The ownership of a mineral royalty (a contractually established financial asset) over a producing or near-production mining asset has been the basis of many Australian fortunes. For instance, the iron ore royalties held in the Pilbara by the Hancock/Rinehart and Wright families coupled with prudent investment decision-making has allowed them to build enduring and significant wealth. Another well-known example is the Weeks oil & gas royalty encompassing a large portion of oil & gas production in the Bass Strait.
A mineral royalty provides the holder with the right to receive a portion of revenues from a particular mining operation or area. Royalties are reasonably bespoke, contractual agreements; accordingly, there are many variations and structures. We consider the most attractive royalty structure to be a 'gross overriding royalty' ('GORR') which entitles the royalty owner to a share of the market value of the commodity being produced less delivery costs borne to a point of sale.
The advantages of a GORR royalty structure are as follows:
Other risk factors associated with royalty investments are primarily linked to the risk of the asset becoming non-productive which are:
Royalty companies have become big business, with a multitude of listed exposures available on global markets. These companies generally hold diverse portfolios of royalty interests and commodity exposures.
Franco-Nevada ('FNV') is the world's largest listed royalty company with a market cap of around US$26 billion (AUD$37 billion). Prima facie it positions itself as a gold royalty company, whereas in reality it has exposure to a range of precious and base metal longer-life projects with an average mine life of 20 years. It achieves top line revenue of approx. US$800 million whilst enjoying strong EBITDA margins in excess of 80% (typical of royalty companies).
It has a diverse board of mineral industry participants including Tom Albanese, Rio Tinto's former CEO. In a nutshell, it provides an ideal investment vehicle for institutions and individuals alike for lower-risk exposure to the commodity markets.
The sole Australian royalty company of scale is Deterra Royalties ('DRR'), recently demerged from Iluka Resources. Deterra hold what we consider to be the best single royalty exposure available on the listed markets globally in the Mining Area C Royalty ('MAC Royalty').
The MAC Royalty is a GORR of 1.232% of Australian dollar denominated, free-on-board (FOB) revenue from product mined from Mining Area C, a major growth hub for BHP's Pilbara iron ore operations which are some of the largest globally. In addition, DRR also enjoys one-off $1 million per 1 million tonne increases in annual production capacity for the areas encumbered.
Main factors that contribute to the quality of this royalty interest are:
Given the valuation of global royalty peers, we contend that DRR would make a viable and attractive M&A candidate. For instance, in a scenario where FNV acquired DRR, we could expect FNV to increase their revenue by over 20% from 2023 (assuming spot FX and iron ore prices hold) and a likely value uplift of over US$5 billion (AUD$8 billion) should their multiple remain stable which we consider conservative given the sheer quality of the MAC Royalty.
DRR trades today at a mere AUD$2.2 billion (USD$1.54 billion) or around a quarter of its potential value to a leading royalty company.
An alternative hypothetical scenario could see BHP purchase and internalise the royalty interest given the long mine life and the present rock bottom interest rates. Iluka Resources maintain a 20% interest in DRR, making them a king-maker in any M&A action. Given the holding is non-core to Iluka, we would expect a reasonable bid for DRR would see the major shareholder accept.
In summary we believe that DRR provides a defensive, high quality annuity style equity exposure for investors; with potential for large capital appreciation via organic growth and potential M&A action.
Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in DRR.
Since our last update, Adriatic Metals has significantly progressed as a company.
The company has delivered an outstanding Pre-Feasibility Study ('PFS') that confirms the world-class nature of the Vares project.
The headline figures from the PFS are:
Post-tax NPV8: US$1.04 billion
LOM: 14 years at an annual processing throughput of 800ktpa
average annual EBITDA yr 1-5: US$251 million
~45% of revenue projected to come from gold & silver
Capex of US$173 million
1.2 year payback period for capex
$6 in NPV8 for every $1 in capex spent
89% resource conversion to reserve status
By any measure, the PFS confirms the Vares Project as possibly the world's best undeveloped mining project that will be viable in virtually any commodity price environment. The company has delineated the vast majority of the resource to reserve status, providing the highest level of confidence prior to mining development. The mine plan appears to be at a very detailed stage with what appears to be a 1m block model being used. Raw cashflow metrics are superb and the NPV8/capex ratio is amongst the highest that we have seen. The processing plant is expected to produce 4 separate bulk concentrates: copper-lead, zinc, pyrite & barite.
The next major step for the Vares Project will be the delivery of the Bankability Feasibility Study ('BFS') which is expected in March 2021.
The project's permitting process continues to advance steadily, with several precursor permits having been achieved with the full exploitation permits likely not far behind. The delays experienced to date in the projects permitting are not unusual for any mining jurisdiction let alone in Bosnia and Herzegovina where the mining industry is still in its infancy. The company has been publicly listed for a mere 30 months; to bring a discovery to the completion of a PFS within this time-frame is a tremendous achievement and we observe the team are still maintaining great momentum.
The acquisition of Tethyan Resources has been completed and we have started to see good initial results coming through from Kizevak and Sastavci (pending). Considering the historical resources and tenor at these two deposits, we expect significant exploration to be conducted in the near term over these assets. We believe it's not unreasonable to anticipate that these assets have the potential to reach production approximately 18-24 months, post the development of Vares. Adriatic have also been awarded a significant land extension to its current concession agreement, increasing its landholding in the area by 400% to 40 square kms. The new landholding encompasses several historic resources and provides a further avenue of growth for the company.
Adriatic have significantly built up their team of late, most notably with the appointments of Sanela Karic as non-executive director and Dominic Roberts as head of corporate affairs. Karic is a very well-credentialed Bosnian lawyer familiar with the operating environment in-country. She has been appointed Chairperson of the board's ESG committee and will be an integral part of Adriatic's objective to maintain a high level of ESG standards. Roberts is an experienced hand with 25 years of experience in the Balkans. In his most recent prior role, he oversaw the permitting and development of a mine within the same canton where the Vares Project is located. Along with Adriatic's Bosnia General Manager - Adnan Teletovic, Roberts will be a key person in further progressing the permitting process for the project.
Fabian Baker also joins the Adriatic team, as part of the Tethyan transaction, being appointed as corporate development manager. Michael Rawlinson was appointed non-executive Chairman of the Board in place of Peter Bilbe who stays on in a non-executive capacity. This change was in recognition of Adriatic progressing from a mineral explorer to a mineral developer. Overall, we consider the team looks to be much more fit for purpose relative to 6 months ago and provides the company with a strong platform for further growth.
On the financing front, Adriatic have secured terms from two strategic investors: the European Bank for Reconstruction and Development ('EBRD'), and Queen's Road Capital ('QRC') to finance pre-development works. The EBRD are an institution dedicated to investing to build market economies, with a special emphasis on best in class ESG. Initially focused on the former Eastern bloc, it has expanded its operations considerably. The EBRD have agreed to invest US$8 million in an equity placement following extensive due diligence and the entry into a project support agreement where Adriatic will comply with the EBRD's ESG requirements.
QRC are a specialist listed mining finance company majority-owned by a consortium of well-known businessmen and billionaires in Jack Cowin, Andrew Forrest, Brett Blundy and Li Ka-Shing. QRC have agreed to invest US$20 million into an unsecured convertible note, paying an 8.5% coupon, convertible at a price of approximately AUD$2.80 per share. This instrument may be redeemed via a project financing facility or other secured debt financing.
We expect a range of project financing structures to begin being evaluated in preparation for the completion of the BFS in early 2021. We have no doubt that a project financing facility will be keenly sought by market participants, especially given the extraordinarily robust financial metrics.
We also note that the legal dispute between Sandfire Resources ('SFR') and Adriatic which we have previously written about here: LINK, has now been settled. SFR have agreed to pay AUD$8.65 million to maintain a 16.2% holding in Adriatic. The resolution of this dispute will enable the company to move forward without the distraction of a lawsuit as well as providing certainty for investors.
At present, Adriatic Metals has an equity value of approximately US$300 million. At this value, the company's Price/NPV ratio is still only 29%, vs a peer average of 55% for financed projects as previously discussed here: LINK. Much has been written by others about the deficit of high quality mineral deposits available for development. Adriatic's assets are amongst the best undeveloped projects in the world and have the potential to propel the company directly into the mid-tier of mining companies, should Adriatic be able to stay independent till production.
High-quality projects should trade closer to 1x Price/NPV at BFS stage, and we believe the Adriatic will continue to close this valuation gap as the project continues to progress through further studies and permitting. We consider the company vulnerable to corporate activity at these prices, and increasingly vulnerable as the project is progressed further down the development pathway if there is no subsequent price rerate.
Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way. The author holds shares in ADT.