Royal Gold, Inc.: The Bear Case From a Bull

Royal GoldInc.(NASDAQ: RGLD) is among the three well-known companies in the precious metals industry that are into the business of streaming and royalty; the other two being Wheaton Precious Metals (NYSE: WPM) and Franco-Nevada (NYSE: FNV). As a streaming company, Royal Gold doesn't own or operate mines -- it buys gold streams from other miners in return for upfront funding. Such a business can be lucrative for several reasons, as I highlighted in a recent article where I outlined 10 reasons to buy Royal Gold for the long term.

As you might've already guessed, I'm bullish about Royal Gold. But as with any other stock, there are risks associated with owning Royal Gold, some of which could hurt the company's growth prospects and turn the market sentiment bearish.

Heavy reliance on five assets

Currently, Royal Gold has interests in 38 operating mines, but only five of them accounted for as much as 72%of the company's total revenues last year. Those five mines are:

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1. Teck Resources' Andacollo
2. Barrick Gold (NYSE: ABX)-Goldcorp (NYSE: GG) owned Pueblo Viejo
3. Goldcorp's Penasquito
4. Golden Star Resources' Wassa and Prestea
5. Centerra Gold's Mount Milligan

Image source: Getty Images.

Interestingly Royal Gold acquired three of the above five streams -- Andacollo, Pueblo Viejo, and Wassa and Prestea -- only in the fiscal year 2016 (ended June 30, 2016), and if not for those acquisitions, Royal Gold's production in 2016 would've fallen off the cliff, especially since production from Penasquito was already under pressure. Royal Gold's gold deliveries from Penasquito slipped 21% in the fiscal year 2016 because of lower grades and recovery.

Production from Penasquito could remain under pressure for the next couple of years as mining will be restricted to lower-grade ore while Goldcorp expands the mine. While deliveries from other mines should be able to offset any declines, this highlights how dependable Royal Gold's fortune is on a handful of mines. Such dependability is risky, as any adverse development at any of the five mines could hurt Royal Gold's sales and profits substantially.

There's another problem Royal Gold faces: Some of its streaming and royalty agreements have conditions attached that would require the company to look for replacements to keep its sales going and costs under control. Some examples include thePueblo Viejo mine and theWassa and Prestea mine.

Royal Gold has an agreement with Barrick that has 60% interest in the Pueblo Viejo mine. Per its agreement, Royal Gold's stream will decrease to 7.5% of the gold produced from the mine to 3.75% after delivery of 990,000 ounces. Its silver stream from the mine will also dip by half to 37.5% after delivery of 50 million ounces.

Barrick-Goldcorp's Pueblo Viejo mine.

In the second case, Royal Gold is entitled to 9.25% of the gold produced from the Wassa and Prestea mineat a cost of 20% of spot gold price until Dec. 31, 2017. Thereafter, it'll get 10.5% of the gold at 20% spot price up to 240,000 ounces, after which the stream will decline to only 5.5% of production at 30% spot price.

These are just two examples of the kind of limitations Royal Gold faces. The company is going great guns, reporting record revenues and cash flows, but it may not be able to continue doing so if it cannot add more streams to its portfolio before the expiry of existing ones, or keep a tight grip on costs to ensure that the higher later purchase costs (as agreed upon with miners) do not throttle its margins.

Foolish takeaway

The risks Royal Gold faces, especially its heavy reliance on few mines, are real and hard to ignore. That said, these risks aren't an immediate threat to the company's operations, and itssuperior dividend track record and low volatility in cash flows versus rivals like Wheaton Precious Metals make Royal Gold one of the top stocks to invest in among not just the streaming companies, but in gold overall. Investors should just be aware of the kind of situations that could reverse Royal Gold's fortunes.

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Neha Chamaria has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.