Franco-Nevada, The Gold Star Royalty/Streaming Company - Part 1
Summary
- This is part one of a two-part article presenting an alternative investment for gold exposure.
- Royalty/Streaming companies have several advantages to mining stocks. The industry has two dominant players, FNV and Wheaton Precious Metals.
- The optionality embedded in their deals is a very large part of their proposition, often difficult to value precisely but in any case, immensely attractive in the long haul.
Why is gold so valuable? On the one hand it is durable, shiny and malleable. It has been coveted since the beginning of history by most civilizations. The prospect of "cities made of gold" drove European exploration and conquering of the American continent five hundred years ago (with somewhat disappointing results on the gold front, given the high expectations).
On the other hand, it has little “practical” or industrial uses. Jewelry takes up roughly half of yearly production, and investment by central banks and private investors just about the other half. Technological uses account for only 10% of demand on a good year. It is scarce, true, but there are “scarcer” elements that do not command such premiums. Astatine earrings anyone? So rare you will only be able to wear them once.
During medieval times, gold was the main portable asset in kingdom´s “portfolios”. Today, it can be an “alternative” asset in our individual portfolios. It is attractive in part due to its low correlation to other traditional - what would be alternative back then - asset classes. I also cannot answer the question just posed in any definitive manner. Our collective love of gold seems to be the product - like so much in society - of a shared belief that is highly ingrained in our collective history and culture.
Here is how I think about the question of whether or not to have some exposure to gold:
- The unprecedented rate of fiat money creation will have consequences at some point. Be it inflation a weaker USD or a combination of both. When supply (of any item) is forcibly increased – even if policymakers have good reason to do so – this drives up prices of everything else relative to it.
- Gold will continue to serve as a store of value as it has for millennia; even though it may have competition at some point in the form of cryptocurrencies. It is a practical hedge to "Armageddon".
- There are no new continents to search for gold in, so people are starting to look at the skies…but asteroid mining is not here yet!
This is how demand and supply of gold look:
Demand
Source: Gold.Org
Supply
Source: Gold.org
I have called gold an asset to frame the issue as a portfolio diversification matter (the green portion of the demand bars). I do not actually thing of gold as an asset. It will not create a cash flow stream on its own and costs money to store and secure. These are not asset-like features.
Investors usually consider three ways to add gold exposure to a portfolio:
- Buy physical gold. There are many metal exchanges that will quickly ship gold ounces and bars to retail investors. Storing and securing from there is up to the owner.
- Buy a gold ETF. Some gold funds are backed by physical gold. This converts ownership into a security (a share in a trust) that fits nicely with the rest of the portfolio. The downside, there is a fee to cover costs of fund administration and physical gold storage.
- Own gold miner stock. This begins to depart from the desired direct gold price exposure, and has some pros and cons. On the plus side, there is now a cash flow stream, so these really are assets. On the downside, this subjects investors to the operating, legal and environmental risks common to business ownership.
There is a fourth way, not well understood particularly well known, which is through precious metals royalty and streaming companies. In this format, a cash flow stream linked to precious metal prices is created, while most of the business risks of the mining activity are pushed to a secondary plane.
There are two leaders in the business, Franco-Nevada (NYSE:FNV) and Wheaton Precious Metals (WPM). In this article, I will describe their business model in general terms.
The Business Model
In the most simplistic terms possible, the business consists of advancing money to miners in exchange for a share in future precious metal production. Instead of the advanced money becoming a claim on the assets (a loan) or earnings (equity) of a miner, it becomes a claim on the resource.
It should be immediately apparent to the prudent investor that doing this has its own set of risks. Accurate judgement is needed in assessing the prospects for the project, including the quality of the resource, its quantity, the future price, the regulatory environment, operator experience, etc. It is in some sense a form of pre-construction financing.
One way to address this risk is through diversification. FNV, for example, has 56 operating mines, 34 in advance development and a whopping 206 as potential prospects. Because these are contractual rights and royalties on resources, instead of actual operating assets, it is able to manage such diversification with few costs.
Source: FNV asset handbook
Franco, with its $20 Bln market cap, employs a total of 38 people. Its board, though, is not small consisting of 9 directors. I don’t know if there are many (any) companies with an employee/director 4:1 ratio. Expertise in many areas around mining operations, geographies, contract enforcement, etc. is required to make good underwriting decisions. This expertise resides mostly on the board.
In that vein, to use an industry term, I am happy to see Mr. Harquail becoming Franco-Nevada´s Chairman. As CEO, he captained the ship to a 7x return in fifteen years since IPO. Glad he is staying on board (with a substantial portion of his net worth in the cargo hold).
There are two types of contracts prevailing in the industry. Streaming and royalty. To keep this article at a reasonable size, I will leave the details to a future article; where I will also address why I prefer Franco-Nevada to Wheaton.
Between the two types of contracts, the basic concept is the same. Cash out at the beginning, for a share of resource for decades into the future. The model then is to create a portfolio of these contracts and allocate the incoming cash flow between growth and shareholder returns. Cash margins are SaaS-like, given the low corporate expense and nature of contracts, often approaching 80% of revenue.
Capital structures are conservative. Both companies attempt to fund growth with share issuance or internal cash flow shying away from debt. Done well, this can produce EPS growth at a lower risk. Done wrong, it will destroy intrinsic value. In any case, one significant source of value is the cash flow stream, which has a leveraged exposure to the gold price. However, there is much more to the business model, and valuation of current cash flow stream misses a big slice of value.
The hidden return “kicker”
Most of these deals are carried out very early on in a mine´s lifecycle. It is often the landowner or a smaller exploration company that enters into these contracts to fund development (for a later sale to an established miner). The sale of rights allows initial investors to raise funds before there are assets that can be financed and still retain an interest in the future exploration and production.
A key (and in my mind THE key) aspect of these contracts is that they typically cover a concession area, not a particular mining investment. Why is this distinction important? It concedes a free option on future development to the royalty or stream holder. A typical mining project is built in several phases, because of the perpetual nature of royalties or multi-decade length of stream contracts, and the absence of funding obligations; these companies manage to effectively grow production using other people’s capex. They have a call on future exploration success within the concession areas. In fact, it is actually better than a call option - because options imply a strike price that confers a “right but not an obligation” to the holder. In this case, the strike price is zero, they can “exercise” their option without having to contribute any new money towards expansion.
The is no way to account for this value in the company’s books. The markets recognize the value of these options at least partially, as market caps are usually three or more times the asset value (the contract portfolio, carried at cost). But given what we know about these options, we can easily conclude their value is “huge”.
The three main things needed to value an option using Black-Scholes are:
- The term to expiration (the longer to expiration the more valuable the option)
- The strike price (the deeper in the money, the more valuable the option)
- The volatility of the underlying (the higher the volatility the higher the more valuable the option).
As applied to royalty and stream portfolios:
- Multi-decade or perpetual
- Strike price effectively zero, making the option perpetually in the money
- The “underlying” defined can be thought of as the value of streaming/royalty contracts entered at expiration, for a term equal to the expansion phases of the mine. The volatility of these values is at least as high as the metal prices that underlie them.
In short, if one tried to run a valuation on these options, the computer may overheat before reaching a solution. There is a lot of value here, which may not be reflected completely in the stock prices.
To summarize:
Some gold exposure, regardless of where we may be in the cycle, could make sense for most investors. Short of actual Armageddon, gold should hold value as a collectively agreed upon store. Especially in those once-or-twice-in-a-century occasions when central banking credibility runs thin.
Both Franco-Nevada and Wheaton have a portfolio of royalty/stream contracts that are high cash flow producers and present no material cash outflow commitments. Their balance sheets are pristine, with little to no debt and their G&A is minimal. Further, their revenue contracts contain imbedded options around the expansion of current and future mining operations. As such, they provide a more efficient exposure to the precious metals pricing, while limiting operational risk by taking their “share” off the top (from the revenues not the net income) and not having to manage mining assets themselves.
In Part 2, I will discuss more in detail how the different contracts work (royalty vs stream) and why I am leaning towards Franco-Nevada as the better of the two.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FNV over the next 72 hours. 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.
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