April 25, 2016
In Streaming Companies Part 1 we outlined the key characteristics of streaming companies and highlighted the vital risk inherent in this lucrative model – project risk.
In Part 2 we show the approach we take in valuing streaming companies. In The Real Value Of Gold In the Ground we explain our approach in valuing mineral assets. We apply the same fundamental valuation to the individual assets in the portfolio of a streaming company. There is of course an argument to be made that the streaming company has contractual security over the future gold production and is not concerned with the overall health of mining operations, therefore risk is mitigated.
For the most part this argument holds true and has worked well for streaming companies, albeit at the expense of miners’ equity holders; in some cases however as we showed with Sandstorm and Luna Gold in Part 1 if the economics are not robust enough everyone loses.
In our approach to valuing streaming companies, on a project level we apply the same fundamental valuation as we do for advanced developers and producers. On a company-wide level the approach is the following:
VALUING STREAMING COMPANIES
The following tables display summaries of the financial/operating history of the four largest streamers followed by the ratio analysis we apply when valuing them:
OPERATIONAL HEALTH & RETURN ON INVESTED CAPITAL
Since the core operating activity of streaming & royalty companies is investing in mines rather than operating them, Return on Invested Capital becomes central to our analysis operating efficiency. The following tables compare the historic averages:
We use two measures of Return On Invested Capital
Cash From Operations (CFO)/Share Cap + Net Debt and Net Income (Net Income)/Share Capital + Net Debt
Share Capital reflects the value of all equity investments made in the company; Share Capital + Net Debt reflects all equity and debt investments made in the company. Cash Flow from Operations and Net Income as a percentage of total investment are measures of return on invested capital. The companies with the highest ROICs typically enjoy the highest valuation multiples on the market. Silver Wheaton appears to be an exception at present. One reason might be that the company is in a review process with Revenue Canada, for tax evasion and will most likely be paying penalties. This potential reduction in Return On Invested Capital appears be built into the market price at present.
Enterprise Value /Cash Flow from Operations (CFO) & Market Capitalization/ Cash Flow from Operations (CFO)
The two ratios show reflect how the market values the operations of streaming &royalty companies. Historically EV$/CFO and MC$/CFO for Streaming & Royalty companies have been consistent averaging 20Xs and ranging within 15-25Xs CFO. This comes to show that the market values streaming & royalties companies consistently based on their profitability, which in turn depends on selecting good mines to deliver the promised gold.
As we already established fundamentally the profitability of these companies depends on the strength of the underlying assets. An example of how underperforming assets affect the streaming company is the recent performance of Sandstorm. Sandstorm’s CFO to market price multiples have fallen in the last two years (currently trading around 10Xs from their historic average of around 17X). This is a result of their decreased ROIC due to key asset underperformance – the closing of the Aurizona Mine in Brazil (Luna Gold) in early 2015.
VALUE ARBITRAGE OPPORTUNITY
An important point to make is that the market values gold in the ground and gold produced by traditional miners lower than gold attributed to a streaming company. This creates a certain value arbitrage opportunity, which can be captured by timely and wise investment in a streamer with quality projects in their portfolio. The table below compares Enterprise Value to Cash Flow from Operations and Proven and Attributable Probable Reserves for the three segments indicated:
In years of rising gold prices, streaming and royalty companies are valued higher by the market. CFO multiples were as high as 30Xs in the years leading up to 2012 as investors expect higher cash flows and earnings. With the exception of Franco Nevada, recent CFO price multiples for all companies have fallen to an average of around 15Xs from historic 20Xs following the fall in the price of gold.
In our opinion Franco Nevada has maintained higher valuations because of their Consistent Return On Invested Capital coupled with high asset diversification, which mitigates the risk of mine closure and default.
In addition Franco Nevada has been consistently returning the highest percentage of free cash flows to shareholders and has maintained the highest average dividend yield, although our analysis does not shows a positive correlation between dividend pay and market price multiples. A good example here is Sandstorm; the company has never paid dividends yet until recently (Aurizona Mine closure) maintained ratios very much on par with the other streamers. Similarly Silver Wheaton had not pay dividends up until 2011 and actually enjoyed higher price multiples during that time.
In the next part of the series on streaming companies we will review some value benchmarks and outline our future expectations for the four major streamers.
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About Cipher Research
Cipher Research Ltd. is an independent research and analysis company covering Metals and Mining markets. We develop comprehensive valuation models applying the disciplines of Geology, Economics, Statistics and Finance (“Geonomics”). Our valuation models have proven to be successful in generating investing and trading strategies.
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