Resource stocks can offer exciting gains at times as well as a few sobering declines. But what if you could still enjoy that upside with less downside risk? This is what is attracting an increasing number of investors to royalty companies.
But what is a royalty company? Royalty companies act as alternative financiers to help fund exploration and production projects for explorers and miners in need of money but who do not want to issue more equity (company shares). In return for cash, royalty companies will receive a percentage of future production revenue. For example, if a company receives a 2.0% gross value royalty on a mine that produces 100,000 ounces of gold annually, it would generate payments having a value of nearly 2,000 ounces of gold per year. At a gold price of C$1,600 per ounce, this would result in royalty revenue of nearly $3.2 million per year.
Closely related to mining royalties is what is known as streams, these are metal purchase agreements which give the holder the right to purchase all, or a portion, of one or more metals produced from a mine at a pre-set price in exchange for an upfront deposit.
Given the level of risk involved, royalty companies will likely be able to negotiate an agreement that provides substantial upside.
Types of royalties: While there are more than a few kinds of royalties, we will stick to four of the most common.
a) Profit-Based Royalties – This royalty is typically based upon net profits generated by the mining operation. Net profits are generally defined as gross profits minus the costs of production after capital costs have been fully recovered.
b) Royalty in Kind – This gives the holder the rights to take delivery and/or purchase a percentage of future mining production, which is most common in streaming agreements.
c) Production Royalty – This is also known as a Fixed Rate Royalty and is seldom negotiated owing to the fact that it provides a fixed payment per tonne of production, with no consideration to increases or decreases in market prices or operating costs.
d) Net Smelter Return (NSR) – Sometimes called Gross Revenue Royalties this type is common in the mining industry and is based on the value of production, or net proceeds, received from a smelter or refinery. From the owner’s perspective, an NSR provides an income stream that is independent of operational costs of the mine.
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Source: Norton Rose Fulbright guide to mining projects and mining finance in Canada)
Why royalty companies are considered great investments
Unlike traditional mining companies that are subject to input costs that vary (fuel, equipment, labour), royalty companies receives all their revenue from the agreements they negotiate and the cost of those revenues are the responsibility of a project’s owners/operators. As a result, royalty companies have high profit margins along with among the most revenue per employee of any industry. High profit margins create superior earnings growth, which has historically resulted in market-beating stock performances.
Take
EMX Royalty Corporation (
TSXV: EMX) for example. EMX’s stock has surged to a 52-week high of $1.80 in what has been a weak environment for mining and resource stocks.
Also, whereas most junior mining companies have a single project in one country, royalty companies provide portfolio diversification by having agreements with several companies in different jurisdictions throughout the world. This reduces jurisdictional risk, project/production risk, and commodity-price risks that have plagued many mining companies in the past.
Resource juniors have also seen their stock prices suffer due to the need to issue more stock (equity) to raise capital, thereby diluting the ownership interest of existing investors. Royalty companies, by contrast, receive life-of-mine cash flow from their royalties, all but eliminating the need to issue more company shares except, perhaps, to make a large, accretive acquisition.
Given that a royalty is a perpetual option on new discoveries made on the land by the operators, royalty companies offer substantial exploration upside for their investors at no additional costs. And, if the price of the commodity rises, it expands their profit margins even more seeing that the royalty is a fixed cost.
Royalty companies which successfully grow their royalty portfolios organically (using cash flow from existing royalties for property purchases, doing exploration work and market it for sale), should be able to leverage their growth effectively. A great example of a low cost, high upside royalty agreement was EMX Royalty`s 2006 sale of its Serbian properties, including Brestovac West, to Reservoir Capital Corp., for uncapped NSR royalties of 2% for gold and silver and 1% for all other metals. Reservoir Capital later transferred those interests to Reservoir Minerals and EMX subsequently acquired 0.5% NSR royalty interests covering the Brestovac and Jasikovo-Durlan Potok properties. These properties, along with Brestovac West, are included in the Timok Project controlled by Nevsun Resources after its acquisition of Reservoir in 2016.
On September 5, 2018, Nevsun agreed to be acquired by China’s Zijin Mining Group Co. Ltd. for C$1.86 billion, rejecting an offer valued at approximately C$1.4 billion from Lundin Mining. Nevsun’s prized asset is its Timok Project, in which its Upper Zone has an estimated Measured resource of 2.2 million tonnes averaging 8.6% copper and 5.7 g/t gold, along with an Indicated resource of 26.6 million tonnes averaging 3.3% copper and 2.1 g/t gold, based on results from a 2017 Preliminary Economic Assessment. EMX’s Brestovac royalty covers the Timok Project’s Upper and Lower Zones, which should provide EMX millions in future revenue once the Project is put into production.
In fact, the royalty model has proven so successful that acquiring royalties and streams has become highly competitive. Thus, investors interested in royalty companies should consider organic royalty generators. Getting in on the ground floor is key to low-cost acquisitions and EMX Royalty Corporation spent the past 14 years building a diverse portfolio by prospecting for early-stage exploration projects. By completing the initial ground work themselves, this model is made sustainable by attracting senior partners who use their money to advance the project, while EMX retains a royalty interest and receives pre-production payments.
All in all, superior profit margins, portfolio diversification, and low-cost exploration with high upside have all contributed to the investment success of royalty companies. Whether the royalty company generates their own royalties or acquires advanced royalties, it comes down to management’s ability to execute on the model. Finding quality opportunities through a good knowledge of geology is key, as is their ability to build relationships with operators who can get the project over the finish line.
About the author: Jack Graham has more than 20 years of experience as a writer and editor specializing in Canadian small and micro-cap stocks