Is this the most simple company on the ASX?

A strong argument could be made that Deterra Royalties Limited (ASX: DRR) is the most simple business on the ASX. Originally spun off from Iluka Resources Limited (ASX: ILU) in 2020, the company owns six royalty agreements, which entitles the business to a clip of revenue production over the defined mining area. Each quarter it receives a cheque in the mail, which it deposits, pays tax on, then distributes 100% of profits to shareholders. The jewel in the crown is Mining Area C (MAC), which includes BHP Group’s (ASX: BHP) South Flank iron ore operations in the Pilbara. Deterra receives 1.232% of revenue derived from MAC and also receives $1 million per dry metric tonne (DMT) in one-off capacity payments. Currently, MAC has a production capacity of 59 million DMT a year, which is expected to ramp up to 145million DMT a year over the next three years.

What makes Deterra special is that it provides the upside of investing directly in an iron ore miner without as much of the downside. It receives free-carry on any mine expansion while maintaining significantly less operational risk.

In a hypothetical example, let’s say MAC produces 10 million DMT of iron ore and sells it for $100 a DMT. The cost to mine the iron ore is $30 a DMT, including the royalty to Deterra. BHP would make $70 a DMT or $700 million in profit. Deterra would take its royalty clip of $12.32 million.

However, due to higher wage and freight costs, it now costs $40 per DMT for BHP to dig out the iron ore. Its profit falls to $60 a DMT, or 14%, whereas Deterra’s royalty remains the same.

The other benefit is that Deterra’s profit is less exposed to movements in the iron ore price than investing directly in a miner. Using the first example, instead assume the iron price falls 20% to $80 per DMT. BHP is now making $50 a tonne in profit, or $500 million, leading to a 32.5% decrease in earnings. In contrast, Deterra’s profit falls in line with the iron ore price, down 20% to $9.86 million.

It should be said if prices were to increase rather than decrease, there would be relatively more upside for a miner than a royalty stream. But the main point is that Deterra is a lower-risk way of gaining direct exposure to the iron price.

Despite its simplicity, investors should be aware that Deterra is a one-trick pony. If the iron ore price falls, expect the Deterra share price to follow in the same direction, possibly at a faster velocity. Fortunately, the iron ore price looks set to remain elevated for the foreseeable future despite the ongoing lockdown of cities in China and lower estimates of economic growth. Morgan Stanley remains bullish on iron ore prices due to rising steel demand and infrastructure spending across 2022. Adding to the bullishness, Macquarie upgraded earnings for iron-ore miners in February.

While the ramp-up in production over the coming years will benefit Deterra’s royalty earning potential, it also adds supply to the iron ore market and therefore could suppress prices. Management has also flagged that it’s on the search for potential acquisitions. MAC is a world-class royalty stream, therefore any other purchase would likely be inferior or cost a pretty penny.

Overall, Deterra is an effective and lower-risk way to get direct exposure to iron ore. It’s also ideal for an income portfolio, given its 100% payout ratio and extremely low cost base. Investors should be prepared to take a view on the iron ore price if investing, as the company will trade in line with its movements, making it subject to volatile swings through the cycle.

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Lachlan Buur-Jensen

Lachlan is an experienced journalist writing across The Inside Investor and The Inside Adviser.