2023-08-24 00:26:38 ET
Summary
- Labrador Iron Ore Royalty Corporation has a royalty on a mine that can produce iron ore for carbon-free steelmaking, while Deterra Royalties has a royalty on a lower-grade mine that cannot.
- LIORC trades at a cheap price-to-earnings ratio with plenty of production upside.
- Deterra trades at a higher price-to-earnings ratio than LIORC with lower upside and higher risks, making it a less favorable investment.
- LIORC is rated as a strong buy, while Deterra is rated as a sell.
Summary
Labrador Iron Ore Royalty Corporation ( OTCPK:LIFZF ) and Deterra Royalties ( OTCPK:DETRF ) have highly profitable iron ore royalties on world class mines in safe jurisdictions. However, Deterra’s royalty is on a lower grade iron ore mine, whose product can’t be used for carbon free steelmaking with current technologies. By contrast, Labrador Iron Ore Royalty Corporation (LIORC) has a royalty on a mine that can produce products for carbon free steelmaking, and has higher production upside. In addition, Deterra trades at a higher medium term price to earnings (P/E) ratio than LIORC at 13 and 9 respectively. Therefore, Deterra is a much worse buy than LIORC, and I rate it as a sell. In my previous article on LIORC (available here ), I rated it as strong buy, and given that my thesis is unchanged I’m maintaining my rating on LIORC as a strong buy.
Overview
LIORC and Deterra both derive the majority of their revenues from royalties on iron ore mines operated in safe jurisdictions by world class operators. LIORC has a royalty on the 65% grade Carol Lake iron ore mine in Labrador, Canada, which is operated by Iron Ore Company of Canada ((IOC)) which is majority owned by Rio Tinto ( RIO ). Deterra has a royalty on the 62% grade Mining Area C ((MAC)) iron ore mine in Pilbara, Australia operated by BHP Group ( BHP ). While an iron ore grade difference of 3% may seem minor, it is the difference between being able to use this iron ore in an electric arc furnace instead of a blast furnace for steelmaking. Blast furnaces use metallurgical coal to generate steel, and the carbon dioxide generated from this process accounts for around 8% of global carbon dioxide emission. Electric arc furnaces ((EAF)) use electricity rather than metallurgical coal for steelmaking, which could potentially be generated from green sources. However, 65%+ grade iron ore is required for the EAF process, and therefore, high grade iron ore is essential for decarbonizing the steel industry. Due to a higher iron content, high grade iron ore has fewer impurities than lower grade iron ore, which is important for it to be useful in EAF (see chart below). The iron ore at IOC has 3% silicon dioxide and minimal aluminum oxide while the iron ore at MAC 4% silicon dioxide and 2% aluminum oxide. Therefore the MAC iron ore looks similar to Rio Tinto’s Pilbara iron ore which is much less amenable to upgrading than IOC.
LIORC generates revenue from IOC through both a royalty and an equity interest. It has a 15% equity stake in IOC, a 7% top line royalty in IOC and a C$0.10 per ton commission on all IOC sales. IOC sells around 16 million tons of iron ore products annually, of which around 9 million tons are iron ore pellets and the remaining 7 million tons are iron ore concentrates (see graph below). This is significantly below the nameplate capacity of 23 million tons of iron ore products, including 12.5 million tons of pellets. IOC’s iron ore products command significant premiums to the 62% iron ore benchmark price of $159 in 2022, with a price of its concentrates for sale of $185 per ton and a pellet price of $245 per ton. My original article (available here ) provides further details on LIORC, including that IOC has an expected mine life of over 50 years based on stated resources.
Deterra has several non-MAC royalties particularly on mineral sands, but the revenues from these royalties account for less than 1% of the revenues from its MAC royalty, making it effectively a single asset royalty company like LIORC. MAC is a huge mine which is expected to account for 8% of total seaborne iron ore supply once it fully ramps up. MAC has been ramping up supply over the past couple of years and is expected to eventually produce 145 million tons of iron ore annually (see chart below). Deterra’s main exposure to MAC is a 1.232% revenue royalty. Deterra also has a A$1 million one time per ton payment for each additional annual ton produce, which is expected to fall away once MAC fully ramps up. MAC has a mine life of more than 45 years.
Company Financials
Both LIORC and Deterra pay out all their income to shareholders through dividends, which is different from other royalty companies, such as Ecora Resources ( OTCQX:ECRAF ) and Altius Minerals ( OTCPK:ATUSF ), which use some of their net income to buy new royalties. Also neither of these companies have any debt, which means that the main expenses these companies face are company overhead, taxes and asset depreciation/amortization.
LIORC has relative low annual overhead with annual administrative expenses of around C$3 million (see table below). Amortization expenses are also relatively low at about C$6 million annually. Taxes are by far the largest expense category, with Newfoundland taxes and royalties accounting for around C$50 million annually, depending on revenues generated, and general income taxes accounting for around C$65 million annually. Subtracting these expenses from LIORC revenues results in net income of C$381.7 million in 2021 and C$271.8 in 2022. The higher numbers in 2021 were due to higher prices of its iron ore products sold for that year. Dividing these amounts by LIORC’s 64 million shares of results in income per share of C$5.93 in 2021 and C$4.15 in 2022. This compares to dividends of C$6.00 in 2021 and C$3.10 in 2022. The discrepancy between net income and dividends paid per share in 2022 was due to the dividends LIORC received from IOC being substantially lower than the earnings generated by its stake in IOC that year. Dividing LIORCs earnings per share in 2022 by a share price of C$30, gives a P/E ratio for LIORC of around 7.
Company overhead expenses for Deterra are also relatively low, although operating expenses increased rapidly from A$4.6 million in 2021 to A$7.6 million in 2022, while overhead expenses for LIORC were relatively flat between 2021 and 2022. Depreciation and amortization expenses are very low at less than A$1 million. Income taxes were the largest expenditure category and increased from A$145.2 million in 2021 to A$265.2 million in 2022. This was primarily due to the large increase in revenues resulting from BHP ramping up their MAC iron ore production between 2021 and 2022. Subtracting expenses from revenues gives net profit after tax values of A$94.3 million in 2021 and A$178.4 million in 2022. Dividing net profit by Deterra’s 528.5 million outstanding shares gives per share earnings of A$0.178 in 2021 and A$0.338 in 2022. Dividing Deterra’s 2022 earnings per share by a share price of A$4.5 results in a P/E ratio of around 13. Note that their income statement values are calculated from July 1, 2021 to June 30, 2022.
Company valuation
IOC has recently been increasing its investments to bring its capacity up to nameplate, which means that it is likely to achieve this in the medium term (see chart below). Given that it produced around 16 million tons of iron ore products in 2022, it will see its production increase by around 30% when it achieves nameplate capacity of 21 million tons. This will be divided between 12.5 million tons of pellets and 10.5 million tons of concentrates. MAC produced 83.2 million tons of iron ore from July 2021 to June 2022, which will increase by 74% when it achieves nameplate capacity of 145 million tons. Assuming a per ton 62% iron ore price of $100, a per ton 65% iron ore price of $125 and a per ton pellet price of $185, this would result in revenues to IOC of around $3.6 billion (12.5*185 + 10.5*125) and revenues to MAC of $14.5 billion (145*100) annually. Deterra would receive around $180 million of this revenue annually from its royalty. Subtracting around 30% of this revenue in taxes and adding other expenses would result in annual expenses of around $60 million. Therefore, expected after tax annual profits for Deterra would be around $120 million annually, compared to a market of around $1.5 billion, resulting in a P/E ratio of 13 at full MAC production.
The calculations for LIORC are slightly more complicated as it has both a royalty and an equity component. Its royalty revenues would be 7% of total revenues or around $250 million annually. Subtracting Government of Newfoundland taxes of 20% plus other expenses gives royalty proceed to LIORC of around $200 million. The equity earnings depend on iron ore prices, iron ore production and expenses, which could be either fixed or variable. Based on iron ore product production and price estimates for 2022, estimated revenues for IOC were $3.5 billion (9*245 + 7*185) of which LIORC’s share was $525 million. LIORC’s equity earnings in 2022 were $120 million using the 2022 Canadian dollar to U.S. dollar IRS exchange rate for that year. Therefore costs were $405 million for LIORC, which works out to costs for IOC of $2.2 billion, excluding the fixed costs in the chart below. This means that IOC variable costs were $138 per ton of irons ore product. Therefore, IOC variable costs at nameplate capacity would be $2.9 billion, and adding $0.5 billion in fixed costs would give total costs of $3.4 billion. Subtracting this from expected revenues of $3.6 billion would result to in $0.2 billion in pretax profits for IOC of which LIORC’s share would be around $30 million. This value seems low, but is based upon the information available. Given that IOC is investing heavily into their mine, it likely means that these equity earnings assumptions are conservative. Adding LIORC’s royalty and equity proceeds gives total proceeds to LIORC of $230 million. Subtracting income taxes of 30% results in after tax profits of around $160 million. LIORC’s market cap is also around $1.5 billion, which results in a P/E ratio of around 9.
Given Deterra and LIORC has a medium term P/E ratio of around 13 and 9 respectively, it looks like LIORC is more undervalued than Deterra at their current stock prices. This would even be the case if LIORC did not receive any proceeds from its equity stake in IOC which was the case in 2015 (see chart below). In addition, as mentioned above, IOC produces iron ore products that can be used for green steel making, while MAC does not, which means that Deterra has much more downside risk if governments exert pressure on steel makers to decarbonize their steelmaking process. Furthermore, as I mentioned in my previous article on LIORC (available here ), Rio Tinto has previously contemplated bringing IOCs nameplate capacity up to 50 million tons annually. If this were to happen, LIORC’s earnings would increase by 238%, pushing its P/E ratio well below 5. Meanwhile, I am not aware of any plans by BHP to rapidly expand their production at MAC, and this would also likely be logistically difficult given the current massive existing size of the mine. Therefore I think LIORC is a much better buy than Deterra.
Investment Risks
Risks to this thesis that LIORC will outperform Deterra moving forward include price risk, operator risk and technology risk. These risks are somewhat linked as they involve a tradeoff between higher grade and higher cost iron ore and lower grade and lower cost iron ore. If prices of iron ore were to fall, this would impact both LIORC's and Deterra’s bottom line, but could potentially make IOC's mine unprofitable while the MAC mine remains profitable. This could be further exacerbated if the price spread between higher and lower grade iron ore narrows. However, in the $100 iron ore scenario outlined above, the vast majority of LIORC's income would be from its royalty stake rather than its equity stake, so even if the earnings of its equity stake were to decrease, it would not significantly impact its cash flows. Lower iron ore prices could potentially cause IOC to shut down its mine, although this is unlikely as it has been continuously operating for over 50 years, including time periods of depressed iron ore prices, and it has recently been spending significant sums to increase production. Finally, a technology could emerge that could enable lower grade iron ore to be turned into steel without the use of coal. However, even if such a technology were to emerge, higher grade iron ore would likely still be the preferred product for carbon free steelmaking, given its lower level of impurities.
Final Thoughts
In addition to being a better buy than Deterra, LIORC is arguably also a better buy than the two other main iron ore royalty companies, Mesabi Trust ( MSB ) and Scully Royalty ( SRL ). Mesabi Trust would be highly profitable if the Peter Mitchell high grade iron ore mine in Minnesota has a royalty on were producing iron ore at historical levels. Unfortunately, though, Cleveland-Cliffs ( CLF ) the operator of the mine has cut production, as it thinks the royalties are too high, and it is unclear how long this dispute will last. Scully Royalty has a highly profitable royalty on the Scully high grade iron ore mine in Labrador. Unfortunately, though, the rest of the company is an unprofitable mess and it is involved in a lawsuit which could potentially result in it losing all its assets including its iron ore royalty asset.
A microcap company, which owns a royalty on the Mont Sorcier high grade iron ore and vanadium project in Quebec, may however be the best iron ore royalty stock buy from a risk reward perspective. The potential annual royalty revenues for Chibougamau Independent Mines ( OTCPK:CMAUF ) from its 2% royalty on Mont Sorcier would be over twice its current market cap, if Mont Sorcier goes into production. A 2022 NI 43-101 report estimated that a producing Mont Sorcier would pay Chibougamau around $14 million in royalties annually compared to a current market cap of $5 million . The likelihood of it going into production recently increased sharply after Cerrado Gold ( OTCQX:CRDOF ) bought the asset, as it has the financial resources to build the mine. Cerrado may also secure additional funding for the project through a $420 million contribution from the UK Export Credit Agency. Although there may be more stock dilution to come as Chibougamau is currently not profitable, the risk-reward tradeoff is compelling. Also, the dilution risk may be minimized if Chibougamau receives the payments promised on its recent option agreement with TomaGold Corporation ( OTCQB:TOGOF ).
For further details see:
Labrador Iron Ore And Deterra Royalties: Iron Ore Grade The Key Differentiator