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TABLE OF CONTENTS Mar 24 - 30, 2014 Volume 100 Number 6 - 0 comments

Analysts like gold-focused royalty firms

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Royalty and streaming companies make good investments, argue Raymond James analysts Alex Terentiew and Ross Yakovlev in a recent note.

The analysts, referring to both types of firms as royalty companies for simplicity, compared Royal Gold (TSX: RGL; NASDAQ: RGLD), Silver Wheaton (TSX: SLW; NYSE: SLW), Sandstorm Gold (TSX: SSL; NYSE-MKT: SAND) and Franco-Nevada (TSX: FNV; NYSE: FNV) to their gold-mining peers. And they found that the average price-to-earnings ratio was on average 50% higher for the royalty companies, concluding that these firms, in their view, deserve higher valuations for several reasons.

One reason was that they have “strong operating margins, protected by a low and generally fixed cost base,” the analysts note.

Royalty firms normally don’t contribute to the capital, operating and sustaining costs of building and running a mine beyond the set per-ounce stream payments, leading to lower all-in costs.

“With no capital costs, and operating costs limited to stream payments . . . royalty companies realize all-in costs per ounce that are less than half of the costs incurred by their mining peers,” the analysts comment.

Given their fixed costs, royalty firms are less sensitive to commodity price fluctuations. For example, if commodity prices increase, input costs will increase and margins will shrink for miners, while royalty firms will experience better margins, as their costs are set, Terentiew and Yakovlev say. They add that these companies also benefit from lower overhead costs, as they employ less employees. 

The analysts found these reasons provide royalty firms — particularly Franco-Nevada and Silver Wheaton — lower capital costs, meaning they can access debt cheaper than their peers Newmont Mining (TSX: NMC; NYSE: NEM) and Barrick Gold (TSX: ABX; NYSE: ABX).

Looking at risks, many royalty firms have lower financial and environmental risks, because they invest in projects that have environmental permits and secure funds. But they may be exposed to operating risk.

That said, Terentiew and Yakovlev note that these firms spread operating risk over many investments, as they tend to boast more diversified portfolios.

And royalty firms — unlike gold miners that get their ounces from gold mines — receive most of their gold as a by-product from base-metal mines, which brings down commodity specific risk and supports cash-flow, the analysts note.

Royalty companies tend to benefit from exploration success, which could extend a mine’s life or production rate and improve cash flows for a mine’s royalty holder at no extra cost.

These firms tout a history of growing dividends. Royal Gold has bumped up its annual dividend since 2003. Franco-Nevada and Silver Wheaton have both increased their dividends since introducing them in 2008 and 2011, the analysts say.

They add that despite the tumbling gold price in 2013, these three firms hiked up their dividends last year, whereas Goldcorp (TSX: G; NYSE: GG) was the only major gold producer to do so, in contrast to Barrick and Newmont.  

Royal Gold and Silver Wheaton remain Raymond James’ top picks, with target prices of US$83 and US$31, and “strong buy” ratings.  

“We continue to prefer these two companies due to their superior asset quality, low costs, strong cash flow, sustainable dividends, attractive relative valuation and lower operating risk in a declining gold price environment, versus Franco-Nevada and Sandstorm, which get more of their revenues from gold mines,” Terentiew and Yakovlev note.

They have a US$48 target and “market perform” rating on Franco-Nevada, and a US$7 target and “outperform” rating on Sandstorm.

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