SSL..... Junior Mining Weekly | 4
29 February 2012
BEAUTY, THY NAME IS FREE CASH FLOW
No one metric can entirely to describe how a company is trading, and for some
companies, particularly in the junior mining space, traditional metrics, such as price to
earnings (P/E) or price to cash flow (P/CF), are not particularly meaningful given their
stage of development. Nevertheless, free cash flow is the ultimate name of the game,
even for those companies that are years away from generating revenues. Which is why
we are highlighting free cash flow in this week’s Junior Mining Weekly. For our purposes
today, we define free cash flow as operating cash flow after working capital changes and
after deductions for sustaining capital.
Operating cash flow before working capital changes can be subject to accounting
manipulation. It does not reflect the capital required to sustain production or maintain
adequate liquidity for a business. Free cash flow can be used to finance growth, pay
dividends, buy back shares, and/or finance acquisitions. Unfortunately, there are many
examples of mines and companies which generate substantially lower free cash flows
than predicted by feasibility study, company guidance, and/or analyst expectations.
Mining is a tough business, and there is a dearth of qualified mining engineers,
metallurgists, and geologists with the experience to address the normal issues that arise
when building and operating mines. It is in this environment, with operating cost
escalation, depleting margins, and capital escalation sucking up excess funds, that
royalty companies are in a particularly strong position.
Royalty companies, such as Sandstorm Resources Ltd. (SSL : TSX-V : C$1.69 ?
SPECULATIVE BUY : covered by Nicholas Campbell), Silver Wheaton Corporation (SLW :
NYSE : US$38.75 ? BUY : covered by Steven Butler ), Franco-Nevada Corp. (FNV : TSX :
US$44.19 ? Not rated), and Royal Gold, Inc. (RGL : TSX : C$71.63 ? Not rated) have low
overhead, more cost certainty, minimal capital requirements, and are usually structured
for optimal tax efficiency. It is for these reasons that they tend to receive higher
valuations relative to producers. These companies appear to us to be the free cash flow
machines in the mining space, and the royalty space has been getting smaller and
smaller. Over the past three years, we have seen Silver Wheaton acquire Silverstone
Resources, Royal Gold acquire International Royalty Corp., and Franco-Nevada acquire
Gold Wheaton Gold Corp. From our perspective, Sandstorm Gold stands out as a
precious metal-focused small cap royalty company, with a strong balance sheet and
growing free cash flows. Given the consolidation that has occurred in the royalty space,
we believe that it is only a matter of time before Sandstorm Gold attracts the attention of
a larger cap royalty company. While these equities are uniquely positioned to outperform
in an inflationary cost environment, they also benefit from the current volatile equity
markets that have damaged the equity financing environment for junior exploration and
development companies. With fewer alternatives to finance development, the sales of
royalties and metal streams have become much more common over recent years. With
cost pressures continuing and ongoing personnel challenges, the expanding margins,
free cash flows, and growth potential associated with royalty companies should continue
to attract investors and higher valuations in the market. |
