gold sandstorm (NYSE: SAND) talked about its deal pipeline for more earnings Q&As than we remember, and just when we thought the company would end the year without announcing another addition to its royalty and stream portfolio of metals, it pulled out one from his hat – a stream of gold on the Mercedes mine in Sonora, Mexico.

This underground mine is about to change hands, again, and Sandstorm Gold is facilitating this transaction. Junior explorer Bear Creek Mining (OTCQX:BCEKF) is to acquire this Equinox Gold (EQX) mine for an aggregate price of $125 million plus a 2% royalty on future production payable to Equinox. Bear Creek will deploy $15 million in cash, plus $60 million from a financing package provided by Sandstorm Gold to fund the $75 million in cash due at closing. In addition, it will issue $25 million in stock, making Equinox a 16.6% shareholder. And finally, Bear Creek agreed to pay $25 million in cash six months after the closing, expected at the end of the first quarter.

Sandstorm Funding Package

Sandstorm Gold’s $60 million financing package includes a $37.5 million gold stream plus a $22.5 million convertible debenture.

• Under the gold stream agreement, Sandstorm will make an upfront payment of $37.5 million for the right to purchase 7,200 ounces of gold at 7.5% of spot price for 3.5 years after closing. Thereafter, the flow drops to 4.4% of gold production for 25% of the spot price.
• The debentures have a term of three years and bear interest at 6%. Sandstorm may convert the debentures into shares at any time prior to maturity at a premium of 35% to Bear Creek’s stock price at the closing of the transaction.

Let’s take a closer look at the streaming deal and use the latest technical report on the Mercedes mine issued by Equinox at the end of 2020. The reserves, as detailed in this report, support a mining plan until the end of 2025. The gold and silver production profile is presented in the table below ( in a full year). This table also shows the metal deliveries under the various streaming agreements and the royalties due after the closing at the end of the first quarter:

• the new Sandstorm streaming deal;
• the newly created Equinox Royalty;
• deliveries due under the existing royalty to Elemental Royalties (OTCQX: ELEMF);
• the existing Nomad silver stream (NSR);
• and finally, fixed gold payments to Nomad.

(Source: Technical Report, Named Companies Public Disclosure)

Assuming a gold price of $1,600/oz and a discount rate of 5%, the Sandstorm stream will generate $33.1 million in discounted cash flow for Sandstorm, or $4.4 million in less than the initial payment. In fact, a gold price of $1,815 per ounce will be required for Sandstorm to break even on its initial payment for gold flow based on current reserves.

Upside down

Very clearly, Sandstorm is betting on extending the life of the mine. Current owner Equinox has been optimistic about resource conversion, as well as exploration potential near the mine. Some would say that such optimism is normal on the part of a seller and should therefore be taken with a grain of salt; others would argue that a mobile reserve is not out of place for a mine like the Mercedes mine.

Assume for a moment that additional reserves can be defined and developed and an extension of mine life can be accomplished. Sandstorm’s gold flow will be down to 4.4% of gold production for 25% of the spot price at this point, earning just $2.6 million a year. In other words, it will take about two years beyond the current reserve-backed mine life for Sandstorm just to recoup its initial investment, assuming production at current levels. Now Equinox has hinted at the potential to increase production to 85 Koz of gold per year. In the unlikely event that Bear Creek is able to not only fund activities to extend the mine life, but also manage the expansion of plant capacity to accommodate the 85 koz throughput of gold production, Sandstorm’s cash flow would increase to $4.5 million per year. .

Typically, potential life of mine extensions are an integral part of streaming agreements, providing future options and benefits for the holder of the metal stream. It is unusual to see some of this option already embedded in the purchase price of a gold stream. At the very least, we would expect a high premium to be paid for the risks involved in such an arrangement, but that premium is strictly limited in this case as the flow drops back to 4.4% of gold production. once the current reserves have been exploited, the purchase price increases to 25% of the spot.

The Uphill Battle

The “Mining” in the company name is actually kind of an exaggeration. Bear Creek Mining is, in fact, a young explorer with no mining history and very limited mining expertise at the board or management level. And this junior explorer is trying to turn around a worn-out mine that has been passed from Yamana Gold (AUY) to Premier Gold to Equinox Gold and finally to Bear Creek Mining over the past two years – with little evidence of profitability along the way. But let’s not linger, and look at the economic aspects of this attempted turnaround.

The table below assumes a closing of the deal at the end of the first quarter and metal prices of $1,600/oz Au and $21.50/oz Ag. The far right column shows revenue due to Bear Creek after deliveries of metal in the streams and royalties mentioned, and payment of the so-called Extraordinary Mining Tax payable on metals at the mine gate.

(Source: Technical Report, Named Companies Public Disclosure)

From the 2020 technical report, we can also extract the planned operating costs and sustaining investments. The following table below shows these figures along with the resulting gross profit, ignoring the effects of cost inflation since the publication of the technical report.

(Source: technical report, author’s calculations)

Gross profit as calculated above for 2022 barely covers the final payment of $25 million to Equinox in the second half of 2022; and 25% of the gross margin generated in the remaining years will be required to cover the repayment of Sandstorm’s convertible debt.

Working capital was $27.6 million at the end of the third quarter, and after deducting $15 million due to Equinox in the first quarter, two quarters of corporate consumption and various costs associated with the agreement, we estimate that there will be around $5 million left at the end of Q1 when the Mercedes acquisition is due to be finalized. This cash is not even sufficient to meet the working capital needs of ongoing operations at the Mercedes Mine, and we see virtually no wiggle room to pay the bills for growth initiatives in 2022 from the balance sheet. Additionally, we see very limited free cash flow generated from the Mercedes mine in the remaining years to fund growth initiatives after accounting for interest and principal debt repayments to Sandstorm due in 2025.

Bear Creek plans $4.4 million budget for exploration in 2022; however, when we talk about growth initiatives, we are not just talking about a drilling campaign to convert and expand the resource base; we also mean a tailings dam raise which will be a pre-requisite to extending mine life; and we also mean mining development to access ore bodies capable of providing the expected growth. And at this point we haven’t even mentioned a plant expansion to increase throughput and gold production to 80-90 Koz like projected by Equinox.

Of course, our gold price assumptions are probably conservative; but we would say this only offsets the cost inflation that we have chosen to ignore in the considerations above. We just don’t see how the expansion costs can be covered by the cash flow from the Mercedes mine. And of course, we don’t see how Mercedes’ cash flow will contribute to the development of Corani’s Bear Creek project in Peru, as announced on the call following the announcement of the acquisition.

From all of these considerations, we see a very strong likelihood that Bear Creek Mining will require a substantial capital injection to fund a Mercedes mine life extension. Given the short remaining mine life, time is running out and the company will need this capital injection sooner rather than later. And since the Mercedes mine is already congested like few other mines, opportunities to raise capital are limited. This will most likely mean shareholder dilution for Bear Creek shareholders on the one hand; but also an additional risk for Sandstorm on the other hand. Sandstorm has a strong interest in keeping Bear Creek operational and could be asked to contribute capital or accept a haircut if things go wrong.

Summary and investment thesis

All of this to emphasize that Bear Creek Mining is a high risk counterparty, getting into a high risk business – with a ripped small budget. Sandstorm got burned on similar adventures in its early years – think Serra Pelada to name just one example. The company was keen to strike deals with higher quality counterparties and higher quality mining projects thereafter. To see Sandstorm return to the high-risk business model of the early years, it needs to grab the attention of investors who know the company’s history.

At the very least, we would have expected a high premium on a high-risk stream like this. However, we can’t really see that premium for the stream itself, and we certainly can’t see it for the debentures. This deal looks a lot like a deal for a deal, and we don’t applaud Sandstorm for making it.

The Mercedes stream is not large enough to cause a material change in Sandstorm Gold’s investment thesis – we are shareholders and will continue to hold for now. However, when we compare this latest agreement to agreements made by peers, we are disappointed. Sandstorm has been talking about its deal pipeline for some time, and when the Mercedes stream is all the company can muster, it’s food for thought.