With rising interest rates in the U.S., economic uncertainty and widespread risk-off sentiment, fundamentals point to a long-term increase in the price of gold. As individual investors, there are few well-established methods of gaining exposure to this increase.
The first, and perhaps most direct, is bullion purchase. This type of exposure has its benefits but requires a large up front capital outlay to gain exposure to any meaningful return.
A second alternative is investing in gold mining. There are the incumbent entities in the space – Barrick Gold Corporation (NYSE:ABX), Newmont Mining Corp (NYSE:NEM), etc. – that offer a relatively low risk, but concurrently low return exposure, or at the other end of the scale, junior miners. These, of course, have a higher potential reward but are far riskier than the mega caps in the space.
A third, and perhaps less well-known, opportunity to gain exposure to a rise in the price of gold is gold royalty. Raising capital in the development stage gold space is often difficult, and many of the more traditional financing methods are closed off to junior miners as a result of their risk profile. This isn’t just gold, it’s the case across the entire commodities space. Commodities-based ventures are often riskier and more drawn out than those in other areas, and capital is more readily allocated to the low-risk ventures – especially at the volume required to fund things like gold exploration.
One of the primary methods of alternative financing in the sector is gold royalty stream companies. Royalty stream companies provide capital to junior miners in various stages of development in return for a royalty on production. Because capital is difficult to come by for the juniors, royalty stream companies can demand high levels of return on their allocated capital. This return makes these types of companies attractive as both an exposure to the gold sector and as a risk-mitigated alternative (they don’t carry the traditional junior miner risks such as permitting, exploration, etc.) to junior development.
Current leaders in the space include the Toronto-based Franco-Nevada Corp. (NYSE:FNV) and Royal Gold Inc.Ă‚ (NASDAQ:RGLD). A new company is about to enter the arena, however, and it has the potential to grow rapidly as gold gains.
That company is Preston Corp. (OTCMKTS:PSNP).
Preston Corp., operating under the name Preston Royalty, is a Texas-based royalty stream company with a focus on the developing gold miner space. It’s just given markets a number of key updates and looks set to gain strength throughout the remainder of 2016 on the back of the implications of this news. Beyond 2016, the company’s operating model affords it the luxury of benefiting from three combined elements: low operating costs, high and sustained return on capital allocated, and the above mentioned gain in gold.
Let’s look at each of these points in a little more detail to clarify why they feed into Preston’s attractiveness as a gold exposure.
First, low operating costs. Preston Royalty is not a gold mining company. Gold miners have to bear the costs of exploration, a large workforce,Ă‚ building and maintaining a processing plant and drilling equipment, etc. This, after all, is why companies like Preston Royalty exist. Preston Royalty is a finance company. It has a small team of geologists, engineers, administrative, financial and managerial employees and operates out of a fixed location office in Austin, Texas.
As gold has declined over the last half decade, operating costs – specifically, all in sustaining cash costs – have become a focal point of the industry. A miner’s ability to maintain per ounce profitability has all but consumed analysts’ coverage of gold miners large and small. Some miners are running with operating costs that far exceed EBITDA. Preston Royalty is targeting year-one operating costs of 53.85% of EBITDA. In five years, the company expects to reduce this figure to just 1.41%.
Second, high and sustained return on capital allocated. For every dollar sent out, Preston is seeking at least $1.50 in return – a 50% return on its investments. At the top end, it is seeking an 85% return. Further, and just as important, the company is seeking this rate of return on a fixed minimum term of 10 years.
What does this look like in dollars? Year one, Preston is seeking $2 million royalty revenue. Year three, $20 million. By year five, the company expects to pull in $98 million royalty revenue. With the above mentioned 1.41% OC/EBITDA, this translates to a net income of $61.8 million. Net present value of its expected cash flows (5% discount) for the same year is a little over $604 million. Preston’s current market capitalization is just $48 million – less than 50% of its projected year-five revenues.
Finally, gold’s price rise. We’ve already briefly discussed the justification behind a rise in the price of gold. Safe havens are king in uncertain times, and with China still reeling, a Europe and U.K. split imminent, and what is shaping up to be one of the most unpredictable (both in terms of results and implications) election years in recent history in the U.S., uncertainty looks set to dominate sentiment going forward. Couple this with supply and demand mechanics – specifically, gold producers’ inability to expand operations at current prices and the resulting impact on global supply – and the next half decade has to bring a price rise in gold.
Preston is a finance company, but unlike more traditional financial institutions, it doesn’t loan capital for an interest rate. Its royalty payments are determined as a percentage of production revenues. When the gold price increases, the value of every ounce Preston-funded companies pull out of the ground increases. Because the company’s royalty is linked to this per ounce value, it increases concurrently.
These points addressed, what recent updates demonstrate Preston’s ability to meet its forecast targets? On April 25, the company announced an agreement with Western Mine Development LLC, a gold production acquisition group with a number of development projects in the Western U.S. The agreement will see Western act as an agent between Preston and the development projects to facilitate the capital allocation and royalty negotiations. At the time of this announcement, Preston sais that it expected something tangible to come of this partnership immediately and that it would announce this tangible result within 10 days.
True to its word, the company announced on May 3 that it had executed a preliminary lease agreement on a gold mine in California, with Western acting as the agent on the deal. The agreement will see Preston inject a minimum of $250,000 in the project this season, and the company expects to hit a 50% ROI on the capital investment on an annual basis – in line with its target ROI as stated above.
Going forward, then, we are looking to more of these announcements as upside catalysts. Preston has a detailed roadmap of its path to year five $98 million royalty revenues, and these agreements are small, but crucial, steps as part of this wider plan. As each is announced, the company moves a little closer to its projections and becomes a little bit more valuable from a market capitalization perspective.
Preston is a young company with exciting prospects that offers an exposure to rising gold. Further, the exposure is potentially higher return than buying bullion and lower risk than direct junior miner investment.
The company’s current market capitalization sits at just 50% of its projected five-year revenues and just short of 80% of its projected five-year net profit. If it can meet these projections, Preston’s current market capitalization will look like a dramatic undervaluation come 2020.
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