David Harquail sums up the advantages of the royalty and streaming approaches to mine financing crisply and succinctly.
“It’s the best business because you don’t have to do the risky exploration, but you still can get the upside of a great discovery.”
And Harquail speaks from experience. He is president and chief executive officer of Toronto-based Franco-Nevada (FNV-T, FNV-N), which in the mid-1980s pioneered the use of the royalty and streaming models in the precious metals sector. The company hit what proved to be a monstrous home run in its first at-bat.
In 1985, Franco-Nevada paid $2 million for a royalty interest in a small Nevada mine called Goldstrike, which then had proven reserves of 30,000 oz. gold. One year later, Barrick Gold (ABX-T, ABX-N) purchased the property. Further exploration revealed a motherlode of 50 million oz. gold, and Franco-Nevada gets a royalty on every ounce that comes out of Goldstrike for the life of the mine.
“We’re going to collect over $1 billion for our $2-million investment,” Harquail says. “That was our company builder.”
Nobody hits it that big every time out, but Goldstrike validated the business model and Franco-Nevada, which was taken over by Newmont Mining (NMC-T, NEM-X) in 2002, then spun off again in a 2007 IPO, has acquired a large and geographically diverse portfolio of gold royalties and streams since its Goldstrike investment. It now has a market capitalization of some $7 billion, making it one of the major players in the game, along with Vancouver-based Silver Wheaton (SLW-T) and Denver, Colo.-based Royal Gold (RGL-T, RGLD-Q).
In the current climate of ever-escalating capital and operating costs, royalty and streaming companies also offer investors another huge benefit — protection from the operating risks that have eaten into mining companies’ profits, even as commodities prices remain at historically high levels.
“Our model mitigates some of the inherent risk,” says Nolan Watson, president and CEO of recent arrival Sandstorm Gold (SSL-V). “A lot of investors don’t make money in mining because of capital cost and operating cost overruns. With royalties and streams, if there are cost overruns, those are the operator’s problems, not ours.”
Sandstorm’s performance since its formation in 2009 suggests investors are catching on to the unique advantages royalty and streaming companies possess. The Vancouver-based company started out with a market capitalization of $4 million, but by July 2012, was worth more than $660 million.
Although they are often spoken of in the same breath, royalties and streams are, in fact, quite different creatures. Harquail explains that royalty deals are usually struck with the original discoverer of an orebody, either a prospector or a junior mining company. In most cases, the exploring individual or company wants to realize a financial benefit from the discovery in the short term rather waiting, perhaps for years, until a big mining company purchases an option and begins to develop the deposit.
The companies that acquire royalty interests — a Franco-Nevada or a Sandstorm — must wait until the orebody is fully explored, developed and put into production, at which point they typically collect — on a cash basis — two per cent of the value of the metal that comes out of the smelter.
“It’s often ten years before anything happens on a property,” Harquail says. “We buy out the explorers so they can move on. We’re willing to be patient and to take risks on the value of the commodity and size of the deposit.”
Streaming deals are usually struck with an operator who needs more money to put a mine into production. The streaming company agrees to make a certain investment in return for a percentage of the output, at a set price for the life of the mine. For example, Sandstorm Gold has an agreement with Brigus Gold (BRD-T, BRD-X to purchase 12% of life-of-mine production from its Black Fox mine, in Ontario, for US$500 per oz. Sandstorm paid US$56.3 million for the stream in 2010, with the mine expected to produce 70,000 oz. this year and more than 110,000 oz. per year starting in 2013, and a current mine life of eight years.
According to Harquail, streaming offers several advantages for the operating company. It is selling a future interest and therefore can defer the taxes due on the funds it receives from the streaming company. If it sold an outright interest in the property, the cash received would have to be reported as income and tax would be due immediately.
Streaming and royalty companies also present an attractive option for investors. In terms of their risk profile, they are midway between low-risk, exchange-traded funds (ETFs) and higher-risk investments in operating companies. Essentially, says Harquail, they offer plenty of potential on the upside while minimizing many of the risks associated with the industry.
“Streams and royalties are becoming more popular investment destinations because people want to do better than buying a bar of gold sitting in a bank vault,” Harquail says. “All you get with a gold ETF is the appreciation in the price of gold. You don’t get dividends and you don’t share the growth that results from exploration and discovery.”
The operating company is at the other end of the risk spectrum. “If you buy a gold company, it gives you tremendous exposure to gold,” Harquail says. “But the capital costs may be higher than projected. Operating costs may be higher. There may be technical problems or tax grabs by government. A lot of investors have been surprised recently by all the bad things that can happen to operators.”
A large streaming and royalty company also reduces risk through diversification. Franco-Nevada has a portfolio of 342 assets at all stages of development and they are scattered geographically from Canada, the U.S. and Mexico to various parts of Africa and a few locations in southeast Asia. About 90 per cent of the portfolio is precious metals and three-quarters of it is gold. The company has an interest in 43 producing properties and another 25 are due to come on stream.
“There’s no gold miner in the world that that can have assets spread over such a large portfolio,” Harquail says. “We can provide a much more dependable outcome without the concentrated risk of an individual operator.”
But as the numbers indicate, it takes a lot of streams and royalties to produce a few winners.
“We’ve created a huge portfolio of these because some will never produce and some won’t produce for a long, long time,” Harquail explains. “When we’re looking at a property we put a probability on it. We ask: ‘When is this property going to go into production, if ever?’”
Sandstorm appears to be hitting well above the industry average. The company has 10 assets in its portfolio, including seven gold streams (five of which are on producing mines), and three NSR royalties. The company also recently announced it will be raising $150 million to acquire new precious metal streams and royalties, and at presstime, had just listed on the NYSE MKT LLC Exchange (formerly the Amex) in New York.
Sandstorm’s take from its portfolio of assets in 2012 will be about 30,000 oz. gold, says Watson, who left Silver Wheaton to form Sandstorm. That will generate revenues of nearly $50 million, if the price of gold this year averages US$1,600 an oz. The expense side of the company’s balance sheet demonstrates another reason why streaming and royalty company attractive investments.
Sandstorm can generate those revenues with a mere 15 employees and annual operating expenses in the neighbourhood of $10 million, leaving the company with some $40 million of free cash flow with which to shop for new properties. By comparison, Nolan notes, a mining company with $80 million in annual revenues might have $10 million free cash flow, or less due to much higher operating and capital costs.
Watson foresees bigger things ahead. He says that within two years Sandstorm’s royalties and streams will yield 50,000 oz. in either gold or cash equivalents, and at an average cost of US$400 an oz. At today’s price, that would generate some $60 million in free cash that would be used to expand the company’s portfolio.
For now, while it is in the buying and building phase of its evolution, Sandstorm isn’t paying dividends. But the bigger and more mature Franco-Nevada, which is projecting revenues in 2012 of $430 to $460 million and has a mere 20 employees on its payroll, has been paying dividends for several years. Indeed, Harquail proclaims proudly that the company pays a monthly divided, has boosted it in each of the past five years, and has been in a position to do so.
“Over the past four and a half years, we’ve substantially outperformed the gold operating companies and we’ve outperformed gold,” he says.
But for all the upside, no mining venture is fail-safe and neither are the streams and royalties that may be attached to them. Only one in 20 properties generates what Harquail describes as “spectacular returns” and the rest are break-even propositions at best. Furthermore, operators occasionally look for a way out of a long-standing agreement that has produced extraordinary returns.
“Operators sometimes forget how they got started and after ten years they want to get rid of a royalty agreement,” Harquail says. “We need good courts of law to protect our deals. Our contracts are written in Western countries and we’ve never actually lost a royalty or had a legal dispute.”
Future growth looks rosy for royalty and streaming companies, which are sitting on mounds of cash.
At presstime, Franco-Nevada had just announced a record $1-billion streaming deal with Inmet Mining (IMN-T) on its 80%-owned Cobre Panama copper-gold project in Panama. The funding schedule for the project will allow Franco-Nevada to make another US$1 billion worth of acquisitions in the short term, while Royal Gold had US$430 million in working capital at the end of June.
With mining companies struggling to raise the money they need to develop new mines, more deals are sure to follow.
— The author is a Toronto-based freelance writer and former senior writer with Macleans.
This article originally appeared in the September 2012 issue of Mining Markets magazine.