Value Investors Club / Royal Gold, Inc. (RGLD)

Description

ROYAL GOLD, INC. - SHORT

INVESTMENT SUMMARY

Royal Gold is in the business of acquiring and managing various metal royalty streams throughout the world. The company has a passive interest in mining projects and does not operate any mines. Shorting RGLD stock represents an excellent risk/reward given its lofty and unjustified 3.6X multiple to NAV, leveraged downside to precious metal prices via sliding scale royalty contracts, and the opportunity to hedge out gold and silver exposure and therefore mitigate commodity price risk in the position. Note that engrm842 and mitc567 wrote up Royal Gold on VIC as a short in October 2005 and February 2003, respectively.

THE BUSINESS AND COMPETITIVE POSITION

Royal Gold owns precious metal royalties, primarily through participating interests in streams of income produced from gold and other various commodity mines. The company is not involved at all with any operations or mining. Whenever various metals are produced by the mines, Royal Gold secures a percentage of the proceeds according to an agreed upon, sliding-scale royalty formula. The company primarily derives its royalties through properties in Nevada and Mexico, including the Pipeline Mining Complex, the Robinson project, the SJ Claims project, the Leeville project, the Bald Mountain Mine, and the Peñasquito mines. In addition, the company owns royalty interests in various properties located in Mexico, Argentina, West Africa, Bolivia, Chile, Canada, Nicaragua, Australia and various other parts of the U.S. The company also recently acquired royalty interests in Barrick’s non-core mines.

Over the years, Royal Gold has diversified its metal exposure away from solely gold. Below is a breakout of each metal based on its NAV. Note that the company’s gold and silver exposure can easily be hedged out from the short position.

Breakout of Metals-to-NAV:

Gold 66.3%

Silver 12.9%

Zinc 8.0%

Copper 6.6%

Lead 2.9%

Potash 2.3%

Nickel 0.9%

Molybdenum 0.1%

Due to the weak economic and financing environment, Royal Gold has recently come into favor as many mine operators are unable to secure financing to continue working on and exploring mines. This has given Royal Gold a temporary lift which is not likely to be sustainable over the longer term given that mine operators prefer to use financing or royalties from larger operators with expertise, which Royal Gold does not have.

INVESTMENT CONSIDERATIONS

Valuation:

Royal Gold is not a mine operator and should not be valued as one.

The value in the company comes from the following:

- Existing reserves of precious metals in the ground

- Additional reserves found in existing holdings or successful exploration of additional holdings

- Reinvestment opportunities

- Issuing overvalued shares

Below is an analysis of the existing precious metals in the ground which make up the vast majority of value in Royal Gold. Although various scenarios have been modeled, the analysis below is a static table for simplicity of presentation with precious metals at current spot prices. While some mines provide a flat royalty rate regardless of the price of the specific metal being drilled in that mine, others operate on a sliding scale. Thus, as commodity prices increase, the royalty rate paid to Royal Gold from the sliding scales increases as well. The majority of royalty rates are gold-price specific. However, the critical issue here is that Royal Gold has already maximized all of its upside with respect to its sliding scale contracts as gold prices have risen significantly, so NAV will now move essentially in line with the price of the commodities as commodity prices increase and fall faster than commodities as commodity prices decrease. If rising precious metal prices are of concern to investors, this can easily be hedged out by purchasing GLD and SLV.

		Market	Contained	Revenues	Discount	W.A. Life
	Royalty	Price	Units (mm)	($mm)	Rate	(years)	NPV ($mm)

Pipeline Mining Complex at Cortez, NV
GSR1	5.00%	$857.40	1.6490	$70.7	8.50%	5.2	$46.2
GSR2	5.00%	857.40	0.2730	11.7	8.50%	5.4	7.6
GSR3	0.71%	857.40	1.9230	11.7	8.50%	5.2	7.7
NVR1	0.39%	857.40	1.3870	4.6	8.50%	5.7	2.9

Robinson	3.00%	857.40	0.7720	19.9	8.50%	6.7	11.5
Robinson (Copper)	3.00%	1.43	1,563.0000	67.2	8.50%	10.4	28.7
Robinson (Moly)	3.00%	9.75	1.0000	0.3	8.50%	1.0	0.3

Leeville N	1.80%	857.40	2.1610	33.4	8.50%	5.2	21.8
Leeville S	1.80%	857.40	0.0000	0.0	8.50%	5.2	0.0

Goldstrike-SJ Claims	0.90%	857.40	6.9600	53.7	8.50%	8.8	26.2

Troy (Silver)	7.00%	11.12	6.4450	5.0	8.50%	5.0	3.3
	6.10%	11.12	1.7000	1.2	8.50%	5.0	0.8
	2.00%	11.12	1.9410	0.4	8.50%	5.0	0.3
Troy (Copper)	7.00%	1.43	53.7890	5.4	8.50%	5.0	3.6
	6.10%	1.43	14.1000	1.2	8.50%	5.0	0.8
	2.00%	1.43	16.6440	0.5	8.50%	5.0	0.3

Bald Mountain	1.75%	857.40	0.8890	13.3	8.50%	10.0	5.9

Penasquito	2.00%	857.40	13.0510	223.8	8.50%	17.0	55.9
Penasquito (Silver)	2.00%	11.12	863.8590	192.1	8.50%	17.0	48.0
Penasquito (Zinc)	2.00%	0.54	12,808.0000	137.8	8.50%	17.0	34.4
Penasquito (Lead)	2.00%	0.52	5,886.0000	60.6	8.50%	17.0	15.2

Mulatos	1.50%	857.40	1.6890	21.7	8.50%	14.1	6.9

El Chanate	4.00%	857.40	0.8320	28.5	8.50%	16.6	7.3

Taparko	15.00%	857.40	0.8000	27.6	8.50%	3.0	21.6

Siguiri	1.88%	857.40	2.6290	42.3	8.50%	7.0	23.9

Martha	2.00%	11.12	8.2930	1.8	8.50%	2.6	1.5

Don Mario	3.00%	857.40	0.4380	11.3	8.50%	6.0	6.9
Don Mario (Silver)	3.00%	11.12	8.1530	2.7	8.50%	6.0	1.7
Don Mario (Copper)	3.00%	1.43	0.1800	0.0	8.50%	6.0	0.0

El Toqui	3.00%	857.40	0.1670	4.3	8.50%	7.0	2.4
El Toqui (Zinc)	3.00%	0.54	759.0000	12.2	8.50%	7.0	6.9

Williams	0.72%	857.40	0.8470	5.2	8.50%	6.7	3.0

Allan (Potash)		800.00	90.0000	21.8	8.50%	7.0	12.3

El Limon	3.00%	857.40	0.2170	5.6	8.50%	5.0	3.7

Balcooma	1.50%	857.40	0.0180	0.2	8.50%	7.0	0.1
Balcooma (Silver)	1.50%	11.12	1.8420	0.3	8.50%	7.0	0.2
Balcooma (Copper)	1.50%	1.43	135.0000	2.9	8.50%	7.0	1.6
Balcooma (Zinc)	1.50%	0.54	185.0000	1.5	8.50%	7.0	0.8
Balcoona (Lead)	1.50%	0.52	73.0000	0.6	8.50%	7.0	0.3

Mt. Goode (Nickel)	1.50%	5.15	116.0000	9.0	8.50%	7.0	5.1

Dolores	1.25%	857.40	2.4440	26.2	8.50%	10.0	11.6
Dolores (Silver)	2.00%	11.12	126.6450	28.2	8.50%	10.0	12.5

Pascua-Lama	1.08%	857.40	14.6000	135.2	8.50%	10.0	59.8

Gold Hill	2.00%	857.40	0.7500	12.9	8.50%	10.0	5.7

Marigold	2.00%	857.40	0.8670	14.9	8.50%	8.0	7.7

Benso	1.50%	857.40	0.2520	3.2	8.50%	10.1	1.4

Meekatharra	$10 per pound	857.40	0.3080	2.0	8.50%	7.0	1.1

Wharf	2.00%	857.40	0.2200	3.8	8.50%	7.0	2.1

Holt-Holloway	0.00013 Au*	857.40	0.4860	0.0	8.50%	7.0	0.0



	Pre-tax value of royalty claims			$1,340.5			$529.7
	Tax-rate			31.0%			31.0%
	After-tax value of royalty claims			925.0			365.5

	FD shares outstanding			34.23			34.23

	After-tax value per share			$27.02			$10.68
	Implied cash royalty value			1.84			1.84

	Total NAV per share			$28.86			$12.52

	Current share price			$44.65			$44.65

	Current share price to NAV			1.55x			3.57x

The analysis above is focused on the NAV of Royal Gold from a discounted cash flow perspective, conservatively assuming that it costs literally nothing to run the business. Also, the analysis ignores the slippage between gold in the ground and what is actually sold, about 10-20%, while also only accounting for proven and probable reserves.

The above analysis provides numbers based on 0% and 8.5% discount rates. In no other business would one use a 0% discount rate, but the reality is that investors are happy to hold gold with no interest. So, should the company’s discount rate be 0% as well? Since the company is a financial asset, not a real asset, even though its assets are commodities, it does not make sense to discount it at the same rate as the commodity, but rather to apply a normalized, financial discount rate. It is important to note that because investors can hedge out the value of gold and silver attributable to Royal Gold, it is most reasonable to value the company with NAV based on a discount rate.

Reason for Shorting the Stock: At $44.65 per share Royal Gold has a market cap of $1.53bn and an enterprise value of about $1.47bn. RGLD currently trades at 3.6X NAV. While it is unlikely the current price will decrease to NAV, an NAV of 1.5X (a decrease of approximately 58% from the current price) is reasonable.

As Royal Gold has grown larger since its inception, it is increasingly difficult for the company to find similar reinvestment opportunities to what it has historically found. Royal Gold would need to spend a very large amount of money to move the needle today, making it quite difficult for management to expand the company into its current valuation. Also, since Royal Gold has sliding scale royalties (which are currently maxed out), a change in commodity prices (primarily gold) will have a stronger negative impact if prices fall compared to a positive impact if prices rise.

Although management is not fraudulent, they have historically adopted very aggressive accounting practices with respect to the deal at Taparko Mine. In exchange for $35mm of financing, Royal Gold will receive production payments over time from the mine operator, High River, until they are paid back this $35mm loan. Royal Gold will then receive a nominal tail royalty of 2% based on gold production from defined areas of Taparko. This deal is essentially project financing and the return of principal is being booked as royalty revenue and thus cash flow. Management should rightfully have structured the deal as a loan with warrants. The cash flow is being capitalized by the market even though it will tail off significantly once the $35mm is paid back. In addition, the Taparko mine has faced various challenges/issues since its inception by Royal Gold. At the current time, Royal Gold has only been repaid approximately $7.4mm of the loan, and it does not seem too likely that the entire amount will be repaid because of significant problems with the mine.

How to hedge? If investors do not have a view on the price of gold or silver, or are concerned they may rise, they can hedge this risk by purchasing shares of GLD and SLV, the most liquid gold and silver ETFs, respectively. It arguably makes sense to hedge roughly 1.5X-2.0X the NAV of Royal Gold with respect to the appropriate metal breakdown of gold (66.3%) and silver (12.9%). 1.5X-2.0X NAV is an appropriate hedge ratio because the price of RGLD will likely contract to this value, if not lower, over time.

Why is the price of the stock so high? Management has benefited from good timing in the commodities cycle. They bought royalties representing the majority of Royal Gold’s value when gold was closer to $400 per ounce. If they redeploy capital today they will be buying in an environment of $850+ per ounce of gold. Thus, they are essentially buying gold during an expensive time to do so.

Retail investors in particular see Royal Gold as an easy play on the price of gold. Over time, it has been a nice levered play given the company’s increasing percentage royalties as gold has gone up in price. However, investors are missing several key points:

- The company has no more upside to sliding scales.

- The company has real depreciation based on what it paid for the royalties. The cash flow is not all profit, and replacing the very valuable Pipeline/Cortez/Robinson mines will be difficult.

- There is likely little opportunity to reinvest in royalties at high rates both because there just are not many royalties out there and because those groups that do want to offer royalties would prefer to get them from a big operator with expertise, which Royal Gold does not have. While more mines are in need of sources of financing in this economic environment (which Royal Gold can potentially provide with its cash position and revolver availability), the company would need to invest in increasingly larger scale mines to have a material impact. There are not many opportunities of this kind.

- There is likely not big upside in either the existing producing properties or the exploration activities since the majority of mines are older and their reserves have been clearly established and stated.

- The company should not trade in line with other mine operators because it adds no value and provides no expertise to the mining operations in which it owns royalty streams. Hence, the market is placing a multiple of approximately 3.6X NAV on a company that should trade more in-line with NAV.

RISKS

Commodity price risk: A highly inflationary environment in the U.S. poses the risk of gold and silver prices increasing in the future. However, investors can protect against commodity price risks through hedging in GLD and SLV.

Significant share count increase: If the company issues a significant amount of shares at an already expensive valuation, that could make it harder for the market to eventually realize Royal Gold’s NAV.

Acquisition of significant mines: If Royal Gold is able to acquire large-scale mines for relatively low cost, its NAV could increase. However, the company would need to purchase significantly larger mines than it has historically, while not many of these opportunities exist.

CONCLUSION

Shorting RGLD is an excellent risk/reward. Royal Gold is currently trading at 3.6X NAV per share, greatly overvaluing the future royalty streams of the business. Furthermore, the company has maxed out all of the upside in its sliding scale royalties and now is levered to declining precious metal prices. As referenced above, investors can hedge out the risk of gold and silver price movements, thereby limiting commodity exposure in the position.

Catalyst

Although this investment is not at all “catalyst” based, the stock price will likely decrease as investors realize the large discrepancy between the current market price and intrinsic value of RGLD.

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			2009	2010
Price:	44.65	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	1,528	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT
Borrow Cost:	NA