Why Mining Royalties Are Becoming the Preferred Resource Investment

• Royalty companies in the mining industry provide lower-risk exposure to commodities by collecting a percentage of revenue from mining operations without operational costs or risks.
• A recent significant transaction involved Orogen Royalties' tier one royalty on the Silicon deposit being acquired by Triple Flag, highlighting the value and scarcity of tier one royalties.
• The tier one royalties (on large-scale assets in good jurisdictions) are rare in small public companies and carry premium valuations of 10-20x revenue.
• Only cash-flowing royalties or those with clear paths to production have significant value.

Mining royalty companies represent a unique investment opportunity within the resource sector, offering lower-risk exposure to commodities while avoiding many of the operational challenges faced by traditional mining companies. In a recent discussion between Samuel Pelaez, President & CEO, and Derek Macpherson, Executive Chair, at Olive Resource Capital, the value of royalty investments was explored in detail, with particular focus on recent market developments and investment opportunities in this space.

The discussion was particularly timely given the recent news of Orogen Royalties' tier one royalty on the Silicon deposit being acquired by Triple Flag, highlighting the scarcity value and premium pricing that quality royalty assets can command in the current market environment.

Understanding the Royalty Business Model

Royalty companies operate on a fundamentally different model than traditional mining operations. As Sam explained, 

"The concept is an individual or a corporation has a right to a percentage of the revenue, typically in gold described as the net smelter return." 

This provides exposure to commodity prices without the corresponding exposure to operational costs or risks.

The royalty model originated in the oil and gas industry but has been successfully applied to mining, particularly in gold where the returns are straightforward to calculate. Typically, these royalties are set at 1-2% of revenue, as higher percentages can make project development challenging when combined with government royalties.

The key advantage of royalty companies lies in their risk profile. They have "no exposure to the cost portions or the risk that's attributable to cost overruns and margin compression," with their sole exposure being to commodity prices and production success. Additionally, most royalty agreements include rights to any exploration upside, covering new discoveries within an area of interest.

The business model is notably capital-light. Derek highlighted Franco Nevada as an example, noting their C$46 billion market cap with only "30 or 40 employees." Once due diligence is complete and royalties are secured, the business essentially involves waiting for royalty checks to arrive.

Premium Valuations & Market Appeal

Royalty companies typically command premium valuations compared to traditional mining companies. The discussion noted that they generally trade at 10-20 times revenue, with Franco Nevada at the upper end of this range. This reflects their lower risk profile and appeal to generalist investors seeking gold exposure without the complexity of evaluating individual mining projects. As Sam explained:

"When a generalist investor comes over for the first time to the gold market, typically the first purchase is Franco Nevada... because ultimately they're chasing gold exposure, not exposure to individual projects."

This broader market appeal has contributed to their strong performance, with Franco Nevada up 43% year-to-date.

Compass, Episode 12

The Scarcity Value of Tier One Royalties

The expert discussion focused on the concept of "tier one royalties" – royalties on large-scale assets in good jurisdictions. These premium assets are rarely held by small public companies, with most belonging to major players like Franco Nevada, which holds royalties on significant mines like Macassa, Fosterville, Detour, and Gold Strike.

The duo highlighted two examples of tier one royalties that emerged in smaller companies: Great Bear Royalties and Orogen Royalties. In both cases, they identified significant valuation gaps between the royalty company and the underlying potential of the assets.

Orogen Royalties recognized the potential value of their royalty on AngloGold Ashanti's Silicon-Merlin project in Nevada. As Anglo continued drilling and expanding the resource to what is now approximately 16 million ounces, the value of Orogen’s 1% net smelter return (NSR) royalty increased substantially.

The recent acquisition of this royalty by Triple Flag valued it at approximately 15-16 times projected annual revenue, based on estimated production of 500,000 ounces per year. At a 1% royalty and assuming $3,000 gold, this represents annual revenue of approximately $15 million to the royalty holder.

Evaluation Methodology for Royalty Companies

The duo outlined their approach to evaluating royalty companies, emphasizing that they only ascribe value to royalties that are either currently cash-flowing or have a clear path to production. As Derek noted:

"A royalty that isn't producing cash flow or doesn't have a clear path to production is worth zero."

Their valuation methodology considers two primary approaches:

• Revenue Multiple: They evaluate royalties based on projected annual revenue multiplied by an appropriate multiple (typically 10-20x). For example, a royalty expected to generate $15 million annually might be valued at $150-300 million.
• Resource-Based Model: They also consider the in-situ value of the resource, applying a percentage (typically 50-80%) to the total resource value multiplied by the royalty percentage.

The duo noted that royalty companies often display a "hockey stick" revenue curve as projects move from development to production, creating significant rerating opportunities when these inflection points are reached.

For Investors

Mining royalty companies offer a distinctive value proposition for investors seeking exposure to precious metals and other commodities with reduced operational risk. The premium valuations these companies command reflect both their lower risk profiles and their scarcity value, particularly for royalties on tier one assets in favorable jurisdictions.

For investors, the key is identifying royalty companies where the market has not fully recognized the value of existing royalties or where near-term catalysts like projects moving to production could trigger significant re ratings. Particularly attractive are situations where a smaller royalty company holds a disproportionately valuable tier one royalty, as was the case with Orogen Royalties.

As gold prices remain strong, royalty companies continue to offer an appealing way to gain leveraged exposure to the precious metals sector without taking on the full range of risks associated with mining operations. Their capital-light business models, exposure to exploration upside, and inflation-resistant revenue streams make them worthy of consideration for both specialist resource investors and generalist investors seeking diversified commodity exposure.