Time for shareholders to get more than just a hole in the ground – introducing the Production Linked Dividend model

David Baker, Managing Partner at Baker Steel Capital Managers argues poor capital management is high on the list as to why investors are selling their gold shares.  In an effort to restore the trust between investors and management Baker Steel has proposed the Production Linked Dividend.  This model is quickly catching on; the feedback from the early adopters is very encouraging – more discipline, more focus and higher returns for shareholders.  Read on to find out more.

Many gold shares are poorly rated by the market and rightly so

It is our view that the current business model for developing a new gold mine is broken.  Investors are deserting the sector as financial returns to shareholders have in general been abysmal.  Fee hungry banks, royalty companies and mezzanine financiers are often the ones who get the benefit of the ounces produced not the shareholders.  Investors understand that their gold is being syphoned off to other parties, and are leaving the sector disillusioned and disappointed.  In an effort to secure a gold stream, investors are buying the royalty companies who have the legal right to this stream, and considering their outperformance investors are prepared to pay for this privilege.

Avoiding equity dilution at any cost often results in a big dilution in the margin left for shareholders

Many mining executives appear too focused on dilution; believing that gearing up single asset companies increases returns to shareholders.  It is now apparent that every action has its price – avoiding dilution and leveraging the balance sheet and/or selling a royalty pushes shareholders returns further into the future and often increases the risk that shareholders end up with very little economic benefit.  Leveraging the balance sheet comes at the cost of diluting the margin left for shareholders; the message is clear shareholders need to get more than just a hole in the ground.

Gold funds have had redemptions and hedge funds are shorting the shares, but good sound business propositions can and are being financed by the equity market.  Dilution can be avoided by treating all shareholders equally and having viable business models on realistic assumptions with defined returns to shareholders.

The hidden costs of bank financing

Bank financing may at first glance minimise equity dilution, but the real costs far exceed the headline interest rates.  There are set up and arrangement fees – typically 3% of the loan amount on top of this legal and consultants fees – can be upwards of 2% of the loan.  Projects are structured to repay the banks with the cream of the project leaving little left for shareholders.  Hedging may have been a reasonable strategy 18 months ago, but not 36 months ago, timing is everything.  Gold futures are an opaque market where the hedging fees are embedded in illiquid bid/offer spreads and the dollar amount hedged is often a multiple of the debt – the fees rack up.  Hedge books often have to be restructured with shareholders footing the bill.  Equity buffers and restrictive covenants shackle management to operate the mine for the benefit of banks not shareholders.

Offtake agreements are no better

Then there’s the off take agreement which seems to be gaining popularity, these agreements in return for finance give the lending party the option to select the gold price over a quotation period of 12 or 9 days.  Given the volatility of gold this is akin to a net smelter royalty – in the case of Asanko’s recent deal with Red Kite, BMO calculated this is the equivalent of a 2% NSR FOR THE LIFE OF THE MINE, around 6.4% of the average free cashflow of a mine.  I say nice work if you can get it!

Royalty companies have taken the premium rating in the sector

Then there is the royalty deal, presented by the royalty companies as being hardly noticeable; yet a 2.5% net smelter royalty is akin to 10% of the average gold projects margin ie the ‘icing on the cake’.  The concern is that management seem to be able and willing to give away our margin to third parties but when it comes to shareholders we just don’t even get a look in – we don’t even get offered the same terms as the royalty company.  More reason to sell the gold shares.

How to restore some trust between investors and management

As investors we want to know ‘just who gets our gold’ and companies need to ask – ‘what can they do for shareholders’.  Once management understands that shareholders want to see a margin and the return of part of that margin we will be on the same page.  Treat all shareholders equally; which means unwritten rights offering should be the preferred method of financing.

Introducing the Production Linked Dividend

One way to rebuild the trust between managements and shareholders is the PRODUCTION LINKED DIVIDEND.  This is defined as follows;

The dividend paid to shareholders is defined as a fixed percentage of the company’s annual production or revenue

This is on a best endeavours basis and unlike a royalty not legally binding.  Ideally it is paid in precious metals but realistically in a dollar equivalent and has similarities to the gold royalty business model, and like a royalty should be paid from day one of the mine.

Returning a fixed percentage of revenue/production to shareholders as a dividend;

  • Is easy to communicate and understand
  • More closely aligns management and shareholders
  • Restores discipline and accountability to management
  • Links gold in the ground to shareholder returns – exploration is rewarded
  • Links returns to the gold price – no ‘clipping’ of shareholder returns
  • Provides shareholders an ‘exploding’ coupon as gold prices rise – real yield protection
  • Links returns to production
  • Ensures management focus on returns not ounces
  • Potentially raises the cut off grade on mines, this may limit the development of marginal mines
  • Helps investors to efficiently allocate capital to the highest return assets
  • Provides better discipline when companies embark on M&A
  • Sends a strong message to shareholders that they do matter
  • Is a step towards the re-rating of the sector as trust is restored.

Discipline, Accountability, Returns Trust – DART gets management on target for shareholder returns

Early adopters of the model are changing their business plans to the benefit of shareholders

This policy has todate been adopted by

  • Evolution who pay a 2% equivalent production linked dividend,
  • Mandalay Resources pay a 6% revenue linked dividend, and
  • Aureus Mining recently announced that they will pay the equivalent of 2% of production on their New Liberty project in Liberia.

And we believe other companies will follow these industry leaders.

In summary

It is clear that the business model for the junior developer is broken, too much of our gold is being syphoned off to other parties leaving little free margin for shareholders.  Investors have responded by selling the shares, making it even harder for companies to raise the capital.  Discipline, accountability returns trust which is the first step to a re-rating of the sector.  The Production Linked Dividend model is a small step towards restoring that trust.


©2018 - Precious Metals Investment Symposium

Precious Metals Investment Symposium