Why Iluka Resources’ lucrative iron ore royalty is back in the spotlight

Why Iluka Resources’ lucrative iron ore royalty is back in the spotlight

Source: The Australian Financial Review.
By: Tess Ingram.

For more than a decade, Iluka Resources has been assembling a very large file on the opportunities that surround a royalty it gets from a BHP Billiton iron ore project.

The file has expanded over that time as, at various intervals, the company has examined whether the lucrative royalty from the world’s biggest mining company could be sold off or spun out to create value for shareholders.

That discussion is back on investors’ radars again, and for good reason.

For the uninitiated, the mineral sands producer’s business can be separated into four key pillars. As well as being the world’s largest producer of zircon, used in the production of ceramic tiles, it produces titanium dioxide minerals, predominantly used as a pigment in paints.

Its third and newest pillar is Sierra Rutile, which it completed a takeover of this month. As its name suggests, the company produces rutile, a titanium dioxide feedstock. But considering its size and that it is yet to be fully integrated into the business, it is fair to consider it alone.

Iluka’s fourth pillar is the royalty received from BHP in regards to its Mining Area C (MAC) iron ore project in Western Australia’s Pilbara region.

The long-standing arrangement provides Iluka with a royalty rate of 1.232 per cent on MAC sales revenues as well as annual capacity payments of $1 million for every 1 million tonne increase in annual production from MAC.

Iluka has no exposure to capital costs, operating costs or state royalties and has a right to the royalty as long as BHP is selling iron ore from the relevant tenements.

Legacy arrangement

Given it provides upside to both higher prices and production expansions, the legacy royalty has been a valuable asset, delivering $621 million in earnings before interest, tax, depreciation and amortisation over the past decade.

This is has been particularly welcome over the past four years as mineral sands prices declined and continue to remain a far cry from 2012 highs.

As one Iluka shareholder rightly notes, whether to spin-off such a prized asset that provides crucial diversification is obviously ultimately a question of value, but now could be an “appropriate time”.

Another albeit smaller but more vocal shareholder, activist fund manager Sandon Capital, recently published a public white paper calling on Iluka to reconsider opening its MAC file.

Here’s why. After just shy of a decade at the helm, the miner’s long-standing managing director David Robb has passed on the baton to a new chief, former Wesfarmers executive Tom O’Leary.

It is not that Robb was opposed to flipping it out. In fact, he had his eye on it for years and mentioned as recently as 18 months ago the company was still slowly working on options.

It is understood Iluka has considered almost every kind of corporate break-up during and since a formal 2003 sale process for the royalty: a trade sale; listing it alone in a separate vehicle; or developing a royalty business in which it could be aggregated with other royalty streams, either in public or private hands. But the result was never ideal. More on that later.

New chief, new strategy

O’Leary says the board has given him the opportunity to craft his own strategy for Iluka which, along with a review he is undertaking of the company’s assets, opens a window for the MAC spin-off to be revived.

Externally, market conditions are supportive – the iron ore price has recovered from as low as $US38 a tonne 12 months ago to about $US80 a tonne and a growing list of analysts have become more positive on the medium-term outlook for mineral sands prices, particularly zircon.

The potential for a mineral sands price recovery has given analysts the confidence Iluka could do without the alternative revenue stream and higher iron ore prices obviously lure interested parties.

But the key reason separating the royalty is back in the spotlight, and central to Sandon’s argument, is BHP’s development plans.

BHP has kicked off studies on its South Flank development project, which it is considering as a replacement for its massive Yandi mine, which has between five and 10 years life left in it.

South Flank has the potential to be an 80 million-tonne-a-year mine with a life of about 30 years and importantly for Iluka, it sits within the royalty area – BHP’s mining lease 281 – whereas the ageing Yandi does not.

Sandon values the MAC royalty at $840 million to $940 million but says if BHP proceeds with South Flank as its replacement option for Yandi, the royalty could swell in value to $1.7 billion to $1.9 billion.

Calls for demerger

Sandon wants Iluka to demerge the royalty via an in-specie distribution to existing shareholders. Such a company could be listed in North America, where royalty-based companies such as Franco-Nevada and Labrador Iron Ore Royalty enjoy strong support, enough for it to take on a suggested $300 million of debt.

Iluka had net debt at June 30 of $124 million. The Sierra Rutile transaction, through which its assumes $80 million debt, takes its gearing as at June 30 from 8.7 per cent to 32 per cent, with Iluka noting it would repay the Sierra Rutile debt with its own facilities, which total $1 billion.

Iluka took control of Sierra Rutile only on December 7 so O’Leary has rightly said his priority is to successfully integrate it into the business while completing 2017’s budgeting process and conducting his review of the company.

As well as the MAC royalty, that review will include looking at the company’s two key development projects, Cataby in Western Australia and Balranald in NSW.

Iluka has roughly guided annual capital expenditure will average between $200 million and $250 million over the next five years and flagged this month it expects to spend $US60 million on operational improvements within Sierra Rutile over the next two years and a further $US160 million on the division’s growth projects over three to five years.

And this is where it gets interesting.

Tax implications

Given that chunky capex list, there is a view in the market Iluka would be wise to become more comfortable with the trajectory of mineral sands prices and BHP’s intentions in regards to South Flank before making a decision on any split.

Analysts are unlikely to factor in the South Flank upside until BHP confirms the project as its preferred option and any spin-off is likely to take about 18 months to arrange regardless, which makes pegging the iron ore price environment very difficult, given its relative volatility over the past two years.

When iron ore prices were climbing towards their peak in 2011, Iluka publicly contemplated spinning off the royalty, which it then valued at about $1.5 billion, but opted to hold on, which in hindsight was well-timed considering the resultant descent of mineral sands prices.

A 2003 bid for the royalty, understood to be about $100 million, received through a formal sale process conducted as Mining Area C began production was also decided against, reportedly due to shocking capital gains tax implications.

A direct sale of the royalty remains unlikely to be in shareholder interests as it is currently held on Iluka’s balance sheet at $5.1 million.

There is also a possibility ratings agencies and Iluka’s lenders could recast their eyes over the miner’s debt if it flipped out the reliable revenue stream.

Given the technical challenges, one astute analyst tips that O’Leary is likely to review the royalty’s position, have it poised for action but then work to trim the company’s debt.

If a time comes when its gearing is lower but the iron ore price remains robust, then the eject button could be polished off.

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