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Fond Memories of Mining

“I must be a genius!” I thought to myself in the summer of 2010 (Ryan here). I had just made an investment in Yukon-Nevada Gold Corp. The investment thesis was simple: for less than $200 million you could buy a quality mining asset with large reserves in the safe jurisdiction of the United States. Better yet, it was on the verge of huge production expansion with a margin of safety backed by its “one of a kind” roasting facility, a scarce tangible asset with a value estimated at over a $1B.

After completing a turnaround facilitated by Sprott, one of the world’s top resource investors, Yukon-Nevada was going to ramp production steadily and exit the year at a steady state production level approximating 150,000 gold oz. per year. The resulting cash flows would be almost $100 million.

This means that we lucky investors could buy this mine backed by a $1B dollars worth of assets at less than 2x cash flow! To make things even more interesting management was predicting that within five years, Yukon-Nevada would be in a position to produce up to 1 million oz. per year, a level of cash flow that would be over 7x its estimated near-term run rate! Sounds like a bet worth making no?

Regardless, I was in good company, as many other skilled value investors had performed similar levels of due diligence. They, too, agreed on the promising potential and large margin of safety. In fact, crazily enough, I wasn’t even the only member of the Portfolio Ops team that felt this way, as (unbeknownst to me at the time) my co-editor and proverbial “brother in arms” Eugene was invested right along with me and by and large for the exact same reasons.

A “Perfect Storm” in Metals & Energy

Portfolio OpsAbove Average Odds Investing’s

Portfolio Ops — Sandstorm Metals & Energy (SND) March 4, 2013

Action to take: Buy Sandstorm Metals & Energy (SND.V, STTYF) up to 50 cents per share.

Target: $1.20–2.00+ per share over 3 to 5 years

Risk: Low

Synopsis: After building Silver Wheaton and Sandstorm Gold into billion dollar companies, Nolan Watson created Sandstorm Metals & Energy along similar lines. It earns streaming royalties on min-ing & energy assets. The stock trades at absurdly low multiples — our estimate is less than 4 times

March 2013 Issue 002

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Within a few months the stock had rocketed up over 300%, with plenty more upside left to go. What could possibly go wrong with this investment?

When Genius Failed, Redux

Oh, let us count the ways!

Yukon-Nevada suffered a harsh winter. The company needed millions of dollars to fix all the damaged facilities. Since the mine was not producing enough to generate positive cash flow, management had to raise cash by issuing more shares and warrants.

Over the next several months things got even worse, as equipment breakdowns caused further production delays. To try to provide a short-term fix, management agreed to let other mining companies use their roasting facility to help them “bridge the gap”. Yet, in their desperation, the deals they struck actually caused Yukon-Nevada to lose money in the process.

The company had to raise even more cash. It signed an agree-ment that would give up a significant portion of their future production to an investment bank. By the end, these moves diluted shareholders by over 50% and Eugene and I were left with some cheap tuition and a newfound appreciation for an age old saying amongst industry guys, namely that whatever can go wrong in mining, will go wrong.

I guess age-old sayings are “age-old” for a reason. That, and while success is a lousy teacher, the reality of the mining

business and owning 2nd and 3rd tier resource assets, not so much. Hopefully the last time I find myself needing to relearn what the fish have always known, it’s the shiny flies that often have lethal hooks!

Scarred by Battle, But Valuable Lessons Learned

The lesson here is that mining is simply a horrible business. The management of Yukon-Nevada was not entirely incom-petent. They had a large mine that had fallen into disarray and had to fix an endless list of problems. Even worse, dur-ing this turnaround effort they were barraged by numerous additional problems that were outside their control. All of this costs money, lots and lots of it. Management was so busy putting out fires that they couldn’t focus on growing production and without production (at least of the profit-able variety) they quickly kept running out of cash. The result was a vicious circle, a negative feedback loop that gives way to what in industry parlance is referred to as a the death spiral. Sounds fun doesn’t it?

The mining business is even worse than the airline business. Suffering from many of the same type of problems, Buffett often talks about how he has experienced a similar level of frus-tration with airline investments, with their large fixed costs, endless capital expenses, volatile fuel costs, extreme cyclicality, constant cost pressures (labor unions), lack of pricing power etc. and how in the end (all things considered), investing in busi-nesses with these type of characteristics is essentially a suckers bet, at least it has been in his experience and historically. We

agree. Their very nature makes generating sizable profits, at least consistently and over a full cycle, a tough slog. I mean you know something’s wrong when an industry hasn’t made a dollar of profit in aggregate in ~100 years. Such an astounding fact breathes life into Buffett’s witty, sarcastic, and always amusing partner Charlie Munger’s comment that, “There are answers worth billions of dollars in a thirty dollar history book.” Indeed!

So the problem with owning a miner is that it’s generally an unattractive proposi-tion (investment wise) regardless of the

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price. With the exception of low cost producers, as businesses they are entirely unpredictable — even worse, they can accu-rately be described as low return cash-consuming black holes. By this, I mean the type of business where a high percentage of its cash flow must be plowed back into its assets simply to keep it from losing ground. And even if they do manage to grow, any growth will inevitably be accompanied by a large, risky upfront cash investment where the return of capital is often more of a concern than your return on capital. It’s the stuff that haunts this value investors dreams.

As a quick aside, I couldn’t help but laugh the other day when a tweet framed miners as akin to businesses that invest in lotto tickets, and that on the rare chance they win, they just plow those winnings right back into even more lotto tickets. There’s a lot of truth to that.

Your editors think Charlie Munger expressed our sentiment perfectly when he said, “These are businesses… where you just constantly keep pouring (cash) in and pouring it in, but where no cash ever comes back…. One of the things that keeps our life interesting is trying to avoid those and trying to get into the other kind of business that just drowns you in cash…” Amen! As Munger points out, the question is why would you even want to own a business that has to work so hard simply to keep its overall revenue and profits flat and where the investment required to do so year in, year out, is not only sizable, but prone to capital destroying hiccups by its very nature?

So who cares if a business like that is statistically cheap, if over the long-run it will have such a hard time producing economic value for its owners. By economic value we mean “owner earnings” or the amount of money an owner can take out of the business after all costs without injuring its earnings power and competitive position (it’s basically the cash we can utilize to either pay ourselves or reinvest to grow our total profits in the future). Why risk ones hard earned money if your ability to benefit from value creating “dividends” is a long shot at best? The point is that an unpredictable low quality business that has difficulty generating free cash is sim-ply a business not worth owning pretty much by definition.

Luckily Eugene and I eventually woke up and started to ask ourselves what a business like that was worth? Experience informed answer? Not much, often zero actually and even if there is a lot of value there unrelated to the resources in the ground, like with Yukon’s roaster asset, that value is more

likely than not to be eroded away over time. It’s actually rather astonishing how fast it can happen. And that leads to a related question, namely whether such businesses will even be around in a couple of years, let alone in 10 — and again, even if it is, will investors have been diluted into oblivion at that point? Who knows, and that’s the problem.

Anyhow, like Buffett, your editors make a habit of avoiding businesses of the resource extraction variety on principle, and that extends really to all bad businesses in general. The lesson for me in this saga was simply that life’s to short. I’ll pass on all the heartburn, and just stick to buying wonderful busi-nesses on the rare occasion they get cheap.

Better to spend our time looking for the next “epic investment for posterity” like GEICO or Gillette, than the next Yukon Nevada, investments with the exact opposite attributes of your typical miner: low fixed costs and expenses, a permanent cost advantage, the ability to generate large increases in revenues and profits without requiring large sums of cash, and most importantly: a huge runway of growth to continually reinvest these profits at ever increasing rates of return allowing your investment to compound upon itself for decades. In other words, the secret ingredients of wealth creation.

Yet many smart investors today are drawn to the resource and mining industries because they see so many problems in the current state of the world, problems only compounded by ineffectual politicians and misguided central bankers. We get it, and we think that fear is warranted. We also get that in theory investing in the resource and mining sectors is one of the few ways investors can go about protecting themselves from the above issues.

But as you can see, the answer is not to buy a mine, at least directly. What we want here is exposure to this sector by finding the proverbial GEICO of resources and mining. Like GEICO, we’re looking for a business with very low market share in terms of the total addressable market, attractive cash economics, a tremendously long runway for growth, hard to replicate cost advantages, and compelling incremental economics. In less jargony terms, we want to find a well run business where its competitors can’t eat away at its profit generating capabilities and where it has a long runway to invest its money at high and increasing returns. A business that provides us with a substantial amount of low-risk leverage to rising commodity prices — so a business defined by having pretty much the opposite characteristics,

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at least qualitatively, that one would expect to find in a miner. In short, a resource-based investment where the risk-averse investor can have his cake and eat it to.

And that brings us to our recommendation: Sandstorm Metals and Energy (SND).

Briefing Summary

Truth be told, your editors got a bit weak in the knees (in the figurative sense) when we started running the numbers on this one, especially given Sandstorm has nearly all the qualities we look for in a great long-term investment. These are:

1. The stock is unsustainably cheap, both in the absolute sense and relative to similar businesses.

2. It is run by a smart, proven, and properly incentivized management team.

3. It possesses a highly attractive long-term business model with massive opportunities for future growth.

4. There is a high likelihood of meaningful improvements in near term profitability and cash flow.

5. We have multiple, high probability, catalysts in front of us that we expect will unlock substantial amounts of value in the near to medium-term.

In other words, we expect to make a substantial sum of money with very little risk, and sooner rather than later. Indeed, for many reasons we think investors stand to earn anywhere between 2x to 10x their money on Sandstorm Metals & Energy over the next 5 years. Better yet, the odds of losing money at the current price are practically non-existent.

We’d be remiss not to mention that this initial overview only scratches the surface of this hidden gem. It provides merely a foundational blueprint of sorts on why we believe at the current quote, an investment in Sandstorm represents such a remarkable opportunity for the long-term, risk-averse investor.

While a complete, detailed analysis of each of the compa-ny’s assets is beyond the scope of this briefing, rest assured we will continue to peel the layers back of this one of kind, multi-layered onion in our alerts going forward. Stay tuned and keep an eye out for coming updates.

The Business Model — Simple yet Stunning

What does Sandstorm do? Sandstorm is a “streaming” royalty company. It provides a source of financing to metal and energy companies to bring development stage projects into production. In exchange for a large upfront payment, Sandstorm gets to purchase a future “stream” of their production at an agreed upon fixed price — usually at far below market prices, thus ensuring a source of high-margin recurring revenues.

The “streaming” business model was first pioneered by Seymour Schulich and Pierre Lassonde, godfathers of the resource mining space. Together they started Franco-Nevada Mining Corporation in 1982, initially intended to explore for gold in Nevada but later transitioned into the world’s first gold royalty company. (Technically speaking, a stream-ing model is slightly different from a pure royalty, which typically gets 2–3% of the gross revenues produced by the mine. A more detailed explanation of the streaming model will be illustrated below.)

The streaming model is a particularly attractive source of financing for both the resource company and the streamer. This symbiotic win-win relationship is why we believe that streaming companies like Sandstorm will be able to capital-ize on tremendous runway of growth and value creation for years to come.

Call it a “break-through value proposition”

For the resource company, many attributes make a streaming deal far superior to traditional forms of financing like issuing equity or debt.

1. Streaming is a flexible source of funding, spreading the risks of mining mutually between both companies.

2. The resource company can immediately capitalize and realize part of its mine’s value upfront before production. Obtaining a quick source of financing enables faster time to produc-tion yielding a quicker return for shareholders.

3. Streaming is safer and less restrictive than traditional bank debt. Any bumps along the road to production (which are inevitable in mining) can imperil the company because banks are usually inflexible in their covenants and will move to seize the assets bankrupting the company.

4. Streaming is cheaper than issuing equity. It is less dilutive

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to shareholders who will still maintain ownership rights allowing more future opportunities.

5. Streaming enables resource companies to finance projects on a location-by-location basis. They can tailor a streaming deal to one particular mine, or one particular commodity. It allows room for additional streaming deals in the future for the company’s other assets. In other words, it does not tie up the entire company’s assets like debt or equity.

For the streaming company, these deals provide a highly attractive business model.

1. Leverage to underlying commodity prices. We believe that the future is much more likely than not to see higher prices due to inflation and emerging market population needs. Streaming companies offer an excellent investment vehicle to gain exposure to rising precious metal, base metal, and energy prices.

2. It is low risk, unlike the mining business itself. Usually, after providing the initial funding, the streamer is not responsible for: any further capital expenditures, cost overruns in devel-oping the mine, escalating operating costs of the mine once it’s in production, nor any further exploration costs. As long as the mine is producing, this model almost ensures the streamer is cash flow positive with little risk of bankruptcy.

3. Massive operating leverage. Streaming is a low fixed-cost business model. The core operation of a streaming com-pany is a handful of key employees evaluating potential deals. There are very few physical assets or costs. This enables maximum leverage of the firm’s intellectual and financial capital.

4. Huge potential upside. In addition to the streaming deal itself, the streaming company usually also gains exposure

to any future exploration discoveries and production upside. If a world-class asset is carefully selected, and if the deal is properly structured, this attribute can generate a literal snowball of growing cash flow for decades. This essentially-free call option cannot be underestimated, and it is the reason why shareholders of streaming companies like Franco-Nevada, Royal Gold, and Silver Wheaton have realized multi-bagger returns.

An Inside Look at a Blockbuster Streaming Deal

To fully appreciate the sheer power and hidden levers of the streaming model, let’s take an in-depth look at an exemplary deal by one of the pioneering companies of the industry: Silver Wheaton and the Penasquito mine.

We did not choose this example at random. Nolan Watson is the CEO of both Sandstorm Gold and Sandstorm Metals and Energy. Prior to founding Sandstorm, Watson was one of the key players and founding members of Silver Wheaton. Watson was promoted to CFO of Silver Wheaton in 2006 where he was instrumental in the company’s strategy and financing until he left to start Sandstorm in 2008. At Silver Wheaton, Watson helped engineer the Penasquito streaming deal, which was signed in July 2007.

The Penasquito open pit mine is one of the crown jewels of Goldcorp, which owns and operates the mine. It was the largest undeveloped silver mine in the world. In July 2007 Silver Wheaton entered into a streaming deal where they paid Goldcorp an upfront payment of $485 million. In exchange, Silver Wheaton received the right to buy 25% of the silver production for the entire remaining life

of the mine at only $3.90 per ounce. At the time: the price of silver was about $13 per ounce, ensuring a healthy $9 margin per ounce of almost pure profit.

Penasquito had plenty of ounc-es too with 860 million ounces of proven and probable silver reserves (215 million ounces attributable to Silver Wheaton).

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The expected production was 5.5 million ounces per year with a 17-year mine life. Therefore, this deal should produce about $50 million per year in cash flow, yielding a respectable 10% return on invested capital.

Furthermore, Silver Wheaton’s streaming deal had downside protection: no further funding obligations, no responsibility for any capital expenditures, and no obligation to fund any future expansion costs associated with the mine (even though they now had a right to 25% of the entire mine’s production forever). The risk was also reduced by obtaining cash guarantees that Goldcorp would complete the mine by certain milestone dates.

Production ramped up in 2010, and Silver Wheaton received 3.8 million ounces generating over $50 million in operating cash flow, which was higher than initially expected due to higher silver prices. The Penasquito silver was purchased from Goldcorp at $3.90 per ounce and sold for an average price of $21.60.

It is currently estimated that for fiscal year 2012, Silver Wheaton will receive over 7 million ounces of silver yielding over $150 million in operating cash flow — a stun-ning 30% annual return on capital invested of $485 million. As of September 2012, the Penasquito mine had cumulatively delivered over 12 million ounces, resulting in cumulative operating cash flow of over $300 million. That’s right:

within 3 years of starting production, Silver Wheaton had already recovered over 60% of their initial investment back.

Even better, these tremendous returns carried very little risk. Whereas mining itself suffers all of the potential problems we discussed above, the streaming companies can prosper even in bad times. Let’s imagine a horrible year where silver production falls in half to 3.5 million ounces, and simulta-neously silver prices crater in half to $15 per ounce. Even in this scorched earth scenario, Silver Wheaton would still have approximately $40 million in cash flow yielding a still respectable 8% return.

“Time is the friend of the wonderful business, the enemy of the mediocre.”

— Warren Buffett, 1989 Annual Letter

What makes the streaming model such a fantastic business is the very likely possibility of huge future expansion of the mine. When the Penasquito stream was executed in 2007, the deal looked quite decent on paper: world-class asset, little downside risk, and very respectable returns of about $50 million or 10% per year. But what absolutely crushed the ball out of the park, was the huge future upside built into the deal:

1. Leverage to metal prices: Since the deal was signed, silver had skyrocketed from $13 per ounce up to $30, peaking as high as $45. This has tripled the profits that were originally mod-eled, since cash costs are fixed at $3.90 per ounce.

2. Future exploration upside for the entire life of the mine: For a well-selected world-class asset, the mine will have huge

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potential resources that will be developed into reserves as the mine is further explored. Within two years, the reserves at Penasquito had been revised upwards by 25% to over 1 bil-lion ounces (over 260 million ounces attributable to Silver Wheaton). The expected life of the mine had increased to over 25 years, significantly higher than the originally mod-eled 17 years. Even these increases significantly understate the future potential, since they do not even account for the additional vast underground resources, of which Silver Wheaton is entitled to 25% of all future production.

3. Production growth: If a streaming deal is reached with the right mining partner, over time, their successful execution can result in significantly greater returns. The Penasquito deal originally modeled 5.5 million ounces of production per year. For 2012, it’s now estimated that production will be over 7 million ounces. For 2013 and beyond, it’s estimated that Penasquito should produce well over 8.5 million ounces per year for at least 25 years.

Let’s chew on these numbers for a moment. If Penasquito delivers 8.5 million ounces to Silver Wheaton, that’s over $200 million of operating cash flow at recent silver prices. That’s a 40% annual return on capital! For over 25 years!

Quick quiz: what’s the net present value of a 25-year bond that yields 40% ?!?

Consider further, that of the $485 million paid to Goldcorp, Silver Wheaton financed this deal with a loan of $446 million. So technically speaking, less than $40 million of equity capital was invested, and the theoretical annual return on equity approaches an astronomical 500%!

Back to Sandstorm Metals and Energy

Sandstorm Metals and Energy was spun off in 2010 from what is now Sandstorm Gold. It was initially capitalized with $100 million, and raised an additional $50 million in 2011 by issuing equity. Nolan Watson decided to spin out Metals and Energy to capitalize on what he (and we) believe will be a huge growing market — providing financing alternatives for metals and energy companies, not just precious metals miners. At the moment, they are the only player in this highly attrac-tive niche, as no other streaming company has a primary focus on the non-precious metals space.

Sandstorm has invested a total of approximately $125 million diversified among four different commodities. Below is a brief snapshot of their portfolio. In future issues we will delve into the details about some of these streaming deals and why even just one of these deals can justify the value of the entire com-pany today.

1. Copper: Brace-McLeod mine, with Donner Metals and Xstrata. Invested $27 million for 25% of life of mine production.

2. Natural gas: Gordon Creek property, with Thunderbird Energy. Invested $25 million for 35% of production.

3. Palladium: Serra Pelada, with Colossus Minerals. Invested $15 million for 35% of life of mine production.

4. Copper: Oyu Tolgoi, with Entrée Gold. Invested $5 million for 2.5% of production.

5. Coal: Rex and Rosa mines, with Novadx.

Sandstorm is Ridiculously Cheap

Based on conservative estimates, we believe that Sandstorm Metals and Energy will be on track to generate run-rate cash flows of a minimum of ~$25m within two years. At its cur-rent price of $0.39 per share, the enterprise value of the entire company is only ~$120 million — that is after accounting for a current market cap of $125 million and the ~$5 million in excess cash in the company’s coffers (so after adjusting for all of its potential commitments).

That said, the capital light nature of the company should ensure that all of the cash generation in the interim should drop straight to the bottom line and considering that, we think it makes sense to subtract another ~$21m from the present Enterprise Value (which is stock market value plus debt less cash; think of it as the theoretical value the market puts on the whole company) to arrive at an implied normal-ized EV come year-end 2014.

Taking that adjustment into account we’re looking at a pro forma YE ‘14 EV that should approximate ~$99m. Keep in mind our back of the envelope estimate assumes SND only generates ~$25m between now and then, which is very con-servative. Once we’ve subtracted the company’s operating expenses we’re able to arrive at the ~$21m debit used above.

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Yes, rub your eyes, this high quality asset-light company with massive growth potential is trading for approximately 4x nor-malized cash flow. For some perspective it’s streaming peers such as Silver Wheaton, Royal Gold, and Franco-Nevada all trade at over 12x to 15x estimated 2015 cash flows.

Let’s consider just one stream, the Brace-McLeod copper stream with Donner Metals and Xstrata, which is set to ramp up production in the imminent future. Notably, this one stream is poised to conservatively generate ~$16 million + in operating cash flows for many years, perhaps decades, to come.

At today’s stock price, you will be getting this one enduring, high-quality streaming asset for only ~7x normalized cash flow, plus you get all the other streams and their huge future potential for nothing. That’s like being dealt Aces, plus you get to simultaneously play at least four other hands of pocket pairs for free!

Granted, we love having multiple ways to win and little risk of loss with our investments as much as the next guy, espe-cially when they possess an imminent hard catalyst like we have here with first production at the Brac-McLeod mine expected to come on in the imminent future. Candidly, that alone would be enough to get us interested given the implied valua-tion, the quality of this asset, and the reality that production is literally right around the corner. I mean come on, when Sandstorms largest and perhaps most lucrative stream comes

online the company’s cost of capital should start to rapidly decline pretty much by defini-tion. As it does, its multiple will naturally expand, offering investors positioned ahead of time the type of low-risk lay-up we’re all constantly digging for.

Yet it’s the fact we are getting a bevy of additional high margin annuity like cash flow streams with tremendous embedded growth potential, streams we should add that by our calcula-tion are likely worth several hundred million dollars that really blows our mind. The opportunity to purchase a won-derful asset with contractually

guaranteed senior security at an attractive price, while getting similar assets worth a couple of multiples of that value for free just doesn’t come around very often. We think its wise to seize them when they do.

Huge Upside, but Low Downside Risk

What ultimately makes Sandstorm Metals and Energy such a uniquely compelling investment, is not just the huge potential upside trading at an extremely low valuation. It’s that all this upside comes with very little downside risk. Based on our above discussion of the streaming model in general, this kind of business doesn’t have any of the risks usually associated with mining.

Even more specific to Sandstorm in particular, Nolan Watson has carefully crafted each streaming deal to provide maximum protection with a keen eye on minimizing risk of permanent loss of capital. Each streaming deal is structured as a senior secured agreement, fully collateralized by all of the assets of the mine itself — including both the world-class resource deposits and the mining infrastructure. Each deal is carefully designed so that Sandstorm can get back its principal payment within 5 to 7 years, with annual cash repayment guarantees of over $80 million among its portfolio projects. In other words,

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at the current enterprise value, you are almost guaranteed to get all of your investment repaid in cash.

Furthermore, Sandstorm Metals and Energy is not a lever-aged company, at least not in the traditional sense. It has well over $30 million of cash on hand presently to fund its commitments, corporate operations, as well as to deploy towards future opportunities. This is a huge cushion of liquidity, especially when you consider that this is a business with very low fixed costs and very few physical assets — primarily just a handful of key employees. Remember as well that SND’s operations should start generating another ~$1–2m in cash per month in the near-term as its natural gas stream continues to ramp and its copper and (perhaps) met coal streams come online. Because corporate level expenses are only ~$2 million a year, Sandstorm will be able to both generate large amounts of excess cash regardless of where we are in the current economic cycle and can contin-ue to operate/sustain itself for many years, regardless of the economic environment.

The Jockey — Nolan Watson is the Real Deal

As you know, at Portfolio Ops our resolve is to concentrate our investments in great businesses run by extraordinary, proven managers with substantial skin in the game. While this doesn’t guarantee success by itself, it certainly stacks the odds of market beating returns in our favor. Rest assured your editors have and will continue to spend countless hours studying their track records, incentives, operations, and pick-ing their minds on site and/or in the office. The goal being to develop maximum conviction that they have what it takes to both protect and grow per share value over the long run.

Given the weight that we place on the quality of management then, it is still very rare that we are as impressed by a CEO as we are with Nolan Watson.

To point out a few highlights, Watson graduated from Canada’s elite University of British Columbia and quickly thereafter became a chartered accountant and CFA while beginning work at Deloitte’s corporate finance department doing business valuations and M&A.

Watson was soon taken under the wing of mining legend Ian Telfer, and in 2004 became the very first employee at

a brand new company called Silver Wheaton. Watson was promoted to CFO at Silver Wheaton in 2006, which is a notable achievement considering Watson, at the ripe old age of 26, was the youngest CFO in the NYSE’s history. As CFO, Watson was instrumental in its growth on both the strategic and financial front, raising over $1 billion in debt and equity over the course of his tenure.

Silver Wheaton, armed with a Watson raised treasure chest, proceeded to practically invent the commodity streaming business model as we know it — not to mention make a fair amount of coin for themselves and their shareholders. Actually, they proceeded to make an almost indecent amount of money during Watson’s tenure, but who’s counting (we certainly are!). As evidence, note that Silver Wheaton grew from an obscure $200 million micro-cap into a ~$3 billion wealth creation juggernaut.

Not bad for a mid twenty something guy’s first gig, no?

In 2008, right in the teeth of the great recession, Watson decided to leave Silver Wheaton to start his own company Sandstorm Resources. A value guy and entrepreneur at heart, and fully aware that the most significant fortunes are often built when there’s “blood in the streets”, Watson and fellow partner David Awram hit the road looking to raise money for his new venture.

Armed with an innovative, winning model, along with a fanati-cal devotion to building a truly great, enduring business, Nolan planned to hit every bank or potential source of financing in every city in North America to make it happen. In fact, that’s not an exaggeration, as that’s exactly what he and Awram did. The two pledged to literally not return home to Vancouver until they had the requisite money in hand.

As an aside, besides being bold, remember, this was in the heart of the worst financial crisis in a generation — so besides being just all around awesome — we it offers us a glimpse of the type of gritty, nose to the grindstone passion and raw determination to succeed that is the hallmark of all true great entrepreneurs and business men. Not only that, it must have taken a tremen-dous amount of courage to leave a cushy job at the preeminent stream finance company in the world and attempt to stand on his own two feet, especially with the global financial system shaking beneath them.

The intention here isn’t to lionize the guy, just to point out that the above example provides some real insight into the

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man’s competence, character, courage and overall determina-tion to succeed. Which is why we couldn’t be more fired up to partner with him as he goes about growing the business over the long-term. Point being, he’s smart, proven, motivated and not the type of guy that will give up (he’s got it all on the line) and considering that, its hard to imagine a reasonable scenario where he doesn’t grow the value of this business over the next 3, 5, 10 years from today.

Turning back to the topic at hand, the pair succeeded raising the money and it wasn’t long before Nolan’s money-making magic was once again on full display as he was able to grow his baby into a billion dollar company in less than four years. Along the way, Sandstorm Resources was renamed Sandstorm Gold, after spinning out Sandstorm Metals and Energy.

It’s also well worth keeping in mind that Watson’s salary at Sandstorm Metals and Energy is only $89,000 a year! Comparisons to Warren Buffett and his shareholder-based stewardship of Berkshire Hathaway are more than fair, we believe. And that’s because of a variety of policies, perhaps the most obvious being that nearly his entire net worth is invested in both of the Sandstorm companies. Like most great stewards of capital, Watson puts his money where his mouth is in more ways than one.

Insiders continued to purchase more shares in the open market last year between $0.32 to $0.35. (Because of the event-driven nature of the streaming deal business, it’s very difficult for management to purchase shares without violating insider-trading regulations.) From our discussions, they would love (and expect) to own a lot more because they believe that the future of Metals and Energy will be especially tremendous — with a first mover advantage, basically zero competitors and the requisite street cred and rolodex vis a vi both the opera-tional and financial sides of the business, its hard to argue with that conclusion, especially taking into account the sheer volume and range of potential investments that will come across their desk in the months and years ahead.

For what its worth, Watson is actually on record stating that he believes SND will eventually grow to be a $50 billion dollar company (and yes, that’s $50 with a B)!

For those taking score, Sandstorm M&E’s present market cap is only $125m.

The Importance of Management and Moats

Demonstrating the economic power of the streaming/royalty business model, the success of Silver Wheaton and others like Franco-Nevada and Royal Gold have not gone unnoticed. In the coming years, there will be lots of competition from new royalty companies, financial institutions, and private equity. Being an asset-light business, the primary assets of a streaming company are its people. In an industry where lots of people can simply provide capital and write contracts, the quality of management will be the key differentiating driver of success (not unlike insurance). The presence and durability of an economic moat, if any, will emanate directly from the quality of management.

In this regard, once again we believe we are especially fortunate to have the opportunity to partner with someone of Nolan Watson’s caliber. Not only is he a proven and capable manager, but we also believe he has the vision and foresight to stay at the leading edge of the industry.

But what possible innovation could there be in financing a mine, you ask?

“ The reason that we started Sandstorm is that we strongly believe that streaming is an attractive alternative to debt and equity financing for mining companies of all sizes across the globe, and that it complements other forms of traditional project finance. When building a mine, every company’s finance needs are different and I think one of the weaknesses in resource finance has been that the industry has taken an unimaginative and plain vanilla approach to funding a mine, despite each mine and its funding requirements being unique. What we endeavor to do at Sandstorm, is to work with our mining partners to determine the best way to finance their project into production. Streaming finance will always be at the core of what we do at Sandstorm, but we have found that being flexible in our approach has increased our deal flow and given us access to opportunities that we would not have had otherwise. Streaming finance is very much in the early stages of its evolution but I believe that Sandstorm is going on the forefront of what will be the best financing solution that the mining industry has ever seen.”

— Nolan Watson, Sandstorm Gold, 2012 Annual Report (emphasis added)

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As Watson sees it, the industry of resource financing is undergoing a paradigm shift. The days of writing a simple “life-of-mine” stream for a fixed percentage of production at a fixed purchase price is coming to an end. In the early days, the streaming companies structured deals that would extract maximum profits at the expense of the mining com-pany. But a stream is often not the best form of financing for a particular resource asset.

Watson believes that the future of the industry will be in creating innovative win-win financing solutions. Mining is an incredibly complex and difficult business, and each resource will require its own specific set of needs. Watson wants Sandstorm to be viewed as a true partner with not only financial capital — but also intellectual and creative capital. They want to be the very first phone call when a mining com-pany needs financing. This flexibility and speed can form the kind of moat that a great manager can create in this space, not unlike the moat Ajit Jain created with Berkshire Reinsurance Group in the commoditized reinsurance industry. We believe that Watson is innovating, not only to head off the competi-tion, but also to truly provide its partners with the best possible solution to create value for all parties.

In the future, we will see Sandstorm on the cutting edge of financing innovation. Sandstorm may elect to mix in a small equity stake or a small amount of senior secured debt. The most recent deals at Sandstorm Gold offer a glimpse. In their deal with Mutiny Gold, Sandstorm will give an upfront cash payment as usual, but will also provide: an additional lump-sum payment if production hits a milestone, an option to repurchase up to half of the stream under certain conditions, and an offer to contribute towards the capital expenditure costs of developing neighboring mines in return for a stream of their production.

Sandstorm is also starting to do small royalty deals where the assets are too early in development to warrant a full streaming deal. By providing a small amount of development capital in exchange for a royalty, Sandstorm can also secure the right of first refusal to any future streaming deals. This is a very low risk approach to building a pipeline of future streams.

In another brilliant move demonstrating the Sandstorm management’s ability to look forward and around corners with we deem unusually creative foresight, they purchased a majority interest in Premier Royalty, which is a much smaller royalty company. Sandstorm Gold was getting swamped

with a deluge of potential deal flow, but often these projects were too small to contribute meaningfully to Sandstorm Gold’s bottom line. By partnering with Premier Royalty, Sandstorm not only removed a future competitor, but also found an avenue to pass along their unusually attractive, but smaller-sized deal flow that should not only help Premier Royalty’s business but better yet, ensure the company will continue to profit in the future from the typically more lucrative smaller end of the stream finance investment spectrum. As you’d expect from Sandstorm, this transaction created a mutually beneficial win-win for both parties and will ulti-mately help grow the value of both companies faster together than apart. In other words, it appears a 1+ 1 = 4 dynamic.

This video highlights Watson’s view on the future of resource financing, and why we believe that Sandstorm will be at the forefront of the industry with massive growth opportunities ahead.

Here’s another on Watson’s charity Nation’s Cry. This won-derful TedX speech entitled “Compassion Kills” discusses how we can reform charitable giving in order to become more effective humanitarians.

If you can teach a man to fish…

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Why Is It Mispriced?

Given that the present valuation stands at less than 4x our estimate of the company’s normalized cash flows within the next two years, we need to start by asking ourselves a very simple question. Why are we so lucky?

This valuation is typically reserved only for a truly terrible business in a terminally declining industry. So there has to be something wrong with Sandstorm, right?

Well, the short answer is no, not at all. As natural skeptics, your editors abhor the thought that we’d end up the prover-bial “Patsy” at the poker table, because usually if something appears too good to be true…

However, in Sandstorm’s case, we believe that this is the exception to the rule. In a nutshell then, we think Sandstorm is mispriced because:

1. It’s an illiquid Canadian micro-cap spinoff with little institutional coverage. It’s not surprising to us that the majority of intelligent investors are completely unaware of the company’s existence.

2. Its operating history is practically non-existent.

3. Streaming companies are often mispriced, especially in the beginning. Most traditional valuation measures fail to cap-ture the true value of the streams. Financial statements offer a very limited view of Sandstorm’s future earnings power because it takes time for production to result in revenues and profits that fall to the bottom line. Indeed, to date the financials have only shown the cost of acquiring the streams, but almost no revenue and cash flow given the natural lag between Sandstorm’s initial investment and production.

4. Traditional financial metrics fail to consider the considerable future growth prospects, especially during the beginning stages. Financials also fail to capture the most critical key of success: management’s ability to select the right deals, struc-ture them correctly, and navigate the potential setbacks along the way.

5. Finally, Sandstorm’s partners are junior resource com-panies, and this is arguably the worst environment for commodity finance in decades and unlikely to improve in the near future.

However, we would like to let in you in on a little secret (sssshh!) — the miner’s pain is Sandstorm’s gain. While

somewhat counterintuitive, what most others view as a nega-tive, the contrarian souls of your editors see as a magnificent positive. For example, the difficulty in the current environment to raise debt and/or equity capital has left most companies, even those with world-class assets, in dire straits.

Alternative financing like streaming, or a creative combination of solutions such as Sandstorm’s recent offerings, is unsurpris-ingly becoming more and more attractive to resource compa-nies both large and small. In our view then, this “negative” is actually hugely positive as turmoil within the capital markets improves the company’s terms of trade and improves their deal-flow. Said another way, difficult times in mining land helps lay a foundation for the company to underwrite more, much more lucrative deals than would otherwise be possible.

Hard to complain there ;)

In summary, what we have here is a temporary situation where a few hiccups within the company’s earliest streams, a pro-longed period of turmoil within the resource capital markets, and the company’s (backwards-only looking) financial state-ments have come together to temporarily mask the company’s ability to generate copious amounts of revenues and cash flow. In other words, we have a “perfect storm” that has temporarily obscured this remarkable hidden gem from view temporarily.

Notably many of the greatest wealth creation stories of the last century also suffered a perfect storm of events. Think of GEICO near bankruptcy, or American Express after the salad oil scandal of the 1960’s. It was precisely this type of perfect storm that offered savvy long-term investors like Buffett who where willing to dig deep in order to discern the difference between perception and actual reality with one of his defining investments of his lifetime. For context, the salad oil scandal provided Buffett with the impetus to take the time to really look under the hood of what was by any sane measure a wonderful business priced as if it was the opposite (read on the road to bankruptcy). Once he’d concluded the issue facing the company wasn’t permanent, and likely to recede in relatively short order, Buffett was able to take advantage and exploit the temporary window of opportunity given him to generate truly massive risk-adjusted returns. That’s exactly the type of situation we think we have with Sandstorm Metals & Energy.

Better yet, SND is rapidly approaching a game changing inflec-tion point, as it’s on the cusp of realizing prodigious and

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growing cash flows from a variety of its past investments. As we’ve highlighted here and there throughout this report, the Brace-McLeod copper mine is set to start production within a few weeks. In other words, its time to get ready, as this will be just the first of many hard, high probability catalysts over the next few years that we expect will close the gap between today’s price and intrinsic value, with this one in particular set to drive a swift, upward re-rate in the value of SND’s stock.

Like Gretzky, at Portfolio Ops we aim to go where the pucks going to be, not where it’s been and hence tend place a high premium on getting in position ahead of time. So the slot is open, but remember that time is running out, the proverbial “pulled goalie” set up we have currently won’t last forever.

So How Much Can We Make?

Let’s finish up this briefing by looking over some scenarios…

On an absolute basis, companies such as Sandstorm Metals and Energy with 50%+ profit margins that operate in large and growing markets with zero maintenance capex requirements and no tax liabilities (based in Barbados) deserve to trade at very high multiples of cash flow and should be priced accordingly. These businesses should be reasonably worth a multiple of at least 12x to 15x cash flow. Given that Sandstorm is still very early in its evolution, we believe that a 12x multiple of enterprise value to cash flow is reasonable, if not somewhat conservative.

A 12x multiple of Sandstorm’s estimated $25 million normal-ized cash flow by the end of 2014 implies an enterprise valuation of $300 million. This is about 3x higher than our implied YE ‘14 enterprise value of $97 million. At an unreasonably cheap 10x multiple, this would imply a $250 million enterprise value, or a return on investment of 2.5x.

On a relative valuation basis, Sandstorm appears even cheaper. If we use the average of appropriate comparable streaming and royalty compa-nies (Franco-Nevada, Silver Wheaton, and Royal Gold),

Sandstorm should trade at 14x cash flow. At 14x, the company would be worth $350 million, or over 3.5x its current value.

Not to nitpick the details here, but we believe our $25–30 million in cash flow estimate in two years time will prove to be too conservative. Remember the hidden levers behind the substantial cash flows and value creation in Silver Wheaton’s Penasquito deal? Those same principles will apply to many of Sandstorm’s current streaming deals, and in future issues we will dive deeper into the details of some of these world-class assets.

Conclusion

What’s not to love? In fact, we don’t think it’s at all hyper-bolic to state that the underlying economic characteristic of Sandstorm M&E make it the type of enterprise that should fan the flames of any self respecting capitalists desire. Of course, it’s also run by a superb, visionary owner operator with a long paper trail of success and substantial skin in the game, not to mention it comes with a price tag so cheap we can’t imagine how we can lose.

In short then, it’s the type of opportunity that your editors live for. We advise taking advantage, opportunities like this won’t last, they never do

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Summary Recommendation

Buy Sandstorm Metals & Energy (SND.V) up to 60 cents per share for a wonderful business that boasts excellent management, generates fantastic returns on capital has massive growth potential and yet is currently trading at less than 4x estimated cash flows come year end 2014.

Your Portfolio Ops TeamRyan O’Connor,

Eugene Huang,

Chris Mayer,

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