Annual Letter to Shareholders and Outlook
Annual Percentage Change
Abitibi Royalties Performance vs. GDX Index and Gold
|Gold Miners Index
*Numbers may be slightly different than your own due to different sources for prices and exchange rates
**All percentages rounded
May 9, 2017
To the Shareholders of Abitibi Royalties Inc.
Abitibi Royalties’ share price increased by 161% in 2016, as we continue towards our goal of becoming The Best Gold Company. In 2017, the share price has increased an additional 3% (as of May 8, 2017), increasing our share price to CDN$9.05, for a market capitalization of approximately CDN$102 million. Over the previous three years, our share price has generated a compounded annual growth rate of 192%.
These impressive returns are certain to slow as our market capitalization increases, becoming a larger anchor. To give you an example how difficult it is to generate the same return using an ever-increasing base, I turn your attention to the Dow Jones Index. Last century the Dow Jones increased from approximately 65 to 11,500, which amounts to a gain of 5.3% compounded annually (excluding dividends). If the Dow Jones generated the same return in the current century the index would have to increase to approximately 2,000,000! We are 16.5 years in and currently sit near 21,000.
On the previous page we showed our share performance versus the Gold Miners Index (GDX) (stated in Canadian Dollars for easy comparison) and the price of gold (stated in both U.S. and Canadian dollars). Overall, it was an excellent year for shareholders, as Abitibi Royalties outperformed the GDX and the gold price in both currencies by a meaningful percentage. As stated above, I suspect our returns will slow but anticipate that the shares of Abitibi Royalties will outperform due to the caliber of our assets. If we were unable to deliver a superior return, I believe it would be better to sell the Company and for you to invest the proceeds in an index fund or gold bullion. It is our job to grow your investment. If we cannot deliver a superior return, it is also our job to understand this important fact and correct it. Although underperforming the market by 5% might not sound significant, over multiple years it could cost all of us a lot of money. Consider a company that generates a compounded annual return of 5% over 25 years. An initial $100,000 investment would be worth $340,000. Now consider that same investment but at a rate of 10%. It would be worth $1.1 million or 2.2x! As has been said by many famous people “men lie, women lie, numbers don’t lie”.
The goal of becoming The Best Gold Company is not meant to be disrespectful to the others in the mining sector. However, if the management team you have invested in doesn’t wake up each morning and strive to be the best (which should always be defined by share performance over the medium to long term) then you might question why you have invested your hard earned dollars in that company. We continue to study successful organizations both in and outside mining such as American Barrick (1985-1992), Goldcorp (1995-2005), Franco-Nevada and Berkshire Hathaway. The idea is not to copy any of these companies but take ideas from each and shake them up in order to build upon our initial accomplishments. When joining Abitibi Royalties in August 2014, I thought it would take 4-8 years to achieve the goal of building The Best Gold Company. I have been in the job for 2.5 years, which gives me 1.5-5.5 years to achieve this goal.
1. Long-Term Vision
Our long-term vision includes a number of key principles that you will find in each shareholders letter and investor presentation. They don’t change month-to-month or even year-to-year. This list has always been a sobering reminder of our principles and allows us to cool off before doing something irrational that would only feed our egos and probably cost you money! If you have been a shareholder for more than a year, you may have seen this list. We have gone into a little more depth this year.
a) Share structure: The Company has a small number of shares outstanding. Investors who purchase shares become partners in the business. They are also treated like partners.
At the end of the day a company’s share price will be equal to its total value divided by the number of shares outstanding. Given enough time, the market will ensure this simple formula plays out (it can take a long time in some cases). When a company issues shares in order to make an acquisition, it is not strictly buying an asset. It is also selling part of its existing business to strangers. There are times when issuing shares can create additional value, where 1+1 does equal 3 (Goldcorp’s acquisition of Wheaton River in 2005 is one example), but those situations are rare and require a lot of patience. I would be lying to you if I said the thought of issuing Abitibi Royalties shares didn’t give me heartburn.
b) Per share value: The Company generates meaningful cash flow on a per share basis.
Despite our royalties at the Canadian Malartic mine being in the development phase and without production until next year, we think it is important that the Company generate cash today (which we will do for a third consecutive year in 2017) while it aims to generate larger amounts in the future. It forces a certain discipline on management, in that they have to make do with current resources and cannot just rely on equity markets for funding.
c) Physical gold: The Company takes a portion of its royalty income in gold bullion, which should continue to grow each quarter. This should also defer tax.
This is something we have not done for the simple reason that our previous royalty revenue from the Gouldie deposit at the Canadian Malartic mine did not give us this option. The first time we will be able to take our royalty income in gold bullion will be in 2018. Building an ever-larger stockpile of gold would give shareholders more leverage to the metal, which not only doesn’t take a salary or stock options, but has also outperformed the majority of senior gold miners during the past 15 years.
d) Share buybacks: The share count goes down, not up. Few, if any, mining companies follow this strategy. We aim to be different.
One of the reasons why gold bullion has outperformed the majority of gold companies is that it cannot dilute itself. Only mining companies can do that through the unrestrained issuance of new shares. As you will read in this letter, one reason I think the sector has underperformed most investors’ expectations is that shares have been issued by gold producers in their quest for growth by paying high premiums versus the value they receive and by junior explorers who issue shares on unattractive terms in order to fund their exploration programs.
e) Exploration: Provides exposure to exciting discoveries.
The good news is that we have a meaningful royalty on a significant discovery at Canada’s largest gold mine that appears to have all the right ingredients to keep getting larger and move towards production. This has been the driving force behind our share price and the reason we have outperformed our peers and gold. The story is no different when you look at the histories of American Barrick, Goldcorp or Franco-Nevada. They were all driven by great discoveries. However, when a mining company touts the “value” of their logistics system to shareholders, you know the days of high returns are probably over.
Truly great gold discoveries are rare and becoming increasingly so. Without a great discovery, it becomes hard to separate yourself from the crowd. We should feel lucky knowing Mother Nature has been good to us.
f) Growing the business: Continually builds its royalty portfolio through cash flow and other creative means.
In mining, “growth” is now a dirty word. Large investors want free cash flow at all costs. Many of these investors were previously beating the drum for more production, more reserves and more leverage! It’s funny how the pendulum can swing from one extreme to the next. The fact is good projects and mines generally deliver excellent returns in both good and bad metals markets. It is up to the management teams to conduct an honest assessment of the economics and risks associated with a project, removing any emotional attachment (I have seen first hand how money can be diverted to a certain project that is favoured by management when clearly a better alternative existed).
The key for profitable growth in mining is to have a small financial footprint, good margins and a quick payback. However, from 2004-2012 almost everyone was looking to build “mega” projects that didn’t meet the above criteria. Today, most companies are either retrenching or afraid to announce a mine build because its share price will decrease.
One of the best pieces of advice I received while working for Rob McEwen, was that if you do the same as everybody else you shouldn’t expect more than the average. This makes a lot of sense and I am sure most would agree with this statement, but how many wake up with this mindset each day? I firmly believe you don’t achieve big things by accident. We also have no desire to be average at Abitibi Royalties because the rewards for being the best are not just a little bit better, they are a lot better. There are many industries or different sports where this plays out every day, but my favourite is the world’s fastest man. Everyone worldwide knows the name Usian Bolt. He is showered with adulation and endorsements. We may never see a sprinter like him again, but do you know who the second fastest man in the world is? He is only a fraction of a second slower (you can Google him). It is amazing how being a little better can translate into a much larger reward. Our objective is to be creative with our growth. We will look internally at organic opportunities such as further developing the Abitibi Royalty Search mentioned later in this letter and developing new royalty ideas.
2. Cash Flow - It Looks Better Coming In, Than Going Out!
At 40,000 feet, the simple explanation as to how Abitibi Royalties intends to outperform the gold price and its peers is to consistently increase the Company’s free cash flow on a per share basis, year over year, while maintaining a pipeline of high return opportunities that provides future growth a decade from now. Although everyone in the gold industry sings this gospel, the vast majority will fall short.
In 2016, Abitibi Royalties generated cash flow of approximately CDN$920,000 (royalties, dividends and option premiums). The Company’s cash flow is expected to increase further based on our royalties at the Jeffrey Zone and Barnat Extension entering production. This increase in cash flow excludes any potential production from our largest royalty, Odyssey North or from the Near Pit Targets, both of which are located at the Canadian Malartic mine and outlined below.
For much of this letter, we will detail how we expect free cash flow to increase both short and long-term with NO new shares being issued. In fact, we expect the share count to DECREASE.
3. Royalties at Canadian Malartic – Canada’s Largest Gold Mine
In 2016, Canadian Malartic remained the largest gold mine in Canada, producing approximately 585,000 ounces of gold. None of this production came from areas where we hold a royalty, since these portions of the mine are either being permitted for production, which is expected to start in 2018 (Jeffrey Zone and Barnat East) or they are at an advanced exploration stage.
The biggest issue facing the Canadian Malartic mine is replacing its reserves within the open pit, which have been falling for a number of years and decreased again in 2016. We think this is a positive for our royalties since it gives the operators of the mine (Agnico Eagle and Yamana Gold) an incentive to invest heavily in exploration and move Odyssey towards production. It is also having them look at commencing production from several Near Pit Targets around and below the open pit, where we also own a royalty. We think the combination of near term cash flow, development of Odyssey North/Near Pit Targets, along with a large exploration program that includes significant drill results such as those coming from Odyssey North/Internal Zone, is setting the stage for continued outperformance.
A) Odyssey North Discovery (3% NSR) – Be thou also bold, / And Merit praise from ages to come
In 2016, the operators completed one of the largest drill programs in Canada at the Odyssey Project, which totaled approximately 120,000 metres of drilling. This was double the initial 60,000 metres budgeted at the start of the year. In 2017, the operators are undertaking another large drill program. Should exploration continue to discover more ounces, we would not be surprised to see the amount of drilling increased, similar to last year. Abitibi Royalties holds a 3% NSR on the portion of Odyssey that is within the boundaries of Malartic CHL (part of the Canadian Malartic mine), which includes Odyssey North and a small portion of Odyssey South. Please see our corporate website (www.abitibiroyalties.com) for maps showing the project area.
It is my view that our royalty on Malartic CHL, where Odyssey North is currently the largest driver of value, has the potential to become one of the sectors best gold royalties:
- Initial Resource: The initial inferred resource for Odyssey, within the boundary of our royalty, totaled 1,039,941 ounces (14,969,946 tons (metric) at an average grade of 2.16 gpt). This was after only 1.5 years of continual drilling.
- New Discovery: The resource estimate did not include the new Internal Zone, where a number of significant drill results have recently been released that could increase mineral resources and enhance the economics of the Odyssey Project by adding higher grade ounces, requiring minimal additional infrastructure to access (please see our news releases dated February 21, 2017 and May 8, 2017 for full details). Last year we stated that the total number of ounces needed to be classified as a “world-class” royalty would be 4 million. With the initial Odyssey resource, combined with the other zones on the property where a resource has been calculated, plus the new Internal Zone and opportunities such as the Norrie Zone, good progress is being made towards this goal.
- Additional Exploration: As highlighted above, the mine operators are planning another large exploration program in 2017. Odyssey has the type of potential where a single drill hole could have a significant impact on the share price of Abitibi Royalties. Not many gold discoveries have this “game changing” ability.
- Possible Production: Yamana states that Odyssey supports optionality for enhanced production and life of mine at Canadian Malartic and that it could operate between 8,000-10,000 tonnes per day (tpd). Although more details are needed from the operators to determine the impact this will have on our portion of the royalty, it is big step forward and we are impressed with the progress that is being made.
Why do we think our Odyssey royalty is moving into the category of world-class? First, our royalty is sizable at 3%. Second, the deposit is demonstrating significant size and growth potential after only 1.5 years of continual drilling. In the world of gold mining, Odyssey is moving ahead quickly with the operators having a real incentive to see it enter production. Third, and this is a point not recognized by a lot of investors, it is part of Canada’s largest gold mine, which includes a very large mill at 55,000 tonnes per day (tpd). Why is this important? The grade of Odyssey is approximately twice the grade of the current open pit and therefore with the same amount of rock, you get twice the number of ounces. Should the operators believe Odyssey’s ounces are more profitable to mine, they can scale back the open pit and ramp-up Odyssey. There is a lot of optionality for Odyssey with a mill that large. Few royalties enjoy this type of advantage because the daily tonnage for most mills is fixed or if expanded, take many years to complete. Abitibi Royalties enjoys a “free” option that is unique in the royalty sector.
B) Jeffrey and Barnat East (3% NSR)
The Jeffrey and Barnat East deposits, where Abitibi Royalties holds a 3% NSR are expected to become our next source of near term cash flow. In previous letters we outlined how shareholders should not be surprised if the permitting process to begin production took longer than the operators had indicated. Permitting always takes longer than you think, even when you have two great operating companies like Agnico Eagle and Yamana running a mine. As of this letter, the final permits appear to be approximately 6 months behind schedule. Therefore, production is expected to start in 2018. This doesn’t concern us at all. Although there is always an opportunity cost associated with a delay and one can’t dismiss the time value of money, we won’t be losing any sleep or incurring any costs over the delay. Best of all, gold doesn’t have an expiry date. Canadian Malartic is a large driver of economic activity throughout the Abitibi region and we fully expect the few permits that are outstanding will be approved shortly.
C) Near Pit Targets (2-3% NSR)
Abitibi Royalties owns various royalties that are located south (2% NSR on the eastern portion of Gouldie and all of the Charlie Zone) and east of the main Canadian Malartic open pit (3% NSR on the eastern portions of Barnat East, Sheehan and the Barnat South Wall Contact). The operators of the mine began exploring these target areas in 2016 and have recently announced that they are evaluating the possibility of production between 2018-2020, which could include the areas where we own a royalty. This would represent a new source of cash flow for Abitibi Royalties that could be reinvested and thus compounded. Although we don’t believe these areas are in a reserve category, nor have they been officially approved for production, we like the steps that are being taken in order to move them forward.
The best royalty to own is one that delivers high rates of production over decades. This is why we invest in royalties. In addition to Odyssey, the target area around the Canadian Malartic open pit that we think holds this type of potential, although at an early stage, is Barnat East. Below the proposed Barnat East open pit, there was underground mining, which is now covered by our 3% NSR. This area of underground mining was part of the East Malartic mine. At the bottom of East Malartic a bulk tonnage zone was discovered known as Norrie, where historic drilling intersected several wide intervals of gold mineralization (a confirmation drill hole was completed in 2008), but at the time no mining method was known that could extract the gold at a profit. However, new mining techniques are reshaping the economics for these types of deposits and making them profitable to mine. Examples include Agnico Eagles’ Goldex mine, located approximately 20 kilometres east of Canadian Malartic.
The biggest unknown is how much further the Norrie Zone extends, both to surface and at depth. Although very early and not without risk, we believe this area could become an important, long-term asset for Abitibi Royalties.
4. Agnico Eagle and Yamana Gold Shares
In our first letter to shareholders back in 2015 we wrote, “The shares of Agnico Eagle and Yamana should be viewed as another royalty within our portfolio (and a valuable royalty at that!)”. Today, I stand firmly behind this statement.
During the two and a half years we have owned shares in Agnico Eagle and Yamana they have been a good source of cash flow through regular and special dividends of approximately (CDN$0.9 million), call and put option premiums (CDN$1.2 million), share price appreciation and capital gains (CDN$5.1 million). Our initial shares that were worth CDN$35 million have generated a total value of approximately CDN$42.2 million.
The cash flow generated from dividends and the call/put options premiums has also been valuable for reasons that might not initially be apparent: 1) they help pay the Company’s operating costs, 2) they have contributed to our share buyback and purchase of early stage royalties and 3) they have ensured that no new shares are issued in order to fund the Company, thus avoiding share dilution. This last point, although hard to quantify, is truly worth its weight in gold. The cost to existing shareholders when equity is issued is always high in mining (and most industries for that matter). Shares are typically issued at a discount to market (up to 20%), fees are paid to financial advisors (typically 7% of the total raised), warrants are given to new investors in order to “entice them to buy” and some are good for up to 5 years! Lastly, there are legal and exchange fees. Add it all up and you can see why issuing shares is a costly exercise. You will probably hear counter arguments such as, “that didn’t stop my junior explorer from doubling or tripling in 2016”. It is best not to confuse brains with a bull market.
5. Royalties - Growing the Business
It is also important not to confuse patience with inactivity and being patient doesn’t bother us. As pointed out by Warren Buffett, “I would rather be certain of a good result than hopeful of a great one”. During Berkshire Hathaway’s first ten years of existence it made only two meaningful acquisitions. Franco-Nevada made one. American Barrick and Goldcorp, after their respective discoveries were made, didn’t make a sizable acquisition for at least seven years (For full disclosure, Goldcorp did go through a restructuring in order to simplify the company’s ownership of assets).
Most acquisitions in the mining sector are value decreasing (and that’s putting it gently) for the unsuspecting shareowners of the purchasing company. Most banker meetings I have attended include a “pitch book”, which typically shows production/cash flow/resources all increasing and costs declining! What could be better? Rarely do they present a section on “Risks” or what might happen to the share price of the acquirer post announcement (this is referred to as the “settle” price). If a banker cannot state with confidence that the share price will increase for both buyer and seller, why do the deal? To paraphrase Seymour Schulich, the co-founder of Franco-Nevada, if you’re at a poker game and you can’t figure out within 30 minutes who the patsy is, you’re the patsy.
In previous letters we stated that our ideal acquisition would be a “world-class” royalty that would be in production, with a long mine life and would hold considerable exploration potential. As you probably know, this has not happened. The main reason is that we do not have sufficient cash to make this type of purchase today (despite having one of the strongest balance sheets among companies our size). We could raise equity or debt, but we don’t believe this is in our best interests. Personally, I have avoided debt at all costs and have no intention to start professionally. Leverage is addictive and what initially can be a wise business decision ends-up sinking the ship and shareholders will rightfully question who the business is being run for…the debt or equity holders.
You may be wondering just how much a world-class royalty will cost. I wish it was possible to give you a precise answer, but it ultimately depends on numerous variables. For the sake of argument we can assume a minimum of $100 million will be needed. Over time, I believe Abitibi Royalties has the potential to build its treasury to this point through capital appreciation of its shares in Agnico Eagle and Yamana, in addition to the continued improvement in our cash flow and by making other sound investments. This process will not happen overnight. We want to ensure our growth is managed in a way that does not harm existing owners through share dilution or debt.
I want to leave you with some M&A (merger and acquisitions) thoughts that were shared by Peter Munk, founder of Barrick, at that company’s Annual General Meeting a year before he stepped down as Chairman. His words left a considerable impression on me. Mr. Munk outlined how in the early 1990’s Barrick (then known as American Barrick) owned the best mine in the western hemisphere (if not the world) in Goldstrike, which is located in Nevada’s Carlin Trend. Barrick was riding high, producing 2 million ounces annually from that one property. However, Barrick then went out and acquired Lac Minerals. This was followed by the acquisition of Arequipa Resources, Sutton Resources, Homestake Mining, Placer Dome and finally Equinox Minerals. The company spent billions building new mines in the Dominican Republic and the high Andes during this time, among other locations. Mr. Munk concluded by saying that if only he had placed his feet on his desk in 1990 and done nothing for the next 25 years, Barrick’s share price would be higher today (you can argue much higher).
6. Royalty Search – Growing the Business Organically
In 2015, we launched the “Abitibi Royalty Search” (www.abitibiroyalties.com). As most of our shareholders know, this is an online platform we created where companies and prospectors can upload their geological data and have the property taxes/claim fees paid by Abitibi Royalties in exchange for a royalty. This is providing one avenue of potential growth by having us invest a small portion of our cash flow for a potentially large return (also the cost of acquisition can be used to offset future tax). In order for us to agree to a transaction, the property needs to be near an operating mine, with good geology and have evidence of mineralization through previous exploration. With these items in place, we felt the odds of a royalty being successful would increase. The plan called for us to stay 80% gold and 80% North America.
Our objective has been to build a portfolio of 25-30 royalties around some of the world’s larger mines, with the goal that one or two would be successful. We view these as bolt-on acquisitions that resemble perpetual lottery tickets.
Since last year’s letter, we have increased our interest on some projects, in addition to acquiring several new royalties. Details are listed below:
- Increased the existing royalty on the Menderes project in Turkey, which surrounds Eldorado’s Efemckuru mine to 3% (previously 2%) for CDN$20,000.
- Increased the existing royalty on Nordic Minerals project near HudBay’s 777 mine in Manitoba to 3% (previously 2%) for CDN$4,500.
- Purchased a series of new royalties around Goldcorp’s Red Lake mine and New Gold’s Rainy River mine in Ontario for CDN$15,000 and CDN$16,000, respectively.
To date, approximately 140 properties have been submitted and 18 royalties have been purchased. Our total investment to date is approximately CDN$195,000. We seek to be the partner of choice in this part of the market, where the due diligence is fast, bureaucracy non-existent and the cheques are promptly sent. By building this portfolio, we are getting a lot of potential upside and limited downside. I am pleased to report that we are starting to see progress on the various properties, as the owners have started to complete surface sampling (with encouraging results), geophysical surveys and one project is now part of a joint venture. We like these type of investments and look forward to adding more royalties during 2017 and beyond.
7. Share buyback
Share buybacks in mining are rare. The usual argument is that gold companies trade above their net asset value (NAV), are depleting assets (last year’s letter provided an alternative way of looking at this particular point) and it would be value destructive to buyback shares. However, issuing lots of shares above a company’s theoretical NAV certainly hasn’t caused the gold mining sector to outperform the broad markets! That said, determining if a company should repurchase its shares versus making an alternative investment or distribution to its owners is never easy. It depends on number of variables that ultimately includes an estimation of future after tax cash flow, gold prices, interest rates and future exploration success. It is important for shareholders to understand that we will never make repurchases in order to inflate the share price nor will we use it to support the price in a falling market (we wish to repurchase as many shares as possible and this means getting them at a fair price).
Last year we set aside additional funds to repurchase shares due to two unique events. First was Rob McEwen agreeing to purchase shares from exercised options. One of the conditions Mr. McEwen requested was that the majority of the funds received by the Company (Abitibi Royalties received approximately CDN$1.1 million) from the exercise was to be used for share repurchases. The second, albeit much smaller, was the board’s decision to use the sale proceeds from our Brio Gold rights (CDN$40,000) for the same purpose. The rights came as a dividend in-kind from our holdings in Yamana Gold and the board thought it made sense to reinvest this amount back into our own shares.
Beyond the two events mentioned above, we have always held the desire to repurchase our own shares assuming the price was right. Last year we stated that repurchases would occur if we could buy “$2 worth of assets for $1”. As our royalties continue to move towards production, I would like to update you on my thinking. In previous years our internal NAV calculation was based on a number of important variables, with some being educated estimates that used public data supplied by the operators of the Canadian Malartic mine. Although confident in our conclusion, there remained a high degree of uncertainty. As our royalties around Canadian Malartic advance and results have met our expectations, we are more confident using shareholder (your) funds for repurchases. I am certain shareholders will see additional repurchases in 2017 beyond the money set aside from the two events mentioned in the previous paragraph. It is important to note that the funds for this type of repurchase will come from cash flow and not our current treasury. My goal is to see our share count reduced to 10.0 million. This would increase your ownership in Abitibi Royalties by approximately 11.5%. As of this letter we have repurchased a total of 129,600 shares at an average price of CDN$5.62. These shares, which have been cancelled, would have a market value of CDN$1.2 million today, netting shareholders approximately CDN$445,000.
8. Shareholders of Abitibi Royalties
In the world of gold mining, our shareholder base is like no other. We have neither a large percentage of institutional investors, index funds such as the Gold Miners Index (GDX) or Junior Gold Miners Index (GDXJ) or boutique investors that typically populate the share registers of juniors due to private placements. Our owners tend to be long term, which is expressed through their ever-increasing ownership positions. There are approximately 10 groups that make up 80% of the total outstanding shares. We view Abitibi Royalties as a partnership, where the Company just happens to be public. I believe a large majority of our shareholders have been owners for at least 3 years. Through our management style and share structure, we hope to discourage investors who are short-term oriented, since our goals and their time frames are not aligned.
Companies tend to attract investors that mirror the style of management that runs them. Some companies offer high yields, while others focus on share appreciation. Certain companies have high trading volume and lots of shares outstanding and some (like us) have low volume and a small amount of shares outstanding (just the way we like it). You will often see companies focus on M&A and others look to organic growth.
Our low trading volume doesn’t bother us one bit. We would rather focus our time keeping smiles on the faces of current shareholders than trying to win over strangers. Low turnover also tells us shareholders are pleased with the Company and happy to watch it grow.
We believe that over an extended period investors will award a premium to those companies that act in the best interest of its owners. It is truly a relationship that is built on trust. Examples in the gold sector include Goldcorp when Rob McEwen was CEO and Agnico Eagle (from Paul Penna to the current CEO Sean Boyd). Both companies previously restrained themselves from issuing equity, set manageable growth expectations, continually stuck to their plan, embraced a culture of excellence and executed year after year. The relationships these companies built with their respective shareholder bases is a worthy goal. Alternatively, those companies whose actions suggest they are more concerned about the self-interest of management, such as unrestrained issuances of shares/stock options and large compensation packages while delivering little to negative return for its owners, will and should trade at a discount. From my experience observing such companies, the time spent in the “penalty box” could last for a long period. Often it pays to watch what management does and not what they say. This is not to suggest that shareholders of Abitibi Royalties will always agree with the decisions made by management and the board, but we hope our actions to date and future decisions demonstrate that our number one priority is looking after our shareholders.
We want to address a question that has been coming up recently and that’s if we are planning a share split, which is generally believed to be a “positive” event for the share price. The simple answer is no. Let me explain why. First, there is no fundamental change to the Company’s assets when the shares are split. It is still the same Company, dividend by twice the number of shares (with each investors ownership percentage remaining unchanged). Stock splits remind me of a smoke and mirrors show. No actual value is created, just a slight of hand, where people buy with a short-term orientation now that the price is “lower”. I think we would be doing you a tremendous disservice by splitting the shares because a high price attracts quality, longer term owners, not short-term thinkers, who believe there is more value because of the new, lower price. We have no desire to be like every other mining company and maintaining a high share price is just one of the ways we can standout. We think Berkshire Hathaway is a shining example of how a company’s share structure should look and at US$250,000 per share one can assume the lack of share splits didn’t hurt the price!
I wanted to inform each shareholder that it is my intention to keep using the after tax portion of my salary to purchase shares in the Company. This was started 2.5 years ago when I joined Abitibi Royalties. It is important to note that I didn’t get any founder or “free” shares, which is all too common in junior mining. Every step is being taken to ensure I walk in the same shoes as you. Why am I doing this? First, as several smart people have said, “whoever washes a rental car”? Your mindset changes when you continue to build an ever-larger stake in a company and you know that any future compensation will also become equity. Second, when a company becomes a large portion of your wealth it becomes an extension of your own personality. In the case of Abitibi Royalties, this may cause the Company to stay with certain principles and corporate strategies that others find conservative and old fashioned. This will surely cost all of us money as we decline to proceed with certain opportunities. However, Abitibi Royalties is being built to succeed today and for many years to come. It’s important to remember the first rule of investing, which is not to lose money. The second rule is not to forget rule number one! Last and most importantly, I believe Abitibi Royalties will continue to deliver a superior return over other alternatives. Ultimately, I am investing in Abitibi Royalties in order to make money like you.
9. One Company – One Great Mine Thesis
History has repeatedly shown that companies in mining that generate high returns and who typically only own one mine, go on to purchase low return mines in an effort to diversify (who likes high returns anyway?). In many cases when you add the cost of acquiring a company (plus the premium over the market price and golden parachutes paid to the former management), cost/time to build the project (and associated cost overruns that are bound to happen) and compare it against investing the same amount in a bond yielding 2-4% (that can also be compounded by making other investments from the interest payments received), you can quickly see that most newly touted purchases will have a hard generating more free cash flow over a 10 to 20 year span than the bond. This makes sense, because I haven’t met too many management teams, owning world-class mines that were looking to sell!
What often occurs when a management team who owns a great mine purchases another company is that focus and returns get diluted. More and more time will be spent on the low return asset(s), while the crown jewel becomes neglected (in addition to shareholders owning less of that crown jewel since shares are typically used to make the acquisition in question). When company A purchases company B, you always hear about all the great benefits to shareholders in the initial news release. However, I can’t recall a company ever informing its shareholders about the risks associated with a acquisition (best not to let facts get in the way of a good story), such as management will no longer be spending 100% of its time on its highest return asset and that they expect this number to drop in most cases well below 50%. You will also never hear about expected returns (they are often close to zero or negative), salary increases or bonus claw backs should the benefits of the deal fail to materialize.
Why do these transactions happen if they so rarely benefit the shareholders of the acquiring company (this isn’t to say all mergers and acquisitions are flawed, but I do think it covers the majority of deals)? I believe there are a few reasons 1) Boredom. Management believes they are paid “to do things”. 2) Ego. You don’t typically become CEO without an aggressive personality. 3) Bankers. They are very good at sales and telling you what you want to hear (it is the CEO who signs their cheque after all) and 4) Compensation. Managements salary and bonus will rise equal to their new larger peers, which will more than offset the decline in the shares they own. The amusing part about issuing shares in order to make an acquisition and “grow” is that all of the existing assets will shrink in the process. As a shareholder it becomes quickly apparent what is most important to management, expansion regardless of costs or the wealth of its owners.
10. Gold Price
Although we are not ones to make predictions (especially on a macro level), we have always believed that it is important for the owners of Abitibi Royalties to understand and evaluate management’s view on the gold price and where we think the metal is in the cycle. Someone’s view of future gold prices will surely influence their approach to management and capital allocation. For example, if a management team believes the price of gold is going higher over the next 10 years, they may look at acquiring higher cost projects or increase the amount of debt the company has on its balance sheet to add leverage. Alternatively, if management believes the price of gold is going lower, they may hedge the price of gold or reduce debt. Everybody wishes to buy low and sell high, but history has proven this is easier said than done.
Last year’s letter stated, “I believe the United States will continue to raise interest rates in 2016, albeit at a measured pace, while many countries around the world will remain in negative interest rate territory. This leads me to believe gold will be range bound for the reminder of the 2016. The bottom of my range is USD$1,125 per ounce, while the top is USD$1,425 per ounce”.
After last year’s letter was published, gold reached a low of USD$1,125 in December and a high of USD$1,365 per ounce in July. Although our forecast was fairly close, you should know this had more to do with luck than skill (I have no plans to leave my day job and take on George Soros just yet!). We tend to use ranges versus exact prices because a) it is difficult to predict something that closely and 2) we feel Abitibi Royalties should be run based on a numerous possibilities.
A couple of themes that we may see for the remainder of 2017: 1) Strength in US Dollar, 2) Rising yields in the US (perhaps at a slightly more moderate pace than the market is pricing) and 3) Flat to slightly positive yields in the rest of the world. What does this all mean for the gold price? My best estimate for the coming year is that the price of gold will be range bound, similar to 2016, which will include short term price swings up and down that will have commentators suggesting we are in the next bull or bear market. I am not sure we are in either. Therefore, my price range will be even more liberal in 2017. The bottom of my range is USD$985 per ounce (which I hope we don’t see), while the top remains USD$1,425 per ounce. We will continue to operate the Company based on conservative assumptions, but ensuring our investors benefit from any rise in gold.
Equally important to our Company is the United States/Canadian Dollar exchange rate. Our revenues are stated in Canadian Dollars and so is our share price. A weaker Canadian Dollar helps our business. How? Assume the price of gold in US Dollars declines by 2%, but the Canadian Dollar falls by 10% (relative to the US Dollar), our revenues in Canadian Dollars would still increase despite the lower gold price. Today, when we make cash flow projections or consider stock repurchases, we use spot prices for gold and currencies. This could change should we find ourselves in a situation where prices rise or decline dramatically from current levels.
I hope this third letter to shareholders has given you greater insight into your investment. Our business model is simple and we will look to keep it that way by focusing on: a) improving the earnings power of our businesses on a per share basis, b) further growing the Company through cash flow, c) strengthening our already golden balance sheet and d) looking to decrease our outstanding shares, which will subsequently increase your ownership percentage in the Company.
I want to thank our shareholders for your ongoing trust and confidence and our board and employees (who don’t get nearly enough recognition for the wonderful job that they do). I believe the best days for Abitibi Royalties are very much ahead of it.
President, CEO & Director