Description
Royal Gold is an overvalued company that engages in the acquisition and management of royalty streams from gold mining companies that operate primarily in Nevada. Following the rebound in gold prices, speculation has resulted in RGLD’s stock increasing 382% since December 2001. Specifically, RGLD has soared relative to the gold price index and other un-hedged gold stocks. With an assumed gold price of $360 per ounce — its recent high — RGLD is currently valued at 28.8x our estimated FY2003 EBITDA and 23.86x FY2003 sales. Based on the present value of its future cash flows and a gold price of $360 per ounce (gold is trading at $345/oz today), RGLD has an intrinsic at between $3.15 and $4.20 per share compared to yesterday’s closing price of $25.75. The valuation section later in this report will justify this assertion and demonstrate that RGLD is overvalued regardless of how spot gold prices change going forward. There are only 1.18mm shares or 7.9% of the current float being shorted, so RGLD should not be particularly hard-to-borrow at this point.
A Pure-Play Royalty Company: Unlike the larger and well-known mining companies (e.g. Newmont Mining Corporation, Barrick Gold, Placer Dome, etc), RGLD has no involvement in the exploration and production of gold. RGLD earns its profits from seven primary royalty streams. Consequently, one of the few positive characteristics of RGLD is that no capital expenditures are necessary. Moreover, RGLD continually emphasizes to investors that its corporate overhead is minimal and that it has only 9 full-time professionals. "It's a good business model because it doesn't carry the same amount of risk as an operating company," said Jay Taylor, editor of Jay Taylor's Gold & Technology Stocks. "Capital required is much less than putting a gold mine into production. And you don't have the labor work force of a mining company." This explains why RGLD has a ROE of 47.8%; other bull arguments include a clean balance sheet with no debt; this is why some investors may prefer RGLD to the more complicated and capital-intensive business of the direct-operators mentioned above.
A Roll-Up Strategy: In late 2000, RGLD used its stock to acquire 93.5% of High Desert from a controlling shareholder and subsequently froze out the minority shareholders, thereby buying the business for approximately $31 mm. According to CEO Stanley Dempsey, RGLD has no intention of entering the direct mining business. Because its business cannot grow organically unless additional gold is discovered, RGLD has made five significant acquisitions in the last five years. While roll-up strategies may be quite profitable under the right circumstances, RGLD appears to have paid high prices for its acquisitions. For example, High Desert cost the Company $31 million and we estimate that the investment will yield total cash flows of $39 million over a 10 year period. (Using a $360 gold price and a favorable mining schedule) This translates to an IRR of less than 5%. Should gold prices fall below current levels to $320 an ounce, the IRR is less than 1%.
Overview of Properties: Specifically, RGLD has four straight-forward gross royalty streams and three more complex royalty streams earned net of mining and processing expenses. RGLD earns approximately 83% of its revenue from four royalty streams located on one principal property—the Pipeline Mining Complex at Cortez, Nevada. The Pipeline complex is a joint venture operated by Cortez, which is a subsidiary of Placer Dome and Kennecott Explorations, a subsidiary of Australian gold company Rio Tinto. In addition, RGLD owns two royalties through the High Desert acquisition: the “Leeville” project and the SJ Claims project operated by Newmont and Barrick Gold, respectively. It is important to understand each specific royalty stream in order to model potential cash flows based on the sometimes floating royalty percentage, the number of gold ounces to be mined, and a corresponding mining schedule.
It should be noted that RGLD has no influence on when gold is removed from the ground. The gold operating company gives management an estimated schedule of how much gold will be mined per year. For example, on the 10-K, management estimates 950,000 ounces of gold will be mined from the Pipeline Property in 2003. According to management, operator schedules must be planned in advance. This means that even if gold suddenly spikes, a gold operator cannot quickly increase production. Similarly, gold operators do not significantly cut back production if gold prices have a big downward price movement because they need to absorb their fixed operating costs. Each gold mine lasts around 10 years.
The owner-operator of a certain area also breaks out the number of proven and probable reserves to RGLD. Proven reserves constitute gold that has been clearly identified and is ready to be removed from the ground. Probable reserves are not immediately ready to be removed from the ground. It can take several years of planning and exploring to have an ounce of gold be proven as opposed to probable. According to the 10-K, “these deposits do not qualify…until further drilling and metallurgical work are completed, and until other economic and technical feasibility factors based upon such work are resolved.” There is no guarantee that these probable reserves will generate revenue for RGLD.
Valuation: RGLD shares are currently trading around $25.00 per share. With an assumed gold price of $360 per ounce, RGLD is currently valued at 28.8x our estimated FY2003 EBITDA and 23.86x FY2003E sales. Below is a Q2 run-rate equity-market valuation based on the quarterly earnings report out today:
Run-Rate Q4
Stock Price Rev EPS EBITDA
$15.00 24.7x 59.8x 36.5x
$20.00 32.9x 79.7x 48.6x
$25.00 41.2x 99.7x 60.8x
$30.00 49.4x 119.6x 72.9x
As stated above, determining the true value of RGLD is a rather simple exercise because the amount of gold reserves and royalty rates are clearly outlined in public filings. The only crucial variable is the price of gold—which is sensitized below. There are 19.1 mm diluted shares outstanding and 1.4 mm shares were issued for the merger.
The table below examines the net present value of the expected stream of cash flows for RGLD based on expected royalty streams from its investments. Each stream has been gleaned from public filings and/or discussions with mine operators.
Discount Rate
Price of Gold
10% 12% 14% 16% 18%
$260 $1.45 $1.41 $1.37 $1.33 $1.30
$320 $2.89 $2.76 $2.64 $2.53 $2.42
$340 $3.43 $3.26 $3.11 $2.97 $2.84
$380 $4.55 $4.32 $4.10 $3.90 $3.73
$420 $5.58 $5.28 $5.00 $4.76 $4.53
$460 $6.70 $6.32 $5.99 $5.68 $5.41
$500 $7.63 $7.19 $6.80 $6.45 $6.14
$550 $8.47 $7.98 $7.54 $7.15 $6.79
$1000 $16.03 $15.06 $14.19 $13.42 $12.72
Using a 14% discount rate and a $420 gold price, RGLD is worth about 20% of its current stock price based on a discounted cash flow analysis. There are a few things that cannot be predicted with certainty: (1) The exact schedule for when gold operators remove the gold from the ground, (2) The percentage of probable reserves that will ultimately be mined, (3) The potential for these gold operators to suddenly come across a large amount of new gold. This model has been run with logical and conservative assumptions to address the first two concerns. First, schedules are consistent with a run-rate using FY2002 numbers and FY2003 estimates and were checked to the fullest extent possible by speaking to management. Second, RGLD was given the benefit of the doubt and the model generously assumed 100% of the probable gold reserves will be mined. The third point is more difficult to address, but it appears unlikely that these gold operators will suddenly discover a significant amount of gold. However, RGLD is so overvalued that there is a huge “margin of safety” to address this risk. Hypothetically, if the Pipeline Mining Complex, which accounts for 83% of revenue, discovered 20 million ounces of proven reserves tomorrow — which is almost three times as many ounces as it currently has — RGLD would remain overvalued as shown in the following chart:
Discount Rate & Price of Gold
10% 12% 14% 16% 18%
$340 $9.31 $8.92 $8.55 $8.22 $7.91
$380 $12.46 $11.91 $11.42 $10.96 $10.54
$420 $15.30 $14.62 $14.00 $13.43 $12.90
$460 $18.41 $17.58 $16.83 $16.13 $15.50
$500 $20.94 $19.99 $19.13 $18.33 $17.61
Insider Selling: Clearly, the large amount of insider selling suggests that management realizes its equity is overvalued. In October and November of 2002, Chairman Stanley Dempsey sold 14,200 shares. Practically every single Director and Officer has been dumping shares since August, 2001. Director Peter Babin purchased 4,016 shares at the $10 range in April 2002, but subsequently unloaded 84,153 in the next week. The last significant purchase was by a Director at $4.75 per share. Please refer to http://biz.yahoo.com/t/R/RGLD.html for a quick list of trades.
Below is a detailed breakout of the different royalty streams that provide the foundation for the model.
GSR1: There are 6.8 mm contained ounces of gold in the Pipeline Mining System. Management was comfortable with the assumption that “around 1.1 mm ounces of gold” will be mined per year for the next six years.
Since GSR1 is a sliding-scale royalty directly tied to the gold price, it is possible to calculate revenue with the gold price sensitized. For example, if an ounce of gold is $360, Pipeline yields 1.1 mm ounces of gold, RGLD earns revenue at a sliding-royalty scale of 4.00% X $360 X 1.1 mm ounces—revenue of $13.8 mm. Now, if gold prices were only $260 per ounce, the GSR1 royalty is 1.30% X $260 x 1.1 mm ounces—revenue of $3.8 mm; this illustrates the tremendous exposure to the RGLD price. However, if gold rises to $550 per ounce, the royalty rate is only 5.00%, RGLD because it is capped once gold passes the $470 level, RGLD records revenue of $31.7 mm. Hence, there is declining upside at current price levels.
There are also 292,500 ounces that are uncontained—probable but not proven. Even though there is no guarantee that this gold will be successfully mined, I estimated that RGLD would wait until its existing reserves were depleted and earn royalties of approximately $0.9 mm annually on 73,000 ounces of gold — commencing in 2009 and ending in 2012.
GSR2: This royalty is also a sliding-scale royalty. However, this royalty only covers 2.27 mm ounces of gold that are uncontained in the Pipeline Complex. Because these reserves are years away from being mined and are not guaranteed, RGLD will earn relatively higher royalties of 2.34% and 7.20%, assuming gold prices at $260 and $400, respectively. I conservatively estimated that RGLD would in fact earn royalties on all 2.27 mm ounces—starting in 2009 and concluding in 2012—yields revenue of $12.5 mm per year.
GSR3: This 0.71% royalty is fixed and does not change with the gold price. It was purchased in 1999 that covers the same Pipeline Mining Complex cumulative area as GSR1 and GSR2 do. Assuming a gold price of $360, RGLD will earn $2.9 mm per year from 2003 from this specific royalty stream until the Pipeline Complex is depleted and approximately $1.6 mm subsequently from the probably reserves.
NVR 1: This royalty is a 0.37% fixed-rate royalty, net of processing-related costs that are included in the 0.37%. (RGLD is not responsible for mining-related costs) NVR1 covers a portion of the Pipeline Mining Complex that is excluded from GSR1, GSR2, and GSR3. There are currently 5.0 mm ounces of proven reserves. Assuming a gold price of $360, RGLD will earn $.87 mm annually for six years and $.64 mm for four years starting in 2009 based on probable gold ounce reserves of 2.4 mm.
Bald Mountain: In 1998, RGLD purchased a 1.75% fixed-rate, net royalty from a property located near Elko, Nevada. This royalty stream is very small, with only 231,000 contained ounces and 691,600 probable ounces. Management explained that this particular area is “near the end of its mine-life.” Assuming a gold price of $400, RGLD could earn $490,000 annually for three years and $1.45 mm annually for the subsequent three years until 2008.
Leeville Project: This royalty stream from areas controlled through Newmont Mining was acquired through the High Desert merger. Based on public filings from Vancouver-based, High Desert, RGLD earns a 2.00% net return royalty on approximately 4 mm ounces of gold. RGLD management stated that it will earn royalties on the difference between the price of gold and the mining cost, which is around $205.00 per ounce. However, information obtained from Newmont Mining’s web site states that “Leeville” is currently being explored and developed, so no gold can be mined for a few years. This was confirmed by speaking to Newmont investor relations. Assuming production begins in 2006 and the same gold price of $360 per ounce, RGLD will earn royalties of $1.55 mm annually for eight years based on 500,000 ounces of gold mined each year.
SJ Claims: This royalty operated by Barrick Gold was also acquired through the High Desert acquisition. This net returns royalty of 1.00% covers 9.76 mm ounces of proven gold reserves. It is estimated that this royalty should earn RGLD about $3.42 million annually based on a $360 per ounce gold price. This figure is very generous as High Desert only received $1.4 million from its two streams for the nine months ending September 30th, 2003.
Non-Producing Royalties: RGLD owns several non-producing royalties in Nevada and the Greek island of Milos—all of which do not contribute and are not expected to contribute to the bottom-line. RGLD owns silver royalties from Yamaha Resources based in Argentina—which are immaterial to RGLD revenue due to the low value of silver.
Catalyst
Catalysts
(1) Any meaningful decline in the price of gold. It might be a good idea to hedge this short against the price of gold via options or purchasing a larger, liquid gold company such as Newmont Mining that is not hedged against the price of gold.
(2) Any positive news on the situation in the Iraq.
(3) Time for investors to realize the irrational valuation.
(4) Additional insider sales