Sandon Capital believes Iluka’s iron ore royalty over BHP Billiton’s Mining Area C (MAC) is worth close to A$2/share in its current form. If and when BHP Billiton decides to proceed with the development of its South Flank iron ore deposit, we believe the royalty could be worth >A$4/share to Iluka shareholders. Iluka has one of the better track records in capital allocation in the global mining industry over the past decade. We believe the company has an opportunity to enhance this track record by demerging the company’s iron ore royalty into a separately listed entity where it will be valued more appropriately.
In Sandon’s opinion, Iluka’s MAC royalty is the best asset in the Australian mining sector and the cheapest. Despite having a book value of only $16.7m, the asset has generated Earnings Before Interest & Tax (EBIT) of almost A$650m for Iluka since Mining Area C first produced iron ore in 2003. The royalty provides direct exposure to the revenues of iron ore production from Mining Area C without the typical risks that are inherent in mining assets. Iluka does not have to concern itself with permitting, exploration, financing, capital expenditure, mine construction, operating costs, mine and equipment repair and maintenance, rehabilitation and all of the other risks that come with the ownership, development, operation and closure of mining operations. Iluka simply collects a royalty cheque from BHP Billiton each quarter that Mining Area C produces iron ore. The major risk for any royalty is counterparty risk, and in the case of BHP Billiton, the MAC royalty counterparty is the world’s largest mining company and Mining Area C is one of the lowest cost iron ore mines globally.
Furthermore, the MAC royalty enjoys all of the upside that comes from exploration success and production increases with no additional capital expenditure or operating costs. We expect this attribute to become apparent as BHP Billiton depletes the reserves at its Yandi operations and looks to replace this production from other assets within its iron ore system. We expect replacement production to come from a new deposit at South Flank, which is located ~8kms to the south of the existing Mining Area C operations and sits within ML281SA, the mineral lease to which Iluka’s iron ore royalty pertains. The Yandi production that South Flank will replace does not sit within this mineral lease and hence is not subject to the MAC royalty.
Sandon Capital believes the royalty is significantly undervalued whilst it is housed within a mining company and would be more appropriately valued in a separately listed, pure play royalty company. Based on offshore comparables, the royalty today could be worth A$840m-940m. Should BHP Billiton proceed with the development of the South Flank deposit, we believe the royalty could be worth between A$1.7-1.9bn.
In order to properly value the MAC royalty and maintain the integrity of Iluka’s balance sheet, we think the company should demerge the royalty via an in-specie distribution to existing shareholders. A focused standalone royalty company, with its own dedicated board and management, would be able to focus on growth opportunities such as adding other royalties or even looking at ‘streaming’ deals such as those undertaken by North American royalty/streaming companies. The powerful cash flow generation of the royalty could support at least $300m of debt in a standalone entity. Transfer of the debt at the time of the demerger would leave Iluka’s balance sheet unencumbered.
The remaining Iluka mineral sands business would be left with a lowly geared balance sheet that could accommodate the plethora of capital investment opportunities available to the company. For example, production growth at Sierra Rutile (assuming the deal closes), or new production at Cataby and Balranald.
When our estimate of the value of the royalty is combined with the A$500m of excess working capital that currently sits on Iluka’s balance sheet, we estimate the implied value of the world leading mineral sands assets is ~A$500m, well below tangible book value (~A$1.4bn) and at a multiple of ~3x current EBITDA.
Background to the Royalty
Iluka has a royalty over iron ore produced from specific tenements in BHP Billiton’s Mining Area C province in Western Australia, representing a deferred consideration from sale agreements dating back to 1977. An antecedent company to Iluka, Consolidated Goldfields, originally had a one-third interest in the Mt Goldsworthy Mining Associates Joint Venture. This interest was divested for a consideration of A$29m, which in 1994 was converted into a royalty and capacity payment arrangement. Iluka’s right to the royalty is an in-perpetuity right – it is active as long as BHP Billiton produces and sells from this part of its iron ore tenements. Iluka has no exposure to capital and operating costs, nor State or Federal taxation changes.1
Main Components of the Royalty
Iluka’s income from the MAC Royalty Area comprises a revenue based royalty and production capacity payment covering the Mining Area C (Mining Lease 281 containing various deposits) and consists of:
- the greater of:
(i) ongoing quarterly royalty payments of 1.232% of sales revenue from the MAC royalty area (less all export duties and export taxes), or
(ii) A$0.25 per tonne of all ore produced from the MAC royalty area in that quarter
- when applicable, annual capacity payments of A$1m per million tonne increase in the annual production level from the MAC royalty area during any 12 month period ending 30 June above the previous highest annual production level, paid within 30 days of the relevant amount of production being produced.2
Mining Area C Mining & Transport Operations
Mining Area C is located in the Pilbara region of Western Australia, 92kms north-west of the town of Newman. The mine is majority owned (85%) and operated by BHP Billiton, with the minority owners being Mitsui (7%) and ITOCHU (8%). Iron ore produced at Mining Area C is crushed and screened before being transported 360km by the Mt Newman JV-owned rail to Port Hedland where the ore is loaded onto ships at Finucane Island and transported to international markets. According to a CRU cost curve produced in 2010, Mining Area C is close to the lowest cost iron ore mine in the world, which stands the asset in good stead to produce iron ore in any pricing environment.
The ore produced at Mining Area C is also of high quality with a product grade of ~61%, low silica and alumina content (~6.5%), and a high proportion (~38%) of premium priced lump in the product mix.3
Mining Area C Reserves & Resources’
BHP Billiton no longer report reserves and resources by mining hub. The last time this was reported was FY12 and at that point in time, the resource statement showed that the Mt Goldsworthy JV Area C was particularly well endowed with a total resource base of in excess of 5.5bn tonnes, at a grade of 60% and with low impurities. Assuming that half of the resource base will eventually convert to reserves and be mined, Mining Area C has around 55 years of mine life at current production of 50Mtpa, or close to 30 years of mine life at production of 100Mtpa.