Cheap For A Reason: Osisko Gold Royalties And Fortuna

Osisko Gold Ro (TSX:OR) (OR:TSX; OR:NYSE, US$9.69) has moved further away from the pure royalty model with the acquisition of Bakerville Gold Mines for equity valued (at the time of the bid) at CA$338 million. Based on the August PEA (preliminary economic assessment) on Bakerville's Cariboo project in British Columbia, this is an acquisition price of 0.6 times net present value. Osisko, which already held 33% of Bakerville, says it intends to develop the project and then monetize it, "ultimately," when the junior market improves.

At the same time, Osisko announced it had formed the North Spirit Discovery Group, intended to develop and finance projects in Canada, in conjunction with joint venture partners or private equity. Few details were revealed.

Royalties or Development: Which Is Primary

Though the Bakerville acquisition is accretive to net assets—it does reduce cash flow per share—more importantly to us, it moves Osisko away from the pure royalty model. It has long been a hybrid, with its increasingly important "accelerator model." But rather than financing a junior in exchange for royalties, it increasingly seems to be using royalty revenue to acquire and develop projects. It is fair to say that CEO Sean Roosen is a mine builder at heart; he and his team built Canadian Malartic, one of the largest mines in the country. They lost the mine after a hostile takeover fight initiated by Goldcorp Inc., eventually selling to Agnico Eagle Mines (NYSE:AEM) and Yamana Gold (NYSE:AUY) (YRI:TSX; AUY:NYSE; YAU:LSE) in exchange for an attractive royalty, the foundation of Osisko Gold Royalties. We agree with Roosen when he says that there are tremendous opportunities in Canada and that the industry has underspent on exploration, drilling and development.

Good Deal, but Increased Risk

So this opportunistic acquisition may be a good deal, but it adds to the risk at a royalty company that was already a higher-risk company than its peers. Because of this, it has traded at lower multiples than other royalty companies. Now the risk is increased, and so too is the justifiable discount at which it should trade. From $12.25 per share at the beginning of the week, the stock plunged after the deal was announced to close at $9.70.

This is overdone, and Osisko can be bought here, but no longer with the expectation that the valuation gap should completely close over time.

New Mine and Saving Another

In other recent developments, Osisko saw the first gold pour at Victoria Gold Corp (TSXV:VIT) Eagle Gold Mine in the Yukon, on which it holds a 5% royalty. This is a successful example of the company's accelerator model.

It also announced the successful completion of a restructuring of Stornoway Diamond (TSX:SWY); with other creditors, Osisko acquires Stornoway, on whose Renard mine it holds a 9.6% stream. Renard, which continues to operation, represents about 3% of Osisko's royalty revenue, so again, this is a significant investment, which may prove successful but deviates from the royalty model.

Not unexpectedly, Pretium Resources (TSX:PVG) (PVG:TSX; PVG:NYSE) bought back an offtake agreement from Osisko, following its repurchase of a royalty on its Brucejack Mine. This is a bad result for Osisko since the offtake was a low margin asset after losing the royalty, and adds over US$40 million to the cash balance. Together with an increase in its credit facility (to $400 million), this puts the company in a strong position, with about CA$525 million liquidity by year end.

More Risk and Lower Valuation Than Peers

Osisko is a dynamic company, with two foundational cash-flowing royalties (Malartic and Eleonore), other cash-flowing assets, and an increasing pipeline; it has a strong balance sheet, and aggressive and technically strong management. But it carries significantly higher risk than a traditional royalty company, risk that appears to be increasingly not diminishing. So it should trade at a discount to pure royalty companies.

But its current value of price-to-book of 1.2x, and price-to-free cash flow of 24x, with a yield of 1.6%, compares very favorably with, say, industry-leader Franco-Nevada Corporation (TSX:FNV) (FNV:TSX; FNV:NYSE) multiples of 3.6x book; 35x cash flow (the free cash flow number is distorted for this year); and a yield of less than 1.1%. Franco remains our core holding, but Osisko is a buy at this level.

Fortuna's Next Mine Nearly There

Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE, US$3.27) has announced the start of pre-production mining at its Lindero gold project, another milestone toward first gold pour in the first quarter of 2020. In building the mine, Fortuna experienced a modest delay and cost overrun, largely due to unusually heavy rains which flooded the road to the site. But the mine is well on its way to completion, 70% complete as of the end of August. The company's website includes a brief video showing the progress on site. Guidance for the mine to produce 145,000 to 160,000 ounces of gold in its first 12 months remains, and representing nearly half of the company's free cash flow by 2021, after the ramp-up is complete.

Earlier in the month, Fortuna issued a convertible debenture with interest of 4.65%, raising $40 million. The funding was not necessary to complete construction at Lindero, but Fortuna, a very conservative company, wanted a minimum of $50 million cash on hand until Lindero is successfully producing.

Argentina Risk

Fortuna has three strong mines (long-life and a high-grade silver mines in Peru and Mexico, respectively, in addition to Lindero), a strong balance sheet, and technically strong and conservative management. The problem is that Lindero is in Argentina. The opposition, with former president Christina Kirchner as running mate on the presidential ticket, is expected to win next month's election handsomely, bringing concerns of a return to the disastrous economic policies of her administration. After a win in a primary election, the peso has collapsed, leading supposedly pro-market president Marci to introduce capital controls and renegotiate the terms of much outstanding debt. Although presidential front-runner Fernandez has made some placating sounds, there are concerns that the country will see higher inflation, export controls, and another debt crisis.

All this has real impact; Fortuna's VAT refund after mine completion may turn out to be considerably less, in dollar terms, than what it paid, for example, while inflation will lead to higher wages at the mine, and most important, export controls may limit what it can take out of the country in dollars. Since it has, more or less, completed its construction costs, it is now in no need of pesos in the country. In addition to the reality is the perception, which will affect investors' willingness to hold companies heavily exposed to the country.

Buy. . .and Trade

Unfortunately, this could get a lot worse before it gets better, so we expect Fortuna to trade below comparable valuations for other growing producers. From $4.33 per share at the beginning of the month to $3.27 today, the stock, already undervalued as discussed in our previous write-up, is discounting most of the risks. At this price, it is trading at only 85% of book, with a cash-flow multiple of 7.5 times. At today’s level, Fortuna is a buy and a strong one. We do expect further volatility as the Argentina situation develops, so you should be ready to trim positions on rallies, and add on any shocks that may come along.

Support for Almaden

Mexico's environmental authority recently held a public consultation meeting regarding Almaden Minerals Ltd (NYSE:AAU) (AMM:TSX; AAU:NYSE) Ixtaca project in the town of Santa Maria on June 25. The meeting was recorded. You don't have to be fluent in Spanish to get a feeling that there is support among local people for this project.