Royalty companies trumpet their low-cost model

Managing a royalty company these days is like running a MASH unit, Douglas Silver, chairman and chief executive of International Royalty Corp. (IRC-T, ROY-x) told analysts and investors at the recent Denver Gold Forum.

“We’re buried in deals,” he explained. “We have a US$40-million line of credit and in this market there are a lot of people who need help.”

Business really started to boom in January with the subprime mortgage crisis and since then has continued to pick up steam, Silver said in a subsequent interview.

“The credit markets and equity markets are drying up, while inflation is hitting these mines as well, and a lot of people are running short on money,” he said. “We’re basically financial engineering houses, serving as mezzanine or gap financing.”

International Royalty has a total of 84 royalties including an effective 2.7% net smelter return (NSR) royalty on Vale’s (RIO-N ) Voisey’s Bay nickel mine, a sliding-scale NSR on Barrick Gold’s (ABX-T, ABX-n) Pascua Lama gold project in Chile, a 1.5% NSR on Inmet Mining’s (IMN-T, IEMMF-o) Las Cruces copper project in Spain and a 1.5% NSR on about 12,140 sq. km of gold lands in Western Australia.

Among its latest acquisitions are four mineral royalties from Atna Resources (ATN-T, ATNAF-o) for $20 million in cash. The portfolio includes an NSR interest in all precious metals from the development-stage Wolverine massive sulphide project in the Yukon.

International Royalty wasn’t the only company at the Denver gold conference to sing the praises of the low-cost royalty model. Presentations that followed by Franco-Nevada(FNV-T, FNNVF-o)and Royal Gold (RGL-T, RGLD-q) all echoed his views that royalty companies are experiencing phenomenal growth at a time when credit is increasingly scarce and capital and operating costs have never been higher.

In an analysis of 650 feasibility-stage projects, International Royalty concluded that average capital costs since 2005 have climbed 44% per year and operating costs by 20% per year, while the average internal rate of return was just 20%. Royalty companies by contrast typically receive percentages of revenues without having any exposure to rising costs.

And there’s no reason to hope that costs are going to ease any time soon. In an equity research update in early September, analysts Barry Cooper, Brian Quast and Cosmos Chiu of CIBC World Markets wrote that operating costs for gold miners, when measured as cash cost per oz. gold, have risen at an annualized rate of 18%. Of that amount, 6% can be attributed to grade, the analysts calculated, as gold producers mine lower-grade ore to take advantage of higher gold prices.

The CIBC study analyzed operating costs over 14 quarters from the first quarter of 2005 until the second quarter of 2008. Capital cost escalation was calculated on the basis of feasibility cost estimate overruns in two different time periods: 1995-1997 and 2005-2008.

The study also found that capital cost increases of 47% over feasibility study estimates were “the norm” while the “actual costs of building a gold mine have only risen at a rate commensurate with the U. S. rate of inflation.”

CIBC’s findings were based on a study of 100 mines owned by 15 companies representing about 40% of the world’s gold production.

The beauty of the royalty model is that it requires limited capital and minor direct operating costs and less risk. “You buy it upfront and you never put another dollar in,” David Harquail, chief executive of Franco-Nevada explained during his presentation in Denver. “It’s a business model that just delivers cash and that’s powerful in this type of market.”

Franco-Nevada was formed as a resource sector royalty and investment company to acquire components of Newmont Mining’s (NMC-T, NEM-n) mining and oil and natural gas royalty and equity portfolio.

Franco-Nevada went public on Dec. 20, 2007, listing at $15.20 per share. At presstime, the company traded at about $20.68. “I’m told that’s a success story in this marketplace,” Harquail joked.

The company, which holds a diversified portfolio of about 285 royalties across precious and base metals and oil and natural gas, has free cash flow of $58.7 million and a credit facility of $150 million.

“We could spend all of our money five times over and still not touch the top of the mountain in terms of opportunities open to us,” Harquail said, noting that he has been in the mining business for 20 years and has never seen as many affordable business opportunities as he does today.

Harquail pointed out that the royalty business is also a simple one to administer and manage and doesn’t require a lot of people to monitor assets, which frees up staff to hunt for acquisitions. Franco-Nevada’s staff of 16 are split between Denver and Toronto.

In addition, royalty companies do not face environmental liabilities or fundamental mining risks yet get the same benefits as if they were invested in mining exploration and development.

Tony Jensen, chief executive of Royal Gold noted that his company concludes on average about two to four deals a year. In July, Royal Gold agreed to pay Barrick Gold $150 million in exchange for 77 royalties from the Toronto-based gold major in a deal that was set to close on Oct. 1.

Following the acquisition, 70% of Royal Gold’s portfolio will be precious metal royalties and the remainder base metals and others, including potash.

The Barrick portfolio consists of royalties on 77 properties, including eight producing royalties, 20 development and evaluation-stage properties, and 49 exploration projects. Over 75% of the portfolio is made up of precious metals royalties. Last year, royalty revenue generated from Barrick’s royalty portfolio reached about $12 million.

Indeed, business is so good for the three big royalty companies these days that other companies are starting to look at adding a component of the business to their own operations or highlighting the fact that they may already have royalty revenues as part of their business model.

In June, Solitario Resources changed its name to Solitario Exploration & Royalty (SLR-T, XPL-x) to “highlight its success in building value and royalties through successful exploration,” the company stated in a release. Solitario is enhancing its royalty positions through net profit interest royalty structured joint ventures with global mining companies.

Other companies spy opportunity too. Jack Stoch, president and chief executive officer of Globex Mining Enterprises (GMX-T, GLBXF-o) has shifted the company from an exploration focus to an exploration, discovery and royalty company.

But more competition doesn’t seem to worry any of the big three players already on the field.

“I’m not concerned at the number of participants,” Franco-Nevada’s Harquail said. “I see it as a sign that this is an attractive business to be in. There’s lots of space for everybody.”