Tuesday, July 12, 2011

Resource junior paying 10% fully franked dividend

Royalco Resources (RCO) is an interesting little company. They were incorporated in 2001 to acquire royalties and then listed on the ASX in 2006. Royalty payments started in 2008 with the largest payment currently coming from the Reefton Project in New Zealand (belonging to Oceana Gold, ASX: OGC). RCO's focus is not to manage projects from exploration all the way to production, but to sell them off beforehand maintaining a royalty interest to provide future income streams. As far as I'm aware they are the only company on the ASX that operate in this fashion with a precious metal and resources focus. Their strategy as per the latest quarterly is:
The Company’s strategy is to expand a core royalty portfolio of income producing base and precious metals interests. This may be achieved by direct acquisition, exploration initiatives, or as a result of mezzanine/project financing activities. In addition, successful exploration activities will be maximised to the benefit of shareholders in whatever corporate format deemed appropriate.
Their unique model makes direct comparison to peers in the resource sector difficult; however a review of their current position makes them an almost irresistible proposition.

A great summary on why royalties are a smart way to get exposure to resources was detailed in the companies original prospectus:
The rationale for acquiring royalty interests was to acquire the potential cash flows as the underlying assets are developed. The establishment of a mining house with cash flows based on royalties over a wide range of assets and commodities has several important advantages over resource companies based purely on exploration, or with operations over a limited number of projects.

• Cash flows from a diversified range of royalties may provide a basis to more readily identify the fundamental value of a company – a diverse royalty portfolio provides an asset more readily capable of being valued than a single exploration play. This structure can provide as much or more exposure to upside in commodity prices as a pure exploration play – but with a much lower level of risk.

• With royalty interests, the income flow from operations is not directly reliant on project profitability. Most resource royalties, whilst being exposed to metal price risk, are not exposed to the same variables and risk factors as is the owner of the underlying tenement. Royalty owners are not usually subject to production cost risks, environmental obligations, and resource rent taxes; nor are the royalty streams subject to any project financing charges. The project operator will invariably attempt to optimise mine life and recovery of metals, yet the royalty holder has no requirement to spend any further capital, whether it be for exploration, infrastructure or additional mine development.

• Royalty assets have the significant advantage that they are usually purchased for a single upfront payment, based on known reserves and recoveries at the time of acquisition. An operator will usually attempt to increase metal recoveries and extend reserves - at no cost to the royalty owner, yet improvement in either of these factors enhances the value of the royalty assets. This can often represent significant “hidden” value, and is a substantial benefit of investing in the resource sector through royalty based assets. These factors can create considerable potential upside at no cost to the royalty owner.

• Royalties are leveraged to metal price movements. Some royalty agreements contain “escalator clauses” that can result in a much higher participation in production and price movements than the simple percentage movement in the price.
I have held them on and off over the past couple of years. Last week I bought a new position at 40c (ahead of an expected bi-annual dividend which should be due around mid to late August).

One of the major risks for junior resource companies is their continual need to raise capital (in such volatile times this risk can crush companies, look at Navigator Resources [ASX:NAV] recent attempts to raise capital and how this has affected the share price). The royalty streams that RCO receive means no dilution, no discounted shares to brokers, they can self fund exploration/administration costs and the income recently (February 2011) resulted in the payment of a healthy dividend (annualised rate of 10% fully franked, pretty much unheard of for junior resource companies).

Here are some of the basic figures:

Shares Issued: 52.7m
Share Price: 40c
Market Cap: $21m
April 1st Cash: $14m (should be around $15m EOFY)
Dividend: 2c (biannual basis, fully franked)

RCO is paid a royalty from the Reefton Project of 1250 ounces (before tax) per quarter or around 5000 ounces per year (around $7.25m gross pa at current Gold price of AUD$1450). After withholding tax this is roughly 1060 ounces net. Here are some further specifics on the Reefton Project royalties:
As the Reefton royalty specifically relates to MP41 164 and the royalty will cease when cumulative production reaches 400koz the aggressive drill programme on the near mine targets is highly positive for RCO. The structure of the Reefton royalty is as follows:

* The maximum royalty payable is 5,000ozpa until the royalty ceases once the total combined production from the Globe Progress mining lease reaches 400koz, which should be reached in DH12.
* The royalty will only be reinstated as a 1.5% nsr once the total production from the Globe Progress mining lease (MP41 164) and other surrounding tenements, which are also under separate RCO royalties, exceeds 1.0Moz’s.
* A sliding royalty of 1.0% to 3.0% will apply to any production where RCO has royalties from the 6 other tenements in the Reefton gold project. Other existing resources in the Reefton royalty asset portfolio are the historic underground Blackwater mine (340koz at 21.9g/t, EP40 542) and the shallow Supreme deposit (40koz at 1.5g/t Au, EP40 183).
* At the Sam’s Creek gold project located to the north-east of Reefton, a separate 1.0% flat royalty applies (31 Dec 09 resource of 0.8Moz).
Courtesy of Veritas Securities Limited.

So even though the most lucrative royalty payment will cease (likely in second half 2012), the production royalty from other various tenements will continue to provide RCO with ongoing income.

There are far more royalties and potential prospects than Reefton. In early 2011 the total number of producing royalties has increased from two to four.

They have a 3% Net Smelter Return on production from the original Mt Garnet tenements, this resulted in over $400k revenue in the March Quarter.

In early 2010 Vale (one of the largest mining companies in the world) completed an option agreement for the Gambang tenement (Philippines). $1m has already been paid to RCO, Vale must now spend a minimum $1.5m (up to $3.5m spend over 3 years) on exploration and pay $5m to Royalco in order to purchase the tenement. A net smelter royalty would be payable if the deposit is developed. RCO has other tenements in the Philippines (Pao & Yabbi).

Recently RCO has entered into MOUs in Ethiopia and Uganda (East Africa) where they can earn an interest in each of the projects with a set expenditure.

To sum up Royalco Resources has cash backing at 26c (is likely to be more like 28c, waiting on June Qtr report for confirmation), is paying a fully franked dividend of 10% (at 40c SP), has ongoing income to be paid from existing royalties with many more prospects in the pipeline. A recent on market purchase by one of the directors (approx $40,000 worth at 40.7c average) is a healthy sign.

RCO isn't without its risks. The large percentage held by management and other top holders results in a fairly illiquid share price (Directors and Anglo Pacific hold over 50%), so trading can be thin and a fast exit not always possible if you hold a large number. The latter half of 2012 could bring an end to their largest royalty which means their ongoing position following this could change quite dramatically.

All things considered I think RCO is one of the safest small cap precious metal/resource plays on the ASX presently. There is potential upside from several tenements being explored (although news from these can be quite slow) and in my opinion RCO is already well undervalued at the current share price.

That said, even as I write this the markets are tanking with the debt crisis worsening in the Eurozone and concerns about the US debt ceiling which will come to a head within the next few weeks... it's a dangerous time to be in the market and care should be taken when purchasing any equities. My position has not changed a great deal over the last couple of months and I am still largely in a mixture of cash and physical (or equivalent) precious metals, with only a small percentage of my portfolio assigned for precious metal related stocks.


Disclosure: Position held in RCO. Not investment advice. Do your own research.

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