Wide-moat Deterra Royalties (ASX: DRR) has offered to buy London-listed Trident Royalties via a scheme of arrangement for GBP 0.49 cash per share—around GBP 144 million or $276 million. Trident also had about USD 22 million ($33 million) in net debt as of May 3, 2024.

The acquisition is subject to Trident shareholder approval, court approval, and other conditions. While there is the possibility of a higher bid from a third party, we think the offer is highly likely to succeed as Trident directors intend to recommend it to shareholders.

We do not change our fair value estimate for Deterra of $4.20 per share. We currently value Trident at cost and assume the acquisition neither creates nor destroys value. Deterra intends to lower its target payout ratio to a minimum of 50% from 100% after paying its fiscal 2024 final dividend.

This makes sense as it will likely enable the company to repay debt taken on to fund the acquisition without having to raise equity. However, this is likely one of the drivers of the 6% fall in the shares on the 14th of June despite Deterra having previously announced that its payout ratio could be reduced in the event of a material acquisition. The shares are currently trading slightly below our fair value estimate. 

Another likely driver is uncertainty over the value of the acquisition. Trident owns 21 royalties or royalty-like assets, such as gold offtakes, with 12 currently generating cash flow, of which nine are gold offtakes.

Gold accounted for nearly 80% of Trident’s 2023 revenue of around USD 10 million ($15 million), with much of the remainder from royalties on mines with short remaining lives. We think the gold-related assets will likely be sold, given they are inconsistent with Deterra’s strategy to focus on acquiring additional royalties or streaming arrangements in bulk, base, and battery metals.

As such, the offer is a bet on Trident’s development assets. The most attractive is the large, long-life Thacker Pass lithium development project owned by no-moat Lithium Americas.

Deterra business strategy and outlook

Deterra Royalties aims to grow into a diversified royalty company with multiple cash flows. New royalties are likely to be added in time, but we believe disciplined investment is likely, given the managing director's background at Iluka Resources and the discipline shown since Deterra listed on the Australian Securities Exchange.

The royalty over BHP Mining Area C provides cash flow without exposure to capital or operating costs. The low historical cost for the royalty means returns are enviable. BHP is expanding output from 60 million metric tons of iron ore in 2019 to about 145 million metric tons in 2024 through the development of its South Flank mine. This benefits Deterra through a proportionally increased royalty. Deterra receives 1.232% of the Australian dollar value of iron ore sales revenue from the royalty area, FOB ex-Port Hedland. Deterra also receives $1 million capacity payments for each 1 million metric tons of annualized increase in production above the high-water mark.

The leases and operations supporting the MAC iron ore royalty are 85% owned by BHP, with minority shares owned by Japanese firms Itochu and Mitsui. North Flank has a mine life of about 30 years and South Flank about 25 years. The royalty area also encompasses most of the Tandanya and Mudlark deposits, which represent future development options. BHP’s long-term strategy is to continue to produce iron ore from the MAC hub for at least 50 years.

Deterra lacks control over exploration, life extensions, or the development of new deposits, but BHP has a vested interest to maintain operations. Given North Flank and South Flank’s position around the bottom quartile of the cost curve, we think it is likely the mines remain operating in almost any likely iron ore price environment.

Deterra is leveraged to China fixed-asset investment, with China accounting for about 70% of global traded iron ore demand. Long term, we see demand for steel in China declining as returns on fixed-asset investment worsen, scrap takes a growing share of new steel supply, and the stock of infrastructure and housing matures. We also expect supply to improve as Vale recovers and new entrants come on longer-term.

Moat rating

Read more about how to find companies with sustainable competitive advantages.

We assign Deterra a wide economic moat, underpinned by intangibles and cost advantage. The intangible relates to the MAC royalty agreement among BHP, BHP’s minority partners and Deterra. The agreement sets out terms for royalty payments for iron ore produced from the MAC royalty area and additional payments for increasing mine capacity, and defines the royalty area itself.

The cost advantage stems from both the low cost to acquire the MAC royalty area and the low-cost iron ore production which underpins the royalty. The certainty of the cash flows that arise from the low-cost nature of MAC iron ore production, which in our view means production is highly likely to continue even in a cyclical downturn in iron ore prices, underpins the value of the intangible asset that is the MAC Royalty Agreement.

The royalty is on Deterra’s books for approximately $10 million for an asset we expect to generate post-tax earnings of around $160 million per year over the forecast period. The low asset value reflects the acquisition cost of the royalty asset for its previous owner, Iluka Resources, from which Deterra was spun out in October 2020. Iluka and predecessor parent companies had a direct ownership interest in the area that MAC covers dating back to the 1960s, with the interest sold in the 1970s. The MAC royalty was created in 1994 to release BHP and its joint venture partners from the deferred consideration arising from the sale.

Production from MAC began in 2003 from the North Flank mine, which ramped up from an initial capacity of 15 million metric tons per year to 60 million metric tons in 2019. The addition of the South Flank mine should see a further 85 million metric tons of iron ore produced once fully ramped up, likely in 2024. MAC is part of BHP’s Western Australian Iron Ore operations, which we expect to produce about 290 million metric tons of iron ore in fiscal 2024.

The MAC royalty is based on revenue rather than profits and so isn’t directly affected by cost inflation and the margins BHP earns on its MAC production. If anything, we think the MAC royalty would likely benefit from inflation assuming it ultimately flows through to a steepening cost curve and higher commodity prices.

While the royalty is affected by changes in MAC production volumes and iron ore prices, we think the only material considerations for the moat are if the mines in the area covered by MAC will remain open and whether the royalties will be paid. To that end, the MAC hub including North Flank and South Flank is a core asset for BHP and a core, low-cost production source of globally traded iron ore. When fully ramped up, we expect the MAC hub to contribute roughly 50% of BHP’s iron ore production and one third of group EBIT. On payment, we have very high confidence that BHP will pay the royalties it owes. We think BHP represents a trustworthy counterparty headquartered in Australia. The contract is backed by an effective legal system and a very financially strong counterparty.

The North and South Flank mines are expected to sit around the bottom quartile of the global cost curve once fully ramped up. Resources are sufficient to underpin at least 30 years life at North Flank and 25 years at South Flank. Further life extensions are also likely from some combination of exploration success to extend North and South Flank, development of the Tandanya and Mudlark deposits and new discoveries. We expect any new discoveries or developments to be similarly competitively advantaged. BHP intends to operate the MAC production hub for at least 50 years.

Moreover, South Flank’s ore is high quality, with 62%-63% iron content. It is expected to increase WAIO’s average iron ore grade from 61% to 62%, and the overall proportion of lump sales from 25% to around 31% to 32% once fully ramped up. We think this means it is likely that ore from MAC earns a premium to the 62% benchmark.

Given the significant capital investment BHP has made in MAC, including most recently USD 3.1 billion for the South Flank development, and the attractive returns it is likely to make even at significantly lower iron ore prices, we think it is in BHP’s interest to maximize the value of ore produced from the royalty area. We see the risk of a reduction in activity and production from the royalty area in the foreseeable future as almost zero, even in a cyclical downturn.

Risk for Deterra’s royalty asset is low and has more in common with a toll road—albeit with leverage to the iron ore price—than a typical mining asset. Deterra has no operating costs and no capital costs. Deterra owns royalty rights on current and future developments on the royalty area, regardless of the capital costs or operating costs to BHP. The considerable expansion of iron ore production, and consequent forecast higher royalty revenue, requires no new investment by Deterra. The company only has a small exposure to costs though corporate costs, with EBIT margins forecast to average 95% for the five years ended fiscal 2028. BHP is the primary counterparty and is in strong financial shape with minimal debt.

Terms used in this article

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.