Financing was a recurring theme at this year’s eightieth Prospectors and Developers Association of Canada convention in Toronto. With debt markets in Europe faltering and equity markets globally not performing up to snuff, miners looking to develop mines are finding capital harder to come by.
But the International Panel Luncheon held on March 6 reminded attendees that even more financing awaits in 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 could take advantage of growing capital.
Joining Silver on the stage was Tony Jensen, president and chief executive of Royal Gold (RGL-T, RGLD-Q); 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 by explaining that there are four different basic structures to the royalty business: exploration, classic royalties, metal streams and income trusts.
He groups Silver Wheaton, Franco-Nevada and Royal Gold into the metal stream category and notes that the trio represent 10% of the royalty market, and have a combined market capitalization exceeding $20 billion.
Moderator Silver began the conversation by getting the executives to comment on how they drove company growth in the early years.
Jensen: We began in 2003 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 capital expenditure of hundreds of millions of dollars.
Smallwood: We started with a little company called Wheaton River, which was the predecessor to Goldcorp (G-T, GG-N). We had too many by-products, mainly copper and 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 without the risks in terms of the costs, so we were never mining-focused. We recognized that 75% of silver production comes as a by-product, 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 a bull market. Once we got to Bre-X, the business was dead.
Silver then steered the conversation to 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 then clarified that streams are made up of an upfront payment, followed by ongoing production payments that are made as the project matures. Jensen noted the royalty company can put a little less money upfront and then pay on a discounted per-ounce basis after that.
Silver then asked the panel about factors that would lead a royalty company to give a lower valuation on a prospective project
Jensen: Some things that impede value are that 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 “explorationists.”
Silver queried the businessmen on where they see future royalty growth 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 a 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 conversation switches to the importance of choosing a discount rate in evaluating potential projects — discount rates give a percentage that future cash flows are discounted at, which gives a project’s present value.
Harquail: We don’t look at the discount rate too hard. At heart we’re explorationists. 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 20 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 overpaid 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 is whether or not a project’s minimum size should 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 asked the men whether they 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 agreements 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 it’s 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 Exploration (NOB-V). It’s a pure exploration play, right next to Kidd 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.
Silver asked about purchasing royalties from governments.
Jensen: We have tried. We worked on a deal with the blessing of an 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 decisions . . . so I don’t think it’s the right place for us to be.
Silver then asked about countries to avoid.
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 by-product 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 noted that the three companies represented by the panelists have made fantastic returns, while keeping company overhead at a minimum.
Harquail responded that Franco-Nevada’s annual revenue of US$400 million 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.
Smallwood finished the panel discussion with a summary of why juniors should be interested in royalty companies, given 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. Based on where we see the world in the near-term, it’s pretty promising for all of us.
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