(Editor's Note: Investors should be mindful of the risks of transacting in illiquid securities such as CCNMF. Callinan's Canadian listing, CAA.V, offers somewhat stronger liquidity.)
An Overview of Callinan Royalties
Callinan Royalties (OTCPK:CCNMF) is a royalty company that flies under the radar. It has one cash-flowing royalty asset on Hudbay's (NYSE:HBM) 777 Mine as well as a couple of secondary royalties on development and exploration-stage assets, as well as some equity positions in exploration stage companies whose market capitalizations are just a few million dollars and a convertible debt position in Gold Royalties (OTC:GRYCF)--a nanocap royalty company. Finally it has a C$27 million working capital position (as of the end of September)
I first recommended Callinan in August when I calculated the value of the company's discounted cash-flow to be slightly below its then current market capitalization. Given the numerous ways in which the company could improve the valuation of any of its assets, its cash/equivalent position, and its relatively consistent cash-flow I felt the downside risk was minimal. This has, in fact, been the case: shares are down ~8% while the values of the underlying metals on which the company collects royalty income have fallen further, with copper (the top revenue generator for Callinan) falling 10%. The company also paid a C$0.02/share dividend, which means the actual decline experienced by Callinan shareholders is ~7%. Finally a temporary shutdown at Hudbay will hurt Callinan's Q2 (Oct. 1 - Dec. 31st) financials, and some weakness could be attributed to this.
However all of this misses a crucial underlying change in the company that should be taken to be an incredibly positive development.
The HudBay 777 Royalty: From NPI To NSR
1: What Happened?
About 3 weeks ago a 7 year lawsuit was finally settled between Callinan and Hudbay in which Callinan alleged that Hudbay had "not properly accounted to Callinan for the Net Profits Interest ("NPI") under the Net Profits Interest and Royalty agreement with Hudbay dated January 1, 1988" (Cf. Callinan's August 26th, 2013 press release). As a result both company's agreed to amend the terms of the royalty agreement, Callinan received royalty interests on nearby (near 777) exploration zones, and Hudbay agreed to carry out exploration on these properties.
Regarding the royalty, at the beginning of next year the structure of the company's 777 royalty will change from a 6.67% NPI (net profit interest) to a 4% NSR (net smelter return). Don't let the percentage decline fool you--this is an immensely positive development, and one that I will demonstrate should have caused a spike in Callinan shares that we simply didn't see.
2: What makes an NSR royalty so much more valuable than an NPI royalty?
An NPI royalty entitles the owner the right to a share of a given mine's profits--that is revenue minus the costs incurred in operating the mine. Clearly there are many different things that can be counted as applicable costs, but in the case of the royalty in question these include:
- 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
In August I calculated this to be ~$105/tonne milled vs. revenues of ~$235/tonne milled. This cost is not only nearly half of the mine's revenue, but it means that Callinan's royalty revenue is much more highly leveraged to metal prices. With a ~10% decline in said metal prices since then the revenue per tonne drops from $130 to $106, or ~20%. This decline is substantial enough so that one might argue that the decline in Callinan shares was insufficient to reflect the lost value of this royalty coupled with the lost value of the company's other assets, which are leveraged primarily to copper and gold.
The switch to an NSR royalty means that Callinan gets a percentage of the revenues generate ($235/tonne) minus smelting costs, which are not insignificant, but not substantial either--maybe 1-3% depending on the specific circumstances. I will provide readers with a more complete analysis of the financial ramifications of this, but just working with the old numbers given above a 6.67% NPI royalty generates $8.67/tonne whereas a 4% NSR royalty assuming 3% smelting costs generates $9.12/tonne--a 5.2% increase. The increase is larger if we assume lower smelting costs.
But it gets better. The problem with an NPI royalty--and I cautioned readers of this in August--is that operating costs are variable, and an adverse event can greatly reduce the revenue generated by the royalty even if roughly the same amount of metal is produced. So for instance Hudbay announced a 2-week shutdown in October at the 777 mine, which means the company incurred costs during that time while producing nothing. An NSR royalty would only see a decline (assuming flat metal prices) of 1/7 in revenue since the mine was down for two weeks out of 14. However an NPI royalty would be hit by the aforementioned costs incurred.
This means that NSR royalty income is more predictable, and therefore more valuable, than NPI royalty income: this can be reflected in our models by using a smaller discount rate.
So the NSR royalty not only generates more income--at least in the current production cost estimate scenario at 777, but this income is more predictable, meaning that the value of the 777 royalty increased substantially in a constant metal price environment. While Callinan shares have outperformed metal prices this lackluster performance hardly reflects the new valuation of the royalty, especially when we compare Callinan's valuation to other royalty companies which own portfolios that are predominantly comprised of NSR royalties.
Re-Evaluating The 777 Royalty
According to Hudbay the 777 mine has the following production schedule. Note that figures have not changed since August and so I am replicating those figures used in August while omitting 2014 figures since the year is effectively over.
|Year||Ore Produced (Ktonnes)|
Each tonne of ore contains the following:
- .93 grams of gold, worth $36
- 11 grams of silver worth $6
- 38.5 pounds of copper worth $112
- 64 pounds of zinc worth $61
This gives the ore a total value of $215/tonne, or $209/tonne after 3% smelting costs. Since this is a 4% NSR royalty Callinan should expect to receive $8.34/tonne, which translates to the following revenue estimates at current metal prices year-by-year. I have put a post-tax estimate in parenthesis and taxes in British Columbia being 26% (15% federal, 11% BC)
|Year||Revenue (in millions)|
In August I discounted this cash-flow at 6.5% and 10.5% to get aggressive and conservative valuations. This is too conservative for an NSR royalty, which again I must stress generates a far more predictable revenue stream since mining costs don't factor in (metal prices and total production still matter, of course). In the past I have used 3% and 7% in order to value NSR royalties, and I will do so again. Amounts are in millions of USD.
|Discount Rate/Metal Prices||-10%||Current||+10%|
Investors will recall that in my current metal price scenario in August using my conservative discount rate I arrived at a valuation of $36 million, which is lower than the figure I came up with today in spite of the fact that metal prices are down, and in spite of the fact that the current mine plan has less production since 2014 production is past us.
Valuing Callinan Royalties (NAV Estimate)
Valuing royalty companies using DCF calculations is crude and it doesn't reflect these companies' true potential values, but it does give us an idea as to what we are dealing with. Before moving to actual numbers, however, it is worth noting that royalty companies often trade at substantial premiums to their NAV's and at lofty valuations relative to their annual cash-flow for reasons I will discuss in a subsequent section.
In addition to the 777 NSR royalty the company also has $23 million in working capital (CADUSD = 0.86) (as of 9/30) bringing the conservative valuation to $64.4 million, or just $7.5 million below its current market capitalization.
The company has other assets, however, that easily bridge this gap and then some.
1--The Gunnison Royalty
The company owns a 1% gross revenue royalty (the same as an NSR only we don't subtract smelting costs) on Excelsior's (OTCQX:EXMGF) Gunnison Project in Arizona. This project is slated to produce ~110 million pounds of copper per year for 10 years starting in 2018, which at today's copper price ($2.90/lb.) would generate $2.4 million in annual revenue for Callinan. Discounted at 7% out 4 years this is worth $13.8 million. Investors should note that financing and permitting remain issues. Permitting in particular has been a greater hurdle in Arizona than one might expect, however even if we slash this asset's value in half it is still worth $6.9 million.
While the company owns other royalties these are too early in their development to be given any nominal value at this time.
The company owns 6.25 million shares in Excelsior worth $1.5 million. It also owns 8.3 million shares of Wallbridge Mining (OTC:WLBMF), which operates the Broken Hammer Mine--a polymetallic mine in Ontario--worth $350,000. It has other stocks but these other companies appear to be dead assets.
Finally the company owns $5 million in convertible debt in Gold Royalties, although convertibility is at $0.80/share while shares trade at just $0.07/share as investors have largely given up on that company's largest assets (mistakenly I might add). These notes are paying 10% interest but unless that company's royalty assets move forward this debt is not worth much. Conservatively it is probably worth $1 million in addition to the $1 million in interest payments Callinan will collect over the next couple of years, although this is a worst case scenario.
So conservatively the company has a royalty worth $41.4 million, $23 million in financial assets minus liabilities, another royalty worth $6.9 million, $1.8 million in stock, and $2 million in notes and related interest payments due, for a total of $75.1 million--a slight premium to the current $72 million valuation. However we have heavily discounted the Gunnison Royalty and the Gold Royalties notes.
Now these figures are a little high since we need to take other expenses into consideration such as G&A (although Callinan has cut G&A expenses considerably in recent quarters from ~$3.5 million to $2 million annually) we also have to take into consideration that these expenses have resulted in value creation, which is evidenced in Callinan's strong performance over the years, meaning we can conservatively say that these effects cancel each other out.
Other Considerations--Optionality Value
While it might seem that Callinan Royalties' undervaluation is little more than a rounding error I should go back to the point I mad regarding the valuation of royalty companies, namely that royalty companies often trade at substantial premiums to their calculated NAVs. Royalties have embedded optionality insofar as the mining company has to pay the royalty on all metal produced at the mine, regardless of whether it is currently included in the mine plan or whether it is known to even exist. While Hudbay has to pay geologists and mining engineers in order to figure this out Callinan can just sit back and collect when Hudbay gets lucky. And Hudbay gets lucky a lot. Just consider the following graphic, which shows the 777 Project's annual production, annual reserves, annual reserve replacement, and hypothetical reserves assuming no reserve replacement.
(Source: Callinan's Presentation)
So the mine started out 10 years ago with 16 million tonnes of ore and it has produced 14 million tonnes and yet still has 10 million tonnes. So for every tonne of ore produced Hudbay has found an additional 0.57 tonnes of ore meaning that (assuming the pattern continues) while the remaining 10 million tonnes of ore will be depleted over ~6 years the mine's life is closer to 9-10 years, and the tapering off of production that is apparent in the above 777 royalty cash-flow figures could be mitigated by additional discoveries. While this cash-flow is discounted in my valuation scenarios we could easily add ~50% in additional undiscounted cash-flow to the above figures. But of course the mine's life could be extended even further into the future on Hudbay's dime.
This "optionality"--described in the context of peer Franco Nevada (NYSE:FNV) by that company's chairman Pierre Lassonde in the following quotation from an interview he gave to Sprott--is enormously valuable.
Here's the thing - why the Franco business model is so incredibly powerful - and very few people understand this. None of our competitors do. They don't understand what we have when we create a royalty. I'm not talking about a stream; I'm talking about a royalty - like the GoldStrike royalty or the Detour royalty. We get a free perpetual option on the discoveries made on the land by the operators, and we get a free perpetual option on the price of gold. Think about this - if someone hands you a free perpetual option on 6 million acres of land, and you don't have to put up a penny, don't you think that at some point, you're going to get lucky?
That's what it is. We have put together a land package by purchasing and creating royalties where we end up with a free perpetual option. It's the optionality value of the land, the value of the operator spending money on our land, and the optionality to higher gold prices. And that is worth so much money. And yet, when the analysts calculate an NAV, none of them ever look at the optionality that we have in our portfolio. Frankly, it's what's worth the most. It's absolutely what's worth the most, and it's what's given us the GoldStrike billion dollar royalty, the Detour billion dollar royalty, the Tasiast royalty, and so on. (my emphasis)
Now consider that Franco Nevada trades with an NEV to annual cash-flow multiple of 25-30. Callinan has an NEV of about $50 million and it is going to generate post-tax cash-flow of nearly $10 million next year at current metal prices. Even if we subtract out $3 million for G&A the NEV to cash-flow multiple is just ~7. Similar comparisons can be made if we consider Osisko Gold Royalties (OTC:OKSKF), which trades at ~20-times cash-flow, and Royal Gold (NASDAQ:RGLD), which also trades at ~20 times cash-flow. While part of the disparity can be explained by the fact that these companies are all more diversified (especially Franco Nevada and Royal Gold)--diversification increases the chance that a partner company gets lucky with a large discovery--Hudbay is trading like a mining company with depleting resources--not a royalty company with this embedded optionality. True, the 777 Mine is depleting, and it is the company's only cash-flowing asset, but right now if the 777 resource is depleted without any additional discovery Callinan is undervalued. Additional discoveries at 777 or at any of the company's other royalty assets (in spite of their current minimal value) can add significant value to Callinan shares, especially given its relatively small market capitalization.
The Bottom Line
The market has largely ignored Callinan's 777's royalty transformation from an NPI to an NSR. The latter is more like a mine that is shielded from losses with the aforementioned optionality. It is a quality asset for sure, but it doesn't have the appeal of predictable input costs. The NSR--while smaller in percentage terms--has this, and we can see from the above figures that it is actually more valuable than the NPI royalty. But more importantly it stabilizes the last of the three variables that any mining company faces--metal prices, amount of metal produced, production costs. That's a big deal, and it makes the 777 royalty far less risky.
In spite of this the stock has fallen slightly since I last wrote about the company in August, and it doesn't reflect the added cash-flow potential or the aforementioned added predictability, which makes future cash-flow predictions more reliable and valuable.
Even if we just look at the assets assuming no mine-life extension, and even if we are very conservative in valuing the company's non-cash-flow generating assets such as the Gunnison Royalty Callinan offers good value. However what makes this stock especially appealing is the fact that it has this value along with the exploration optionality--described above--which has induced investors to pay what appear to be elevated valuations on an NEV/cash-flow basis for royalty companies. Such value simply cannot be found in these other companies and investors justify their positions by assuming future exploration success that will lead to production growth at no cost to the company. This sounds risky although it has been a strategy that has worked consistently throughout the space--if you make enough bets you'll get lucky, and this is a good situation to be in if you aren't paying for continuous bet placement once the first bet is made.
Investors don't see this in Callinan and it appears as though they are mistaken. With this in mind there is a valuation gap that makes Callinan particularly attractive both as a longer term investment and as a potential takeover candidate, as one of the aforementioned royalty companies may act upon this opportunity.
There is no need to rush into this stock. We will likely see tax loss selling put pressure not just on this stock--which is down 10% for the year--but on metals as well, all of which are down with the exception of zinc.
While this is a potential long-term investment I see no reason why this stock shouldn't trade with an NEV of 10-times cash-flow. Pre-G&A post-tax cash-flow is $9.7 million, meaning that the company should have a $97 million NEV or $120 million valuation, giving the stock 67% upside from here. It can, of course, trade at a much higher valuation should the valuation gap close even further, and I see no reason why it shouldn't.
Disclosure: The author is long RGLD, FNV.
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 will probably initiate a position in Callinan Royalties before the year's end.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.