Description

Franco Nevada Corp. (FNV) is a gold royalty company that allocates capital to gold operating companies for purposes of completing mine projects. In return, FNV receives a royalty or stream of gold oz. over the life of the mine as payment for the project financing. The return on investment depends on the volume of gold oz. coming out of mine multiplied by value realized per unit (market gold price).

FNV is in the asset allocation business, whereby the management team seeks to cut deals with highest odds of capturing rights to future commodity streams. By building out portfolio with greatest odds of success, the management team adds capacity/share, and thus shareholder value through greater leverage to the cycle. A successful mine financing provides large upside, as most recently evidenced by the Cobre Panama project that alone doubled the Proved & Probable (P&P) Gold REUs YOY from 2012 to 2013, and management noted on Q3 2013 conference call that shows strong track record of 1/20 deals that move from exploration stage to full-scale mine productions.

The secret sauce of the royalty business (and FNV in particular) is compounded by a final factor – Bigger is Better – that manifests itself in 3 ways:

1)      Sourcing the deal - FNV is industry leader with most available liquid capital and respected reputation, therefore first on call list from mine operators and exploration cos., giving first bite at larger and potentially more attractive deals and terms

2)      Financing the deal - the ability to issue equity at a premium and finance the mine production at so-called par

3)      Leveraging the deal - operating leverage through increased royalty streams at faster pace than personnel increase due to  minimal continuing servicing needs (already G&A accounts for less than 5% of revenue)

We submit that using Royalty Equivalent Units (REUs) as reported in annual Asset Handbook and updating this figure throughout the year is the most accurate and logical method to value FNV in real time. 

Here’s a brief explanation of what a REU represents and its implications: FNV essentially acts as a gold venture capital firm, funding mine development production or rights to exploration up front in return for future gold royalties or streams, and the expected payout of a given deal changes based on the fluctuating gold price. In order to best reflect the mix of deal structures under FNV’s portfolio at a given point in time, FNV management goes asset-by-asset and converts the various deal structures into a common reporting unit known as the Royalty Equivalent Unit (REU), providing breakdown and sum totals in the annual Asset Handbook (starting in March 2012).               

The REU unit represents the equivalent of a pure royalty stream on 1 oz. of gold, referred to as Net Smelter Return (NSR) royalty, where for example a common deal term will specify that FNV is entitled to 4% NSR royalty on any gold that is produced from a given mine (or specific area of mine) either for the rest of the mine’s life or other specified timeline. As management notes in 2013 Asset Handbook, the weighted average length of expected royalty stream among the FNV portfolio is 23 years. So when we take an Enterprise Value/ REU we’re measuring the aggregate measure of the what the market is paying for the average expected oz. of gold to be received over the next 23 years.

To further illustrate the concept - if the annual production for a mine is 100,000 oz. of gold, a 4% NSR royalty calls for the mine operator to set aside 4% of the gold oz., or 4,000 oz., over to FNV for delivery whereby FNV accepts the gold and sells the gold oz. at the current market price. The delivered 4,000 gold ounces can be turned into cash at almost pure profit - FNV incurs an almost immaterial cost of $5 per ounce on average to receive and transport the gold from mine to market.

Before quantifying current market valuation, very quickly, the remaining two types of deal structures are 1) Streams and 2) Developed or Undeveloped Net Profit Interest (NPI) – a stream deal calls for a cash payment from FNV to acquire the gold oz., and for representative purposes FNV uses the common deal term of $400 per oz., lately 25% - 35% of market gold price. Due to the working capital necessity, a Stream deal is not technically considered a royalty.

Since the oncoming production from Cobre Panama is structured as stream deal, a brief example here again may be worthy - to compare on apples-to-apples basis, using gold prices in asset handbook, FNV would pay $400 off the realizable market price of $1,600  - a comparable 4% stream deal based on a mine production of 100,000 oz. of gold will still yield FNV 4,000 gold oz., but since 1,000 of gold oz., or 25% of production (based on $400 cash to mine operator off baseline $1,600 market price), the effective net value to FNV is 3,000 oz., or 75% of what a comparable 4% NSR royalty will net to FNV. When computing the total Precious Metal REUs, any stream gold oz. is therefore factored by 75%. The Developed or Undeveloped NPI calls for a different type of reduction in realizable value for computed gold ounces so is discounted even further. As of the nine months ended 09/30/13, FNV’s mix included 44% NSR royalty-based revenue, 40% stream-based, and 16% NPI and Working Interest.

To round up the above introduction, and based on my computed conversions of certain Mineral Assets and Oil & Gas properties, the market is currently valuing the gold oz. equivalent, REU unit at $700 per oz... so as owners in the Company we are paying $700 for the future right to an oz. of gold.

Based on the above valuation metrics, we believe FNV should be trading at $65 today with 1300 spot gold price.  At 1500 spot gold price, we believe FNV will trade to $75/share.  And at a spot gold price of $2000+, we believe FNV will trade well above $100/share.  To the downside, at spot gold price of 1000, we value FNV at $40 per share.

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