“The Best Royalty Streamer You’ve Never Heard Of”

In the early 2000’s, investors wanting exposure to precious metals had few options.

For those that wanted a leverage play, mining companies were the best option. However, that does not mean these stocks were good investments.

In fact, they were terrible investments. Investing in mining is akin to buying a lottery ticket; it’s often all or nothing, but the right ticket can bring a tremendous return.

You see, to the investor that wants leveraged exposure to precious metals, miners were the skinniest kids at fat camp- the best of no good options.

Why?

There are several reasons why miners make for poor investments- they often succumb to a myriad of serious and sometimes fatal problems.

First, miners own and operate the mines, which are tremendously expensive. Often, a few mines will tie up a majority of a company’s assets. As a result, few miners are able to achieve a diversified portfolio; they just do not have the available capital.

Second, mines are a black hole for money. Miner’s can, and often do, go broke by throwing good money after bad in hopes of recovering their original investments. This coupled with their lack of diversity, turns an inherently risky situation dire.

Third, the expenses to build out and or expand the mine often required debt financing, which require regular payments. However, in a cycle commodity with euphoric heights and manic lows, regular payments can be tricky.

Miners needed a better way to finance their mines, and investors needed a better way to gain exposure to the commodity. The industry needed innovation; they found it in the royalty-streaming model.

The model is simple; unlike traditional financiers, royalty streamers give producers money upfront in return for a cut of the production later.

By adding an element of flexibility, both the investor and the producer earn better returns. Royalty streaming creates a vehicle that alleviates those problems miners experience, while doing so more profitably.

The results speak for themselves.

The model has been applied with unusual success in the metals and mining industry. Silver Wheaton, Franco-Nevada, and Royal Gold all helped to pioneer the business

model and in the process, these companies made early investors tremendously wealthy.

The heart of the models advantage, the reason for the magic returns, is that royalty streams are a collection of risk-lowering passive income plays. The stream’s passive nature necessarily means that other people do the heavy lifting, assume the costs, and own the assets. This hands-off attribute keeps precious time and capital free. Over time, the flexibility of these two assets allow these income plays build on one another, and like the first snowflake that triggers an avalanche, things escalate quickly. Today, there is an opportunity to get in on the ground floor of a similar company in a new industry, facing a similar situation, except this time the company is poised to perform even better. Let me explain.

Fields and Streams

In 2005, Doug Elmsly and Brad Farquhar founded Assinobia farmland, a private equity alliance whose missions was to buy and improved farmland. At the time of their sale in 2014, Assinobia had built a portfolio of 160,000 acres of farmland and returned an impressive 19% a year to investors.

The same management team now busies themselves with their new company Input Capital (INPCF), the first agricultural streaming company.

Management took what they learned, how to improve farms, and found a way to scale it. Except under the new model, they don’t have to buy the land. Instead, the team leverages their expertise, contacts, and money to improve other farms, all, of course, in exchange for a passive income stream.

In this way, Input can scale up with dramatically fewer costs; create more value by improving more acres, much like metal streamers did.

Canola: The Most Profitable Canadian Crop

Currently, investors that who want exposure to agriculture generally get it by investing in companies that supply potash, the fertilizer farmers use to improve yields. Other investment alternatives are companies that provide products that farmers use like Monsanto or John Deere. However, there are few ways available to the public to directly invest in farms.

Enter Input Capital; located in Canada, they are the first agricultural streaming company. Input focuses on canola, which seems odd at first blush.

Consider, however that according to the Canola Council of Canada canola contributes an estimated $19.3 billion to the Canadian economy annually, making it Canada’s most valuable crop.

Equally as interesting is that the industry is also in a growth phase. The annual export market for Canola has grown almost by 20% per annum since 2002. The pace is set to continue based on demand for biodiesel fuels, feedstock, and healthier foods; canola is considered more heart healthy than olive oil.

As I will explain later, Input has positioned itself better than metal streamers ever could have at their inception. For now just know that Input is in a massive market, one that is growing.

Farmers Win

First, a primer on why growth will be dramatic;

Farmers, like most other entrepreneurs, are generally undercapitalized. Like other enterprises, an undercapitalized farm is leaving a lot of money on the table. An undercapitalized farm sells crops at lower prices and buys inputs at less than ideal times and at less than ideal prices.

Farmer’s aren’t dumb. They know that additional capital would help improve their business. They’ve just never been able to get acceptable terms on credit.

Its no secret that bankers are not known for flexibility. Loans are often the only way to gain access to capital. Often, loans, if available at all, must be secured with either a personal guarantee or with assets. For farmers the risk is too great because the business is cyclical- farms make their all of their money at harvest.

Additionally, equity financing doesn’t make sense for many small farms. It represents an outright sale of a piece of the business, one that could mean a loss of control over operations and quality.

Royalties are akin to a hybrid of debt and equity. The farmer doesn’t relinquish ownership and the creditors can’t foreclose on assets.

Farmers go to Input for flexibility; they then realize that an added benefit of working with Input is that they act as a partner who is focused on making the farm more profitable.

After specialists, called agronomists, are brought in to improve crop yield and money is used to purchase equipment at the optimal time, farmers realize what they’ve been missing. These farmers talk.

Input is building tremendous good will within the community.

As it stands right now Input has no competition. No other financiers offer the terms that Input does and almost none could. Farmers value relationships, right now Input is creating a lot of good will among these farmers because they are substantially improving their farms. At this pace, it is unlikely new competitors will be able to meaningfully compete with Input.

Growth upon Growth

At fiscal year end on March 31, 2015, Input has built a portfolio of partners with 68 farmers and $80 million in capital deployed, of which Input should conservatively receive at least $130 million back over a period of about 6 years.

With these numbers in mind, realize that there are 50,000 canola farmers in western Canada alone.

A large number of these farmers would jump at the chance to partner with Input, because Input provides a lot of value for them. Many of these farms have not taken full advantage of available technology to optimize yields and many more could benefit from securing additional working capital. There is nothing tethering Input to canola. In fact, they are already considering soybean. Remember, every additional crop variety adds an additional layer of diversification.

Moreover, there’s no reason they couldn’t expand globally where farmers are even more undercapitalized and have no access to modern farming techniques. Finally, consider that insurance is a natural extension of Input’s business. Once Input begins to expand into other crop varieties, there is no reason they couldn’t expand into crop insurance and use other people’s money to add leverage.

Insurance would dramatically reduce Inputs main cost, the cost of capital. Insurance after all is the only business with a negative cost of capital.

Therefore, Input’s market is not actually canola but the entire farming industry. So while canola is a $19.3 billion dollar industry, Input’s growth prospects are substantially larger.

Natural Compounding

Compounding is most commonly thought of in investment returns. When an investor reinvests dividends, the returns start to earn a return, which is compounding.

With Royalty Streaming Companies, compounding is “natural”, and organic within the company. The compounding does not stem from reinvested dividends on the behalf of the individual investor, but instead from the company’s investments earning a return and then reinvesting the return on a new investment.

In an investment opportunity, it is ideal to combine the two. Eventually, once Input’s pipeline of investable opportunities slows downs, there will likely be a dividend. However, it is going to be a while before that happens. Until then investors should be happy with Input’s staggering ability to compound.

Every new contract Input strikes with a farmer will immediately add value, because payments start next harvest. This nuance adds tremendous value over time, especially when compared to metal streams, which often take as much as two years to start paying returns. New crop streams can pay within six months.

This unique power, and their abnormally high return on investment, averaging now at a staggering 30%, makes Input not only a better natural compounder than metal streamers, but one of the greatest natural compounders I’ve ever seen.

Inching Closer to Riskless

One of the best qualities of Input’s investments is their low-risk profile.

With any type of investment the risk lays with the counterparty. For Input, the danger lays with the non-productive farmer.

While farmers face many risks, most risks are associated from either crop price movements or yield.

Neutering Farm Yield Risk

Input has found a way to virtually eliminate farm yield risk.

Input requires that the farmers buy crop insurance. Coverage often extends to as much as 70% of production, but it at least enough to honor their contract with Input.

In this way, Input ensures that no individual farm will miss payments because of a bad year or freak incidence.

Unbelievably, Input doesn’t pay for the protection, the farmer does.

By the way, each additional investment Input makes ads an additional layer of diversity.

Input’s average deal size is a little over $1 million dollars. In 26 months, Input has deployed $80 million, with 68 farmers. At this pace, they will deploy $200 million in capital on 230 farms within a few short years.

A write off of one farm would not mean much at all to input’s bottom line.

Conquering Price Risk

Crop prices play an important role for the farmer. It is important for Input as well and it’s probably their biggest risk. However, input bears little price risk.

First, food prices are generally stable because “baby’s gotta to eat.” The most stalwart stocks are in consumer staples because consumers can’t live without their products.

Consumer staples are susceptible to downturns like any market, its just that the downturns are not as bad.

Second, Input is able to respond quickly a new pricing environment.

Input’s typical contract is six years, which means that every 6 years the contract turns over. After inputs sixth business year, contracts will turn over every year. As a result, Input will be able to respond to a new pricing environment every single year. Third, as Input grows, they will begin to capture larger percentage of the canola market. This is the magic that really neutralizes price risk. Markets, particularly food markets, as a whole, do not change dramatically unless there is a fundamental shift in demand.

Prices generally respond to changes in supply so as to match demand. The total demand is generally more stable.

Additionally, Input regularly sells canola for more than the spot market.

Input operates in local markets. Some localities have better yields than others. The disparity in local markets allow for arbitrage opportunities. The spot market very broadly reflects the average of local pricing across the country. This disparity allows Input to buy in low market and sell in high. This shows up in their income statement as profit from trading.

In any event because the market is so fractured Input can regularly achieve prices above spot.

Ballpark Valuation

Bear with me as we ballpark a valuation. Input currently sports a market capitalization of about $240 million. Input has $50 million in cash and no debt.

To date, Input has invested $80 million in 68 canola contracts with a total of roughly 345,000 MT due to them; contracts are typically 6 years in duration. If Input can maintain consistent cash margins of 84%, and there is no reason to doubt that, the value of contracted tonnage is about $130 million (with 0 bonus tonnage), of which almost all will be free cash flow. Now with $50 million in cash and a strong pipeline of demand, then I expect tonnage to be at around 560,000 MT, a value of about $210 million. Input expects 70,000 base tons in canola, which ought to bring $25 million in EBITDA in 2016.

However, this does not include trading profits. We mentioned earlier how fragmented farming is. These markets are still just not that efficient. Input is able to profit from moving canola from areas of low demand to areas of high demand. I expect this to continue at least in the short term and could goose profits by another $3-5 million consistently for the next few years.

Because Input dramatically outperforms metal streamers in the three cornerstones of value: natural compounding, growth, and risk profile- Input should trade for a premium over metal streamers. Most metal streamers now trade for between 15 to 20x next year’s EBITDA. Input trades for about half that. At today’s prices, we can buy a fantastic business, with near exponential growth, and reinvestment rates of 30% for around 10x next years EBITDA or slightly more than their backlog of passive income.