Description

Long : Franco-Nevada (FNV)

Gold is attractive in this environment, and Franco-Nevada should outperform the price of gold. We have often kept an allocation to gold through large liquid gold miners, and GLD. Deficits, money printing, flight-to-safety...Everyone here knows the stated reasons to own gold. The Gold/SPX ratio would likely appear attractive to those that appreciate technical analysis, though that is not the reason for this write-up, and certainly not the reason we own Franco-Nevada; we've owned it when it looked quite awful in this regard. 

Franco-Nevada Corporation is a gold-focused royalty and streaming company. The company operates in two segments: Mining and Energy. The company manages its portfolio by focusing on precious metals like gold, silver, and platinum. It also engages in the sale of crude oil, natural gas, and natural gas liquids. The company was founded in 1986 and is headquartered in Toronto, Canada. Franco-Nevada is not a sexy idea with imminent corporate catalysts, but rather what we consider a top tier investment choice for a precious metals allocation, managed by a world class operator, and which should outperform most large cap precious metals stocks and physical gold.

Investment Thesis

Franco-Nevada is the most significant gold royalty and streaming company in the world. Roughly 68% of its revenue comes from precious metals, with 25% coming from oil and gas royalties, 4% from iron ore, and the rest from other commodities. A royalty company is truly the best way to invest in precious metals because it reduces investors’ exposure to some of the difficulties and expenses of the mining business. Mining is a capital-intensive, highly cyclical, and low-margin business. Mines cost millions or even billions of dollars to build before generating a single dollar of revenue.

A royalty is a real estate interest that entitles the holder to a share of minerals produced from the property. It is not a portion of the profits after all the expenses are paid. A royalty comes right off of the top line, before most expenses are paid—royalty holders get paid first. Royalties do not bear the burden of capital investments, either. When the mine operator invests millions or billions of dollars to expand production, the royalty holder does not pay any of that cost. However, they still receive their share of the additional production. That’s the “optionality” of royalties: Royalty holders get their share of current mine production, but they also own an option on all future production from that property.

Franco-Nevad went public in 2007. Since then, gold reserves from its original 2007 portfolio – plus all the gold produced from that original portfolio – have increased threefold. In other words, there was three times more gold to mine than implied by the initial reserves. Mining companies spent more on exploration and drilling to expand their resources. At the same time, Franco-Nevada did not pay any of that cost, even though it benefited from all the additional production. Franco-Nevada also invests in streaming agreements. These are like royalties but with one key difference. If one has a 2% royalty on a mine, the mining company agrees to pay the royalty owner the revenue from 2% of its production. If the mine produces 100,000 ounces of gold, one receives the revenue from 2,000 ounces. If you have a 2% stream on a mine that produces 100,000 ounces, the mining company agrees to sell you 2,000 ounces of gold. The price usually represents a substantial discount to the prevailing price when the streaming agreement was made. Although some streaming agreements have royalty-like optionality, most streaming agreements generally have an expiration date. By contrast, royalties do not expire.

Franco-Nevada owns 428 royalty and streaming assets covering properties totaling more than 25,000 square miles. And yet, the company’s operating expenses are minimal. The company is an investment operation that allocates capital on behalf of shareholders. Its corporate and stock compensation expenses total less than 2% of revenues. Today, 116 of its 428 properties produce and generate cash flow for Franco-Nevada and its shareholders: Forty-seven assets in precious metals, fourteen in other minerals, and fifty-five in oil and gas.  Forty-two more assets could see production within five years, and 270 are still in exploration. Another forty-four properties are in the advanced stages of development and moving towards becoming producing mines. The remaining 259 properties are in various stages of exploration and may not be productive for years. Franco-Nevada’s portfolio is well-diversified in politically stable regions. Roughly 90% of its revenue comes from North America, South America, and Central America.

Only some businesses produce cash, like royalty companies, and Franco-Nevada is among the best in the world. In some years, free cash flow may fall, but that is simply because the company found a new royalty investment, setting it up for years of new cash flow generation. The margins for royalty companies exceed software companies margins. A royalty does not require massive capital spending to operate, and it does not require a large workforce and machines to meet the demand for a product. A royalty is a claim on the mineral production from that asset. Franco-Nevada’s balance sheet reflects its opportunistic management style of capital allocation. If there is a reason to borrow, it will borrow. Then, it pays the debt down and waits for another reason to borrow. Franco-Nevada has had year-end positive net debt in only one of the past five years. The company is in the best possible financial condition today, with over $1 billion in cash and zero debt. The company patiently awaits the next opportunity to finance another significant royalty acquisition.

Valuation

Franco-Nevada is the blue chip of precious metals mining and trades at an operating cash flow multiple higher than its big competitors (Royal Gold, Wheaton Precious Metals, and the actual mining companies). Franco-Nevada’s goal is to be the gold stock for the generalist investor. Whenever this general investor may find gold interesting, Franco hopes / expects this investor to buy FNV shares. FNV stock has outperformed the physical metal for years now. Franco-Nevada launched an initial public offering in December 2007 at $15 per share and gold at $800 per ounce. At the current price of ~ $140 per share, Franco-Nevada is up over 830%, which is far more than gold’s gain of approximately 135%, to $1,980 per ounce.

Franco-Nevada’s focus on a property’s optionality is critical to the company’s long-term success. Franco is willing to pay full price for long-life royalties and streams with good potential for more ounces to be found and generate further upside. Consider that the total royalty ounces at the company’s top thirty-seven properties were approximately 100 million at its IPO in 2007. By the end of 2019, those properties had produced thirty-seven million ounces and generated $1.4 billion in revenues for Franco-Nevada. Yet, these same assets still have about 139 million ounces of mineralization. More importantly, the Proven and Probable reserves subset, or the ounces from producing mines or those shown to produce by a feasibility study, have grown from approximately thirty-two million to sixty-nine million.

To better understand how Franco-Nevada operates, consider their July 2022 financing of G Mining Ventures in Brazil. Franco-Nevada committed $353 million of the total $481 million that fully funded G Mining Ventures’ required capital investment. Franco-Nevada funded this investment from the cash sitting on the company’s balance sheet, which totaled $1.3 billion. The $353 million financing included $28 million in common shares, a $75 million loan, and $250 million for a stream on G Mining Ventures’ Toca gold project in Pará, Brazil. Production from the Toca gold project should begin in the second half of 2024 with an estimated annual production of 175,000 ounces of gold annually with all-in-sustaining costs of $681 per ounce. The streaming arrangement is for 12.5% of production, or an estimated 21,800 ounces per year, with a cost pegged at 20% of the spot gold price. If we estimate $2,000 per ounce of gold, Franco-Nevada nets $34.9 million annually, plus the 8% interest on the $75 million debt and possible upside from 44.7 million shares purchased at $0.62 per share. Lastly, Franco-Nevada has the right of first refusal on any future streams from Toca’s 996 square kilometers of property or any new G Mining properties worldwide.

Franco-Nevada is the best-performing gold stock since it went public in late 2007. The company is a better play on gold than the metal itself, especially since it pays a dividend that has increased for fifteen consecutive years. The company’s annual dividend is now at $1.36, or a 9.1% yield on its cost at the IPO. Franco-Nevada expects its portfolio to produce 760,000 to 820,000 gold equivalent ounces in 2027, with 74% generated from precious metal assets, or about 15% to 20% greater than the company produces today. Royalties and streams are the best assets to own in inflationary times—contracts fix their costs while their revenues expand on higher prices. We currently estimate that Franco-Nevada’s fair value is ~ $180 per share.

Risk to Investment

As a holder of royalties, streams, or other interests, Franco-Nevada has limited access to data on the operations or the actual properties themselves. This could affect its ability to assess the performance of the royalty, stream, working, or other interests. Additionally, Franco-Nevada’s royalty, stream, and other payments are calculated by the operators of the properties on which Franco-Nevada has royalties, streams, or interests based on the reported production. Each operator’s calculation of Franco-Nevada’s royalty, stream, or other payments is subject to and dependent upon the adequacy and accuracy of its production, cost, and accounting functions, and errors may occur from time to time in the calculations made by an operator. Lastly, the Candelaria and Cobre Panama streams are currently significant to Franco-Nevada. However, as new assets are acquired or transitioned into production, the materiality of each of Franco-Nevada’s assets should be reconsidered. Any adverse development affecting the production operation from or recoverability of mineral reserves from Candelaria and Cobre Panama may negatively affect Franco-Nevada’s profitability, financial condition, and results of operations.

Catalyst

Continued execution and operational excellence. Gold price stability or appreciation.