How To Make Money Off A Hole In The Ground: Franco-Nevada

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RB Equity
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Summary

  • Streaming companies provide exposure to gold without the many downsides of physical ownership or the risks of mining companies.
  • Franco-Nevada is my preferred player in the space, also the largest and best performer.
  • Although not cheap, the company appears poised to continue unit growth (GEO sales) anchored on Cobre Panama, which recently became its main asset and is just beginning its useful life.

Belt conveyor in an underground tunnel. Transportation of ore to the surface

Nordroden/iStock via Getty Images

“A gold mine is a hole in the ground owned by a liar.” – sometimes attributed to Mark Twain.

Owning gold outright has been a poor experience. Owning gold miners, well, Mr. Twain had a point. There is a better way, one that provides diversification to other metals, exposure to a large number of mines and jurisdictions, expansion optionality, and if that were not enough...even pays a dividend.

FNV is a Pioneer in the precious metal royalty business; a business it helped create in the 1980s and still dominates to this date. Many royalty and streaming companies exist today, however, most activity is consolidated around three players: FNV; Wheaton Precious Metals (WPM); and Metals and Royal Gold (RGLD). As the following chart shows, Franco-Nevada stock has done better than its peers.

FNV vs peers in price % change
Data by YCharts

The business

FNV has an unusual business; here are some facts that highlight its atypical nature:

  • Just 35 full-time employees in total, run a company with $26Bln market capitalization. A ratio of $743 million per employee;
  • In Q1, FNV earned a typical 85% EBITDA margin;
  • Despite having a recurring revenue stream, FNV has $0.7Bln in cash, no debt and can grow unit sales without any incremental capex;
  • It has positive exposure to inflation (revenues increase faster than costs).

In a way, we can think of FNV as a type of closed-end fund. Instead of their holding investment in securities on our behalf, they hold royalty and streaming contracts with mining operators. These contracts give them the right to receive a slice of revenues, in the case of royalties, or a portion of production at discounted prices, in the case of streams.

Mining is a risky business. If it were not, traditional sources of financing would probably suffice, as they do in most other industries. What royalty and streaming agreements represent is an alternative method of financing.

From the mine operator's perspective, these contracts have several advantages:

  • They have few covenants;
  • They provide cash upfront without a contractual repayment schedule. Repayment is subject to actual production;
  • The contracts are not recorded as debt in the balance sheet;
  • In the case of streams, they allow monetization of “ancillary” precious metals which are not the main mine output;
  • They are available when other more traditional funding methods are not.

From a royalty/stream holder, there are advantages as well:

  • Exposure to commodity prices with no risk from operating mines;
  • No impact from increased cost of mine construction, as long as mine reaches commercial operations;
  • No impact from inflation, as streams have fixed prices and royalties come out of gross revenues. Inflation may actually benefit due to potential to stoke higher metal prices and due to the inclusion of energy-linked royalties;
  • Optionality on future expansion ounces & exploration successes.

The last point is extremely important, impossible to accurately quantify, but nevertheless a crucial feature of these contracts.

Perhaps a case in point will come in handy.

The Goldstrike story

In 1986, Pierre Lassonde, one of FNV´s two founders purchased a Royalty on the Goldstrike mine in Nevada for $2m. Shortly after, Barrick purchased the mine and conducted additional exploration. It ultimately revealed a 50 million ounce orebody that launched Barrick's success (and along with it, FNV's). From its initial investment, FNV has received in excess of $1Bln in revenue, without having to fund another dollar.

This is an extreme example, to be sure. However, it serves to highlight the “hidden” value in royalty agreements. As FNV's CEO likes to ask, “Where is the next major gold deposit most likely to be found?...Right around where gold has already been located.” This is true because operators already holding concessions are most likely to focus exploration efforts around their existing operations, before looking elsewhere.

FNV has 112 operating assets, 42 in advance stages and 250 royalties or streams on exploration stages. Many could lay dormant for years. But equally, a handful of them may become a version of Goldstrike. A few outliers have the potential to carry the day. In a sense, this approximates a venture capital type of outcome profile.

Already, we can see the difficulties in valuation. In a way, it looks like a close-end fund, with royalties producing revenues and cash flow that we could put a value on. But on top of this, there is a large number of royalties and streams on non-producing assets that look like a portfolio from a venture capital firm.

The numbers

Franco-Nevada has a market capitalization of $26Bln and a slightly lower enterprise value ($0.7Bln in cash and no debt). The royalty and streams book carries a value of $5Bln on the balance sheet. The balance sheet is as clean as can be. On the asset side, you have cash a minimum of receivables and the royalty/stream contracts. Nothing worth mentioning in the liabilities side, the equity is $6Bln. There is no recognition in the financial statements of the value implied in the real options that exist with royalties. However, the market knows about them and assigns a premium to these assets. Such premium is about 4x the company’s net worth.

As far as cash flows go, the company earns typically $200m to $240m in operating cash per quarter, or about $0.8Bln to $1Bln. The cash flow yield on the $25Bln enterprise value is therefore 4%. Not cheap, but not ridiculously expensive given that there is no debt, very little fixed expenses involved and it grows. Again, it is similar to buying a portfolio of securities, in a sense. In fact, G&A expenses as % of market cap is less than 0.20%, more similar to a fee from an ETF than a standalone company.

Management Skill

The reason I prefer FNV to the other two large players in the space is its management. Because of the quote at the very beginning, about the hole in the ground and its owner, you need know what you are doing. Franco-Nevada has a world-class board, including Mr. David Harquail, the prior CEO who was instrumental in assembling the assets already acquired. In this company, board expertise is essential for advising management on deal selection. The board contains two ex-CEOs of the largest gold mining companies, for example.

More recently, under Paul Brink, the current CEO, FNV took advantage of depressed energy prices during the pandemic to diversify. It purchased royalties on gas and oil in north America at what has already proven to be bargain prices. The timing was perfect, and cash is already cascading back. This action was mimicked by none of the others, it was a departure from the traditional focus on precious metals, but it has proven to be a fantastic allocation of funds. During that time, it also acquired exposure to iron ore royalty from Vale, again at favorable prices.

None of this means the focus will shift permanently to other types of royalties. Revenues from precious metals are still over 75%. And, on the recent earnings call, Mr. Brink confirmed they are done for looking outside the box. The main observation is that current management seems skilled at deploying capital, a key competence always.

Cobre Panama

Franco-Nevada invested over $1.3Bln in Cobre Panama in exchange for a streaming deal that began paying back in 2019. The mine is a world class copper asset in the Caribbean side of Panama, not far form the Canal. The ability to bet big is important, this investment represents almost 25% of FNV assets. By 2022, the mine has become FNV´s main revenue source as well and also its main near-term growth engine.

Cobre Panama had some overhanging risk with regard to its concession and the way it was awarded originally. During 2020 and 2021, negotiations began with the government of Panama on all aspects of the project. Earlier this year, an agreement was reached which substantially increased profit sharing with the government, putting an end to legal uncertainty. First Quantum, the mine owner, has announced an expansion to 100Mtpa from 85Mtpa, motivated by high commodity prices and the settlement with its host country. This 17% expansion in metric tons per annum comes, again, at no cost to FNV.

Goldilocks

Franco-Nevada can grow even if the price of gold is stagnant. Below, we see gold has increased a mere 16% in the last ten years, but revenue per share has doubled. I use revenue per share because FNV occasionally issues small amount of shares, particularly when priced high, to finance new royalty investments.

Gold Price in US dollars % change and FNV revenue per share % change
Data by YCharts

The environment in the past decade, a stagnant but not low gold price (of around $1,800/oz), is perfect for FNV. Unless, that is, you want to sell FNV stock in the near term, where a very high gold price is best; a price like we have experienced has the advantage of keeping mine operators mildly starved for capital. But still willing to expand. This is good for capital providers like FNV.

I have no insight to offer on the future prices of gold, I just hope prices stay around these levels so that FNV can grow its investments...getting ready for the next leg up, whenever that will be.

On a long term perspective, gold - the preferred store of value since humans needed to store value - should be a beneficiary of all the easy monetary policies that have prevailed in the developed world. It may occasionally appreciate precisely when distress hits other assets, as well. A neat, diversifying feature that should also make FNV hold up better in times of real bad markets.

This article was written by

RB Equity profile picture
830 Followers
Striving to compound knowledge. Long-time fan of Warren and Charlie. Always invert. "To finish first, you must first finish". Investing own and family funds for +20 years. Senior finance roles at public and private corporations for most of that time.
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Disclosure: I/we have a beneficial long position in the shares of FNV either through stock ownership, options, or other derivatives. 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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