Money manager Adrian Day explains why he is a
believer in holding royalty company shares in a bull market.
There is a common perception that the royalty—and streaming—companies are
defensive in a bear market, but that you don't want to own them in a bull
market since they lack leverage. We disagree, and think the major royalty
companies should continue to form cornerstones of a precious metals portfolio
in a bull market.
No doubt, we do not expect any of the major royalty companies to be the very
top-performing stock in a precious metals portfolio during a bull market.
But:
- Royalty companies have plenty of leverage from
expansions at existing mines and new mines coming into production on
higher gold prices; the royalty company contributes no additional
capital to see a dormant asset start generating revenue.
- Royalty companies continue to exhibit, on balance, the
lowest risk of any precious metals sector, second only to bullion
itself.
- Royalty companies tend to pay dividends above the PM
universe average, and with tremendous free cash flow generation, have
the ability to increase dividends.
- The royalty companies will attract new money in the gold
space; generalists will go to Franco, U.S. retail investors to Royal
Gold.
- If not necessarily the best performing stocks in a bull
market, the returns from royalty companies will be more than
satisfactory.
In short, I will put a portfolio of four or five royalty companies against
four or five miners any day.
Franco remains the crown jewel
Franco-Nevada
Corp. (FNV:TSX; FNV:NYSE, US$92.78) is the crème of the crop; its shares have
outperformed the index about 10 times since its re-listing in 2008. It has
top management, innovative and conservative; a solid balance sheet, with
modest debt only twice in that time frame; a willingness to act
counter-cyclically; strong diversification in its portfolio; a low cost
structure; and a deep pipeline of assets.
Only two of its assets contribute more than 10% of its revenue, and the
top operator is responsible for only 12%. This diversification is broader
than for other companies, and means Franco is not at risk from a failure
either of an operator or an asset.
As for costs, its G&A is not much higher today than it was a decade
ago, despite the tremendous growth in revenue, representing today less than
5% of its revenue.
Strong quarter and stronger year
Franco reported strong revenues, above estimates, in its latest quarter,
with oil and gas revenues offsetting slightly weak metals sales. The company
expects metals sales to be at the higher end of guidance for the rest of the
year, as Cobre Panama, its latest major asset, ramps up. And oil and gas
revenues are expected to continue strong as well, including from the recent
Marcellus shale acquisition.
First deliveries from Cobre Panama came in July, a little later than
expected, and therefore are not contributing to first-half revenues at all.
But operator First Quantum is reporting better grades and higher recoveries,
leading to expectations for a rapid ramp up, and a strong contribution to
second-half revenues. This mine lays the groundwork for five years of revenue
growth for Franco, even absent other developments.
Even after final capital contributions to Cobre Panama and the Marcellus
shale acquisition, Franco ended the quarter with a strong balance sheet, with
virtually $400 million in cash against $385 million in total debt. It has
$1.1 billion of available liquidity, more than sufficient to make additional
large-scale acquisitions. The next acquisition is expected to be in the
precious metals, not oil and gas.
Franco recently implemented an "ATM" program for up to $200
million, allowing the company to issue small amounts of shares from treasury
into the market. This tool is better than raising capital in one go, which
tends to have a negative impact on the market. Together with cash flow, this
new equity could extinguish the debt rapidly.
Royal recoveries strong, though one risk remains
Royal Gold
Inc. (RGLD:NASDAQ; RGL:TSX, US$124.64) lost some revenue in the last
quarter, both early on from the reduction in operations at Mt Milligan due to
water shortages, and from the suspended operations at Peñasquito after a road
blockade. Both operations are back up to speed now. The result was revenue
slightly under expectations.
Mt Milligan saw sequential improvements and next quarter should be a
strong one, but the underlying water issue is unresolved, and operator
Centerra has indicated that there may be another stoppage this winter. With
both Mt Milligan and Peñasquito up to normal operation levels, and with the
resumption of revenue from Voisey's Bay following an agreement with Vale, the
balance of the year should see strong revenues.
Royal has a strong balance sheet, with $119 million cash, $220 million
recently drawn down on its credit line, and available liquidity of $780
million. This puts them in a strong position for new acquisition; the company
indicated they had been receiving numerous requests for financing, many from
earlier stage projects. We expect to see some acquisitions in coming months,
but perhaps smaller ones that won't move the needle much in the near term.
Royalty Companies versus Miners Since May
![Chart](http://www.24hgold.com/24hpmdata/articles/img/The%20Gold%20Report-Adrian%20Day%20Stay%20with%20the%20Royalties%20in%20a%20Bull%20Market-2019-08-21-002.jpg)
![](../style/all/img/bouton/Zoom_in_6.png)
Source: Bloomberg
The royalty companies have mostly lagged the major miners since gold took
off in mid-May, but the picture looks different if we look at the entire year
or any longer period.
Osisko sees recovery in revenues
Osisko
Gold Royalties Ltd. (OR:TSX; OR:NYSE, US$12.15) reported a small beat to
expectations, partly due to better-than-expected production at Pretium's
Bruejack, though ounces were down on a year ago, partly due to the Renard
diamond mine, currently in restructuring. But the company is expecting a
significant improvement in ounces in the second half of the year as the new
Eagle Mine of Victoria Gold comes on stream, with first production expected
next month, as well as improvement in production from the Éléonore Mine.
The most important development in the last quarter was the deal with
Orion, a private equity firm. Osisko bought back from Orion shares in
exchange for cash and the transfer of several junior investments. The shares
repurchased were returned to treasury, resulting in an 8% reduction in shares
outstanding, while there was no reduction in the cash-generating assets (but
a $2.5 million reduction in dividend payments). Orion is now down to just
over 6% ownership.
The result at quarter end was liquidity of $450 million, plus an
investment portfolio now valued at $282 million, down from $400 million prior
to the Orion transaction.
Osisko tends to be more involved in the companies on which it holds
revenues, whether through its accelerator program—there were several advances
at such companies owned by Osisko Mining, in which Osisko Royalties owns over
16%--or in helping companies in difficulties. Osisko is taking an active role
in the restructuring of the Renard mine.
Undervalued vs peers
As we have said before, the accelerator—or "incubator"—program
certainly adds an element of risk, in addition to the greater leverage not in
a traditional royalty company. That, plus Osisko's size relative to the
"big three," partly account for its lower valuation, but the gap
has now become quite extreme. Osisko's price-to-book value, for example, is
1.5x compared with up to 3.8x for Royal; its free cash-flow multiple is 29 x
compared with over 1,000x for Franco, and non-existent for Wheaton (both
temporary anomalies).
Wheaton down to loss
Wheaton
Precious Metals Corp. (WPM:TSX; WPM:NYSE, US$26.49) reported a financial
loss despite strong operating results and higher sales (notwithstanding
temporary suspension of operations at Peñasquito during the recent quarter).
The higher sales were offset by higher costs—cost per ounce can increase
under some streaming deals—and higher G&A.
The financial loss was caused by an impairment charge on its recent cobalt
stream (a deal criticized at the time) after a company with a similar stream
(on the same mine, Voisey's Bay) was sold, crystalizing the market value).
Even without all adjustments, earnings still declined from $72 million a year
ago to $45 million in the latest quarter.
Wheaton is looking a strong second half, forecasting record gold
production for the year, with Peñasquito back on line.
One asset which was to be one of its medium-term growth drivers, Hudbay's
Rosemont Mine in Arizona, received a setback with a district judge issued an
injunction against construction of the mine. Wheaton's payment of $230
million only occurs once construction is underway, so the risk is limited.
Wheaton's balance sheet is the weakest of the four major royalty
companies—or perhaps we should call it the "least strong," with $87
million of cash against net debt of over $1 billion. Cash flow in the latest
quarter was $109 million, so it would take a while to pay down the debt.
Available liquidity on the unused portion of its credit line is $900 million.
All the royalty stocks have moved up and we are expecting a near-term
pullback in the gold sector, so you should wait before buying. Franco is a
core holding, so you should take a position on any pullback if you do not
own. Osisko, the least well-valued, can also be bought on a pullback. Royal
has moved too far, too fast, notwithstanding prospects for a strong next
quarter, and Mt Milligan remains a risk, so we are holding, as are we
Wheaton.
Adrian Day, London-born and a graduate of the London
School of Economics, heads the money management firm Adrian Day Asset
Management, where he manages discretionary accounts in both global and
resource areas. Day is also sub-adviser to the EuroPacific Gold Fund (EPGFX).
His latest book is "Investing in Resources: How to Profit from the
Outsized Potential and Avoid the Risks."
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