Valuing Prospect Generators Part 3 - Benefit Weighted Spending
A lot of prospect generators will talk about partner funded exploration. For example here's Orogen Royalties (a prospect generator) talking about partner funded exploration of $3.2 million in 2021.
So, what do we do with that information?
Rick Rule has stated something along the lines that you should compare the partner funded exploration expenses against the royalty generator's G&A expense. Mr Rule has a longer and better track record investing than I do, so you should probably do that. But I'm going to tweak that a little bit.
Baseline
Let's imagine that there is a single company that owns the entire lifecycle from staking ground, prospecting, proving it up through drilling, publishing economic studies, building a mine, and mining metal out of the ground. Let's call this PureCo.
PureCo spends 100% of the investment expenses and gets 100% of the profit. If we knew all of the future spending and profits we would know the current value as the present value of that future cashflow.
Let's then imagine we have a prospect generator GenCo. It stakes ground or buys it cheap, does some exploration prospecting type work and then sells the prospect to an exploration company for cash payments, shares, royalties, and interest in the project.
The third company is OptionCo. It only acquires prospects from GenCo.
Benefit Weighted Spending
OK, now that we've set the stage lets introduce the point of this article. Benefit weighted spending.
PureCo has a benefit weighted spend of zero. If it invests $1m in exploration it gets $1m in benefits on that exploration investment. The spend and the benefits offset.
To illustrate a more complex, but still slightly simplified compared to the real world, benefit weighted spending imagine GenCo and OptionCo have a 70/30 joint venture (JV) earn in. GenCo spend $250,000 prior to the agreement, and OptionCo spends $5,000,000 on exploration to earn their 70%.
GenCo spend $250,000 but only gets 30% of the JV. So its benefit is $250,000 * 0.3 = $75,000. OptionCo meanwhile benefits $250,000 * 0.7 = $175,000.
Benefit Weighted Spend at Option Signing
| GenCo | OptionCo | |
|---|---|---|
| benefit | +75,000 | +$175,000.00 |
| spend | -$250000 | $0 |
| benefit weighted spend | -$175,000 | +$175,000 |
Another way you could look at it is GenCo is secretly a type of exploration finance, a specialty bank if you will. They essentially just lent OptionCo $175,000 in exploration spending. It's an asset backed "loan" as the property gets returned to GenCo if OptionCo doesn't "pay" by completing the earn in. GenCo's main value adds are in assesing assets they will use to secure the loans (jurisdiction, likelyhood to contain gold, access to infrastructure, etc), and in assesing the borrowers likelyhood to pay them back (exploration expertise, ability to raise financing, etc).
OptionCo then spends $5,000,000 on exploration. OptionCo benefits $5,000,000 * 0.7 = $3,500,000. GenCo benefits $5,000,000 * 0.3 = $1,500,000
Benefit Weighted Spend from Exploration
| GenCo | OptionCo | |
|---|---|---|
| benefit | +$1,500,000 | +$3,500,000 |
| spend | $0 | -$5,000,000 |
| benefit weighted spend | +$1,500,000 | -$1,500,000 |
So at JV formation GenCo would come out ahead.
Benefit Weighted Spend at JV Formation After Earn-In
| GenCo | OptionCo | |
|---|---|---|
| prospecting bws | -$175,000 | +$175,000 |
| exploration bws | +$1,500,000 | -$1,500,000 |
| benefit weighted spend | +$1,325,000 | -$1,325,000 |
Every deal's numbers will be different, and many prospects that are generated are never optioned or the option isn't earned in and the project is returned.
Cash Payments as Benefit Weighted Spend
Option Agreements often have cash payments. These can be thought of as Benefit Weighted Spend negative for the OptionCo and positive for the GenCo at face value. They don't have to be weighted for the ownership.
It's worth saying that like earnings you can't eat Benefit Weighted Spend from partner exploration expenditures. A prospect generator has real cash expenses and has to fund them. Cash payments from option agreements are a preferred way to fund expenses rather than going to the market to issue shares in private placements or bought deals.
Buy-down Royalties as Benefit Weighted Spend
Royalties that can be bought down aren't really royalties, they are potential future cash payments.
Shares as Benefit Weighted Spend
Often option agreements will have OptionCo issue shares to GenCo. Shares have cash value and can be considered a cash payment. This is even more true because prospect generators often do sell some of their shares in other companies to fund cashflow needs.
Returning To Orogen
In the link I shared to start this article Orogen had partner funded spend of $3.2 million. I looked at their active projects and they have a mean of 1.96% NSR on them, so let's call that 2% NSR. We don't know how much of the spending was at development or construction stage assets versus pure exploration assets, which can greaty effect the equity equivalent of the NSR from 15% to 80%. We'll just use 50% as a rough number, I think this is likely concervative as they have 13 active JVs and only two more advanced in Ermanito and Silicon. Orogen also had $1.9m in cash payments and mangement fees.
So $3.2m * 0.5 + $1.9 = $3.5m in benefit weighted spend from partners.
We don't have the full year results yet, but in 9 months they had $1.4m in exploration expenditures, which pro-rated for the year is $2m in exploration expenditures. Using the 50% above that is -$1m in benefit weighted spend.
$3.5m - $1m = $2.5m net benefit weighted spend in their favor. With an $80m market cap that's a 3.125% benefit weighted spend yield to market cap. Another way we might look at it is $2.5 million a year at a 10x multiple might be worth $25m.
Flaws
Knowing the net benefit weighted spend assumes all exploration spending is equal. As Filo or Solaris are showing today some exploration spend has much higher return than other spend.
Wrap Up
Partners are spending more on Orogen's behalf then Orogen is spending on their behalf. That's a good prospect generator business. I like the $25 million valuation on the generation business. Current market cap is $80m, so that leaves $55m unaccounted for. The next step would be to walk through the assets they currently have and see if the valuation of those assets can add up to at least $55m, hopefully more to build a big margin of safety, because all these methods of valuation are hugely imprecise.
Full Disclosure
At the time of this writing I have no current or past positions in the companies mentioned including Orogen Royalty.