Sandstorm Metals & Energy (TSE:SND)

I just got done reading "Running Money" by Andy Kessler, fantastic read. Made me really think about the industrial revolution and the flow of capital.
One of the key takeaways was the American transformation from manufacturing to service/post-industrial(the patent age?). Essentially we capitalized on the rest of the world's desire to escape agrarian society. We gave them the means via thinking, designing, and innovating things for them to build. It can slide away just as quickly as it came.

While not based in intellectual property Sandstorm (SND) displays many of the characteristics held by these companies. They are the only player (that I found) in this capital light, high return business. This time though we are not betting on the success of a microchip or an erection pill. This time we are betting on commodities and capital allocators.

Company:

Sandstorm is a Canadian firm that provides late stage financing to natural resource players. By providing capital with very low interest rates (or none at all) SND lets these fields/mines hit a point of production. This is done without the debt that can so often cripple these mines, or the equity that can destroy shareholder value.

In exchange for this financing, SND purchases the underlying commodity at a price defined in the streaming agreement. They then turn around an unload it on the market collecting the spread between the contracted price and spot market price. This is the same model that Silver Wheaton (SLW) used and it worked out OK for investors (~800% returns in 7 years for the common equity).

Sandstorm was spun off from Sandstorm Gold, a company run by the same group that runs Sandstorm Metals & Energy.

Properties/Contracts:

I am not going to go through every scenario for pricing as I feel that it isn't necessary, plus it entails a slew of speculation. Since their costs remain set by the initial contract, we can abide by one simple rule: if commodities go up so will profits with little incremental cost.

     Thunderbird

Gordon Creek, a gas field located next to Drunkards Wash in Utah. Drunkards Wash is a huge gas field that is absolutely fascinating to read about. Seriously. It has amazing geographic features and Gordon Creek shares similar attributes. They have paid $25M for the rights to purchase 35% of the gas produced at $1/mcf. The first wells are scheduled to come online in early 2012 and full production is scheduled by 2014. Management estimates that this will produce after tax operating profit of $5M in 2013 and $8-10M in 2014 based on $3.50/mcf natural gas.

     Donner Metals

Bracemac-Mcleod mine in Quebec. For $20M SND received the right to buy 17.5% of copper produced at the mine for $0.80/lb if copper is more than $2.75/lb or $0.55/lb should copper fall below $2.75/lb. Production is expected to start in late 2012 early 2013. Management estimates that Donner will generate ~$2M in operating profit in 2013 and ~$5M in 2014 if copper is $3.00/lb.

     Terrex Energy

Two Creek and Strathmore projects. They purchased the rights to buy 15% of the oil from Terrex for $15/bbl. Management estimates that if oil is $80/bbl than Terrex will generate $1-2M in operating profit in 2013 and similar amounts in 2013.

     NovaDX

Coal mining operations in Alabama and Tennessee. For $30M they purchased the rights to buy 25% of production from both mines for several years. Their share decreases to 16% after several years. They are able to buy coal at $75/ton the whole time. Management estimates that if metallurgical coal costs $160/ton and thermal coal costs $70/ton operating profit will be ~$4M in 2013 and ~$7M in 2014.

Surge Capital helped connect NovaDX and Sandstorm and received a finders fee and shares.

     Royal Coal

Coal mine in Kentucky. They have shut down and the investment was written off. To say this was a mess is putting it lightly. To make a complex story more confusing, NovaDX invested in Ikerd Coal Company. Ikerd Coal Company turned out to be a total failure and NovaDX suffered. Six weeks after the settlement Royal Coal went belly up. An embarrassment for NovaDX and more importantly Sandstorm. Royal Coal, like most mines I'm sure, was full of hope and endless riches.

Management

Nolan Watson's background can be seen in his Wikipedia page. The article has been revised numerous times by "Denvyboy." While it is only speculation, there seems to be a faint familiarity between the editors user name and Denver Harris, IR Manager at Sandstorm.

There is plenty of promotion for the company via Youtube videos, interviews with small podcast reporters, and individual investors. The company promoted stuff shouldn't be too surprising since the board and management has several people who worked in IR or on the sell-side.

There are no mining experts on the board or in management that I saw. It mostly consists of investment bankers. I personally would want to see a few people with a deep expertise of mines not just of investing. Overall I don't have a firm opinion one way or another of management.

Margin of Safety

Each streaming deal carries along with it cash flow guarantee. According to the SND presentation all cash flow guarantees and cash on the book roughly equal the market cap today (~$125M).  But how guaranteed are those promises from the various resource collectors?

Royal Coal offers us some indication as to the value of these guarantees. Given that they have gone under the only question now is: how much is Sandstorm getting back?

The answer right now is: I don't know (and I've yet to find anyone who does). These streaming agreements are a mix between debt and equity. Senior secured like debt, upside like equity. For investors in mining though, all that matters is a hole in the ground produces more cash than it loses. While these guarantees are great, they really only apply if the mine is making enough money to pay them. The margin of safety exists in the mines.

In the Q4 CC Nolan highlighted that they now have a large tax benefit due to the Royal Coal write-off. I would rather have cash from the original agreement. When asked about changes made to the due diligence process going forward answers have been vague and in my opinion, unsatisfactory.

Are the individual properties worth investing in?

Luckily all of the mines and fields that Sandstorm has invested in are traded on Canadian exchanges, so information is plentiful. The NovaDX mine has generated quite a bit of optimism from one blogger, so let's examine them a little.

     NovaDX In-depth

All sources with (pg --) are from the Rex Mine Technical Report.

NovaDX has two properties that are interesting to Sandstorm investors, Rex #1 and Rosa. From the SND presentation, Rex #1 should produce 500k tons/year and Rosa should produce 150K tons/year. Rosa is currently in commercial production and generated $1.6M in revenues in Q4 2011, $233K going to SND(pg 28 Dec 31 2011 Financial Statement). Rex #1 is under construction and should be up by Q3 2013.

The company itself is cash flow negative and has $3M cash to $3.7M in debt. They will probably need to issue more debt, equity, or streaming agreements soon due to cash burn and capital expenditures required before Rex #1 is fully operational. With SG&A of $1.2M and COGS of $3.8M in Q4 2011 they've got a ways to go before becoming profitable.

While the blogger above believes that metallurgical coal has restricted supply and steady long term contracts, this mine needs to first be cash flow positive to benefit from either scenario.

Another hurdle is getting the Stinking Creek Plant (what a name) processing facility up and running. Right now they are selling coal at a discount ($90/ton, pg 69) to a 3rd party metallurgical alloy and specialty coal producer (pg 36). The plant is scheduled to be operational in Q3 2012 (pg 67) and the mine should be at full production in Q3 of 2013(pg 64).

SND reported Rex 2P reserves of 32M tons (slide 10). The most recent technical report from NovaDX lists 2P reserves at 11.2M tons (pg 18). The new report was much more conservative and the SND IR presentation hasn't been updated yet. A 65% reduction in reserves is a lot and while doesn't take away from the potential investment(on a 10 year time span), it certainly takes away from the mentioned blogger's extremely long life of mine assessment.

Finally, Neil MacDonald is CEO and Robert Payne is COO. They both resided over the acquisition of Ikerd's Flatwood property, which was done with Sandstorms knowledge. This did not end well. They then got shares and ownership to Royal Coal, which as explained above, did not go well either. There is a lot of money and pride riding on the success of the Rex and Rosa mines.

With cash costs of ~$80/ton(pg 73), selling prices of $90/ton and huge capital expenditures, it's hard for me to get comfortable with NovaDX. Factor in their history of investments and it's even less appealing. Right now with my limited knowledge I put NovaDX in the "too hard" pile. This could change upon new information regarding the processing plant, cash flows, and consistently less deleterious investments.

Conclusion:

Sandstorm offers a compelling story. And for me right now that's about it.

The bull thesis hinges on Nolan Watson and his team executing. I would like to understand his successes and failures at SLW better before declaring him a visionary. This is 100% a bet on management and I lack conviction in them right now. For reasons unknown to me, Libra Advisors is selling large blocks of shares at a rapid clip.

In two years the company might be generating $25M in FCF. Relative to today's EV gives SND a FCF/EV yield of ~29% (MC of 125M minus 40M cash on the books). This FCF figure depends on the commodity prices outlined by SND here. Some are higher now(oil), some are lower now(natural gas). If we assume that cash will get spent in a year or two (Nolan said they were starting to look for new streaming agreements in the Q4 CC) than EV=MC. In that case 2014's FCF of ~$25M gives us a 20% yield. Good, but not great given the uncertainty of mining.

I will follow up with some other posts that try to examine the individual value of the Donner, Terrex, and Thunderbird Streams. This investment as a whole sits in the "too hard" pile currently. It may be cheap, but with a few more Royal Coal's, it may be bankrupt. Being a sucker for predictable cash flows I will keep on researching. This might very well make a phenomenal investment, but right now it's not so clear to me.