A Smarter Way to Invest in Gold: Royalty Streamers
Larry is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The Federal Reserve favors continued easing years into the future. That’s a boon for hard assets, like gold, to hedge against inflation. But what’s the best way to invest in gold? Something called royalty streamers.
Advantages: They give you exposure to gold’s appreciation because they are liquid, traded on major exchanges, easy to store in a portfolio, and with minimual exposure to mining risks. Bullion, exchange-traded funds, and mining companies do not have these advantages. Our pick of this lot is Sandstorm Gold (NYSEMKT:SAND)
Many choose to buy physical bullion because it is transparently priced and tangible. Physical gold is not very easy to buy or sell, and transport and safe storage are expensive. Gold ETFs don’t share those drawbacks, but they still don’t provide the investor with cash flow. SPDR Gold Shares (NYSEMKT: GLD), for instance, gives you no dividend. This ETF is up 30% from 12 months ago. Sandstorm has tripled in price.
Mining companies provide investors with an income stream from dividends and exposure to the price of gold, but are prone to all sorts of other risks including increasing operating expenses, union interference, litigation, environmental regulations, capital expenditures, and availability of capital or credit. Over the course of the last year, there has been a flight from mining companies for these reasons. Gold mining companies’ share prices have declined more than the price of gold itself, with gold miners trading at the lowest price-to-book ratios since 2008.
Royalty streamers are classified as mining companies, but they are not miners at all. They purchase long-term royalty streams from mining companies at a fixed price. This is essentially a purchase agreement that allows the company to buy a certain amount of the commodity at a fixed price through the life of the mine.
As the price of that commodity rises, so does the cash flow in equal proportion. In essence, they give miners upfront payments for future revenue streams or actual deliveries of the physical asset. Should the contracted mines produce more than originally expected, the royalty streaming company realizes a bonus. Streamers are not responsible for any further operating expenses or capital expenditures of the mining projects.
Even if gold prices remain flat, streaming companies can still increase cash flows if the mines under contract have more resources than originally expected. Since they aren't miners themselves and all that they do hand miners an up-front payment in exchange for a cash flow, streaming companies have low operating costs and high profit margins. Their cash flows, adjusted for prevailing gold and silver prices, are quite predictable. Consequently, they provide compelling investments and are normally quite pricey.
While these companies have very compelling factors, we currently own Sandstorm Gold because our analysis shows that it is undervalued both on a comparative and absolute basis.
Sandstorm’s growth has been stellar. Just in the second quarter, it sold 9,259 ounces of gold, a 150% improvement over the year-earlier period. On Sept. 19, shares rose over 8% after the company struck a deal with Colossus Minerals on a Brazilian gold and palladium mine. Sandstorm put up a US $75 million initial deposit and will buy 1.5% of the gold in the mine for just $400 an ounce for the rest of the mine’s life.
In preparation for its August listing on the New York Stock Exchange, it conducted a 1 for 5 reverse split. Following the NYSE listing, it raised $153 million in a bought deal (private placement with the underwriter), increasing its share count by 20%. With a market capitalization of just over $1 billion on a fully diluted basis, the company is no longer a micro-cap company.
Still, at such a small market cap, plenty of institutional investors are not permitted to invest. The reverse split did put Sandstorm on the radar of some, however, since investors trading on margin accounts are only allowed to buy stocks with share prices greater than $5.
Sandstorm only started in 2008, but it already has first-class management with plenty of experience in the metal streaming sector. Chief Executive Officer and President, Nolan Watson, and executive vice president, David Awram, both come from Silver Wheaton, the world’s largest silver royalty company. Watson was Silver Wheaton’s Chief Financial Officer – the youngest executive to hold the role when the company debuted on the Big Board.
Sandstorm trades at a 50% discount to the more established gold streaming companies. When we initiated a position in Sandstorm at an effective price of $3.90 ($0.78 pre-reverse split), in late 2010, the company traded at six times our estimated 2012 cash flow, a 75% discount to its more established peers.
There are now seven analysts covering the company, up from five only three months ago. Five rate the stock as a buy, one as overweight, and the other as a hold. According to their estimates, Sandstorm trades at 10 times estimated cash flow for 2013, a much more attractive multiple than their royalty-streaming peers.
It is rare that these bigger companies trade at reasonable multiples. The surging popularity of gold, spurred on by commercials on financial television and inflation fears, tend to add a premium to more established gold stocks. Historically, royalty streaming companies have traded at an average of 25 times cash flow.
Sandstorm Gold, of course, is not free of risk. Like all metal royalty streamers, the company can take a hit if its partners miss production targets. If the mining partners produce less than expected, or meet obligations later than agreed, it could hurt Sandstorm’s bottom line. The production estimates are established by an impartial third party, but those estimates could be wrong.
The company works with extractors on advanced stage mines where the total haul is easier to ascertain. We think that as the company matures, it might be able to take riskier bets on less developed mines.
Since royalties are often purchased up-front and far below the current gold price, only a precipitous drop in gold prices would hurt Sandstorm’s bottom line. As for the Brazil deal we mentioned earlier, it risks the initial up-front payment of $75 million. The only scenarios in which this could result in a write down is if the mine falls far short of the third party estimates of its lifetime production, or if the price of gold falls below $400 an ounce. In such a case, Sandstorm can simply stop purchasing gold from the mine.
In conclusion, Sandstorm is a high-growth company with superb leadership that is already turning a healthy profit. Their business model presents fat margins, but few risks. We believe that the company is undervalued on an absolute basis and there is plenty of room for Sandstorm to grow.
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Partners Mark J. Foley and Tina Larsson manage the Pendo International Strategy for international investment specialist Pendo LLC in New York City. Their firm holds a long position in Sandstorm.
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