Royalties explained

A recurring theme at this year’s 80^th version of the Prospectors Developers Association of Canada (PDAC) convention in Toronto is that of financing. With debt markets in Europe faltering and equity markets not performing up to snuff, miners looking to develop mines are finding capital hard to come by.

But the International Panel Luncheon held on March 6, reminded attendees that there was another source of financing waiting to be tapped into — royalty companies.

Moderated by Douglas Silver, a portfolio manager with Red Kite Management and a noted royalty expert in his own right, the session delved into the ins and outs of royalties and examined how companies looking for financing may be able to take advantage of this growing pool of capital.

Joining Silver on the stage were Tony Jensen, president and chief executive of Royal Gold (RGL-T, RGLD-N); Randy Smallwood, president and chief executive of Silver Wheaton (SLW-T, SLW-N); and David Harquail, president and chief executive of Franco-Nevada (FNV-T, FNV-N).

Silver began things by explaining that there are four different basic structures to the royalty business: exploration, classic royalties, metal streams and income trusts.

He grouped Silver Wheaton, Franco-Nevada and Royal Gold into the metal stream category and said that the  three companies represent 10 % of the royalty market and have a combined market cap of over $20 billion.

Silver got the conversation going by asking the chief executives how they have managed such stellar market cap growth over the recent years.

Jensen: We began in2003 and we spent our time just consolidating royalties. That was good for the first five years but then we had to do larger deals. The opportunity was there because folks needed more sources of capital to develop their properties, which could have capex of hundreds of millions of dollars.

Silver pointed out that Smallwood’s former company, Wheaton River, created the streaming royalty model.

Smallwood: We started with a little company called Wheaton River, which was the predecessor to Goldcorp (G-T). We had too much byproducts, mainly copper an silver, so we came up with the idea of streaming as a way of cleaning up the gold company — it was created to pull silver out and give access to silver investors.

We realized we could provide the benefits of mining but without the risks in terms of the costs, so we were never mining focused. We recognized that 75% of silver production comes as a byproduct, so it wasn’t available to silver investors.

Harquail: We started in the mid 1980s. We were acquiring existing royalties. We were the only one doing it at that time. It was Seymour Schulich who had the idea first. He was buying royalties on oil and gas projects, and he asked why no one was doing it in mining. So it started off as just as a side investment. He never dreamed it would grow so big.

It’s the best business because you don’t have to do the risky exploration but still can get upside of a great discovery.

What’s important to keep in mind, however, is that someone else has to do the exploration and they need the funding to do it, so really (the royalty business model) only works in bull market. Once we got to Bre-X the business was dead.

Silver next steered the conversation to the topic of how metal streams differ from classic royalties.

Smallwood: The difference between stream and royalties is that streams are a more tax efficient model. Classic royalties give the holder of the royalty a presence in the country where the project is. But the group that can most efficiently handle the taxes of that country is the mine operator.

So streaming is based on improving efficiency by handing the taxes to the most efficient party, which is the operating company

Silver followed Smallwood by clarifying that streams are made up of an upfront payment, followed by on-going production payments that are made as the project matures.

Jensen said another advantage of the structure is that the royalty company can put a little less money upfront and then pays a bit per oz. after that.

Silver than asked about factors that would lead a royalty company to give a lower valuation on a prospective project

Jensen: Some things that impede value are: if the royalty is capped we won’t be able to value it as aggressively as we would if there were some upside potential; and a right to first refusal is also a detractor for value. We have been working on deals in the past where right at the last hour the larger operating partner with a right of first refusal comes in and takes it right out from under us.

It’s also a more natural flow of things if a company that is looking to capitalize a new project approaches a royalty company first before the banks. If the banks are there first it gets more complicated.

Harquail: It s got to be affordable… that’s the main thing. We want to see more upside exploration potential and we will pay full price for what we see today, but we want to be able to make a bet that there is more than what we see today. At heart we’re exploration-ists.

Silver next asked the men where they see future growth in the royalty business coming from.

Smallwood: The best value right now is with base metal mines. There’s a value arbitrage opportunity there. You bring silver out of a base metal operator and because they trade at lower multiple when you bring it into Silver Wheaton it creates value across the board.

Silver asked Smallwood if Silver Wheaton would consider making royalty agreements on metals other than silver.

Smallwood: We like precious metals as a whole but we still think silver has a few other characteristics that make it attractive even over gold. We spend time looking over the fence but the grass is still greener on our side of the fence

The next topic of conversation was how important of a role does the discount rate chosen play in evaluating potential projects (discount rates are a percentage that future cash flows are discounted back at to arrive at a present value of a given project).

Harquail: We don’t’ look at the discount rate too hard. At heart we’re exploration-ists. We want our money back but if we pick properly, as we have done with deals on projects in the Carlin trend and the Destor Porcupine, we’ll do all right. If we get lots of real estate one in twenty projects will give us spectacular returns and on the others we will get our money back.

When analysts do their discount analysis they say we’ve over paid on a project. But we say we paid full value for what we see today and we’re hoping that over time more will be found…. we’re just trying to buy exploration potential for free.

So we look at what the probability is of the company spending more money on the project. Do they have a big picture of the property outlined in their annual report?

If they do we know they will do more drilling. We want to know that more risky money will be coming into the property from the owners and we can use something as soft as the annual report to help determine that.

Next on the agenda was whether or not there was a minimum size for projects to be considered.

Jensen:  You want a project to be as close to production as possible, but we will go down the food chain and look at more exploration plays.  We’re interested in putting seed money into exploration opportunities as well.

Silver next asked if the men are concerned about governments in the developing world increasing their royalty demands.

Smallwood: The taxes and the government royalties in the country are the responsibility of the operator itself. We look for projects that will generate a margin that is robust enough to handle any issues that can be thrown at it.  These are life-of-mine agreement so we take a long-term view and we want to be in stable countries. If you’re in a project where an enhanced government royalty rate decides if the project will shut down, you shouldn’t have invested in that project in the first place.

Harquail: We never want to make our royalty stop a project from being economic. You don’t have to do a gross royalty, you can do a profit royalty or you can do one on margins, having those options gives the operator some space. We have cut our royalty in half in some situations in exchange for some land, which gives us more optionality. We’re not starving for cash so its good to do something that will make the next chief executive of Franco Nevada look good.

We love exploration deals, we’re doing one outside of Timmins with Noble Mineral Explorations (NOB-V). It’s a pure exploration play, right next to Kid Creek. Now we might have to wait a couple of decades but the more you drill and the more you explore the more you get lucky. Especially if you’re close to the great camps.

As for purchasing royalties from governments

Jensen: We have tried. We worked on a deal with the blessing of operator, in a Latin American country. It would have been a win, win, win situation, for us, the operator and the government, but it’s amazing just how much politics and competing interests come into it at the upper levels of those decision…so I don’t think it’s the right place for us to be.

Silver than asked if there were any countries they wouldn’t want to do a deal in:

Jensen: I’d rather answer that positively. We like Latin America, Australia and parts of Africa. There are a lot of business growth opportunities from byproduct credits, so we think copper porphyries are good hunting ground.

Smallwood: We’re blessed with the fact that there’s not a lot of silver in Africa, so that takes a lot of risk off the plate and allows us to focus on the Americas. There are places in Europe, Asia and Australia that we have looked at.

Harquail: It’s not geography but tenure that matters. We only make our money in the next decade so it takes a long time to for us to get full value. Operators sometimes forget how they got started and after 10 years they want get rid of a royalty agreement. 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. It’s been clear-cut and courts have respected our royalty rights.

Silver then made the point that the three companies represented by the panelists have been able to make fantastic returns while keeping company overhead at a minimum.

Harquail said Franco-Nevada’s annual revenue of US$400 mill was generated with just 20 employees. Smallwood said Silver Wheaton generated US$1 billion a year with just 24 employees, while Royal Gold generated US$260 million with 21 employees.

Silver Wheaton’s Smallwood finished up the panel discussion by summing up why juniors should be interested in royalty companies given the current market conditions.

Smallwood: We provide an alternative form of financing for mining projects. We compete against debt and equity markets so when we see equity markets tightening up and debt markets doing the same thing, it opens up more opportunity for us going forward. So based on where we see the world in the near term it’s pretty promising for all of us.