HERE’S AN EX­AM­PLE OF HOW THIS BE­COMES DAN­GER­OUS:

Finweek English Edition - - INSIGHT: LOCAL -

Re­cently a prom­i­nent North Amer­i­can s i l v e r a nd gold r oy a l t y c om­pany an­nounced the ac­qui­si­tion of a gold two sep­a­rate gold streams from Vale for a com­bined value of around $2.03bn, of which $1.9bn is cash.

I made the cal­cu­la­tion us­ing a $1 700/ oz spot gold price in­creas­ing by around 2% per an­num (the slope of the gold for­ward curve) over more than 25 years, and worked out that my best-case pro­duc­tion sce­nario was an IRR of around 7.5%.

The deal was around 16% of the cur­rent size of the com­pany and would ex­tend the com­pany’s debt po­si­tion sig­nif­i­cantly, so a very ma­te­rial trans­ac­tion. Us­ing pretty stan­dard meth­ods, I cal­cu­lated the com­pany’s cost of cap­i­tal at 7%-9%, so a mar­ginal trans­ac­tion from a the­o­ret­i­cal “value ac­cre­tive/value de­struc­tive” per­spec­tive.

Stress­ing the gold price and pro­duc­tion within nor­mal bounds eas­ily took my IRR to 5.4%. Man­age­ment was in­censed by the no­tion that this looked to be a mar­ginal deal. “It was a com­pet­i­tive process” I was told (ie there were other bid­ders), “th­ese are world-class as­sets”.

When I asked what they thought their cost of cap­i­tal was, I was told “way be­low 5%, all an­a­lysts use th­ese num­bers”. Enough said.

Safe to say t he share price went nowhere, which seemed to con­firm that the deal was nei­ther hugely ac­cre­tive nor di­lu­tive, but I found the dis­cus­sion very in­struc­tive.

I bat­tle to take se­ri­ously any­one run­ning a pub­lic min­ing com­pany who thinks its cost of eq­uity or cost of cap­i­tal is 5% or less, let alone uses this as a re­turn hur­dle rate for a min­ing project.

Even though min­ing roy­alty deals have less risk at­tached than min­ing project

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