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Royalty companies for inflationary period ahead


Arski
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Today, I read a great review of 2020 by Horizon Kinetics. The main topic was about the Fed's expansionary monetary policy and what the consequences could be (inflation).

Link: https://horizonkinetics.com/app/uploads/Q4-2020-Review_Final_Approved.pdf

or https://horizonkinetics.com/whats-new/#4th-quarter-2020-commentary

 

The best companies against inflation are asset-light companies and royalty companies are on the top of that list.

So, the purpose for this thread is for everyone to share their highly promising royalty companies, if you have one.

 

I own TPL, which had a huge run-up lately, but with inflation in mind it could still deliver great excess returns.

Another royalty company I'm interested in is Anglo Pacific, but don't own any shares yet.

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I own a couple shares of Royalty Pharma, which is great except pharma is relatively capital-light anyways.

I am also pretty high on DFH (or you could use NVR), and I think these companies have very asset-light models which act like royalties in a way. They have the negative effect of being exposed to interest rates in a big way which would really hurt their business.

I think payments companies like V, MA, PYPL, and other payments companies function like royalties.

There are also WPM, RGLD, FNV for straight metals streaming companies too.

 

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I'm not a big fan of macro trades or royalty companies for a number of reasons. However, if somebody put a gun to my head... I would probably stop with Anglo Pacific.

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why are royalty companies good since they have a fixed %? Doesn't it depend on what the royalty is? If the parent royalty declines or can't be increased, neither will the royalty holder's income scale.

 

Just shared some thoughts about this on my blog, with an explanation on why asset-light businesses (so royalty companies as well) have an advantage with high inflationary periods.

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Thank you. It is quite accurate. I am puzzled by this one though, "That's why most commodity companies aren't a great hedge against inflation, because most of the time they need a lot of capital to earn some money and therefore fall under the asset-heavy class."

 

Is the idea of commodity companies though that while the costs go higher, so does the base commodity they are selling due to inflation? In a way, bitcoin, gold, and commodities would seem to be in a similar category. They all rise as symptom of a finite supply (real world for the latter and man-made for bitcoin).

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Is the idea of commodity companies though that while the costs go higher, so does the base commodity they are selling due to inflation?

 

Yes, that would be the case. But then, because one dollar is now worth 50 cents, they need to double their earnings to stay even. How do they do that? By doubling their assets, they need a lot of additional capital for that. So, it's economically way more beneficiary to have an asset-light business that needs a lot less capital to double their earnings.

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Does this depend if the asset (mine) is already existing and needs less cap ex to expand in the future vs an outdated asset that needs significant upgrading?

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I see this similar to Scorpion, Royalty companies will be asset light in comparison to the commodity producer they are associated with. But their stream of income is still tied to the underlying commodity and the quantity produced, and this will impact your returns more than any other variable in the macro world.

 

What Warren talks about IMHO with asset light companies with pricing power being desirable in times of high inflation is that they can pass on the cost of inflation to there customers and not have higher costs associated with maintenance and capex rising, thus inflation will improve margins in these businesses.

 

The example you used in your article with the 10 and 30 million dollar company both having to double their assets to double their earnings and thus be earnings neutral in nominal terms, would rely on the market needing double their respective capacity and this may not be tied to inflation.

 

Warren gives an example at one of the annual meetings of See's Candy; since Berkshire has owned it has seen the purchasing power of the dollar erode by approx 80%. And while production has only gone up 75% since his purchase profits have gone up more than 10 fold. This is due to the pricing power of the business and the small amounts of capital it needed to operate. It was able to allow most of the pricing increases to flow to the bottom line. It didn't have great growth prospects so it just printed money for 20+ years.

 

What would make the economics of the two businesses referenced in your papers different all things being equal but the balance sheet is if both were able to pass along the costs or most of them to customers and increase earnings to 10 million dollars, company A with the small balance sheet would be able to retain a much higher percentage because the inflationary costs of maintenance and capital expenditures would be much lower and they would be more profitable. Where the asset heavy companies revenue will rise the net margins will not as inflation will increase their costs at the same rate they are able to increase prices.

 

My two cents...

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I see this similar to Scorpion, Royalty companies will be asset light in comparison to the commodity producer they are associated with. But their stream of income is still tied to the underlying commodity and the quantity produced, and this will impact your returns more than any other variable in the macro world.

 

What Warren talks about IMHO with asset light companies with pricing power being desirable in times of high inflation is that they can pass on the cost of inflation to there customers and not have higher costs associated with maintenance and capex rising, thus inflation will improve margins in these businesses.

 

The example you used in your article with the 10 and 30 million dollar company both having to double their assets to double their earnings and thus be earnings neutral in nominal terms, would rely on the market needing double their respective capacity and this may not be tied to inflation.

 

Warren gives an example at one of the annual meetings of See's Candy; since Berkshire has owned it has seen the purchasing power of the dollar erode by approx 80%. And while production has only gone up 75% since his purchase profits have gone up more than 10 fold. This is due to the pricing power of the business and the small amounts of capital it needed to operate. It was able to allow most of the pricing increases to flow to the bottom line. It didn't have great growth prospects so it just printed money for 20+ years.

 

What would make the economics of the two businesses referenced in your papers different all things being equal but the balance sheet is if both were able to pass along the costs or most of them to customers and increase earnings to 10 million dollars, company A with the small balance sheet would be able to retain a much higher percentage because the inflationary costs of maintenance and capital expenditures would be much lower and they would be more profitable. Where the asset heavy companies revenue will rise the net margins will not as inflation will increase their costs at the same rate they are able to increase prices.

 

My two cents...

 

Those are great points, which I should have included.

 

It is of course not that easy for a royalty company as TPL to increase their amount of oil fields they posses. So, it will depend on whether they are capable of increasing their percentage on those oil barrels, that are extracted. I don't know how able royalty companies are, in general, in raising prices.

 

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Does this depend if the asset (mine) is already existing and needs less cap ex to expand in the future vs an outdated asset that needs significant upgrading?

 

How do you see a mine expand their operations without making large costs, exactly?

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Does this depend if the asset (mine) is already existing and needs less cap ex to expand in the future vs an outdated asset that needs significant upgrading?

 

How do you see a mine expand their operations without making large costs, exactly?

 

I'm just thinking about the difference between an existing mine that might be underproducing, on maintenance and repair, or has adjacent brownfield expansion opportunities vs a mine that has probable reserves that requires building of infrastructure to gain access to the commodity.

 

With commodity price inflation, wouldn't the first mine be better position to capture profit vs the second that requires rapidly inflating capex and thus be less valuable?

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Is the idea of commodity companies though that while the costs go higher, so does the base commodity they are selling due to inflation?

 

Yes, that would be the case. But then, because one dollar is now worth 50 cents, they need to double their earnings to stay even. How do they do that? By doubling their assets, they need a lot of additional capital for that. So, it's economically way more beneficiary to have an asset-light business that needs a lot less capital to double their earnings.

 

Wouldn't operating leverage on rising prices make 2x earnings a low bar when their revenues are also doubling?

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Does this depend if the asset (mine) is already existing and needs less cap ex to expand in the future vs an outdated asset that needs significant upgrading?

 

How do you see a mine expand their operations without making large costs, exactly?

 

I'm just thinking about the difference between an existing mine that might be underproducing, on maintenance and repair, or has adjacent brownfield expansion opportunities vs a mine that has probable reserves that requires building of infrastructure to gain access to the commodity.

 

With commodity price inflation, wouldn't the first mine be better position to capture profit vs the second that requires rapidly inflating capex and thus be less valuable?

 

I think I agree. It would all become clear if calculations are made about the value of mine companies and their mines.

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Is the idea of commodity companies though that while the costs go higher, so does the base commodity they are selling due to inflation?

 

Yes, that would be the case. But then, because one dollar is now worth 50 cents, they need to double their earnings to stay even. How do they do that? By doubling their assets, they need a lot of additional capital for that. So, it's economically way more beneficiary to have an asset-light business that needs a lot less capital to double their earnings.

 

Wouldn't operating leverage on rising prices make 2x earnings a low bar when their revenues are also doubling?

 

There might be some flaws in my thinking here.

 

This is what Buffett says in the See's Candies example about doubling revenues:

"This would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.

 

But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner."

 

I don't know exactly why but he is saying that a business needs to increase their assets in inflationary periods, instead of relying just on increased revenue because of price increases.

 

Maybe someone could help me out and explain why Buffett does not use the concept that when prices increase, revenue will increase and nothing is changed in their inflation-adjusted earnings?

 

Buffett's See's Candy example:

“When we purchased See’s in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets. Let us assume that our hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal operations. Earning only 11% on required tangible assets, that mundane business would possess little or no economic Goodwill.

 

A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In contrast, we paid $25 million for See’s, even though it had no more in earnings and less than half as much in "honest-to-God" assets. Could less really have been more, as our purchase price implied? The answer is "yes" – even if both businesses were expected to have flat unit volume – as long as you anticipated, as we did in 1972, a world of continuous inflation.

 

To understand why, imagine the effect that a doubling of the price level would subsequently have on the two businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.

 

But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner.

 

Remember, however, that See’s had net tangible assets of only $8 million. So it would only have had to commit an additional $8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large – a need for $18 million of additional capital.

 

After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value of its tangible assets, or $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.)

 

See’s, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1 invested.

 

Remember, even so, that the owners of the See’s kind of business were forced by inflation to ante up $8 million in additional capital just to stay even in real profits. Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.

 

And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets ("In Goods We Trust"). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

 

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in the communications business. That business has required little in the way of tangible investment – yet its franchises have endured. During inflation, Goodwill is the gift that keeps giving.”

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Isn't the problem with "asset lite" businesses today that they're all valued on 2050 earnings? OK so your business was insulated from inflation but the multiple was sliced in half, that seems like a loss. If the business is priced like a bond, it will be hurt by inflation no matter what.

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arski - i'm not sure if i'm getting your question but doesn't it just depend on the business whether or not they require additional capital invested? some do, some don't, some are inbetween. taking a stab at it below.

 

-top of the chain - those that don't have to invest to stay alive and have pricing power - i think of a true royalty business like hilton - they don't have to invest in anything to build new hotels or have existing hotels stay up to date, their G&A will go up, but if inflation increase room rates and their royalty rate remains the same (it would) then their revenues go up.

-middle of the chain - they have pricing power but have capital needs to either grow or stay current - maybe see's - they can double prices but they will have to invest for more capacity, buy new equipment when the old equipment expires

- bottom of the chain - they don't have pricing power and are capital intensive - maybe auto manufacturers - i guess they would have some power to increase prices but assume generally consumers have options with keeping their current car longer delaying purchases etc and of course they have large capital requirements with new plants etc.

 

not sure if that is where you were going or if those examples are that great - but generally where my mind was going with this.

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Isn't the problem with "asset lite" businesses today that they're all valued on 2050 earnings? OK so your business was insulated from inflation but the multiple was sliced in half, that seems like a loss. If the business is priced like a bond, it will be hurt by inflation no matter what.

 

this is exactly the dynamic I'm very worried about. best case flat for a decade or small return for high valued stocks even if Inflation should help the m. it would seem one still wants to own these companies but only on a rolling basis as multiples compress and the masses get bored of watching paint dry or not finding it financially rewarding. in disgust they may move to steady bond income, and then stocks would be great buys. it happened in the 80s. time had a cover page "the death of equities". in today's version I can imagine reddit and the robinhooders just totally silent.

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i think there are scenarios where it does not work, but not all royalties are priced dearly.

 

BSM for example is paying $0.7 / unit annualized and covered that by 1.8x, thought they "expect [the coverage] to come down in 2021 w/ lower production/realized px's from hedge portfolio". Plenty of risk (long term volume/production, concentration in some basins, etc), but starting at an 8% distribution yield with some wiggle room that is linked directly to 2 commodity prices* may not be an entirely bad inflation hedge.

 

*though hedged on a 0-1.5 year basis

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Isn't the problem with "asset lite" businesses today that they're all valued on 2050 earnings? OK so your business was insulated from inflation but the multiple was sliced in half, that seems like a loss. If the business is priced like a bond, it will be hurt by inflation no matter what.

 

this is exactly the dynamic I'm very worried about. best case flat for a decade or small return for high valued stocks even if Inflation should help the m. it would seem one still wants to own these companies but only on a rolling basis as multiples compress and the masses get bored of watching paint dry or not finding it financially rewarding. in disgust they may move to steady bond income, and then stocks would be great buys. it happened in the 80s. time had a cover page "the death of equities". in today's version I can imagine reddit and the robinhooders just totally silent.

Tobacco stocks. Fabolous businesses, very cheap. Does great in inflationary environments as it's about as asset light as it gets and has huge pricing power. BTI at a 12 pct FCF yield ATM, good growth, expects to do 40b FCF over 5 years. 65b for the whole thing today. I think it's the biggest bargain in large cap space after Altria ran up. Have 20 pct in total in those two. Not because I expect inflation, but I like a free kicker.

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