Ask The Expert - David Garofalo - August 2022

Man: You're listening to "Ask The Expert "on Sprott Money News.

Craig: Well, greetings again from Sprott Money News and sprottmoney.com. It is August 2022, and it's time for your "Ask The Expert" segment. Of course, that's your production we give you every month, usually featuring a mover and shaker in the precious metals industry and give you a chance to ask the questions and hear from them directly. And this month, we do have a mover and shaker for you. I've got David Garofalo with me. David, of course, has been in the industry for a long time, and famously and most recently, as CEO of Goldcorp at the time of their merger with Newmont, and currently CEO of Gold Royalty Corp. So this is a good chance to bounce some questions off of David. David, thank you for spending some time with me.

David: Well, thanks for having me on, Craig.

Craig: Right. I'm looking forward to run these questions past you and getting your answers. Before we start, just a reminder that this content is provided by Sprott Money, Sprott Money, of course, always having some of the most competitive prices in the market. And right now, you can also get free shipping on any order over $300 bucks. So buy yourself a couple of tubes of Eagles, or even just one, I guess, would do it, and you can get it free-shipped. Also very competitive storage program if you need to check that out too. So go to sprottmoney.com, or, of course, call 888-861-0775 for assistance.

David, before we get started, I kind of gave a basic background of what you've been doing recently, but tell everybody just for a second what Gold Royalty Corp is in case they've never heard of it before?

David: Well, Gold Royalty Corp is a precious-metal-focused royalty and streaming company with nearly 200 royalties throughout the Americas, 8 of them producing, 20 of them in various stages of construction and development, and has a pure leading growth in revenue over the next 5 years and a dividend to boot.

Craig: And again, different from your previous background, you're in a royalty arena rather than going out and finding the stuff and getting it out of the ground.

David: And that was a deliberate strategic move on my part because we are in what I think will be a prolonged inflationary cycle, and mining producers are not immune from that. And I think gold will do extremely well in that type of inflationary environment. But I'm concerned about what inflation is gonna do to cost structures in the mining industry. So I've chosen to create a royalty company that provides optimum leverage to the gold price while insulating shareholders from cost inflation.

Craig: There you go. But you know what's interesting is that's what some of these questions deal with. So I think we've got the right guy and the right set of questions, so we might as well just dig right in with question number one. And I think this is something that I had to learn, and I think this is something that a lot of folks that are interested in the mining sector probably is kind of unclear. So I think it's a good question to start off with. And it's just simply this. In just simple terms, what is the difference between a royalty company and a producing miner.

David: Well, a producing miner takes all of the operating risk at the mine site. Of course, it's a very labor-intensive exercise, very capital intensive. They take on all the jurisdictional risk, the operating risk. What a royalty and streaming company does is provide capital to producers, explorers, and developers at a much more cost-effective basis than they otherwise might access themselves in the equity markets, and we take a royalty back in return. And that royalty provides us top-line exposure. In other words, we get a fixed percentage of the revenue. If the gold price goes up, we enjoy that upside, and it really doesn't matter what the margin is at the mine site because we have no exposure to the operating capital costs of the mine site. I mean, the producer continues to bear that risk, and the opportunity comes with that, obviously. But the other thing that it offers us is exploration upside, because the royalty extends to any growth geologically in the deposit as well. So really, it's almost like owning physical gold with exploration upside.

Craig: In a way, it's...I mean, would it be... I don't know, maybe this is too broad to generalize, but it's almost like you're a bank in the sense that you provide the capital and then your return is the return on investment off the royalty.

David: That's exactly the way to look at it. We're a financial institution that's singularly focused and specialized in the mining industry, and on precious metals in particular. And I think, you know, if you look at the pedigree of our board and management, we have collectively over 400 years of operating a mine development experience. So we bring a wealth of expertise having been in the shoes of mine developers operators, so we can appropriately assess the risk and price it in the capital we're providing, but also, you know, what that gives us is unmitigated access to virtually everybody in the mining industry. We know everybody because, collectively, we have so much experience in the sector.

Craig: And David, one last question before we move on to the next question. Is it...I don't know, do you look at it kind of like a royalty company kind of, not necessarily offsets exploration companies in your portfolio like stocks offset bonds or vice versa, but could you kind of look at it that way?

David: Yeah, look, I think what we do is we do provide that kind of exploration exposure, you know, because we have a broad and diversified portfolio of royalties from early stage exploration right through to production. So we can provide, you know, that kind of exposure right across the broad spectrum of the value creation equation in the mining industry.

Craig: All right. All right. Let's move on to the second question, then. You mentioned inflation, and, gosh, that gets back to the Fed and Fed policy and the dollar and everything else that seems to be driving gold prices these days. With all of that in mind, with your economic forecast in mind, the question is simply where do you see gold prices headed over the next 12 months?

David: Oh, it's a great question. And the most interesting statistic I saw recently was debt service costs in the United States, and they ballooned to nearly a trillion dollars a year on the back of very, very marginal and modest increases in nominal interest rates. In other words, one out of every $7 raised by the federal government in the U.S. is going towards debt service. And that's doubled since the onset of this tightening cycle that we're experiencing right now. So you can just imagine a few more interest rate hikes, what that will do to debt service in the United States.

And the reason I bring that up is what that means, I think, inevitably, the Federal Reserve is going to have to turn on its heels and start to lower rates again, because otherwise, the depth of recession will be unprecedented. And I think it has the potential actually to bankrupt the federal government and bankrupt governments generally who are carrying debt burdens that we've never seen before at 325% of GDP. So, there's very limited latitude for the central banks to raise interest rates, and I think what ultimately that means is we're gonna be in a prolonged inflationary cycle and gold will do extremely well. Gold's gone up about 50% or 60% since the onset of the tightening cycle. In past cycles, when interest rates went down on a real basis as we're experiencing right now, gold's gone up 300%, 400%. So there's still quite a bit of runway here for gold price to go up appreciably from where we are today.

Craig: That's what we're all pulling for, no doubt about that. All right, moving on to question three, David, and it kind of draws on to your experience as a CEO in the mining sector. How do rising energy and inflation concerns impact potential mergers and acquisitions in the mining sector?

David: Well, I think the bigger dynamic here is the lack of reserve growth and cost structures aren't helping in that regard. Reserves in the industry, gold reserves in the ground are down 40% from their peak in 2012. And there's been very little reinvestment back in the ground in exploration to replace those depleting reserves. Obviously, the statistics bear that out. And cost structures inflating as they are will not help that. So if you're not finding it in the ground, you're going to have to buy it. And so, that's led to a dynamic of M&A unlike we've ever seen before in the industry.

And I was the author of one of those deals, the biggest in fact that ever occurred, the $32 billion merger between Newmont and Goldcorp, which fell on the heels of the Barrick-Randgold merger, which happened a few months before that in 2018. And that was really led by the existential crisis the industry is facing. And we've seen a prolonged cycle of M&A since then, now down to the mid-tier. We're gonna see more and more of that happening as companies deal with declining reserves and declining production profiles.

Craig: So, does that affect the underlying fundamentals of the company? I mean, does that impact cash flows which makes M&A harder to do, or is it more just about, "Hey, we're losing reserves. We gotta do something."

David: Yeah, you have to do something. The pie is shrinking for each of these companies. Their reserves are declining, and that means the underlying value of their business is declining. Their production profiles are declined so their cash flow is going down. They're becoming less relevant to generalist investors. They're not achieving the scale generalist investors want. They can allocate their capital anywhere in any sector, the entire mining sector is smaller than Apple. So it really causes you to question how do we create scale and relevance to the generalist investors in the face of, you know, those types of choices that investors have across other sectors?

Craig: Yeah, right. Okay, well, we are having so darn much fun. We're already halfway done, David. We might as well move in...get close to the home stretch. This too gets right into your expertise. And actually, you mentioned your former employer, the merger of Goldcorp and Newmont. You now, Newmont, jeez, just in the last 100 days has seen its share value and thus its market capitalization cut in half. And a lot of that due to issues they're having with costs and inflation, you know, and everything and energy costs and the rest. So as a CEO, and knowing that rising costs impacts your earnings, what steps can a mining company take to minimize the damage that the rising costs are doing to their bottom line?

David: Well, what they can hope to do is achieve scale at their operations through expansions to the extent they have the geological model to support that. They can look at additional mergers and acquisitions to realize synergies and GNA costs and the like, creating that scale, lowering their cost of capital. There's very little that can practically do for inflation, you know, price takers are things like energy, labor, and the like, so there's a limit to what they can do there. But they can create scale, and increase synergies by putting companies together. That's I think gonna be another driver of M&A in the sector is trying to rationalize those types of costs.

Craig: I'm sitting here thinking to myself, I'd never thought of this before. But so many... You know, if you're a coffee producer, maybe you might get in the futures market and hedge your coffee prices or something like that. And obviously, precious metals producers, not so much currently but in the past, used to hedge and forward-sell products. I wonder, do you think it would... A company whose bottom line is impacted so much by energy prices, do you think they'd be in there maybe hedging crude oil costs?

David: Yeah, you know, to an extent they've been able to do that, but of course, that consumes credit lines, and capital is scarce. You know, you've seen companies in past cycles actually hedge their gold production. I think they've learned a painful lesson from never doing that again. And given how low-interest rates are on an absolute basis, there isn't that kind of contango forward curve in gold prices anyways to capture any sort of premium to spot. So, I would say there's very limited scope for companies to really actively hedge out their cost or currency and being caught wrong-footed if they do do that and consuming credit and potentially getting margin calls from financial institutions, which happened the last time that gold price went up violently and many companies that had gold hedged books were caught wrong-footed.

Craig: Yeah. You know, and you end up hurting your bottom line, especially if you think...

David: Or worse, potentially bankrupting the company as those margin calls come in. You know, that's the risk. And, you know, back, way back in the day, when Barrick had a hedge book, they were caught wrong-footed. They had created, you know, $4 billion or $5 billion of value hedging over many years. And then their hedge book went underwater to the tune of $7 billion, $8 billion, basically wiping out all their hedge gains from previous years and putting their balance sheet in peril. They clean that up, and they're a much stronger company. But I doubt you'd ever see Barrick or any major producer put on those types of hedge books again and getting caught wrong-footed.

Craig: Right. Right, especially with the fundamentals where they are and the math being the math. That leads me though, actually, pretty conveniently, to the fifth question. And I'm curious to get your answer to this, but again, just because you've been in the industry and have run companies for so many years. Your current company, Gold Royalty Company, provides capital, as you mentioned. These banks provide capital. They also provide hedging services and the rest, you know, and some essential services to mining companies. But yet, I mean, we just saw this news last week about some of the traders at J.P. Morgan, in fact, their head trader being convicted of spoofing and manipulating the price. Do you think news like that will cause, you know, any mining companies... I mean, they choose to work with the banks rather than work with royalty companies and things like that. Do you think that will cause them to kind of second guess their trust if that's the case?

David: I do think that's the case. And I think the even bigger driver of that in driving, you know, explorers and emerging developers into the arms of royalty companies, is the fact that big banks tend to be very inconsistent providers of capital to mining companies. They're not there through thick and thin. They're opportunistic at the peak of the cycle, and so they're, like, providing you an umbrella when it's a sunny day. And that's not very helpful to producers because we have long investment cycles and [crosstalk 00:15:14.413] consistent providers of capital. And I would say that the bulge bracket financial institutions simply are bad. Royalty and streaming companies have been there through thick and thin. They understand the business, they're singularly focused on the industry, and I think that's why they're able to provide capital on a much more consistent basis and through the ups and downs in the cycle.

Craig: Do you think this sort of thing, you know, in the boardroom level even gets noticed by a lot of mining companies? Would it change some of them the way they look at, you know, these companies they partner with?

David: Yeah, look, I think it does it. For me, it highlights the opportunism that's inherent inside of these financial institutions and that's what makes them inconsistent capital providers [crosstalk 00:16:03.074] transactional value rather than relationship value.

Craig: Yep. And I know, obviously, what you do is totally different from that. And hopefully, it wakes up more companies to wanna work with your company and other royalty companies out there to kind of keep it all within the industry.

David, we've come to the last question. We have already passed the quarter pole and we've gone down the homestretch, and now we got our last question. I think this is another very interesting one and goes right to your expertise, because I get asked this a lot on my site about jurisdictions around the world, you know, "And is that one safe because they're in X country and they've got political upheaval, and God knows what's gonna happen? Well, and are they going to nationalize mines?" And that kind of stuff. So in your experience, what are the best mining jurisdictions? And, you know, especially even when you're taking on royalties, do you worry about mine nationalizations?

David: Absolutely. Rule of law is extremely important. You know, the recognition of our royalty rates and having a legal system and framework around that is extremely important. That's why we're at this point, 100% focused in the Americas and 75% of the underlying value of our business is in Nevada, Quebec, and Ontario, three of the best mining jurisdictions in the world as judged by Fraser Institute for geological potential, low political risk, or low regulatory risk, that matters, and it matters to investors, and we recognize that. So we're very, very selective about the jurisdictions we operate in.

Craig: Well, I think that matters to individual investors too. I mean, anybody listening to us should take that into consideration. I mean, you've done this your whole life. You know this stuff. And so if someone like David Garofalo is telling you to focus on the Americas, you know, and make sure you're buying good companies that are maybe in...where the rule of law is well established is probably a key tenant to building an investment portfolio. I would imagine you'd agree with that.

David: Hundred percent.

Craig: Well, all right, David, it's been great to visit with you. I'll just remind everybody, this has been David Garofalo, who's the CEO of Gold Royalty Corp. That's a royalty company. It actually trades on New York Stock Exchange with a symbol GROY. It's been very fun to visit with him. And I would just, again, remind everybody on your way out that this content doesn't just appear magically on the internet. It's sponsored by Sprott Money. You should keep them in mind next time you're in the market to buy or store physical precious metal, but if anything, just give them a like, or hit the subscribe button on whichever channel you've been listening to this podcast, as that helps them cast a wider net, get the good word out, and educate a larger audience about how the precious metals industry works. David, thank you so much for your time. This has been very informative and really very helpful.

David: Thanks so much for having me on, Craig. It was my pleasure.

Craig: It's been fun visiting with you. And from all of us here at Sprott Money News and sprottmoney.com, thanks for listening. We'll have another "Ask The Expert" segment in September.