How much value is there in royalties? – a quick introduction
Back in 2007 Newmont Mining spun out a well-known royalty business that it had acquired five years earlier.
The name of the company was Franco Nevada and, according to mining folklore, it was the first royalty company to be listed on any stock exchange anywhere.
You might think that Newmont got its timing exactly right.
After all, 2007 was about as good a year to sell any mining asset as there’s been this century.
But fifteen years later, the company that Newmont sold to equity investors for US$1.3bn is now worth more than US$30bn.
So, for those who know how to play in this space, the royalty business clearly offers significant opportunity.
But how easy is it to invest successfully in royalties, and what are pros and cons?
What is a royalty? From small acorns do mighty oaks grow
In their simplest form royalties can look like most other forms of investment: the buyer of the royalty hands over cash now in the expectation of receiving more cash back later.
A company in need of cash to bring a project into production sells a portion of its future revenues to a royalty company which can provide the necessary up-front capital.
If and when the project makes it into production, the percentage of revenue stipulated in the agreement gets funneled directly to the royalty company at no extra cost.
The precise form such an agreement can take varies.
A gross over-riding royalty – a royalty that gets paid before any other deductions – is better than a net smelter return, which is a royalty that’s paid net of certain costs.
A more recent innovation has been streaming deals, in which physical metal is delivered, either in conjunction with or instead of cash.
The key risk in buying an exploration royalty is that the given project never makes it into production.
If it doesn’t, the royalty company gets nothing and loses its money.
Who takes the risk?
If a royalty company buys a royalty on an asset that never goes into production, it will book a loss on that asset and move on to the next deal.
For the operator of the asset, though, particularly if it is a single-asset company, the overall impact of a decision not to develop is likely to be much higher and may involve write-downs and a wholesale re-booting of strategy.
It’s this risk differential that leads many investors to favour royalty companies -because there’s no operational risk involved the valuation can be more directly tied to the commodity in question.
The bigger royalty companies are regarded as the safest, precisely because they already have so many cash generative assets.
Franco Nevada, for example, has a diverse range of producing royalties across multiple jurisdictions, as does Osisko, and even London’s most recent royalty newcomer Trident Royalties now has cash flow coming in from more than one royalty.
All these companies, big or small, have additional exploration royalties on their books, and if some of them never do end up delivering production and cashflow, others will.
Royalty companies fuel their own growth by using existing cash flow to generate and fund new opportunities. The more cash that comes in, the more the company can acquire early-stage exploration royalties that will gradually move along the development pipeline and fuel the next generation of growth.
To some extent, of course, the market does try to compensation the operator for the greater risk it’s taking by delivering greater reward for success. Thus, taking an early-stage exploration project all the way into production, as Greatland Gold is looking to do, has delivered huge rewards for investors. But there are only ever one or two Greatlands per decade. There are scores of royalty companies that are with us all the time.
What’s more, an earlier stage royalty company, like Altus Strategies, which one day may seek grow into a new Altius, nevertheless relies upon debt or equity finance to get itself off the ground.
Operational decisions in other hands
In the case of Anglo Pacific Group, which was for a long time London’s only listed royalty company, the coal royalty it holds over the Rio Tinto’s Kestrel mine in Australia has for a long time delivered significant cashflow.
When the coal price soars, Anglo Pacific benefits.
But it’s not always been plain sailing at Kestrel. Anglo Pacific’s royalty doesn’t cover the entirety of the project, and when operational decisions took the main mining activity away from Anglo’s portion of the mine, income dropped significantly. As a royalty holder, that decision was completely out of Anglo Pacific’s hands.
These days, of course, coal is seen as last century's commodity. Anglo Pacific is now transitioning its portfolio away from coal and towards more 21st Century commodities, like lithium.
But lithium or coal, the fact remains that the ability to manage margins is also beyond the control of the royalty company. If a project turns loss-making, the payment of the royalty becomes a component of the losses and can bear heavily on any potential decision to shut down operations.
None of the operational losses are incurred by the royalty company, but this is not a long-term path to success for either party.
More direct exposure to commodities prices
It’s no accident that most royalty companies operate in the precious metals space. This isn’t true of all of them – with Altius and Trident being notable exceptions - but generally if we’re talking about a royalty company, we’re talking about income derived from the mining of gold and silver. Osisko, Franco Nevada, Precious Wheaton - and Sandstorm as a streaming company - all stand out in this regard.
And as precious metals prices have soared away over the past couple of decades, all have profited hugely.
Investors in precious metals like it that royalties are easy to understand, that there’s a spread of risk across assets, and that the impact of stronger prices immediately feeds through to the bottom line. On the flip side, the also like being able to avoid making complex calculations about cash costs, fuel prices, currency fluctuations, and political risk.
No exposure to increased margins
In the royalty and streaming business, everybody wins when commodity prices go higher.
Some win bigger than others, though.
With mining companies, the real money is made in the margin between revenues and costs – because many of the costs are fixed, if revenues from higher commodities prices go up, margins can go up by an exponentially much higher percentage.
This means that in theory, in a bull market, equities in mining companies perform better than equities in royalty companies.
In practice, this isn’t always the case, since investors also factor in other extraneous risks, like country risk, and technical risk.
But it’s nevertheless true, that in the good times those who invest directly into miners tend to win bigger than those who invest directly into royalty companies.
There’s also another issue that comes into play in bull markets: new royalties become scarcer. That’s because mining companies typically create and sell royalties when equities markets are uninviting and other forms of finance look too expensive. If equities markets are buoyant, flush with cash and ready to invest, then the need for royalty companies drops away.
That dynamic means that royalty companies are often able to cut the best deals when times are bad. When times are good, the advantage goes to the mining company.
Royalty companies need robust legal jurisdictions in which to operate
Most of the big royalty companies operate in North America, and that’s no accident.
For one thing, the royalty model was pioneered there. But there’s more to it than that. Without any actual physical access to the product being sold, royalty companies are beholden to the good will of their partners to make the agreed payments, or, if they don’t, to the legal jurisdictions in which the agreements have been drawn up.
That’s why, of the more than 70 royalty assets held by Franco Nevada, more than half are located in the top-tier jurisdictions of the USA, Canada, and Australia. A significant part of the rest of Franco Nevada’s portfolio is in South America, where it has particular expertise.
Similarly, Osisko’s portfolio of gold royalties is mostly located in North America, and the company’s income is anchored by its 5% net smelter return on the famous Canadian Malartic mine, the largest operating gold mine in very safe Canada.
Altius sticks exclusively to the Americas and Australia, while Wheaton Precious is willing to dip a toe into Portugal and Greece to add to the lustre of its Americas portfolio.
On the London side, Anglo Pacific and Trident both keep focus in Europe, Australia, and North America, although like their larger cousins across the pond both companies dabble in South America too.
Some royalty companies venture into riskier jurisdictions. Franco Nevada has spiced things up with a 2% net smelter return royalty on the Kinross’s Tasiast mine in Mauritania.
But for African exposure generally, Altus Strategies - the London junior miner that’s backed by Sprott - stands out as offering the biggest early-stage royalty portfolio.
Like Franco Nevada, which started out its life as a quoted company worth less than US$5m, Altus has been incubated from scratch. As of today, a few years into its journey, Altus is worth £60m, and with the powerful friends it has, will likely grow still further in the coming years.
Royalty and streaming companies of note
Franco-Nevada Corporation (TSX:FNV)
The number one royalty streaming company by market capitalisation
Wheaton Precious Metals Corp (LSE:WPM, TSX:WPM, NYSE:WPM)
The number two royalty company, focused on assets in the Americas
Osisko Gold Royalties (TSX:OR)
Focused on North America, holds 150 royalties, mostly in gold and precious metals
Brought metals streaming products to a wider investment audience
Altius Minerals Corporation (TSX:ALS)
Also has royalties in base metals and other commodities
Anglo Pacific Group PLC (LSE:APF, TSX:APY, OTC:AGPIF)
London’s oldest royalty company, currently transitioning into energy metals
Trident Royalties PLC (AIM:TRR)
Offers exposure to royalties in Australia, amongst other jurisdictions
Altus Strategies PLC (AIM:ALS, TSX-V:ALTS, OTCQX:ALTUF)
An early-stage royalty company in growth mode
Pros and cons of royalty companies:
Pros Cons
No operational risk Requires robust legal jurisdiction
Clean cash income streams No exposure to increased margins
Direct exposure to commodities prices Operational decisions in other hands