[note: this older piece is from 2008, The “Chaffee Royalty” is being teased again in 2013 but it’s pointed at different stocks, you can see our updated take on the new version of the ad here.]

The people of Gumshoedom have spoken, and they have said, “what is this Chaffee Royalty thing?”

This is one of the more heavily emailed promotions in recent weeks, an ad for Chris Mayer’s more expensive newsletter, Mayer’s Special Situations that touts a few mining royalty companies that you should own …

… companies that he’d be happy to tell you all about, if you’ll just take out a subscription to his newsletter at the “sale” price of $750.

Mayer may be spot on target, and he might be brilliant … but we don’t have to subscribe to his newsletter just to find out what this Chaffee Royalty company is (or companies … he mentions a couple). Not while the Gumshoe is on the case!

So what do we learn about this?

Well, first of all the whole idea of Chaffee Royalties is “teased” out for us — Chris talks about a few investors from history who did extremely well buying mining royalty rights, including the Jerome B. Chaffee who lends this ad its catchy name. Some famous folks in history built their empires in mining in the American West, though much of that was many, many years ago.

So … these Chaffee Royalties are just mining royalties — if you’re unfamiliar with how that works, essentially it goes something like this: A mining or exploration firm discovers a good deposit of ore (or oil, or whatever), and books some level of reserves to the extent that folks will be willing to invest in it.

Then they sell off a portion of their income from those reserves for an up front payment. There are several ways that this can work, but one example is a Net Smelter Return (NSR) — if a mine was predicted to possibly produce 1,000 ounces of gold a year for thirty years, an investor might put up some money to help with the exploration and production costs, and in exchange get a percentage of the net smelter return — the amount of gold that actually gets poured. So if they paid whatever amount they believed it was worth for a 1% NSR, for example, then if the mine does actually produce 1,000 ounces of gold they would own the right to ten of those ounces, and in most cases they would just get a financial return equal to 1% of what they sell that gold for during the year. Probably every one of these royalties has different rules about how costs may or may not be taken out to get to that net return number, I’m not certain if there’s a prevailing standard.

So, you can see that this is in some ways a lower risk way to invest in mining — and lots of folks agree. The royalty owner doesn’t have to pay for the costs of mining, or take the risk (except for the risk capital that they’ve already put in to buy the royalty stream) that the costs will go way up and the mine will go dry earlier than expected.

But there is certainly some risk — there’s risk that there isn’t as much gold as they think, or that gold prices will fall lower and the royalties will shrink — or that prices will fall so low that it stops being worth it for the producer to dig and process the ore. Royalty owners generally don’t get much say in whether or how fast the mining work will be done, they are very much junior participants.

Since the capital required all goes in at the front end, however, royalty companies tend to be pretty high margin — once they’ve got a good stream of royalty-producing projects that are actually creating income, the percentage of their revenue that goes straight to the bottom line is usually pretty high — unless they continue buying lots more royalty positions when prices are high, as is probably always the temptation, since if they stop buying new royalty positions they lose the ability to continue growing over time (their assets are, by definition, depreciating since the ore is gradually all mined out over 10, 20, 30 or however many years).

And since royalties bought early are the cheapest ones, these companies also have the risk that they might invest in a mine that never actually gets started, or that never reaches its potential. If they buy royalties on a site that’s still in the early stages of exploration, they will obviously be cheaper than buying royalties on an existing mine whose output is steady or growing, since predictable income is worth more.

So that’s the general idea or royalties — he then talks in some detail about two companies.

One of them is actually mentioned by name, too, though he doesn’t necessarily connect the dots to the headline teaser. Mayer notes that there is a particular royalty play that closed to new investors in 2002, and that only recently reopened.

That company is the same one he talks about in some detail later in the letter — Franco-Nevada, which is the real pioneer of this business and has become a very large royalty owner across most types of resources.

Franco-Nevada is a justly famous company in resource and mining circles, and it did indeed close to “new investors” back in 2002 — but it’s just a public company, how could it close?

Well, as you may know, it was bought out by another company, and became a subsidiary of a much larger mining giant, Newmont Mining in early 2002.

Then, when Newmont decided (perhaps with the assistance of some investment bankers who were bored and needed some fee income) that they needed to streamline, they took Franco-Nevada public again at the end of last year. It now trades on the Toronto Stock Exchange at FNV, recently getting about $19 a share. It went public around $15 and got as high as about $23 a couple months ago. Trades in pretty high volume on the pink sheets at FNNVF, too, in case you’re limited to investing in US stocks.

Do keep in mind that even though these kinds of teasers always talk about “royalties” as if you’ll be getting the royalities, these companies don’t actually tend to pass any royalties on directly to shareholders. Most of them don’t pay dividends, so the royalties will theoretically keep building up and being reinvested by company management, you’re not actually going to be getting a stream of royalty checks yourself. There are some royalty trusts that actually do dividend most of their income, mostly in oil and gas, and some of those are just royalty owners that don’t pay the production costs … but that’s a different animal than we’re talking about with this teaser.

(If you want to learn about some of these trusts, many of which are Canadian and subject to a new tax regime in a few years, I have written about a few of them — they came up in a monthly dividend article, and at least one is bound to come up in any discussion of high-yield stocks)

So what is the one favorite “Chaffee Royalty Program” that Mayer thinks you should look into, aside from Franco-Nevada? What is the one that he calls the “next Franco-Nevada?”

We get a few clues:

They own a royalty stream on the Voisey’s Bay mine, which is primarily a nickel producer. He says that this mine is the richest Canadian discovery in the last 40 years, and has one of the largest and highest quality nickel reserves.

Here’s an excerpt of Mayer’s description:

“On this Voisey’s Bay deal alone, it should collect royalties between $16–20 million. And yes, that’s if nickel prices today don’t budge another inch.

“What happens if nickel surges again to the record levels it hit last May?

“If that happens, count on another $24 million in royalties going straight to this little company’s bottom line. That might not sound like much for a big, well-known company. But for a company like this — still undiscovered and valued at only just over $400 million on the stock market — this is enormous. And just based on that, I already calculate that this could be an easy way to triple every dollar invested over the next two years.

“But it doesn’t stop there.

“Because, you see, this little “Chaffee Royalty” outfit — like the early Franco-Nevada — has a lot more going for it that just the sweetheart royalty deal on Voisey’s Bay nickel.

“As I said, it carries nearly 100 royalty deals — any one of which could start producing as well or better — and all of which give you even more opportunities to pile up royalty wealth on five different continents… and in 10 different countries… in 18 different commodities.”

He also notes that this company has 100 other royalty deals, and has rich royalty streams from gold mines and others in Chile, Nevada, and Australia. Along with exposure to uranium, oil, natural gas, diamonds, and pretty much all the other exciting natural resources you can think of.

So … we hear more, including some additional details about that mine in Chile, which is operated by Barrick Gold and that this company bought into for $11.4 million in exchange for a royalty share.

But we’ve probably got enough to feed into the hopper of the ‘ol Thinkolator, so let’s open the chute … chewing, chewing, and we learn that this is …

International Royalty Corp (ROY on the Amex, though their main listing is at IRC in Toronto)

The shares are down right now from a high of about $9 last summer, but are having a good day today, perhaps on the strength of this newsletter teaser ad campaign — shares are priced at about $5.50 at the moment, though this can be a very volatile stock that has moved up and down between about $4.50 and $7 just since January.

They do indeed own all those royalties that were teased, 80+ according to the company’s count, though only a few of them are producing properties at the moment (including Voisey’s, which brought a little bit of a disappointment to the last earnings release because of the lower price of nickel year over year). You can see the earnings press release here.

So is it worth owning? I can’t touch an answer to that question with the research I’ve done so far. I like that it’s a diverse collection of royalties, though I’d want to look through them and see what the real likelihood of getting their exploration and development-stage properties online is, and when that might happen. They are profitable and have very little net debt, and as with all these royalty owning companies (including Royal Gold, Franco-Nevada, Silver Wheaton), the valuation is much higher for them than it is for the actual producers, largely because investors perceive these diversified royalty owners as being lower risk. The trailing PE is about 35 for ROY.

And it looks like they might be trying to qualify as a pass-through investment fund of some sort, tax-wise, so note that it’s possible that this might complicate your taxes if they have net earnings that they pass through to you on a taxable basis, whether or not they actually send you the cash. I only briefly looked at their tax information, so this might be my misunderstanding — but it’s worth a look if you’re interested in buying shares.

This is not too different from the discussion we had about the “Nevada Royalties” that were teased by Matt Badiali and the folks at Stansberry & Associates a few months ago, though of course the specific companies are different. If you’d like to see the news articles that were quoted in the ad or just read up a bit more on the topic, here are a few places to start:

Financial Post: How Royalties Turned into Gold

Forbes: Virtual Gold (older article about the history of Royal Gold)

Most of these companies do not have much analyst coverage, and what analysts they do have tend to have a hard time pegging earnings estimates because of the variable nature of production at any one mine, a difficulty which is magnified across the many mines and production sites that each of these royalty holders depends on. So I wouldn’t count too terribly much on those forward earnings estimates, unless the company itself provides some clear guidance. ROY is having its conference call at the end of this week, on May 20, so you could always listen in on that — or even ask some questions if you like — to see how management feels about the future.

Hope that helps you get an idea of what these kinds of companies are, and why Mayer thinks you should buy them. Myself, I dunno … but if you’ve got a strong opinion, or even a tepid one, feel free to share.

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