Description

We are recommending a short sale of Royal Gold Inc. (Ticker: RGLD). This idea was thoroughly covered in Feb. 2003 at $25.75. In the interim, the stock more than halved itself and averaged somewhere in the mid-teens. More recently, with the speculative fervor in gold – the stock has once again returned to $25+ per share and we believe is dramatically overvalued.

We typically avoid shorting stocks that have a strong external driver (like the price of gold) that in the short term may be the primary driver of the stock price. In general we prefer not to implicitly make bets on the direction of such drivers (commodity prices, interest rates, exchange rates, etc).

This specific short idea is not predicated on a fall in the price of gold. For what it’s worth gold is at ~$475 which is a 15-year high – since 1990 gold has ranged from $250 to $480 with an average of $350. There appears a greater likelihood of mean reversion rather than further price increases but that is not part of our thesis. We think this is a good short with gold at its present highs – and even above $500 per ounce. Having said all this – if you as the reader think for some reason that we are going to $600 gold then this is probably not a short for you. Also, for those who like to hedge out certain exposures there is a gold ETF (Note: it would have been a rather imperfect hedge over recent history).

Basic Company Description: RGLD owns gold royalties. These are simply participating interests in streams of income produced from gold mines. RGLD has nothing to do with operations, owns no equipment, does not control production, etc. Plain and simple, when gold is produced from the mines – RGLD participates in a percentage of the proceeds according to a predetermined formula.

Short Thesis Highlights
- At $25 per share RGLD has a market cap of about $575mm and an enterprise value of about $475mm (this is after a recent 2mm share offering which added about $50mm to the balance sheet on top of $50mm cash that the company already had = $4.34 per share in cash)
- Depending on how one looks at the valuation (we use a few different approaches) – RGLD is overvalued buy a factor of roughly 3x. We would not expect the price to necessarily contract to ‘fair value’– but, we believe a 1/3 move to the downside is realistic
- Unlike certain short ideas where perhaps under a rosy scenario a company might be able to eventually grow into an inflated valuation – in this case we are valuing hard assets and the math is simple. Thus, the case for dramatic overvaluation is clear and can be easily calculated. It would be almost impossible in our opinion for management to grow RGLD into its current valuation – the reinvestment opportunities are simply not that great
- A change in gold prices to the downside is more painful to RGLD than a change to the upside is beneficial. This is because RGLD has sliding scale royalties which create strong negative operating leverage to a downside move and yet RGLD is capped out on percentage increases to an upside move in gold. (more detail on this later)
- We’ve not found the borrow too tight or expensive on this short

Valuation: At the end of this write-up we provide an appendix which breaks down each royalty stream individually. This exercise is quite easy to do – pages 4-8 of the recent S4 provide all the information necessary to build a quick and easy model.

For the time being, we treat all the royalty streams in the aggregate. Together, they have a weighted average life of 7 years (same calculation one would do for bond duration). The shortest is 2 years and the longest about 12 years. The life of these royalties is based on proven and probable reserves divided by estimated production per year. Of course this calculation is somewhat simplistic since the reserve estimates can change and production is not linear over the life of the mine. But, these somewhat minor changes do not alter the overall analysis significantly.

We’ve taken two approaches to valuing RGLD. First, we simply look at the current value of the royalties that RGLD owns. Also, let’s for the moment ignore the operating costs of RGLD and assume it requires no effort or cost to collect on these royalties (not the case) – as though we just receive a royalty check every month. Also, at the outset let’s assume that all of the gold is there for the taking and could be extracted today – this will allow us to initially ignore the question of what discount rate to use over the life of the royalties (essentially assumes 0% discount rate). Below are three scenarios for valuation given different prices for gold.

Scenario One: At gold $400 per ounce and silver at $7.40 (current price) – the total value of RGLD’s royalty claims is $190mm pre-tax and $132mm after tax. $132mm after tax = $5.75 per share. This amount plus $4.35 cash per share = $10.10. This is a 60% discount to the current stock price.

Scenario Two: At gold $475 per ounce (current price) and silver at $7.40 (current price) – the total value of RGLD’s royalty claims is $253mm pre-tax and $208mm after tax. $208mm after tax = $7.39 per share. This amount plus $4.35 cash per share = $11.74. This is a 53% discount to the current stock price.

Scenario Three: At gold $500 per ounce and silver at $7.40 (current price) – the total value of RGLD’s royalty claims is $266mm pre-tax and $177mm after tax. $177mm after tax = $7.73 per share. This amount plus $4.35 cash per share = $12.08. This is a 52% discount to the current stock price.

Thus even assuming 0% discount rate AND ignoring all the operating costs of the business AND if gold goes to $500 per share – the market is still valuing this stream of royalties at more than 2x what it is worth.

Clearly if the income to the trusts is coming over time, we should apply some discount rate to them. In the discussion on RGLD two years ago – someone tried to argue that the discount rate should be very low or close to zero. Their logic was that the gold is not at risk because it is in the ground and it is a good inflation hedge by nature so it should not erode in value, thus – if it is not at risk and is hedged for inflation then it should not be discounted. I understand this logic to a point but do not think it really holds up. If so, we would all be glad to take our investment dollars bury them under our porches as long as we could dig them up in inflation adjusted dollars. Is this the return on capital we are looking for? Plus, there is greater risk in the RGLD example because of the volatility in the price of gold which causes uncertainty in the value of future royalty income (e.g. risk) – thus investors should demand some positive rate of return and therefore apply some discount rate to the royalty stream. Maybe it is 5% - maybe 10% but certainly not 0%.

So if we accept that some discount rate is required let’s re-run the three scenarios from above. We will apply a reasonable discount rate (7.5%) to find out what the NPV of the royalty streams is and therefore the corresponding overvaluation in the stock.

Scenario One: $400 Gold, $7.40 Silver. At 7.5% discount rate the value of the stream of royalties plus cash on the balance sheet is worth $8.70 per share – a 65% discount to current.

Scenario Two: $475 Gold, $7.40 Silver. At 7.5% discount rate the value of the stream of royalties plus cash on the balance sheet is worth $9.94 per share – a 60% discount to current.

Scenario Three: $500 Gold, $7.40 Silver. At 7.5% discount rate the value of the stream of royalties plus cash on the balance sheet is worth $10.19 per share – a 59% discount to current.

Thus, applying a reasonable discount rate to the stream of royalties obviously suggests a lower NPV and thus greater overvaluation at the current stock price.

WAIT! This analysis is flawed because it does not give a going concern value to RGLD!

True, it does not. But, it has also not penalized the valuation for the going concern costs of running this business. That takes us to our second method of valuation. Let’s stop just treating RGLD as a stream of royalty payments and start treating it as a company with a future beyond the life of existing royalties. First we examine the costs of running the business and later we’ll consider management’s ability to reinvest income in new royalties at attractive rates of return.

We know the royalty streams that are in place at present and have valued them in detail above. What has been ignored is that there are corporate costs associated with collecting these royalties and looking for new one to invest in. These tend to run about $7mm per year in SG&A and other (obviously ignoring depletion). The NPV of this set of costs over 7 years at 7.5% discount rate (adjusted for they tax shield these costs provide) is $22.5mm.

Subtracting this amount from our NPV calculations above gives the following valuations under each scenario.

Scenario One: $7.72 share price

Scenario Two: $8.96 share price

Scenario Three: $9.21 share price

It is worth noting that this analysis still overvalues the royalty claims of RGLD. The math we use is a function of “Total Contained Ounces” of gold to which RGLD has claim. There are losses of gold during the production and processing of the deposits – these loss rates run from around 12% to 32% (see note 5 on page 5 of the S4). Mgt is somewhat non-specific about production and processing losses – it is pretty hard to know what losses will be until the production and processing actually happen. At the very least one can assume that the above valuation exercise still overstates true value of RGLD share by some material percentage.

What does all this mean? It means that based on the current price of gold, assuming a reasonable discount rate, taking into account the cost of operating the business, ignoring loss rates in production and processing (for conservatism), AND not assuming any reinvestment into new gold royalties (basically the proceeds remain in the corporate entity in cash) – RGLD is worth ~$9.00 per share. This is 64% less than the current price suggesting RGLD is 2.8x overvalued.

What accounts for this discrepancy?

Perhaps mgt are really good investors in gold royalties and therefore overpaying for this existing set of cash flows is worth it. In this case investors are essentially willing for pay $1 for something that is only worth $0.36. Think of how high a ROIC mgt will have to achieve on reinvestment to first earn out this difference and then generate any meaningful positive return beyond the $1 amount. If mgt can make 15% on their future investments (much more than gold has earned as an asset class over time) it would take 7.4 years just to turn the $0.36 into $1.

One might conclude that mgt in this case are good gold investors since past ROIs for RGLD look pretty good. The fact of the matter here is that mgt has benefited from good timing in the gold cycle – they bought royalties representing about 85% of RGLD’s value when gold was closer to $350 per ounce. If they redeploy capital today (we believe they are looking to put the $100m to work) they will be buying in an environment of $475 per ounce gold – thus, they may be essentially buying gold during an expensive time to do so. In fact, rather than being brilliant gold investors mgt may have come closer to building a nice lifestyle company in which they can continue to raise money to purchase gold royalties and pay themselves pretty well ($425k base for CEO).

We believe that shareholders are dramatically overpaying for RGLD - $9 worth of assets and mgt is not worth the other $16 of share price.

What else is there to know?

- There was a fair amount of insider selling earlier this year in the high teens
- Merrill Lynch covers the company. We spoke to their analyst who basically said he initiated on the company at $19 with a ‘Neutral’ because he thought the valuation was way out of whack – by his math, fair value is something like $7.50 per share
- Reserves are an imperfect number – sometimes estimates go down when less gold is found than thought, sometime reserves and mine life go up when more ore is discovered during the mining process (RGLD looks to properties with potential reserve growth – as do other buyers of gold royalties)
- About 60% of RGLD royalties are on what is called ‘sliding scale’. In the case of their largest royalty which accounts for more the half the value of the company – if gold goes to $350 per ounce the company will get 3% of production, at $475 per ounce they get 5% of production. Thus – a 26% decline in the price of gold results in a 56% decrease in revs from these royalties. The sliding scale creates dangerous negative operating leverage. Also, at current gold prices the effect does not work in reverse. A 10% increase in the price of gold would only mean a 10% increase in revs because RGLD is capped out at current percentages on its two largest claims.


Risks and Catalysts
- Price of gold – a negative move will hurt RGLD more than a positive move will help due to sliding scale nature of royalties. Also, we believe that even at higher gold prices RGLD is still dramatically overvalued.
- Potential downgrade to ‘Sell’ from Merrill Lynch if stock price lingers above $25
- Managements buys some new royalties and investors can see that the implied ROI on new investments is not all that great – outsized returns only occur in a rising gold price environment. Mgt was lucky the first time and bought when gold was at $350 and it is now $475. Now royalties are also more expensive and thus they will get claim on fewer ounces for the same dollar investment. This may show the Street that simply buying gold royalties and collecting on them is not an inherently high return endeavor
- More insider selling
- This stock has achieved such lofty valuations before – historically it has dropped back pretty quickly into the teens. This is not exactly a catalyst but perhaps this historical pattern will repeat itself.

Appendix

Below please find a summary of the royalty streams that RGLD owns. I suggest those interested in building their own model use the information provided in the recent S4 as well as the RGLD investor presentation provided on the company website. For purposes of the below calculations we use $475 as the price of gold. We have a more detailed model that looks at the different values for the royalties given different gold prices – for simplicity though we have not provided that sensitivity below.

The Pipeline Complex contains four royalty streams – the anticipated life of the mines where RGLD holds royalties is 6-7 years. Royalties and valuations are:
- GSR1 – Contained units are 5.745mm. At $475 gold RGLD has claim on 5% of these. That equates to $137mm over the life of the royalty
- GSR2 – Contained Units are 0.258mm. At $475 gold RGLD has claim on 9% of the units. That equated to a value of $11mm.
- GSR3 – Contained Units are 6.013. At $475 gold RGLD has claim to 0.71%. That equates to a value of $20.3mm.
- NVR1 – Contained Units are 3.511mm. At $475 gold RGLD has claim to 0.39%. That equates to $6.5mm.

Thus, the rough value of RGLD’s royalties at Pipeline is $175mm. That is a pre-tax amount spread over ~7 years.

The SJ Claims have an estimated life of 12 years. Contained Ounces are 9.679mm and RGLD has claim to 0.9%. This equates to $41.4mm.

There a two royalties at Leeville. The weighted average life at Leeville is about 5 years.
- Leeville North: 2.56mm Contained Units and RGLD has claim to 1.8%. This equates to $21.9mm.
- Leeville South: 0.115mm Contained Units and RGLD has claim to 1.8% for a value of about $1mm.
Thus, Leeville in total is about $23mm pre-tax over five years.

There are both Silver and Copper Royalties at Troy – the life is about 4.5 years for both:
- Troy Silver: 12.275 contained units at 7.0% = $6.4mm
- Troy Copper: 102mm contained units at 7.0% = $12.2mm (this is based on recent per pound prices for copper of $1.71)
BUT – When distributions to RGLD reach $10.5mm then RGLD gets stepped down dramatically in their percentage take - to about 2%. Therefore – we expect that they will hit this cap sometime in year three and perhaps at 2% get another $1mm to $2mm. Thus the value is $11.5mm to $13.5mm.

Bald Mountain (two year life) is a single royalty on 0.44mm - Contained units at 1.75%. This equates to $3.7mm.

Martha Mine (two year life) Contained Units of 3.9mm ounces of silver at 2% = $0.6mm

The combined value of all these claims (assuming constant current commodity prices) is ~$255mm pre-tax over an average life of 7 years. We assume that the tax shield is roughly the remaining book value ($45mm) of the royalties depreciated over this period of time plus $7mm per year in cost of operating the company.

There are a few other small claims listed in the S4. We believe these have little to no material value based on purchase price and comments from company management.

Catalyst