For risk-averse investors wanting exposure to the gold sector, the place to look is among the royalty companies. The royalty business model is low risk compared with mining. With royalties, the financing company is not responsible for ongoing problems and additional costs at the mine; they are the responsibility of the mine owner not the royalty owner. Since most royalties are based on production (such as net smelter return royalties), rising operational costs do not affect the royalty payments. Margins tend to be very high with low headcounts for the size of the company; the largest royalty (Franco-Nevada) spends just 5% of its revenues on G&A. None of this guarantees rising stock prices, of course, but the business itself is very low risk relative to mining.
At the same time, royalty companies do not give up the leverage which is one of the main advantages of a mining company. This leverage comes in many ways, which we discuss below.
Relative to gold bullion, royalty companies have leverage, exposure to exploration upside, and can pay a dividend. Relative to mining companies, they have less or no exposure to capital, operating, and post-mining costs. In short, they have the best of both worlds, though this comes at a cost, namely that the stocks of royalty companies are rarely cheap.
Franco-Nevada (NYSE:FNV) is the leading gold royalty company. The largest, with a market cap of almost $7 billion, it also has sector-leading asset diversification, political safety, strongest balance sheet, and top management. Despite a decline in the price of gold (as well as platinum and oil), company revenues have continued to increase, up year-on-year, if only slightly. This is due to an increase in "gold equivalent ounces," up 23% in the last year, primarily from the addition of a new gold and silver stream on the Candelaria copper mine. Costs continue to be low and very stable, a significant advantage of the royalty business model.
On its current assets and at today's gold price, cash flow for the company, including assumptions on Cobre Panama, a major mine currently under construction, could increase from $439 million this year to a peak of $568 in 2019. The vast majority of this increase comes from Cobre Panama, which many analysts think could generate over $150 million in 2019. Other royalties are stable, or show modest increases or declines depending on whether the mine is ramping up, or moving into or out of ore covered by Franco's royalties.
Royalty companies do have leverage on higher gold prices
In a rising market, Franco has plenty of upside. First, its net profit interest (NPI) royalties have high leverage to gold prices. (Most of Franco's royalties are based on production, but some are NPIs, including part of the Goldstrike royalty and another on Hemlo; two significant mines.)
Second, it has royalties on nearly 250 mineral assets (excluding oil & gas royalties), and only 47 are currently generating revenue for Franco. Some are in the development stage, and some may never generate revenue, but there are many that could become producing mines in a higher gold environment. Since Franco already owns the royalty, it would thus start to generate revenue without any additional expenditure.
Major stream to be renegotiated
One major mine is currently under construction; this is the Cobre Panama copper mine on which Franco holds deals on most of the gold and silver to be produced in a $1 billion transaction, its largest ever, with payments staged according to constructions hurdles. The mine was originally expected to commence production next year, with a 31-year mine life, but since First Quantum took over old owners, Inmet, they have restructured the mine plan and have been trying to renegotiate the streaming deal with Franco.
These negotiations have been going on for some time now. Franco has indicated it is working with First Quantum, but CEO David Harquail emphasized it is "absolutely committed to the original deal." That is, if a mutually agreeable revision cannot be agreed, then Franco can stick with the original transaction. In the meantime, Franco has agreed to make a $275 million payment, "a reflection…that (First Quantum has been) effectively carrying our contributions."
Is there debt in the future?
Despite the company's strong cash position - $688 million at quarter-end - the company has increased its credit lines and did discuss on its earnings call earlier this month the possibility of taking on debt if necessary for a major acquisition. Harquail emphasized that the company's philosophy is not to use debt; "we don't want long-term debt, don't want net debt… we are very reluctant to take on debt." But he said that in this depressed market, the most important thing for the company is that if a major opportunity became available, Franco would want to grasp it, and "then figure out how to finance." It would use its credit line before issuing equity in the current market. If it did take on debt, it would pay down as soon as possible.
Franco has indeed been very active already in this weak market, spending in excess of $1 billion on 35 new royalties in the last 12 months.
I think the discussion on the possibility of debt is a reflection of just how depressed the market is and how attractive deals are, rather than any change in approach at Franco. There has been an expanding universe of royalty and stream deals, including a new source of royalties, namely by senior miners wanting to cut debt. Harquail noted that returns on long-life mines tend to be low, because of competition, but on short-term assets "have never been better."
I have stated many times and repeat here that if you can only buy one gold company, if you want a conservative, buy-and-hold company, that company should be Franco-Nevada. The current price is a good entry point. Though down from a mid-May high of almost $55, it has bounced from a low just over $39 last week. A soft gold market could see it drift back down again. Franco also pays a small dividend, 1.9% yield on the current share price. The company is committed to increasing dividends, having boosted it three times in the past three years. For long-term investors, Franco also offers a dividend reinvestment program, under which dividends are reinvested into shares at a 3% discount. Your broker can enroll for you.
Royal is mitigating its major risks
Royal Gold (NASDAQ:RGLD) is the second largest gold royalty company. A new stream on Barrick's large Pueblo Viejo mine in the Dominican Republic, is a prime example of the new kind of royalty referred to above by David Harquail, to reduce a major miner's debt.
The $610 million transaction, despite a rather modest 5% IRR, is very significant for Royal Gold, in that it greatly adds diversification to the company's assets, away from the Mt. Milligan copper mine which will now be responsible for 31% of revenue and less than 25% of net asset value. Given that the market had been concerned with the one mine representing such a large portion of the company's assets and revenue, this is a positive transaction for Royal, following two other acquisitions. It should be noted that operations at Mt. Milligan continue to improve, so there is less risk in that asset now than there was a year or two ago.
On its current assets and at today's gold price, cash flow for the company should increase, according to many analysts, from $351 million this year to a peak of $558 in 2018, giving the company more near-term leverage than Franco, but at the cost of a "less strong" balance sheet (a relative comment; Royal will draw on its credit facility by about $300 million for the Pueblo Viejo transaction, but still has net cash).
As with Franco, Royal is down significantly from levels earlier in the year, but it has bounced off a $49 low last week. At this price, it's a very good buy, though could drift down if gold falls back. Like Franco, Royal also pays a modest dividend, 1.6% right now, and has boosted it three times in the last three years.
The next royalty powerhouse takes a different tack
Osisko Gold Royalties (OTC:OKSKF), whose primary listing is on Toronto, with the symbol OR, is the third-largest gold royalty company, with the goal of building a portfolio of royalties from its foundation of two of the best gold royalties in the world. These are attractive royalties (5% net smelter return in one case) on two relatively new, low-cost, long-life mines in Quebec, one of the safest jurisdictions in the world.
But it is pursuing a different approach from the two larger royalty companies, Franco-Nevada and Royal Gold. It is challenging to buy significant royalties at attractive prices when competing against these two well-financed behemoths. So Osisko is going about it in a different way, both by generating royalties through its own exploration programs, and by investing in juniors seeking to create royalties from them.
More risk, more time and more potential
This is a longer-term approach than buying a paying royalty, but one that, though a little more risky, will pay off in the long run with potentially more upside.
A current example is the four-way merger underway revolving around Oban Mines, an Osisko-backed exploration company. Osisko will invest $18 million for an additional 18% interest (approximately) in the combined entity, and a right to acquire a 1% NSR on all properties held by the company. The shareholding could also be converted to a royalty at a later stage. Through Oban and other juniors, Osisko has exposure to some of Canada's most active exploration camps.
The two mines on which Osisko has existing royalties are Canadian Malartic and Eleonore. Canadian Malartic, one of Canada's largest mines, was brought into production by Sean Roosen (CEO of Osisko Gold Royalties) and the former Osisko Mining in 2001 just six years after the first drill hole. It was subsequently taken over by Agnico and Yamana jointly and Osisko Royalties created.
Eleonore, in Northern Quebec, was discovered by Virginia Mines (which was acquired by Osisko at the beginning of this year). The mine was sold to Goldcorp in 2006 and began production at the end of last year. It reached commercial production in April this year with an official mining opening just last month. Osisko will start to receive royalty income from this mine in the third quarter (after its advance royalty has been offset). Revenue from these two royalties is expected to grow from $54 million next year (when Eleonore is fully paying) to $69 million by 2018 (even at today's gold price).
Strong balance sheet for future growth
The company has a strong balance sheet with $320 million in cash, as well as credit lines putting it in a strong position for an acquisition. During the course of this year, Osisko has invested nearly $100 million into Labrador Iron Ore Royalty; that generated $1.6 million in the latest quarter. Roosen, Osisko's CEO, has said that, though the focus is precious metals, it would invest outside the gold sector in long-life mines with solid cash flow and this investment fits that profile.
This investment in iron ore has, however, caused some concern. Another concern is that its controlling interests in some juniors could put the company in a position where it needs to pony up more cash. Notwithstanding an at-time combative front, Roosen is well regarded in the Canadian mining sector as a mine finder and builder.
Solid position with strong upside, and a good price to buy
All in all, Osisko has a solid balance sheet, two powerful main assets, strong management, and a goal to create more revenue-generating royalties. Its approach is more long term and a little more risky than buying royalties but also one that has greater potential. The stock has rallied strongly from a sharp dip to $12.75 in mid-July; I would look to buy under $14.50, where it would be a strong buy for long-term patient investors. The company instituted a dividend at the beginning of this year, equating to a 0.8% yield, but we expect to see this increased as Eleonore ramps up.
I recommend buying all three of the major royalties, each with somewhat different characteristics. If you can buy only one, make it Franco, as a long-term core holding. If you are looking for the best near-term upside (over the next six months or year in a rising gold price), the choice would be Royal. And for arguably the best long-term potential, Osisko would be the choice.
Disclosure: I am/we are long FNV, RGLD, OKSKF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Management clients own positions in these stocks.