“One of the places I'm deploying my own capital right now is in the royalty and streaming space,” Rick Rule, CEO of Sprott US Holdings, said during our recent interview at PDAC. Rick also addressed two common objections investors have regarding royalty and streaming companies as well as what makes these companies so attractive right now. What follows is the transcript of our discussion on royalty and streaming companies.
Bill: Rick, what’s your thoughts on royalty companies? This is a genre of company I’ve been turned on a lot more to in the past year. What are your general thoughts?
Rick: If you could expand the discussion to royalty and streaming… love the space. There are some knocks on the royalty and streaming companies. The most common two knocks are that they trade at higher valuation multiples than the rest of the industry, which is true. The other is that their greatest period of growth is behind them, which is false, but let’s observe those two from the first instance, the valuation discussion. They deserve to be priced at higher valuations. In the first instance, depending on how you define margin, the operating companies are generating sort of 14% operating margins, while the royalty and streaming companies are delivering 65% operating margins.
But if you look at the operating sector and you add back write offs, the operating margins fully costing those prior year write offs are much closer to zero. So do you pay up for a business with a 65% operating margin? Or, do you buy zero for a lower number? My suspicion is that the answer is fairly clear. The suggestion in the market that the period of growth for the royalty and streaming companies is over, is wrong. It’s wrong for several reasons. It’s wrong because a big arbitrage exists between the valuations of cash flow for base metals producers, and the valuation of byproduct precious metal streams, the base metals producers trade at five, or six, or sometimes seven times EBIT, while the precious metals streams from those big base metals mines trade in the form of Franco or Wheaton Precious at 12 or 13 times EBIT.
What that means, is that a transaction can occur that simultaneously lowers the cost of capital for the base metals producer, and increases net asset value per share of the streamer. The idea that you can have a win-win transaction in billion dollar chunks, is something that means that these transactions are going to occur going forward. The second thing is that Basel Three banking accords changed the financing market for project and construction finance for non-investment grade issuers. Sprott, of course, has been a primary beneficiary of this with our lending business. But the truth is, that we don’t have enough capital, nor do the other specialty lenders, our competitors have enough capital to finance 10 or $12 billion a year in financings, which is what the non-investment grade community will require in the next five years. The royalty and streaming companies are going to be and are now an increasingly important component in non-investment grade construction finance. A stream is quasi equity, which lowers the cost of capital if the issuer is genuinely selling at a substantial discount to net asset value, which of course, all of them believe they are.
Finally, at the beginning of the discussion, we were talking about mergers and acquisitions. We believe there’s about $14 billion in assets that are in big companies that will be made redundant as a consequence of mergers, and financing the acquisition and development of these $14 billion in transactions will require capital that doesn’t exist necessarily in the industry in conventional form today. And my suspicion is that the royalty and streaming companies will provide as much as a third of that capital, so the suggestion that the big transactions, the formative transactions that cause the growth of Franco, Wheaton, Royal, the smaller ones, Anglo-Pacific, Sandstorm, the idea that the golden period for the deployment of capital by those businesses is passed is wrong.
Bill: Its an excellent perspective. And I know from going to the Sprott Conference, you had a lot of royalty companies there, as well.
Rick: I’m deploying one of the things I’ve been talking about recently, and I will be talking about on BNN, I guess tomorrow night, is what I’m doing with my own money now. I’m deploying money now. Historically, I’ve deployed most of my own money in private placements with warrants, but the truth is, that there are opportunities now for companies that have no need of additional capital. And one of the places I’m deploying my own capital right now is in the royalty and streaming space. I’m prepared to concede, I may be wrong for three or four months. Certainly wouldn’t be the first time that’s happened, but I see the outlook for these companies as being particularly attractive relative to the risk.
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