How Deterra Royalties provides exposure to the mining industry with less volatility

In the most traditional sense, mining companies are highly cyclical and require careful analysis by investors to avoid buying and selling at the wrong time. However, Deterra Royalties (ASX: DRR) provides exposure to the mining industry with much less volatility than owning a mining stock.

Originally wholly owned by Iluka Resources (ASX: ILU), Deterra was spun out in late 2020 with Iluka retaining 20 per cent ownership. The Australian Eagle investment team had long appreciated the assets of Deterra while it was owned by Iluka due to the cashflow reliability and optionality it provided.

As the company name suggests, Deterra owns several mining royalty assets. The crown jewel in its portfolio is Mining Area C (MAC) in the Pilbara region of Western Australia, a world class iron ore mine hub majority owned and operated by BHP.

BHP (ASX: BHP) pays a 1.232 per cent royalty to Deterra on all MAC revenue generated, payable on a quarterly basis. As BHP ramps up production, Deterra also receives one-off capacity payments of A$1 million per 1 million dry metric tonnes increase in annual mine production, payable annually.

In the last financial year, BHP increased MAC production capacity from 105 million tonnes to 118 million tonnes and have indicated their intention to ramp up to full capacity of 145 million tonnes by the end of financial year 2024. This should make MAC the largest single iron ore hub in the world.

With payments calculated on revenue and not profits, this arrangement favours Deterra, especially in the current environment where the iron ore price remains relatively elevated. After years of record low interest rates and inflation, mining companies have recently struggled to contain higher production costs stemming from wage inflation, labour shortages, fuel increases and general cost inflation. MAC provides Deterra with the benefits of higher production and commodity prices with much less downside than owning an iron ore mine.

Despite the perception of the iron ore price being extremely volatile, observers of the Australian government budget may have noticed that iron ore is extremely valuable, representing 22 per cent of Australia’s total exports. As a result, Australia’s financial wellbeing is highly reliant on a profitable domestic iron ore industry so Australia and to a lesser extent, Deterra’s fortunes, remain positively correlated. The investment team has also noted that falls in the Australian dollar has provided some downside protection to exporters during periods of commodity price weakness.

With no drawn debt and a minimal operating cost base, Deterra has a 100 per cent payout ratio to ordinary shareholders, resulting in a solid fully franked dividend yield of over 6 per cent at current share price levels. The dividend yield could increase further from here if BHP delivers on its expansion plans at MAC.

Management has signalled their intention to acquire additional royalty assets by expanding their debt facilities and hiring additional team members to assess acquisition targets, mainly in the battery and base metals space.

The investment team has recently added to both The Montgomery Fund and The Montgomery [Private] Fund’s position to reflect their acknowledgement of Deterra starting a new phase of their journey. We remain cognisant of the company’s future strategic decisions as well as the movements and sentiment surrounding iron ore in the global economy.

The Montgomery Fund and The Montgomery [Private] Fund own shares in Deterra Royalties Ltd and BHP. This article was prepared 20 October 2023 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade Deterra Royalties Ltd and BHP, you should seek financial advice.


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