Description

Gold is at an inflection point and no one is paying attention. Gold did not decline when real rates were rising and is now close to its ATH when real rates are declining. This is real strength. 

We believe the best way to play gold is through precious metals royalty and streaming companies. The idea presented today is a mid-cap company - Triple Flag Precious Metals - that has all the quality characteristics of a large cap but comes at a (relative) valuation discount.

Generalists typically gravitate towards Franco-Nevada or Wheaton for exposure to gold upside. Franco has some 'hair' now as the future of their big investment in First Quantum's Cobre Panama's mine is uncertain. While they may be ultimately able to get a favorable decision, the current uncertainty and the possibility of a writedown will not let the stock re-rate. Wheaton is a good quality company but valuation is already stretched at 30x LTM and 23x NTM EBITDA. Due to this, we look for the next best opportunity and land on Triple Flag. 

Business model

Our preferred vehicle for investing in gold are precious metal royalty and streaming companies (in addition to physical gold). These are high quality companies that also meet my Buffett-esque yearn for yield (and compounding)! Even if you do not believe in Gold, these assets can do very well even if gold can maintain its current price. Importantly, this is a ‘hedge’ for the portfolio that is uncorrelated, pays a dividend, and has upside potential even in a normalized market.

Precious metals royalties companies are businesses that lend capital to a mine in return for a royalty or stream on the precious metals produced from that mine. There are three arbitrages here; 

First, mining is a tough business. It takes years to explore for minerals, conduct feasibility studies, and finally build a mine. All these activities require cash with the aspiration that one day the mine will enter production and generate free cash flow.  There is a cash flow mismatch. Equity or debt capital are not suitable due to which a royalty or stream is initiated which provides the mine operator capital to explore and build the mine while incurring no cash flow mismatches. 

Second, a lot of gold and silver is actually a by-product of base metal production. A base metals miner can ‘sell’ its gold and silver to royalty companies in exchange for cash upfront which helps lower their risk and cost of capital on their core business. No extra points for a copper company producing gold! 

Third, investors value royalty cash flows at a much higher multiple compared to operators which has led mining companies to spin-out or sell their royalty portfolios to independent companies.

Over the last 10 years, royalty and streaming companies have outperformed the broader group, including Gold, GDX and the TSX Gold Index

Some basics on royalty companies:

• A royalty is usually structured at a % of annual production where the royalty company has no further obligation but the operator has the obligation to cut the cheque every year. On the other hand, a stream is a contract where the mine operator contracts to sell the precious metal output at a certain price (or a certain discount to spot) to the royalty company 

• The attractive part of a royalty deal is that it is usually perpetual. This means that if the mining company keeps spending capex to increase supplies from the mine, the original royalty holder keeps getting paid! Due to this, it is a better inflation hedge compared to a mining company which will have inflation in its labor and equipment. 

• A royalty company is no different than an asset management company. Long term success of the venture depends on the capital allocation prowess of the management. With loose monetary policy, royalty deals have been written at very low IRR’s or with unfavorable clauses such as buyout provisions. The royalty companies are essentially a 5-10 people operation with a core team that is underwriting investments with the capital they have at their disposal. Over time, this deployed capital should return cash flow and that is the only way of (a) judging management, and (b) valuing these businesses. 

Over the last five years, trading multiples for the royalty and streaming companies have reached as high as an average of 2.5x P/NAV and 29x P/CF when the gold price approached $2,000/oz. However, at today’s spot prices, the royalty and streaming peer group trades at ~1.6x P/NAV and ~19x P/CF which is at the lower end of their historical range. 

Triple Flag

Triple Flag is 67% owned by Paul Singer's Elliott Management. Elliott is not a mining investor but there were concerned around inflation. They wanted exposure to gold and really liked the royalty and streaming model due to all the attributes of the model we will discuss in this report. However, they reckoned that instead of just buying Franco-Nevada, they create a Franco-Nevada like vehicle themselves. They hired Shaun Usmar who was ex Barrick and Xtrata to build a royalty and streaming company. 

The royalty and streaming industry is fairly concolidated. The reletive deals one sees depends on their balance sheets. Only Franco, Wheaton, and Royal Gold could do the biggest deals. The benefit of having Elliott allowed Triple Flag to immediately compete with the big 3 for deals. They deployed about $1.7 bn in capital that all came from Elliott ($1.1 bn net excluding debt). They were targeting producing or near producing so that capital could be recycled faster. 

They started Triple Flag in 2016 when there was a lot of balance sheet repair happening across the mining industry. They bought some small royalties and streams on good quality assets in Canada but their big deals came around Covid. In the last few years, they have grown from 34K GEO’s in 2018 to 100K GEOs in 2023 and from 79 to 200+ assets.

Importantly, they have a guidence for an average of 140k GEO's for 2024-2028 which means that we should be seeing about 40% growth in volume over the next 5 years. Even if gold remains here, revenues and earnings should grow at 40%+. 

Source: TFPM

Here are their biggest assets:

NorthParks

-24% of NAV

-Large copper mine in Australia

-Has been producing for 30 years and has gold and silver as byproducts

-Their single largest investment at $550 mn

-A lot of room to increase capacity with grades higher in some of the new areas (E22)

RBPlat

-9% of NAV

-PGM mine in South Africa

-Invested in 2019 and streamed the gold byproduct

-Their investment was $145 mn

-Mine life here should be 30 + years

CerraLindo

-8% of NAV

-Copper mine in Peru

-Invested in 2016 to stream silver

-Some production delays earlier this year due to weather conditions but normal now

The rest of the assets are sub 5% but the portfolio is diversified across Canada, Australia, and then South Africa and South America. I believe it has better jusrisdictional risk compared to many of its peers. They have 29% of assets that produce 80% of NAV and the balance of all assets are only 20% of NAV and are yet to produce but are the biggest source of growth and optionality at the company. Assets like Hope Bay, Eskay Creek, Tamarack . This option will only get valued at higher gold and silver prices, which we believe are coming. 

In 2021, they bought a small cap company called Maverix that had a large exploration portfolio. This further consolidated the industry and gave TFPM a lot of optionality in their portfolio. Maverix bought in 140 assets and increased diversification of the portfolio. It also increased liquidity as it reduced Elliott's stake from 82% to 63%. Elliott has since then bought stock in the open market to up their stake to 67%. 

However, not all deals were successful. Over 2017-2021, Triple Flag recorded ~$40M in impairment losses on the Renard diamond stream due to depressed diamond industry conditions combined with a temporary COVID-19-related shutdown of mining operations.

Source: TFPM

From here, M&A, especially in Copper, is an opportunity for the industry. Royalty and streaming companies can provide capital in these deals to help bridge financing for transactions. Especially today when debt is expensive and equity is even more expensive and harder to raise. 

The royalty and streaming business is very similar to the asset management business where one has a bunch of cash and this cash then needs to be deployed taking into account both risk and reward. The management team here are holders of stock and have been been incentivized to generate ROE vs. simply doing deals. Not every deal is the same. There are deals with significant step down provisions where one loses the optionality that comes with a royalty deal. TFPM management looks at transactions with risk adjusted returns.

Valuation

Here are the trading multiples for FNV and WPM over the last 10 years. I am using EV/EBITDA as EBITDA for these companies is very close to operating cash flows. We observe that these companies trade at very high multiples >35x when gold and silver prices are rising but, on average, trade at 20-25x EBITDA. We can also clearly see the multiples diverge for WPM and FNV due to FNV's current issues. 

TFPM is trading at 18x LTM and 15x NTM EBITDA. TFPM is producing around $150 mn in FCF per year out of which ~$40 mn is distributed as dividend but the balance is for deals. 

While not a big discount we will note that the thesis is inflection in the price of gold and silver and investors increasingly looking to other high quality royalty companies as an alternative to Franco. We don't have a price target on this but believe there is significant upside if we are proven right on our near term outlook for gold. As an example, if gold goes to $2,200 then the EBITDA that TFPM will produce will be close to $250 mn i EBITDA giving us a 11x EBITDA valuation at current EV. 

Some investors may prefer direct exposure to mining compaies as valuations are very depressed and if inflation is declining then their operations will incrementally become better. The risk is that if our assumptions are not correct then the downside is much larger than royalty companies due to the very different opex structures. In the case of TFPM, they have a near cash balance sheet, 1.5% dividend yield, and growth and optionality in the portfolio. 

Thoughts on Gold

How one manages risks is very specific to any individual/firm. The below are my thoughts on gold and I allocate 10-15% of the portfolio in precious metal royalty companies as a hedge to a long only portfolio. 

In the last 40 years, we have been in a supercycle fueled by demographics, ever declining interest rates, borrowings and spending by both households and corporates, China’s accession to the WTO, cheap commodities, favorable regulations for businesses, and a relative decline in bargaining power of labor. A lot of business models that are taken for granted today would not have been possible if money was not this cheap money. What if the last 40 years is an anomaly? What if the market regime shifts again? Is a 100% equity allocation the best path forward?

But, how do you value Gold? What is its intrinsic value? 

The simple answer is that gold is a currency and should be valued as such. The way I think about gold is that it is a zero coupon bond in its own currency with no controlling authority. 

The characteristics of USD are: 

• USD has unlimited supply (the Fed just printed or “created”) 80% of all USD in existence in the last three years. 

• USD has a yield. So we can invest for 5 years or 10 years in US treasuries at a certain yield that compensates one for the time value of my money. Many times, this yield is less than the prevailing rate of inflation leading to what some call financial repression. 

• We can keep this USD at a bank where it is my asset but their liability. With the US's sanctioning of Russia’s reserves or the Canadian government’s freezing of trucker’s bank accounts means this liability does not have to be honored.

With record deficits and record debt, we know that the western economics are in a tough position. If nothing else, the probability of higher deficits increases the probability of higher debt balances. 

At a minimum, we can agree that, in the long term, fiat currencies should decline against real assets.

The characteristics of Gold are:

• Gold has limited supply increase of about 1.5-2% per year on average. There is constant demand for gold from jewelry and central bank purchases of gold. 

• Gold does not have a yield and in fact demands some costs for safe keeping. For simplicity, let's assume that the carrying costs are zero. 

• There is no counterpart or controlling authority

In essence, gold does well when:

• Real yields on fiat are negative

• Supply of fiat is expanding much faster than gold

• Authorities that manage fiat are acting irresponsibly or market participants want a ‘outside the system’ asset

There is a myth that gold is an inflation hedge. It is not! Gold is a financial repression hedge. 

Further to this, the core characteristics of gold are particularly highlighted during a market event. Gold is seen as a ‘safe haven’ asset. A part of this is its historical role as ‘no-one’s liability’ but another part of this is the very predictable sequence of - crises -> more money printing/lower rates -> lower real rates -> higher gold. Gold does sometimes go down initially in order to meet margin calls but is one of the first assets to rebound. 

Catalyst

-Gold Price

-Growth