Spinning off Iluka’s valuable iron ore royalty into a new company could be the way to build yield-based exposure to resource earnings that’s currently lacking in the Australian market.
Iluka’s announcement that it will conduct a fresh review of the future of the royalty it earns from BHP’s Pilbara iron ore operations is a big win for activist investor Sandon Capital.
Having first pushed for Iluka to find a way to unlock the value of the royalty back in November 2016 and again in March and October this year, Sandon’s founder and managing director Gabriel Radzyminski is entitled to take a bit of a victory lap, along with L1 Capital, which publicly backed the case a few weeks ago.
But Radzyminski is already moving on. He’s pleased the Iluka board is conducting a formal review of the royalty and says the company should take the time it needs to get the right result.
But he is adamant that Iluka mustn’t waste the opportunity and believes Iluka should spin off the royalty stream into a separate company that could eventually add other resource royalties to create a specialist vehicle.
“People are yearning for yield and royalties can be a low capex way of delivering income,” Radzyminski says.
“It’s an income stream that we think is overlooked and once understood will be highly valued by the market.”
Crucially, Radzyminski has the support of Perpetual, which holds a 10.2 per cent stake in Iluka.
“It needs to happen in the right format for long-term value creation,” Perpetual’s head of equities, Paul Skamvougeras, tells Chanticleer.
“What we’d like to see is a separately listed royalty company created, with a separate board.
“The Australian market understands mining, yet we don’t have a listed royalty company. This is a globally significant royalty.”
While mining mineral sands is Iluka’s main game, its royalty entitles it to 1.232 per cent of Australian dollar revenue from BHP’s Mining Area C (MAC) tenement, as well as a one-off payment of $1 million per million-tonne increase in annual capacity.
The royalty, which forerunners of Iluka acquired about six decades ago, has become increasingly lucrative in recent times, as iron ore prices have soared.
In the six months to June 30, its earnings before interest, tax, depreciation and amortisation leapt 41 per cent to $41.2 million.
But an even bigger bump is coming when BHP’s new $5.2 billion South Flank mine begins production from 2021.
Iluka’s analysis suggests the MAC royalty could produce EBITDA of $239 million by 2023, based on an iron ore price of $US95 a tonne and an Australian dollar at US70¢. Even with iron ore at $US55 a tonne, annual EBITDA would be about $139 million a year.
As Radzyminski says, it is a unique situation, offering investors exposure to a high-quality iron ore tenement mined by a giant of the industry that carries the cost and risks of operations.
The Iluka board, which has had the MAC royalty under constant review, says progress on South Flank – it is now 50 per cent complete – has been the trigger to move toward this more formal progress.
One observer, however, believes the board might have also been prompted by approaches from overseas royalty companies interested in getting their hands on the MAC stream.
The Iluka camp stresses that all options remain on the table: a demerger; creating a specific dividend stream for the MAC royalty that would underscore its value; and of course, maintaining the status quo.
Iluka shares leapt 6.4 per cent on the day of the announcement to $9.37 but have since fallen back to $8.94.
The advocates of the royalty company insist they are not after a quick sugar hit and instead want Iluka to consider building something substantial.
Radzyminski argues the MAC royalty could be used as the cornerstone of a portfolio of royalties that could be acquired over time.
This model is particularly popular in North America, where the largest pure royalty company, Franco-Nevada, has a market value of $25 billion, and currently trades on a price to earnings ratio of more than 59.5 times calendar year earnings. About 65 per cent of Franco’s earnings come from precious metal royalty streams (mainly gold) with oil and gas royalties making up the rest.
One challenge Radzyminski sees for the Iluka board is that a royalty company requires a different style of management and governance to an operational mining company. That suggests directors may need to put their prized asset into other hands.
The Iluka camp, which has promised to update the market on its deliberations by February, says the board will be dispassionate – even with all the passion around this fascinating situation.
By James Thomson