How Risky Is Royal Gold Stock?

By Markets Fool.com

Royal Gold isn't a miner like Barrick Gold . Barrick gets its hands dirty digging up the earth to bring gold and silver to market. Royal Gold is more like a financier that gets paid in gold and silver. And that changes the dynamics investors need to think about in a big way.

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Precious metals count

The first risk Royal Gold investors need to get a handle on is the same one that Barrick Gold investors need to worry about -- precious-metals prices. Since both companies' top lines are the result of selling gold and silver, that's going to be the driving force behind revenues and, thus, earnings.

But that's where things start to diverge. Barrick has to do all the work, and take on all the inherent risks, of mining. Royal Gold doesn't do any mining. What it does is advance money to miners, like Barrick, for the right to buy future silver and gold production at reduced rates. This is called streaming, and it makes Royal Gold look something like a specialty finance company. It also changes the risks investors face in some important ways.

A different model

The basic business model for a streaming company is to use short-term financing of some sort, such as bank lines of credit, to pay for streaming deals. Once a deal is set up, then the company sells equity to permanently fund the transaction. But this means that access to both short-term and long-term financing is vital to Royal Gold's health. Trouble on either side of this equation would stall the company's growth.

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Image source: Royal Gold.

Another risk that's inherent to the process is finding deals. Royal Gold is an alternative financing source for miners, since it allows them to avoid both banks and capital markets. Miners sometimes have a hard time getting bank and debt funding at reasonable costs, particularly like now, when precious-metals prices are relatively low. And selling stock when market prices are weak isn't a great option, either. So trading off future production for cash can be a decent choice.

Barrick and Royal Gold inked a $600 million deal last year. In fact, the recent downturn has been a good time for streaming companies, because miners have been hard hit by the broad commodities downturn. However, if the current precious-metals rally turns out to have some legs, financially strong miners might find other sources of capital more appealing. That could leave Royal Gold and its peers fighting over either smaller or potentially riskier deals -- or both.

One last risk you'll want to get your head around is the success of the mines in which Royal Gold invests. Although the streaming company doesn't take on the risk of mining, if it invests in a dud of a mine, results won't live up to expectations. There are often safeguards written into streaming contracts, but the normal outcome from a failed venture is that the streaming company gets its money back. So the investment would end up being dead money for however long it was tied up.

There's a time value to money issue in that, but remember that Royal Gold uses debt and stock to finance deals. So any costs associated with financing a deal that doesn't work out as planned is a real cost to be faced in higher operating costs and shareholder dilution. Disruptions at operating mines could have a similar, though likely shorter-term, impact. Here it's worth noting that four mines make up nearly two thirds of the company's revenues, but each of the four is operated by a different miner.

How risky?
When you look at Royal Gold, you have to note that it faces a set of risks that miners don't. That said, so far, Royal Gold has proved relatively adept at navigating the trouble spots. Perhaps the best example of how well it's done is the 15 years of annual dividend increases the company has managed, including right through the precious-metals downturn that led to a reduction of dividends at Barrick. Indeed, in some ways, Royal Gold is probably less risky than a gold miner. But that doesn't mean you shouldn't be aware of the risks shareholders do face.

The article How Risky Is Royal Gold Stock? originally appeared on Fool.com.

Reuben Brewer has no position in any stocks mentioned. 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 may not 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.