excellent stock to own, especially if you are bullish of copper--the metal to which the company has the most exposure.
The HudBay 777 NPI Royalty
I have already mentioned this asset although it needs to be analyzed further as an investment in Callinan Royalties is more dependent upon this asset than on any others.
The 777 royalty entitles Callinan to 6.67% of the revenues generated minus:
- operating costs
- capital costs
- milling costs
- administrative costs (11% of the sum of the first three)
- a mill stay in business charge, or 4% of milling
Callinan also gets C$0.25 per tonne of ore mined.
Naturally the costs are going to vary each quarter, although according to the technical report they should be about $105/tonne, or $116/tonne with a 10% contingency. If we add the 11% administrative contingency and a 4% milling contingency (almost negligible) we get about $130/tonne.
Going forward, presuming Hudbay produces according to the schedule laid out in the technical report we can expect the company to produce the following amounts of ore on an annual basis.
|Year||Ore produced in Ktonnes|
|The Rest Of 2014||785|
Each tonne of ore on average is going to generate (assuming constant recovery rates):
- .93 grams of gold, worth $38.75
- 11 grams of silver worth $7
- 38.5 pounds of copper worth $121.28
- 64 pounds of zinc worth $68
This means the value of a tonne of ore will average of $235. Net realized value from a tonne of ore will be $105/tonne, That means that Callinan will get about $2.8 million, or $11.2 million annualized. Note that Callinan received less than this--about $2.1 million. This is due to the fact that Hudbay only pays 75% of what it estimates it owes Callinan while paying the balance during the following fiscal year.
As you can gather from these figures there are a lot of input costs to consider, the same as if we were evaluating a mine rather than a royalty, and as a result we need to discount the cash-flow accordingly. Assuming the mine plan follows the above production schedule--that is assuming there is no further discovery--and assuming flat prices and costs, cash-flow to Callinan should remain relatively constant for the next 4.5 years. Production will fall of in the final two years of anticipated production and so the company's estimated cash-flow will be about $8 million and $5.5 million for those last two years.
Given these assumptions, and accounting for a 26% tax liability, we get the following valuations. Note that when I evaluate mines I use 8% and 12% discount rates. Given that Callinan's input costs are similar to those of a mine I should use these rates for the Hudbay NPI royalty. But since Callinan gets free exposure to exploration, and since it can't lose money--unlike a mine--I will use 6.5% and 10.5% discount rates. I will calculate the values at +/-25% which reflects metal price fluctuations of about +/-10%. Amounts are in millions of dollars.
|Discount Rate/Net Ore Value||-25%||Base||+25%|
The company's other royalties are not generating any cash-flow. There is one, however, that we can argue adds tangible value to the shares despite the fact that production is not expected until 2018 and the company needs an enormous amount of financing. This is the Gunnison Copper Project owned by Excelsior Mining (OTCQX:EXMGF). Note that the company owns 6.25 million shares worth $1.5 million. Excelsior anticipates producing 110 million pounds of copper per year for 10 years, and with Callinan's 1% GRR (gross revenue royalty) it should receive about $2.6 million annually after taxes. Discounted out until 2018 at 5% this is worth about $18 million, although investors should keep in mind that the Gunnison Project still faces several hurdles including financing and permitting. However even if we are conservative and discount it at 8% (after all it is a royalty so it is based only on revenue) it is still worth $15 million.
The company's other royalties are all on exploration properties and include:
- A 1.5% NSR royalty on Avrupa's (OTCPK:AVPMF) Alvito Project in Portugal.
- A 1.5% NSR royalty on Renaissance Gold's (OTC:RNSGF) Golden Shears Project in Nevada.
- A 1.5% NSR royalty on precious metals and a 1% NSR royalty on base metals at Evrim Resources' (OTC:EMRRF) Llano del Nogal Project in Sonora, Mexico.
While these assets are promising they are owned by nano-cap companies that haven't released any concrete mine plans, giving these royalties optionality value which, unfortunately, isn't quantifiable.
We already saw that the company has a $1.5 million position in Excelsior Mining. It also has some other equity positions worth mentioning.
- 14.3 million shares of Sokoman Iron (GDNGF) worth $650,000
- 6.4 million shares of Northern Shield (OTC:NSHRF) worth $220,000
- 8.3 million shares of Wallbridge Mining (OTC:WLBMF) worth $600,000
- $5 million worth of convertible debt in Gold Royalties (OTC:GRYCF).
These additional assets total $6.5 million in value. I should note that the company also owns the right to purchase royalties from these companies at particular amounts (including the right to add to its Gunnison royalty) and it also owns out of the money warrants on these companies that I'm not assigning any value. Clearly, however, they could have value in the face of a large discovery or a sharp rise in commodity prices.
Conclusion: Valuing Callinan Royalties
As we have seen the company has the following assets:
- $27 million in working capital
- The 777 NPI royalty that I am valuing at $36 million using a 10.5% discount rate.
- The Gunnison Royalty valued at $15 million at an 8% discount rate.
- $6.5 million in equity and convertible debt.
The total value of these assets comes to $84.5 million, which is slightly greater than the company's market capitalization.
But while we might be inclined to argue that the stock is, more or less, fairly valued, we should keep in mind that it has an incredible amount of optionality should any of its partners make new discoveries on its properties. This is an issue I bring up in my discussion of Franco Nevada, which is overvalued on a price/NAV basis but which chairman Pierre Lassonde believes has enormous value that can't be quantified due to its optionality.
The same holds true for Callinan Royalties despite the fact that the company's one cash-flowing asset is an NPI royalty, which we have seen is riskier than your typical NSR, GRR, or GSR (Gross Smelter Return) royalty.
Investors should also note Callinan Royalty's pristine balance sheet and uncanny 50%+ net profit margin as reasons to consider owning this stock despite the fact that it is "fairly valued." Finally the company has sufficient cash-flow to not just pay a huge dividend--one of the largest available in the resource sector at 4.5%--but to reinvest its capital into other royalties.
With this in mind, unless you are bearish of metals, and copper in particular, Callinan Royalties is a compelling stock to own at the current valuation.
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.
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