When investing in a company, there are a few key characteristics to look for. Some of these characteristics include a company with high margins, as well as a capital-light and simple, but effective business model. Given this, when we came across a company that has an EBIT margin of 97%, has just about no operating capital requirements and its business model is just collecting royalties, we had to investigate further. Deterra Royalties (ASX: DRR) is perhaps one of the simplest companies on the ASX, which is not a bad thing. Not only does it make the business easy to understand, a lot of the time the most straightforward business model can often be the best business model.
Deterra operates a royalty business model that is involved in the management and growth of a portfolio of mining royalty assets. The company’s royalties are primarily sourced from BHP’s Mining Area C (MAC) in Western Australia’s Pilbara region, which contributes to approximately 99.85% of Deterra’s revenue. Deterra also has five other royalty assets, which are insignificant compared to MAC.
Essentially, the royalty company provides upfront funding to mining companies in exchange for a share of production revenues. In this case, Deterra is entitled to 1.232% of the revenue that MAC generates. Whilst 1.232% might seem like a small amount, this needs to be put into perspective. After the completion of its ramp up to full capacity, MAC is expected to account for half of BHP’s iron ore production, with BHP being one of the largest iron ore producers in the world. In fact, MAC is expected to produce 8% of the global seaborne supply of iron ore. A small percentage of this is still a very large volume.
This is not to mention that by investing in Deterra you would receive this iron ore exposure through a very high margin business model. The reason why the business operates on such a high margin is that there are barely any costs. Whilst BHP does the heavy lifting as the operator of the mines, Deterra just sits back and collects royalties, with a few minor expenses such as employee expenses. As Deterra isn’t the operator of the mine, they have no say in the future of the operations the royalty is tied to. Although this may be seen as a risk, BHP has a vested interest in continuing to explore, develop deposits and extend mine lives where feasible, so we are comfortable with this situation.
In any case, the major mines in MAC have long lives. MAC is comprised of operations in North Flank and South Flank, which have mine lives of 30 and 25 years, respectively. MAC also consists of Tandanya and Mudlark, which are future development options that could provide further upside.
As previously mentioned, BHP is in the middle of a large project to expand MAC’s production capacity, which is focused on the South Flank mine. With MAC having a capacity of 111.1 million wet metric tonnes per annum (wmtpa) at the end of FY22, this is expected to expand to 145 million wmtpa by FY24. Whilst BHP is required to invest in expanding production to increase their earnings from a volume perspective, Deterra will see the benefits of increased revenue at no additional cost to the company. This operating leverage is why we are particularly attracted to this business model.
It is our preference that this is a revenue-based royalty rather than profit-based one, as increasing costs of production do not directly affect Deterra’s royalties. Whilst BHP’s margins may contract as production costs rise, Deterra’s revenue will stay intact, in which it is only indirectly affected if BHP decides to lower production because of rising costs. Starting from a low cost base, the risk of this isn’t large.
As a company that has complete exposure to iron ore, earnings are significantly affected by iron ore prices, just like iron ore mining companies. However, the ramp up in capacity over the next few years will support revenue growth on a volume basis, which will lessen the downside to revenue if iron ore prices fall. After the ramp up, Deterra’s earnings will be more exposed to iron ore price movements. We are comfortable with this exposure as although earnings will vary based on price, they are still supported by a high-volume level. This is because BHP is one of the lowest cost iron ore producers in the world, so they are still making good profits even at materially lower iron ore prices, meaning volumes should remain intact.
On top of the royalty payments, Deterra has a capacity payments agreement with BHP. This entitles Deterra to a payment of $1 million for every 1 million tonne increase in annual mine production over its current capacity. At 111 million wmtpa at the end of FY22, and with MAC set to expand to 145 million wtmpa, there is over $30 million in upside to Deterra’s revenue through to FY24.
All in all, the ramp up in production capacity in MAC will support earnings growth. As the company doesn’t have much of a requirement to reinvest back into the business, Deterra has a high payout ratio, paying up to 100% of net income. Even after the ramp up finishes, Deterra’s earnings are supported by a high volume level. With dividends tied to net income, any downturn in iron ore prices will still allow for a respectable dividend payment. On the other hand, any significant upturn in iron ore prices will result in a high dividend payment.
We believe Deterra has strong prospects of paying out solid dividends over the long-term, with the company paying out 100% of net income as dividends in FY22. Deterra has a trailing dividend yield of over 7%, and considering it is fully franked, this takes the grossed-up dividend yield to over 10%. Based on our analysis, we believe that Deterra will be able to grow their dividends in the short term and although dividends will vary depending on iron ore prices, the production volume level of MAC gives it a sustainable base for dividend payments over the long-term.