Franco-Nevada: The Gold Star Royalty/Streaming Company - Part 2

Summary

• This is part two of the article presenting royalty streaming companies as a preferred way to add gold exposure to a portfolio.
• The business models of Franco-Nevada and Wheaton Precious Metals are analyzed and compared with one another.
• Of the two leading entities in this space, Franco-Nevada appears to be the clear winner going forward despite a 25% higher enterprise value.

In this part two, I will go into a little more detail on Franco-Nevada (NYSE:FNV) and Wheaton Precious Metals (WPM) businesses. In part one, I presented the arguments for royalty/streaming companies as an efficient way to include gold and precious metal exposure in portfolios. The main reason being their asset-light business, with highly resilient cash flow streams.

When compared head-to-head, I prefer FNV and have recently initiated a position I intend to grow gradually through the next few months. However, alternative-approach readers may consider employing this to divide desired exposure equally between the two and simply hold both leaders.

Royalty vs Stream

There are two main type of contracts in these companies' asset portfolios, Royalties or Streams. Both have a few things in common, an upfront cash outlay in exchange for a future slice of production and a direct relationship between revenues and the prevailing spot price of gold, silver and other PMs.

Royalties (or Net Smelter Return, “NSR,” royalty) are a percentage of the net value/revenue the miner gets from metal sales. The “net” part refers to the netback calculation of price after adjusting for transportation, insurance, etc. to reach the smelter facility. Typically, royalties are between 1% and 5% of revenue, and once established, they require no recurring payments to maintain.

Streams, the other type of contract, are an advanced purchase on future production. After the upfront payment (deposit), the stream owner still has to pay, usually a low amount per ounce, to receive its share of production. In the case of gold, for example, currently selling for around $1,700/ounce, the typical stream payment is around $400/ounce.

Streams may have some tax benefits depending on jurisdiction; however, it should be obvious that for the same percentage of production, a royalty offers better economics than a stream. FNV provides the following example:

Source: FNV Company filing form 40-F

In addition, royalties may be registered locally in some jurisdictions and thus provide better protection, especially during reorganizations. The stream in contrast is usually structured as an advance deposit on future production and thus its owner likely to be considered a junior creditor during a reorganization.

Streams, on the other hand, may be structured such that the initial cash deposit (outlay) is only disbursed after the mine achieves certain milestones. Perhaps issuance of permits, construction loan commitments, etc., and thus bear a lower risk than royalties purchased earlier when the viability of the mine is less certain.

Wheaton is almost exclusively focused on streams while Franco-Nevada has a higher proportion of its economics tied to royalties.

Diversification

The two are very similar with regard to their exposure to precious metals as being the overriding variable with regard to revenues. With that in mind, there are different dimensions to diversification that one can consider. FNV, for example, has about 10% to 15% of revenues coming in from oil and gas royalties, while WTM has not. A year ago, this looked like a case of “diworsification,” but today the move is looking better. In any case, management has clearly signaled that it will not go beyond 20% with regard to oil and gas.

We can also look at diversification underlying mining operations (or projects). A large proportion of mines are primarily focused on other metals, so having exposure to a higher number of different sites and geographies is perhaps the best proxy for diversification.

In this light, FNV is substantially more diversified than Wheaton.

Source: FNV company filing form 40-F

Wheaton lists 20 operating mines - below - and nine development projects.

Source: WPM investor presentation

Finally, as for future growth, the higher the number of potential expansion sites, the better. Here again, perhaps because of the greater reliance on royalty vs stream, FNV seems to have a much larger and geographically diversified book of exploration prospects.

Of the two, despite a lower overall revenue level, FNV is more diversified with regard to its exposure to operating and prospective mines. Its small oil & gas deals provide an extra layer of diversification as well both in terms of revenues and in terms of opportunities to deploy capital at low end of cycles.

In part one, I argued a main portion of the value in these companies is their embedded options on future production. This is important for both operating mines and prospective mines, so the larger the overall portfolio is, the more embedded options that exist.

Capital structure

No significant debt exists in either balance sheet. WPM used to carry some debt, but by the end of 2020, both were effectively debt-free. Instead, they have tended to access equity markets for raising capital needs:

Data by YCharts

The result is a very low risk business, given the strength of the cash flow generated by their contracts and the lack of potential claims on such cash flow (other than for metal purchases at prices well below spot or costs of production).

The downside is that returns may be lower than otherwise, as a low level of leverage could improve per share returns on an after-tax basis. I believe this is a fair trade off given the overall desire is to obtain an efficient exposure to gold prices (and thus these companies have to compete with gold ETFs for investors).

Valuation

Because both companies routinely issue shares, I will not look at revenue or EBITDA in a standalone basis. Only per share data and enterprise value (which considers all shares outstanding) are valid from the standpoint of shareholders.

WPM per share data:

FNV per share data:

On a per share basis, WPM has barely grown revenue in the past 10 years, while FNV has increased revenue from around $3 to over $5.

Rationally, the market places a premium valuation on FNV vs WPM. On the whole, the market also places a premium valuation on both. Cash flow from operations was about $700 million for each in 2020. The high multiple on cash is probably due to the recognition by the market of the embedded options, as argued in part one.

Data by YCharts

Conclusion

In this case I agree with the market FNV probably deserves a higher valuation than WPM (implying it offers better look forward returns) due to the following:

• FNV has a higher proportion of royalty contracts vs streaming
• FNV has a higher growth profile from current mines
• FNV has a larger set of embedded options due to the size of its exploration portfolio

Finally, a confession. I cringe at prices of 20-30 times cash flow, most investors should, outside of "momo-land". Such levels imply yields of 3% to 5% which are more appropriate to bonds than stocks. But remember i) there are no debt holders in front of you and the cash flow stream, and ii) the optionality on expansion (requiring no future investment) is intuitively very valuable despite the fact that there is no practical way to accurately estimate this value.

Analyst’s Disclosure: I am/we are long FNV. 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.