Perhaps the most significant development in the mining industry over the past twenty years has been the rise of the royalty business model. For those unfamiliar, a royalty is the right to receive a percentage of production from a given mining operation—most often in the form of a net smelter royalty (NSR) where the royalty owner is entitled to a defined percentage of the gross revenue, less a proportionate share of transportation, refining and smelting costs. Royalty companies, as one can imagine, make their living by acquiring a portfolio of attractive royalty assets and then either (a) leveraging their portfolio for access to bigger and better royalty deals or (b) returning the cash to shareholders through buybacks or dividends.
Investors love this business model for a multitude of reasons. The first is diversification, as the largest royalty companies have dozens of cash-flowing royalties (with dozens more nearing cash flow) held by different operators in different jurisdictions. The second is that the business is extremely high margin, with the world's largest royalty companies generating as much as $3.5 million in net profit per employee. Third is the scalability of the business because, as royalty companies grow in size, their cost of capital drops and larger opportunities become available. Another benefit is that royalty companies don't share nearly as much operational risk as their counterparties, as they bear no responsibility for funding mine development and sustaining capex. Finally, royalty companies get to participate in exploration upside entirely for free, which provides "a free perpetual option on discoveries" in the words of Franco-Nevada Corp. (FNV:TSX; FNV:NYSE) founder Pierre Lassonde.
For these reasons, the royalty business model has been a darling of mining investors for many years now. This infatuation has been particularly apparent over the past twelve months. Franco Nevada, the world's largest royalty company, just hit a new all-time high this week, and now sits at a market capitalization of US$21 billion. Wheaton Precious Metals Corp. (WPM:TSX; WPM:NYSE) and Sandstorm Gold Ltd. (SSL:TSX; SAND:NYSE.MKT) are both up north of 40% since the beginning of last year, while junior royalty players like Abitibi Royalties Inc. (RZZ:TSX.V), Metalla Royalty & Streaming Ltd. (MTA:TSX.V; EXCFF:OTCQB), and EMX Royalty Corp. (EMX:TSX.V; EMX:NYSE.American) have doubled or more over the same period. The royalty space is hot—both with seasoned mining investors and with generalists slowly reallocating to hard assets.
This raises a few questions. The first surrounds what the reign of the royalty business model means for the mining industry generally. On one hand, royalty companies have done a service by providing a source of capital to an industry starved for funds. It is no secret that the past decade for the mining industry has been a rough one, and traditional avenues to raise capital have largely dried up. Over this period, royalty companies have stepped in and provided billions of dollars of funding to both producers and developers alike. Money is the lifeblood of this extremely capital-intensive business.
But this comes with a cost. The royalty companies have no doubt been sucking away investment dollars that otherwise would have been deployed into traditional mining companies. This competition will only become more intense as the royalty complex continues to grow in mass.
Additionally, there have been plenty of cases of royalty companies getting "too good of a deal," and hence encumbering assets to the point where they are not worth developing. In these cases the burden, of course, falls far more unevenly on the operator (who may only have 1–2 assets) than on the well-diversified royalty company.
Another key question is how long this outperformance among the royalty names will continue. That will ultimately depend on the length of the precious metals bull market that is currently underway. Based on the duration of past bull cycles, I'm of the view that we have a few more years to go. Were this to be the case, the royalty names may continue to outperform for another year or two before the operators get their revenge in the later stages of the bull market.
But even if the operators get their revenge late in the cycle, I still expect the royalty companies to become overvalued (perhaps massively so) in the years ahead—to the extent that, as a group, they take a massive hit when the next bear market comes around. Franco Nevada exited the 2011–2015 bear market with a higher share price than with which it began. I doubt that will be the case the next time around. But the good news is that we won't likely have to worry about that for a few more years.
It's also worth considering whether the dynamics discussed above present any opportunities to the enterprising investor. There are a couple apparent to me. The first is that the best royalty opportunities going forward lie with base and energy metals. It's astounding to me that there isn't a single base/energy metal royalty company valued north of US$500 million, especially given that gold only accounts for 15–20% of the total value of global mineral production. The playing field is wide open, and I think it's only a matter of time before investors warm to royalty companies focused on metals other than gold and silver.
The second opportunity is more obscure and only relevant to those of us who invest in the prospect-generation business model. I think there is a window over the next few years for the more mature prospect generators to transition into royalty companies. There are a handful of groups out there with 1–2 cash-flowing royalties backed by a large portfolio of non-cash-flowing royalty interests at various stages of development. I'm not suggesting that these groups go out and overpay for additional cash-flowing royalties just so they can call themselves a proper royalty company. Nor am I suggesting that anyone should disingenuously brand themselves as a royalty company before they have the goods. But at the very least, I do think there may be opportunities for these companies to restructure any existing project-level interests into NSRs and also to structure future earn-in deals with a greater emphasis on the royalty component.
As a final note, it will be interesting to see whether the recent flurry of M&A activity among the precious metal developers and producers translates into any consolidation within the royalty space. I count eight major mining deals in the past 90 days, but the last takeover of one royalty company by another occurred mid-2019 when Sailfish Royalty Corp. (FISH:TSX.V; OTC:SROYF) acquired Terraco Gold. Might we see some more of this in 2020? A deal or two does seem likely, at least among the junior players.
Matt Geiger is Managing Partner at MJG Capital, a limited partnership specializing in natural resource investments. The partnership is long-only and holds a concentrated portfolio of resource equities. Investments include explorers, developers, and producers of energy metals, industrial metals, precious metals and ag minerals. Geiger is a graduate of the Wharton School at the University of Pennsylvania and previously founded a venture-backed technology company recently valued at $150 million.
[NLINSERT]Disclosure:
1) Matt Geiger: The MJG Capital Fund owns EMX shares, Metalla warrants, and has indirect exposure to Abitibi Royalties through Golden Valley Mines. I determined which companies would be included in this article based on my research and understanding of the sector.
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