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Franco-Nevada Bets on Oil & Gas as Candelaria Grades Drop

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On Sep 4, we issued an updated research report on Franco-Nevada Corporation (FNV - Free Report) . In 2018, the company’s performance will be driven by Oil & Gas portfolio’s performance, aided by acquisitions and higher oil prices. However, Gold Equivalent Ounces (“GEO”) production will remain affected in the year owing to the processing of lower grade materials at Candelaria mine.
Q2 Earnings Improve Despite Lower Revenues
Franco-Nevada reported net earnings of 29 cents per share for second-quarter 2018, up from 25 cents recorded a year ago. The company sold 107,333 GEOs in the reported quarter, down 12% from the prior-year quarter. The company recorded revenues of $161 million in the second quarter, declining 1% from the year-ago quarter. In the reported quarter, 84.5% of the revenues were sourced from precious metals (67.3% gold, 11.2% silver and 6% platinum group metals) compared with 91.9% in the prior-year quarter.
Lower Grade Production at Candelaria a Near-Term Concern
In the first half of 2018, 223,004 GEOs were sold, which was 12% lower year over year. Revenues earned from precious metals assets decreased year over year owing to lower average gold price and lower gold equivalent ounces. This can primarily be attributed to processing lower grade at Candelaria.
In November 2017, Lundin Mining Corp. LUNMF announced an updated mine plan in part to address localized pit wall instability. While decreased grades were expected in 2018, the impact on gold and silver production was greater than anticipated. Consequently, Franco-Nevada revised its GEO production to 440,000-470,000 GEOs from its mining assets in 2018 from the original 2018 mining asset guidance of 460,000-490,000 GEOs. Even though production is expected to recover in 2019, the processing of lower grade material at Candelaria is anticipated to continue for the remainder of 2018. The lower guidance is disappointing as the company’s top-line will not benefit from rising metal prices.
Higher Oil Prices to Support Oil & Gas Portfolio
The second quarter was robust for Oil & Gas with revenues surging 137% on stronger oil prices and increased production from the newly added U.S. assets. The company is beginning to realize the embedded growth of these U.S. assets. Backed by better-than-expected contribution from its previously acquired U.S. assets and stronger oil prices, Franco-Nevada now projects generating $65-$75 million in revenues from oil & gas for 2018, higher than the previous expectation of revenues of $50-$60 million.
Cobre Panama: A Catalyst Despite Near Term Uncertainty
For the Cobre Panama project, the company funded a total of $264.4 million in 2017. The company has so far invested $886 million of its $1 billion commitment. The company expects to fund the balance by 2018-end. As of the second-quarter end, the project is 76% complete and phased commissioning of the project is scheduled to commence in 2018 while ramp-up is slated for 2019. Cobre Panama is anticipated to contribute 25% of the company’s NAV and is a key growth opportunity for the company.
Until actual gold and silver starts coming in, it is not clear how well the mine will produce. Considering the considerable investment in the project, uncertainty remains.
Strategic Relationship with Continental Resources a Game Changer
In August 2018, Franco-Nevada announced that it has entered into a strategic relationship with Continental Resources, Inc. to acquire Oil & Gas mineral rights in the SCOOP and STACK plays of Oklahoma — two of the most economic and attractive plays in North America.  Franco-Nevada will make an upfront payment of $220 million for the acquisition of existing mineral rights owned by a subsidiary of Continental. It has also committed, subject to satisfaction of agreed upon development thresholds, to spend up to $100 million per year over the next three years to acquire additional mineral rights through a newly-formed company.
This represents a new business development opportunity for Franco-Nevada.  It gets an acquisition vehicle, which provides the ability to acquire assets at the grassroots level or directly from individual owners. This is a segment of the market previously inaccessible to Franco-Nevada due to a lack of staff or resources to carry out these smaller-scale acquisitions. More importantly, Franco-Nevada benefits from the operator's drill plans, along with their knowledge of local land title and geology.
Poised Well for the Long Term
Franco-Nevada strives to generate 80% of revenues from precious metals over long-term horizon which includes gold, silver and PGM. With around 86% of revenues earned from precious metals in the first half of 2018, the company has the flexibility to consider diversification opportunities outside of the precious metals’ space and increase exposure to other commodities while maintaining its long-term target.
Further, Franco-Nevada appears to be on a promising long-term trajectory thanks to a healthy portfolio of streaming and royalty agreements put in place years ago. With more mines coming online in the next several years, it will benefit from higher levels of precious metals sales as well as higher prices. Furthermore, Franco-Nevada’s balance sheet remains debt free.
Shares of the company have declined 25% over the past year compared with the industry’s slump of 30%.
Franco-Nevada currently carries a Zacks Rank #3 (Hold).
Stocks to Consider
Some better-ranked stocks in the same sector include KapStone Paper and Packaging Corporation KS and Ingevity Corporation NGVT. Both the stocks sport a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.
KapStone Paper has a long-term earnings growth rate of 10%. The stock has rallied 19% in a year’s time.
Ingevity has a long-term earnings growth rate of 10%. The stock has appreciated 61% in a year’s time.
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