A globally significant financial asset trading at a local valuation
The ownership of a mineral royalty (a contractually established financial asset) over a producing or near-production mining asset has been the basis of many Australian fortunes. For instance, the iron ore royalties held in the Pilbara by the Hancock/Rinehart and Wright families coupled with prudent investment decision-making has allowed them to build enduring and significant wealth. Another well-known example is the Weeks oil & gas royalty encompassing a large portion of oil & gas production in the Bass Strait.
A mineral royalty provides the holder with the right to receive a portion of revenues from a particular mining operation or area. Royalties are reasonably bespoke, contractual agreements; accordingly, there are many variations and structures. We consider the most attractive royalty structure to be a 'gross overriding royalty' ('GORR') which entitles the royalty owner to a share of the market value of the commodity being produced less delivery costs borne to a point of sale.
The advantages of a GORR royalty structure are as follows:
- simple to calculate and audit
- lowest risk - with no ongoing capital expenditure required
- no exposure to cost or direct operational risks
- the lowest volatility of cash flow, with a single variable input (the commodity price)
- a readily saleable and reasonably liquid asset
- leverage to increases in commodity price and exploration success
Other risk factors associated with royalty investments are primarily linked to the risk of the asset becoming non-productive which are:
- the particular commodity being produced
- the cost quartile of the producing asset (or relative production cost position)
- the location of the asset
- the mine life of the asset
Royalty companies have become big business, with a multitude of listed exposures available on global markets. These companies generally hold diverse portfolios of royalty interests and commodity exposures.
Franco-Nevada ('FNV') is the world's largest listed royalty company with a market cap of around US$26 billion (AUD$37 billion). Prima facie it positions itself as a gold royalty company, whereas in reality, it has exposure to a range of precious and base metal longer-life projects with an average mine life of 20 years. It achieves top-line revenue of approx. US$800 million whilst enjoying strong EBITDA margins in excess of 80% (typical of royalty companies).
It has a diverse board of mineral industry participants including Tom Albanese, Rio Tinto's former CEO. In a nutshell, it provides an ideal investment vehicle for institutions and individuals alike for lower-risk exposure to the commodity markets.
The sole Australian royalty company of scale is Deterra Royalties ('DRR'), recently demerged from Iluka Resources.
Deterra holds what we consider to be the best single royalty exposure available on the listed markets globally in the Mining Area C Royalty ('MAC Royalty').
The MAC Royalty is a GORR of 1.232% of Australian dollar-denominated, free-on-board (FOB) revenue from product mined from Mining Area C, a major growth hub for BHP's Pilbara iron ore operations which are some of the largest globally. In addition, DRR also enjoys one-off $1 million per 1 million tonne increases in annual production capacity for the areas encumbered.
Main factors that contribute to the quality of this royalty interest are:
- one of the world's best operational and financial counterparties in BHP
- situated in the world's best mining jurisdiction, Western Australia
- minority asset owners and other credit exposures are large Japanese conglomerates in Mitsui & Itochu
- mining assets are within lowest production price quartile, so will produce in virtually any circumstances
- low commodity risk in higher quality iron ore - essential and irreplaceable for further global development as well as politically insulated
- inbuilt organic growth profile with production volumes expected to double by 2023 via the development of South Flank mine
- Length of Mine ('LOM') currently 30 years with expansion potential to >50 years of mine life.
DRR have committed to paying out 100% of net profit after tax ('NPAT') to shareholders via dividends.
Given the valuation of global royalty peers, we contend that DRR would make a viable and attractive M&A candidate. For instance, in a scenario where FNV acquired DRR, we could expect FNV to increase their revenue by over 20% from 2023 (assuming spot FX and iron ore prices hold) and a likely value uplift of over US$5 billion (AUD$8 billion) should their multiple remain stable which we consider conservative given the sheer quality of the MAC Royalty.
DRR trades today at a mere AUD$2.2 billion (USD$1.54 billion) or around a quarter of its potential value to a leading royalty company.
An alternative hypothetical scenario could see BHP purchase and internalise the royalty interest given the long mine life and the present rock bottom interest rates. Iluka Resources maintain a 20% interest in DRR, making them a king-maker in any M&A action. Given the holding is non-core to Iluka, we would expect a reasonable bid for DRR would see the major shareholder accept.
In summary, we believe that DRR provides a defensive, high-quality annuity-style equity exposure for investors; with potential for large capital appreciation via organic growth and potential M&A action.
Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in DRR.
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