The Royalty Report is also available for easy viewing at Metal Augmentor


Introduction


Maybe you already find the royalty model to be an attractive methodto gain exposure to mining and metal prices? Or perhaps you have heardabout royalty companies but don’t have enough information to decide ifone or more of them belongs in your portfolio? Either way, it isimportant to understand the underlying value of a royalty company basedon the current market environment and the future production outlook.Unfortunately up until now, there has been no comprehensive source ofroyalty company valuations available to the public, leaving most retailand many institutional investors in the dark.

We at Metal Augmentorhave had the same problem — but since we specialize in fundamentalanalysis and market research in metals and mining — we have come up witha solution. Using our proprietary database of exploration, developmentand production stage companies, we have individually analyzed well overone hundred royalties and prepared the following report covering thevast majority of them that are held by public companies deriving asignificant portion of their valuation therefrom. For good measure, wehave even thrown in the odd coal royalty. To the best of our knowledge,few others have completed such an arduous analysis and none havereleased their findings for public dissemination.

We believe this summary report and the subsequent comprehensive versions — to be available only to subscribers of the Metal Augmentorservice — will be very useful to many investors since this will be thefirst time royalty companies have been valued at current metal prices onthe basis of cash flows and earnings generated from each individualroyalty calculated on a stand-alone basis. Consider Franco-Nevada (TSX:FNV; Pink Sheets: FNNVF) with its 50+ different royalties: faced withthe sheer amount of data, even large brokerage firms tend to generateprice targets using aggregate cash flow assumptions and estimates oftop-level financial metrics. We don’t blame them given the time andeffort required to complete a comprehensive analysis, but we alsowouldn’t trust our own money to what amounts to a sophisticated wag.

Investors familiar with the royaltymajors will notice right away that we are missing data in this reportfor Franco-Nevada’s closest competitor, Royal Gold (NYSE: RGLD; TSX:RGL). This is because we are still validating all of Royal Gold’sroyalties, a process that has proven to be very time consuming. Weexpect to complete the validation by early January and will be releasinga comprehensive version of this royalty company report to subscribers at such time.


What is a Royalty Company?


A royalty is a payment to a property interest holder by the majorityowner or operator usually based on the amount of mine production (e.g.flat rate royalty of $10/tonne), the value of production (e.g. 2% ofsales less certain costs — see Net Smelter Return), or the netrevenue/profit generated from production (e.g. 5% of net profits). Thereis also the fixed price metals purchase royalty stream, which accruesto the royalty holder based on the difference between the current metalprice and a fixed purchase price, such as the “silver streams” innovatedby Silver Wheaton (NYSE/TSX: SLW).

Royalties based on the amount of production have no directcorrelation to changes in commodity prices other than the possibilitythat production rates could increase in reaction to higher commodityprices and vice versa. Fixed price metals purchase royalty streams androyalties based on the value of production will exhibit a high degree of correlation with movements in commodity prices. Finally, royalties based on the profits generated from production are expected to leverage changes in commodity prices and therefore such royalties can be the most profitable (and risky).

Arguably, the main attraction to investors in royalty companies isthat they generally have no responsibility for contributing funds to aproject for any future purpose, including operating and capital costs,after an initial cash payment or transaction. Thus, an unexpired royaltyessentially represents a fully carried asset with zero future cost.This results in low-risk exposure to mining operations, whether it be adevelopment-stage project or long-established mine, especially duringthe bust period of the boom-bust cycle in mining when purported cashcows become cash vacuums that suck up money and can create massive sharedilution for operators. While a royalty might not generate any revenueduring such downturns, it also won’t impose costs or commitments to makecash payments in most cases.

On the other hand, most royalties do not shelter the royalty companyfrom the ultimate risk of temporary or permanent shutdown of operationsand they provide little relief from the bankruptcy of the mining companyor operating subsidiary. In other words, royalties and royaltycompanies do not offer much shelter from, or recourse against, thetail-end risk of the mining business: failure. Consider the followingdisclosure in Silver Wheaton’s financial statements:

Except in limited circumstances, the Company will not be entitled to any material compensation if such operations do not meet their forecast silver or gold production targets in any specified period or if the operations shut down or discontinue on a temporary or permanent basis.

For the above reason, it is not enough to simply look at royaltycompanies from a quantitative perspective; one should also understandthe quality of the operations underlying the royalty portfolio. Futureeditions of our royalty report, available only to subscribers,will include analysis of several qualitative factors (such as weightedaverage operating margin, production grade, etc.) in our ongoing effortto provide the most comprehensive analysis of the metals and miningsector. In future editions of our royalty company report, we will alsoconsider covering oil and gas royalties in addition to the one-off coalroyalty that we have included thus far.

As of now, however, we have identified 11 companies that can beclassified primarily as metals and mining royalty companies. This 11company universe boasts a combined market capitalization of about $23billion. Silver Wheaton is the sun within this solar system given itsnearly $14 billion market cap (the next closest competitor by size isFranco-Nevada, with a market capitalization of around $4 billion). Butwhereas Silver Wheaton might now be considered a red giant, it wasn’tlong ago that it looked like a white dwarf. Believe it or not, back inlate 2008 during the worst of the financial crisis, Silver Wheaton wastrading for under $4 with a market capitalization less than $1 billion.So in case anyone thought royalty companies were immune from extremevolatility, think again.

Let’s now take a look at how the entire universe of metals and mining royalty companies have performed over the past 12 months:

We can see from the above chart that the royalty companies havegenerally risen along with gold and commodities this year, though thereis quite a bit of variability and several of the companies have beenpoor performers. Silver Wheaton stands out as a top performer, helped inlarge part by the 60%+ rise in silver, the growth profile of itsportfolio, and its ascension as a market darling. Thesimilarly-impressive rise in Callinan Mines (TSX-V: CAA; Pink Sheets:CCNMF) can be explained by its levered net profits royalty structure onHudbay Minerals’ (NYSE/TSX: HBM) flagship 777 mine. [Note: Callinan is an Institutional client of Metal Augmentor.]


The one apparent loser in the group is Terra Nova Royalty (NYSE:TTT), though this can largely be explained by its corporaterestructuring. This restructuring involved splitting up what wasformerly KHD Humboldt Wedag International Ltd. into a mineral royaltycompany (Terra Nova Royalty) and an industrial plant technology,equipment and service company (KHD Humboldt — Pink Sheets: KHDHF). Sofar a total of 25.7 million shares have been spun out to Terra Novashareholders worth about $230 million, largely explaining Terra’sfalling share price over the past 12 months. One last dividend is expected to occur on December 31, 2010.If we adjust for all the dividends paid thus far, Terra Nova has tradedroughly flat during 2010, joining a small group of otherunder-performers in the royalty space.

Among this group of under-performers is Royal Gold, a company thatseems to have a love-hate relationship with the market. One possiblereason Royal Gold has been flat in recent times amid the huge rally ingold stocks is that its showcase Voisey’s Bay royalty (InternationalRoyalty Corp acquisition) has been besmirched by a lengthy strike.Moreover, investors do not appear to know how to value the company(hint: forget P/E ratios) — particularly given the number of royaltieson large development-stage projects — and this is something we aim tochange with our upcoming comprehensive royalty report. We note alsothat Royal Gold held up extremely well during the 2008 meltdown, whichis a sign that the market views its royalty portfolio as a stable,high-quality asset that has nonetheless failed to be inspirational sofar.

Generally we are not surprised to see a low degree of leverage tohigher (and lower) commodity prices since most of the royalty companiesown royalty interests on projects that are not yet in production andwill only stand a chance of producing cash flow after furtherexploration and/or development spending. If commodity prices fall, sotoo will exploration and development budgets as project economics becomeless favorable and financing becomes harder to obtain. But if pricesmove higher then healthy amounts of spending should eventually lead tonew discoveries and the development of new mines, triggering new royaltystreams and increasing expected cash flows for the royalty companiesgoing forward. In addition, the market is expected to re-value a royaltyupwards at the start of commercial production just as the market tendsto re-value mining companies themselves at the start of commercialproduction.

Methodology


Our valuation method is based on a fairly standard discounted cashflow analysis of each royalty interest, using a conservative discountrate of 8 percent. In determining valuation targets, the share structureof each company is adjusted to account for in-the-money warrant andoption exercises. Financial metrics take into account liquid assets anddebt in arriving at enterprise value.

In calculating attributable resources, the royalty interestpercentage is applied to the total resource of each project. Forexample, consider a 2% net smelter return on a 1 million ounce golddeposit. The attributable resources would be calculated to be 20,000ounces. We then adjust contained resources according to assumedmetallurgical recovery rates. In the case of the 1 million ounce golddeposit, if it is estimated that only 80% of the gold will be recoveredin processing the ore, then the attributable resource works out to16,000 ounces. This does not always work out smoothly due to thecomplexity of some royalty interest arrangements, but generally ourfigures will reflect each company’s level of exposure to the producedmetals or commodities.

To determine estimated total cash flow, we simply apply the royaltypercentage interest to the expected production rate of each project in2010, 2011, and the terminal period (defined as 2012 through the end ofthe mine life), adjust for any operating costs associated with theroyalty, multiply by the current metal price of each produced metal orcommodity, sum these amounts together, subtract out any future capitalcosts that the company may be subject to (rare for royalties), and thenadjust for the company’s estimated depreciation, amortization, and taxcharges. When calculating valuation range targets, we adjust for thebase, best, and worst case metal price scenario assumptions using aprice band at +30/-30% of the current level.


See Part II for the Bulk of the Report.

Disclaimer: From time to time we have and may own shares inseveral of the companies mentioned in this analysis but at thepublication we held no material position. No compensation has been received fromany of the companies mentioned except Callinan Mines and FirstMajestic Silver which are institutional clients of the Metal Augmentorservice. This is not investment advice; should youseek investment advice we recommend you discuss the company with alicensed investment advisor or broker.