Strike while the Iron Ore is even hotter

The iron ore market has continued to boom since my note in late August last year with the benchmark 62% price hitting USD220/tonne, a far cry from the ~USD120/tonne spot rate at the time (see chart below).

Source: Custeel.net

Demand has continued to be strong as the steel market itself has boomed, with steel prices (+margins) and Chinese exports strong as well. In addition, supply remains relatively constrained despite many smaller operations starting to get with Vale the main culprit, as they have continued to fail to deliver on their production and sales targets. Despite strong prices, we haven’t seen any apparent or sustained stockpiles building up across the value chain either.

Source: MMIPrices

To me, this is a backdrop that suggests iron ore prices can stay higher for longer than most people think, on the basis that there is no catalyst to drive a material de-rating in demand. All else equal, the outlook for iron ore remains attractive and as higher prices persist, there remains value to be found in identifying companies with mispriced assets exposed to this theme.

At Capital H, we have a value bias and as the larger cap iron ore stocks and an increasing number of the juniors with high cost leverage assets have been re-rated in the last 6 months, we have continued to scour the iron ore universe for mispriced assets with clear catalysts to drive a re-rate. We believe we have found one such opportunity in Talisman Mining (TLM).

From our perspective, TLM’s flagship asset is currently their royalty over the Wonmunna Iron Ore Project. The royalty was acquired when they sold off the project in 2011 to Rico Resources. Under the original deal, TLM was paid $41m in cash and stock in addition to a 1% GSR on all production over the tenement. TLM also has two relatively early stage exploration projects, NSW Lachlan and Lucknow, both in NSW, which are prospective for gold and copper.

The Wonmunna project has a long history of changing hands since TLM held it with it finally ending up in the hands of Mineral Resources (MIN). The brief history is detailed as follows:

• 2010/11: TLM sells project to Rico Resources (RRI) for cash (~$35m), stock (~$6m), and a 1% uncapped gross royalty on all metals. Royalty over E47/1137-I and any mining leases granted over the tenement.
• 2012: Rico progresses the project upgrading the resource, securing native title and mining leases.
• 2013 to 2014: RRI (Called Ochre Group at the time, OGH, liquidated in admin) faffed about not doing much on the asset.
• 2014: Ascot Resources (AZQ) purchased the asset. OCH Paid in cash and stock plus their own 1% GSR on top of the one TLM has.
• 2015: AZQ looks to delist from the ASX due to poor conditions.
• 2018: Ascot sold the project to the Australian Aboriginal Mining Corporation (AAMC).
• 2020: AAMC sells the project to MinRes.
• 2021: MinRes brings the project into production aiming for an initial run-rate of 5mtpa. They have stated the project could support 10Mtpa run-rate.

The project is relatively large with resource statements under AZQ suggesting the project has ~85Mt of iron ore at ~57% Fe and relatively low impurities. However, the reserve is limited to 29Mt which at current could support the current 5Mtpa for ~6yrs. We understand that MIN is drilling out the deposit to convert resources to reserves and test its potential extent. As such, we think there is a strong likelihood that the scope of the deposit will be expanded and able to support a 10Mtpa scale operation for 5yrs+. A few tells that this isn’t a far off the mark assumption are firstly, in the deal to purchase the asset, MIN also gave AAMC a royalty over the first 40Mt produced. Secondly, MIN’s recent site trip presentation states Wonmunna is a part of a 10yr strategy for their Utah Point Hub.

At the current average price for 58% graded ore for CY21 to date (~USD142/t), this implies a revenue run-rate of ~$9 million p.a. from TLM’s royalty. Should MIN be successful in doubling the production run-rate asap, it would imply a revenue run-rate of ~$18 million p.a. on the same assumptions, in stark contrast to the current $37 million market cap. The current exploration budget from TLM is likely to be no more than $4 million p.a. so the majority of the cash will fall to the bank account.

In evaluating a royalty like this, I use a scenario analysis to build a valuation matrix of the NPV of the asset. The most conservative scenario assumes only 5Mtpa rate on the 29mt reserve only with the 58% price reverting to USD80/t by start of CY23, through to the most bullish scenario being a fast ramp to 10Mtpa on a 50mt reserve with the 58% price sustaining at USD140/t. Each scenario uses a discount rate of 15%. This means the value of the royalty ranges from $18m to $49m or $0.09/sh to $0.26/sh. As an aside, using a 10% discount rate would imply a valuation range of $20m to $56m or $0.11/sh to $0.31/sh.

TLM has a current market cap of $37m and ~$12m in cash on hand. If we give their exploration projects an EV of $10m combined, it implies the EV ascribed to the royalty of ~$15 million which as detailed above is worth anywhere from $18m to $49m. Putting the pieces back together, a SoTP approach shows that the value of TLM is between ~$0.22/sh to ~$0.38/sh. Essentially, we are getting paid to wait for the market to appropriately price this royalty and a free option on exploration success.

I should note the key risk. Since MIN took over the project, FMG (who was to be the offtaker to AAMC) has commenced legal proceedings against MIN and multiple WA State Gov departments. This presents a risk that could derail royalty payments to TLM should FMG win. Whilst I have no legal background to comment on that likelihood, I don’t think that MIN would have spent $126m to buy and build the mine in the meantime if there was a reasonable probability they would lose.

Overall, TLM offers a relatively cheap and differentiated way to gain exposure to the higher for longer iron ore price thematic. It’s also worth mentioning that TLM is one of the first positions in our new Active Fund and in the near term we hope to engage with the company to strategise with them on potential ways to unlock the full long-term value that this royalty can offer.

Disclaimer:

Any information contained in this article is limited to general information only, whilst the opinions and views detailed are those of the author only, and as such does not constitute advice or a recommendation in any capacity. The information contained in this article has not taken into consideration your specific financial needs, goals or objectives, so please consider consulting a licenced adviser before considering acting on this information.

The Capital H Active Fund holds shares in TLM at the time of publishing.

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