Hidden Royalty Companies
Several years ago I needed a new car and decided I wanted to buy a Subaru. Suddenly it seemed like Subaru's were everywhere on the road. After I bought one there seemed to be even more of them. What changed wasn't the number of Subaru's on the road, but my attention made me more aware of them.
If you read this blog you know I love royalty companies and project generators that own royalties. Well, like with my Subaru I'm starting to run across royalties everywhere now.
Market Inefficiencies
There is a school of thought that markets are efficient. That is that all past and current data is priced in and future stock price movement are due to random unpredictable events. I don't belive this, and I doubt any readers of my blog believe this. However, it is worth thinking about for each investment why you think the previous dozen people who looked at investing in this company and passed were wrong and you are right. What is causing the market inefficiency. I can then look for those things I that cause the pricing inefficiency as attributes that are likely to make a company not just good, but good at it's current enterprise value that the shares trade at.
For royalty companies I think the market is undervaluing optionality by not including it in NPV and I think that pre-production royalties are undervalued because they have no measurable cashflow yet.
For the pre-production sweet spot I think the market is overly discounting the risk to production, and the investors that invest in cashflowing dividend paying companies can't invest yet.
For prospect generators I think the market focuses on the small percentage of the projects retained, and not on the shift in spend versus benefit that the business model can cause.
For producers I think exploration upside and additional development projects are undervalued by a market that largely prices them on current cashflow and to a smaller extent on NPV of the current mine plan.
This article will talk about 4 companies that aren't royalty companies that own a royalty. The potential inefficiency is that royalty investors won't touch these because of the rest of the business, and that investors that would typically efficiently value the rest of the business won't properly value the royalty.
Talisman Mining $TLM.AX
Last financial report they had AUD$8.9m cash and had received AUD$6.3m in royalty payments from their 1% GRR on Mineral Resource's Wonmunna direct ship iron ore mine. The mine only had reserves of 8 years when mining continued in April 2021, but had another 8 years of resources. It's also possible they could expand the reserves and resources.
The mine currently ships around 5,000,000 tons / year. For round numbers at USD$100/t iron (which it's lower grade than the 62% Fe benchmark, so plug in your own price estimates) you get : 5,000,000 * 100 * 0.01 = USD$5m = AUD$7.17m. That's in-line with the last 12 months revenue.
Vox Royalty Corp.
In May 2022 Vox purchased a sliding scale 1.25%-1.5% royalty on the same mine for US$4.7m cash, US$12.15m stock and a pile of warrants of Vox stock.
Deterra's royalty on mining area C is about 20km away, and Deterra trades around 10x cashflow. So, how do we value this royalty? If you figure AUD$6m a year for 6 years and an 8% discount rate the NPV of the cashflow would be around AUD$29m. If you think the mine life is understated and is more like mining area C then you could price it as 10x cashflow, which would be AUD$63m. If you thought that the production rate was going to increase, and they have permitted a large increase. The operation has minimal processing consisting of dry crushing and blending. Ore is hauled to port via trucks. So expanding production has low capital intensity assuming they can expand the resource size through exploration drilling to not make mine life too short. Just converting the resources to reserves and not adding more resources and not increasing production brings the NPV up to around AUD$49m for the royalty.
Meanwhile $TLM.AX has an AUD$28m market cap with AUD$8.9m cash in the bank for an enterprise value of AUD$20m or so. If you figure the royalty is worth AUD$40m then a sum of the parts values the exploration business at negative $20m. Geologists do like to turn money into rocks, but in my own estimation this team seems pretty competent and seems to have some pretty good exploration assets.
Red Hill Minerals $RHI.AX
As of Sept 30 2022 they had AUD$55m.
They are due AUD$200m (minus say $50m for taxes) when MinRes starts production, which is currently targeted at December, 2023.
https://clients3.weblink.com.au/pdf/MIN/02559559.pdf
Stage 1 targets 35Mpta and Red Hill has a 0.75% royalty. Mineral Resources of 820Mt and 537Mt in Ore Reserves, so that production level lasts quite awhile. That is 262,500 tons per year royalty. At USD$100/t (probably lower given low grade direct ship 5x% ore is below 62% reference price) that is USD$26m (AUD$38.4m) per year royalty.
Here's the basic math. In a year the company will have its market cap in cash. They will then have a cashflowing royalty that will pay 15% of their market cap in cash for 23 years or so. If you do an NPV8 on that it works out to another AUD$376m.
Worth noting is that MinRes puts the growth potential of the project at 140Mtpa. If that happens the royalty at US$100/t would pay USD$105m (AUD$155m) per year.
They have some other projects. There's exploration upside on the royalty adding resource, there's upside on if the royalty expands production beyond the stage 1. There's risk they don't give the cash to shareholders. They might spend it on stupid things. The project might get delayed. Iron ore prices might go down. In a low iron ore price environment this lower grade direct ship ore type operation might reduce volumes or temporarily/permanatly stop alltogether.
Despite the healthy market cap the liquidity is practically non-existent.
Erdene
https://erdene.com/site/assets/files/4360/epr_en.pdf
Erdene will retain a 50% equity interest in EM and a 5.0% Net Smelter Return
(“NSR”)royalty on all production from the Khundii, Altan Narand Ulaan licenses,
as well as any properties acquired within 5 these licenses, beyond
the first 400,000 ounces gold recovered.
I've written previously that the average profit margin for mining is 13.1%. Let's say this project does a little better at 15% profit margin pre-royalty. Which is worth more, the 50% equity stake or the 5% NSR?
15% - 5% = 10% profit margin after royalty. Their 50% stake would then be worth 5% of profits. They also have to contribute 50% of costs to get their 50% of profits, and the cashflow from the royalty is more predictable year to year. I'd take the royalty.
Of course if you convert the royalty to equivalent equity you have to dilute equity to figure the real economic split. 50% Erdene, 50% EM, 50% Erdene royalty would work out to 66.6% Erdene, 33.3% EM. This works out because the royalty dilutes Erdene's own equity. The upside is after EM completes earn-in Erdene only has to contribute 50% of costs and gets close to 66% of the profits.
You have to adjust for the 400koz offset, add in some other factors like the project they kept 100% of, etc.
Interestingly the US$40m cash isn't going to Erdene, but to the JV. If you figure like I do that the JV split is 2/3 1/3 equity equivalent then it would be pretty similar to if EM had paid US$26m to Erdene for a 1/3 equity and they had both contributed proportionally to their equity in the JV, valuing Erdene's at US$52m. Erdene has a market cap of CAD$108m. So EM bought in at a 50% discount.
What's the royalty worth? There's 585koz in M&I currently, so 185koz net of the 400koz offset. That means the royalty is really leveraged to exploration adding more ounces. Given the other drill results I think it is very likely that number grows.
Is Erdene a deal here because of the royalty? I don't know. I don't have a position (though I have had a position in the past it was sold well before this deal).
ZCCM-IH
ZCCM-IH is mostly owned by Zambia government associated entities. 7.47% is owned by minority shareholders. That is of course very concerning for shareholder alignment. On the positive side the dividend policy is that the Company may pay a minimum of 35% of the unconsolidated Net Profit after Tax (NPAT) for any financial year in which a positive unconsolidated NPAT was recorded. The National Pension scheme holds 15%, so there is an aligned interest to pay dividends. The Industrial Development Corportion owns just over 60% and their funding model is that it is self funding, so they probably have a preference for profitability too. It's association with the state also gives them non-competitive entry into some mining projects.
ZCCM converted it's 20% equity in into a 3.1% Gross Revenue Royalty on the First Quantum Mine owned Kansanshi Copper mine. If the average profit margin for the project is 15.5% this is a revenue equivalent transaction.
Company announcement: https://zccm-ih.financifi.com/download/zccm-ih-kmp-royalty-transaction-announcement/
Good thread on the transaction: https://twitter.com/nofairytales/status/1604914961003646976
ZCCM trades on the local exchange and on LSE, but both have no volume. Most shares are traded on Euronext Access Paris under the ticker $MLZAM . At a market cap of USD$244m and figuring a $35m annually cashflowing royalty is worth $350m the other 24 investments are being valued at negative USD$106m.
One of those other investments, the Mopani mine, they took on US$1.5b debt to own under the last president of the country. Under the new president of the country there is a focus on brining in outside investment to the country for mining. Royalties are now tax deductible, and the variable rate royalty scheme applies incrementally based on price rather than all at once. Both of these changes make the country more appealing for investment. Both Barrick and Sibane-Stilwater have publicly expressed interest in the mine. ZCCM has retained a consulting firm to run a process for finding investment in it.
ZCCM has 7 different 100% owned subsidiaries. They have 2 majority owned subsidiaries. 1 royalty only interest discussed above, and 15 minority investments. It would be great if ZCCM turned more of those minority investments into royalties.
The question in my mind isn't if the assets and potential cashflow are worth more than the stock trades at, that's an exercise left to the reader. The real question is how much of a discount do you give to those assets and cashflow being in a minority interest in a government run company in Zambia? Do they default on the debt, sink all the money back into the ground, pay the employees giant bonuses instead of returning cash to shareholders?
Full Disclosure
All of the companies mentioned in this article have low trading volumes, so it is quite easy to move the market price even with small retail limit orders. In this type of stock establishing a position can be very hard, and then the price volatility can be brutal while holding, then the market volumes may not be there if you go to sell. Investing in these companies is very risky, even by junior mining stock standards.
It's my hope that by mentioning 4 of these at once and with my small readership that the market price won't get too disturbed. Hopefully the readers will use these as examples of interesting things to look for in other companies. That's why the companies are viewable only by free email subscribers.
I currently have long positions purchased in the public market in ZCCM-IH $MLZAM, Red Hill Minerals $RHI.AX, and Talisman Mining $TLM.AX. I have had long positions in Erdene in the past but do not at present.