Chances are that even bringing up the topic of gold stocks is a sore subject with metals investors. As someone who currently owns a handful in his own portfolio I can tell you firsthand that it has been a bumpy ride.
Gold loses its luster
Last year saw gold prices decline for the first time in more than a decade as gold euphoria waned and physical demand for gold faltered. According to the World Gold Council earlier this month, gold jewelry demand was down a whopping 30% in the second quarter of this year, with much of that decline attributed to weakness from China and India. Since jewelry demand accounts for slightly more than half of all global gold demand this has acted as a cement anchor on much of the sector.
Traditional gold miners have been left to make some tough decisions over the previous year in the wake of gold prices falling close to 25% since the beginning of 2013. The answer for a majority of miners has simply been to cut capital expenditures and hold off on expanding their operations. Newmont Mining (NYSE:NEM), one of the largest gold miners in the world based on production, has served up a pair of billion dollar-plus writedowns since 2012 (Hope Bay in Canada and two mines in Australia along with stockpiles of gold in Australia) because the cost to develop new mines, along with rising labor costs, simply didn't make financial sense.
This unique company bucked the trend
Despite gold falling 28% in 2013 and gaining back only 7% year-to-date in 2014, Royal Gold shares have skyrocketed 67% in 2014. "Why such a disparity between Royal Gold and so many of its peers?" you ask? There are a couple of key reasons.
First, Royal Gold's business model is markedly different from traditional miners. Royal Gold isn't a miner in the strict sense of the term. Instead, Royal Gold is a royal interest investor in precious metals, predominantly gold. In exchange for upfront cash which mining companies can use to expand an existing mine or develop a new mine, Royal Gold receives a certain percentage of production at an advantageous fixed price which is often way below spot prices. Furthermore, these contracts that Royal Gold sets up are usually arranged for the long-term so there's no concern about Royal Gold's cash flow shrinking anytime soon.
Perhaps the best aspect of Royal Gold's royal interest arrangement is that the company isn't responsible for the day-to-day operations of mining companies. If labor costs rise that isn't going to be Royal Gold's problem as it's strictly on the hook for the upfront cash to be used in mine expansion or development.
As one caveat worth mentioning, though Royal Gold isn't responsible for subsequent mine costs, higher mining costs can hurt the mine owner's bottom line which, in turn, could reduce total production. In other words, Royal Gold is dependent on the production of those companies it contracts with, meaning higher costs can still indirectly affect it.
Mt. Milligan is beginning to pay dividends
Another important factor is that one of Royal Gold's key long-term deals is finally beginning to pay off. In Dec. 2011 and Aug. 2012 Royal Gold worked out financing deals with Thompson Creek Metals (NYSE:TC) for a cumulative 52.25% share in its Mt. Milligan gold and copper mine. Thompson Creek needed to turn to Royal Gold for financing because the ultimate development of its Mt. Milligan mine ballooned from an estimated $900 million to an eventual $1.5 billion.
Based on Royal Gold's separate deals which sent $270 million and $200 million over to Thompson Creek, Royal Gold, in return, receives 52.25% of Mt. Milligan's gold production at $435 per ounce, or the prevailing market rate below that point. Put another way, Royal Gold achieves pure profit on the difference between the current price of gold and $435, which at this very moment equates to about $855 per ounce!
What's been pumping up Royal Gold's stock is that Mt. Milligan came online last year and reached commercial production in February. In short, Royal Gold has seen gold output from Mt. Milligan increase in three successive quarters, which means more cash flow and potentially beefier future dividends for shareholders. Royal Gold recorded $27.2 million in total revenue from Mt. Milligan in fiscal 2014.
New and existing agreements
Lastly, Royal Gold investors have benefited from improved production in existing mines as well as newly orchestrated deals which set the company up for years of success.
In terms of existing contracts, Royal Gold saw Goldcorp's Penasquito mine produce 534,200 ounces of gold in 2014 compared to just 371,100 ounces in the prior year. With a net smelter rate of 2%, even with lower metals prices, this translated into a modest revenue boost for Royal Gold. Though revenue may have been down at other mines, including the Canadian Malartic mine, which is operated by Yamana Gold and Agnico Eagle Mines, and the Cortez mine operated by Barrick Gold, the overall gold output for these mines grew by a double-digit percentage.
When it comes to newer deals, Royal Gold announced in February that it had forged a $75 million deal with Rubicon Minerals (NYSEMKT:RBY) to help pay a good chunk of the development costs for Rubicon's Phoenix Gold project in Ontario, Canada. The deal allows Royal Gold to collect 6.3% of all gold produced from the mine until 135,000 ounces have been delivered, whereupon Royal Gold receives a 3.15% stake of gold produced thereafter. The best part is that Royal Gold only has to pay one-quarter the current spot price of gold for its share.
This is a smart way to play gold
While there is no such thing as a stock without risk, if you're interested in dipping your toes into the metals market, Royal Gold could make for a smart bet. Its long-term contracts and high-margin model mean somewhat predictable cash flow. Furthermore, it can handle wild swings in underlying metal prices a lot better than individual miners can. It's certainly a stock worth keeping a close eye on going forward.
Do you know this energy tax "loophole"?
You already know record oil and natural gas production is changing the lives of millions of Americans. But what you probably haven't heard is that the IRS is encouraging investors to support our growing energy renaissance, offering you a tax loophole to invest in some of America's greatest energy companies. Take advantage of this profitable opportunity by grabbing your brand-new free special report, "The IRS Is Daring You to Make This Investment Now!," and you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.
Sean Williams owns shares of, as well as Jan. 2015 call options on, Thompson Creek Metals, but has no material interest in any other companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.