BHP Billiton’s pursuit of South Flank a big win for Iluka Resources

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

The lucrative royalty Iluka Resources earns from BHP Billiton’s iron ore tenements could double in value if BHP locks in the South Flank deposit as its solution for iron ore production replacement in the Pilbara, according to analysts.

Shares in the mineral sands miner have climbed about 15 per cent in the past three weeks as a number of external factors have pointed to more positive future conditions for Iluka’s business.

Last week, BHP confirmed its large South Flank deposit in the Pilbara was the “preferred long-term solution” to replace its Yandi mine, which is nearing exhaustion and needs to be replaced within five to 10 years.

Iluka’s legacy royalty arrangement with BHP gives it a royalty rate of 1.232 per cent on sales revenues from BHP’s Mining Area C (MAC) iron ore hub as well as annual capacity payments of $1 million for every 1 million tonne increase in annual production from MAC.

Importantly for Iluka, it is understood South Flank sits within the mining lease from which it collects the royalty, whereas Yandi does not, creating the potential for an additional 80 million tonnes of iron ore production to be covered by the royalty for about 30 years.

Value booster

The MAC royalty has been valued at $840 million to $940 million by minority Iluka shareholder Sandon Capital which has said, if the BHP board decides to proceeds with South Flank, the royalty could swell in value to as much as $1.9 billion.

In March, Goldman Sachs analyst Craig Sainsbury increased the net present value (NPV) his team ascribes to the royalty from $450 million to $636 million “to reflect some of the long-term optionality in the asset”.

Mr Sainsbury said if South Flank increased annual production at MAC from its current 55 million tonne rate to as much as 120 million tonnes, as flagged by BHP, “we believe that the NPV for the royalty stream could increase close to $1 billion”.

It is understood Iluka is confident South Flank is within the royalty lease area and is closely watching BHP’s decision on the project given the significant impact it could have on the valuation of the royalty.

It comes as prices for Iluka’s main raw products – zircon and rutile – have shown signs of improvement in recent months.

Iluka is the world’s largest producer of zircon, used in the production of ceramic tiles, and the second largest producer of high-grade titanium dioxide minerals, such as rutile and synthetic rutile which are predominantly used as a pigment in paints.

Prices improving

It is understood Rio Tinto and Tronox, the other major players in mineral sands, put through price increases for zircon for early 2017, leaving Iluka to make a decision on what its price actions will be. Spot rutile prices in China have also popped in recent weeks.

The confluence of positive factors has added further fuel to a debate about whether Iluka should spin out the MAC royalty to create value for shareholders.

Sandon Capital analyst Campbell Morgan said the news on South Flank should act as a catalyst for Iluka to begin a fresh review on the potential for a spin-out.

“The whole company will be close to debt free in maybe three to four years’ time but you could also attach a reasonable amount of debt to a spun-out royalty co because all it produces is a pure stream of cash flow and doesn’t require any capital to run the business, leaving mineral sands co with a completely unencumbered balance sheet,” Mr Morgan said.

However Goldman Sachs argued divesting the royalty was not the way to address Iluka’s balance sheet, which is “under a little pressure” after its recent acquisition of Sierra Rutile tipped it into a net debt position.

“We conclude that although there is potential for Iluka to crystallise cash by divestment of MAC, it is likely to be a better long-term value driver for shareholders inside the ILU portfolio,” Mr Sainsbury said.

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