Deterra Seeks Growth Through Diversification

This story features DETERRA ROYALTIES LIMITED, and other companies. For more info SHARE ANALYSIS: DRR

Deterra Royalties is looking to diversify away from iron ore royalties and provide for growth, in lithium in particular. The trade-off is a much-reduced dividend yield.

-Deterra Royalties makes an offer for Trident Royalties
-Trident offers diversification away from iron ore
-Trident’s main development asset will produce lithium
-Shareholders face a major cut in dividend yield

By Greg Peel

Deterra Royalties ((DRR)) is the largest ASX-listed resource royalty firm, with earnings underpinned by a high-quality, long-life iron ore royalty over BHP Group’s ((BHP)) Mining Area C. This asset accounts for virtually all of Deterra’s valuation.

Cash flows from MAC are relatively stable and require no capital investment from Deterra to grow, but earnings are subject to iron ore price risk. It is BHP investing in growth, looking to expand MAC production from 60mt in 2019 to 145mt in 2024. Volume growth will boost Deterra’s near-term earnings, but a pullback in iron ore prices, which most analysts forecast, will erode that boost.

To that end, Deterra’s strategy is to grow its royalty base and diversify away from iron ore alone through the purchase of other royalty arrangements.

Enter Trident Royalties, listed on the Alternative Investment Market (AIM), a sub-segment of the London Stock Exchange. Trident invests across the breadth of mining commodities including thermal coal, with a bias towards production or near-production assets. It has exposure to lithium, gold, copper, silver, iron ore and other commodities, including precious, base and battery metals, and bulk/industrial materials, via 21 royalty streams.

Deterra has made an all-cash offer for Trident, approved by the board and so far by holders of 28.7% of shares. The offer equates to around -$276m at the prevailing exchange rate, which represented a 23% premium to the last traded price at the time of the announcement, and 32% to the three-month volume-weighted average price.

The offer remains subject to shareholder approval and to the usual regulatory approvals, and if successful is expected to settle some time in the second half of 2024.

A Wealth of Diversification

While Trident appears to offer a plethora of varied commodity exposures, Ord Minnett points out of 21 royalty assets, only twelve of those are currently generating cash flow and nine of those relate to gold. Gold accounted for almost 80% of Trident’s 2023 revenue, with much of the remainder derived from assets with limited remaining lives.

Ord Minnett believes Deterra’s plan would ultimately be to sell off the gold assets given they are inconsistent with management’s strategy to focus on diversifying into bulk, base and battery mineral exposures.

This implies the deal is a bet on Trident’s development assets. The most attractive of these is the large, long-life Thacker Pass lithium project in the US.

Ord Minnett believes Thacker Pass will likely begin production in 2027, initially producing around 40,000mt of lithium carbonate equivalent once ramped up. Phase 2 could potentially double production in the next decade. Thacker is one of the largest lithium resources globally, and could potentially produce up to 240,000mt per year once fully developed.

All well and good, but this is the first red flag for Deterra investors who may have been burnt by the boom & bust cycle of the lithium price over the past few years, or may simply fear the volatile price history of the most volatile metal on the periodic table.

Deterra’s attraction for investors to date has been its reliable yield, driven by exposure to the high-quality MAC iron ore royalty, based off iron ore price exposure which is far less volatile than that of lithium. Deterra pays out 100% of profit as dividends, and currently offers a consensus forecast FY24 yield of 7.7%.

But if the Trident takeover is successful, that will change.

The Trade-Off

The Trident deal represents some 12% of Deterra’s market cap, Canaccord Genuity notes, and will be funded via a GBP150m bridging loan. Deterra also has a $500m undrawn debt facility, so no new equity is required, thus no share price dilution.

However, while Deterra will pay out 100% of FY24 profit as dividends, thereafter that will drop to a minimum of 50%, as the company shifts focus towards growth.

This will clearly scare off those investors who crave yield. The -6% share price drop on the day of the announcement, and over -8% in total subsequently, is testament to investor concern.

Not helping is analyst agreement the offer price looks “full” on an earnings basis, although given investment in development projects, a large portion of Trident’s value will be back-ended.

Canaccord believes the Trident deal makes strategic sense, but notes it may dilute Deterra’s exposure to high-quality MAC iron ore and lower the future dividend yield. To that end, the broker would like to undertake a more detained analysis, and sticks with a Hold rating for now, with a $5.30 target.

Citi can see the value in the deal, but is more focused on investor disappointment over the dividend cut and concern over lithium exposure. Citi retains Neutral with a $5.20 target.

Ord Minnett points out Deterra had previously warned its payout could be reduced in the event of a material acquisition. On the subject of volatile lithium exposure, Ord Minnett believes Deterra is “sensibly” trying to take advantage of lithium prices currently at a cyclical low.

The broker has a Hold rating and fair value estimate of $4.20.

Morgan Stanley takes a cautious stance on the offer for Trident given the limited consensus estimates available and the change in strategy, which anchors Deterra’s valuation to net asset value over yield.

That said, this broker retains an Overweight rating and $5.60 target.

Barrenjoey has a Neutral rating and $4.90 price target, and defines the proposed deal as follows: provided Thacker Pass moves into production, the deal is earnings dilutive until 2027, but value accretive.

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