Why Gold Bulls Have Sights Set on Franco Nevada

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One of the most popular investments among gold bulls is Franco Nevada Gold (NYSE:FNV). Franco Nevada is a royalty company, meaning that it provides capital to mining companies in exchange for the right to some of the gold these companies produce in the future. The deals are designed to be mutually beneficial. Mining companies get the capital it needs in order to explore for gold or develop mines, and Franco Nevada gets revenue that is leveraged to the gold price.

Royalty companies have inherent advantages over mining companies as investments. First, royalty income is directly correlated to the gold price — if the gold price rises, Franco Nevada’s income will rise, and if the gold price falls, then Franco Nevada’s income will fall as well. Mining companies have profits that are related to the gold price, but these profits also depend on the cost of producing the gold. So for instance, suppose the gold price rises from $1,000/ounce to $2,000/ounce. We can say unequivocally that Franco Nevada’s revenue will rise, and assuming its production remains constant, its profits should roughly double. But a mining company may see a different outcome. If, for instance, the mining company’s cost of production rises with the gold price from say $500/ounce to $1,500/ounce, then the mining company will not benefit from the higher gold price; its gross income will remain at $500/ounce.

Second, Franco Nevada and other royalty companies don’t have to spend any money on exploration, but it reaps the benefits of successful exploration. If Franco Nevada owns a royalty on a mine, and the company who owns the mine discovers more gold, unless otherwise stipulated the mining company still has to pay a royalty on any new gold discovered and subsequently produced. Meanwhile, that mining company has to do the following:

  • Pay for drilling
  • Develop a resource estimate
  • Develop a mine plan
  • Apply for and retain permits
  • Construct the mine

While the mining company is paying for all of this, companies such as Franco Nevada just sit back and wait for the money to roll in.

Given these advantages, it comes as no surprise that Franco Nevada and its peers trade at higher valuations than their mining company counterparts. Franco Nevada is going to receive nearly 250,000 ounces of gold this year, and yet it trades with a market cap of $7 billion. A mining company that produces the same amount of gold might trade at less than $1 billion. Furthermore, a company such as Kinross Gold (NYSE:KGC), which will produce 2.6 million ounces of gold this year, trades with a valuation of less than $6 billion — that’s less than Franco Nevada’s valuation despite its production being 10-times greater.

Granted, Franco Nevada has very low costs. It also has a pristine balance sheet with nearly $900 million in working capital and no debt. But given the value of its assets, Franco Nevada is overvalued.

Still, it might be worth owning because management has done a phenomenal job of creating shareholder value. Since going public back towards the end of 2007, the shares are up more than 300 percent. One of the reasons for this is that management has managed to made small initial investments in small projects that turned out to be huge. The most famous of these is probably the Detour Gold project owned by Detour Gold (OTCMKTS:DRGDF). Franco Nevada made an initial investment of just $2 million. Now the mine is producing with a 23 million ounce resource, and Franco Nevada owns a 2 percent royalty! This means that Franco Nevada owns the right to at least 460,000 ounces of gold, which are worth $600 million at $1,300/ounce gold. That is an incredible return on investment, and it also exemplifies how investors should be less concerned with the actual liquidation value of a company’s assets and more concerned with management’s ability to generate large returns for shareholders.

Success stories such as the Detour Gold investment are few and far between, but Franco Nevada Gold’s management owns dozens of similar royalty agreements on exploration properties, any one of which could be the next Detour Gold. Ultimately, given Franco Nevada’s $7.4 billion market capitalization, it might be difficult for value investors to justify taking a position. Nevertheless, given the strength of the company’s business model and management’s past success in creating shareholder value, gold bulls should consider adding some Franco Nevada shares to their portfolios.

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