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Date : 07/12/2022

Deterra Royalties

ASX :

DRR

Market Cap : $2.5 Billion

Dividend Per Share : $0.336

Dividend Yield : 7.10 %

Hold

52 Week Range : $3.91 - $4.94

Share Price : $4.73

Deterra shares are flying high despite iron ore price weakness. We recommend a 'Hold'

Company Analysis

Deterra Royalties (ASX: DRR) needs no introduction to Shares in Value members. They mainly operate BHP’s Mining Area C (MAC) and receive royalty payments. It is a very simple business with high profitability and high dividends. New members can view our earlier coverage by clicking here.

Deterra’s story is about its dividends. Since recommending at $4 a share in March 2021, Deterra has paid out $0.45 a share across 3 dividend payouts. Regarding the share price, we already know the production capacity of the MAC asset and that Deterra pays out 100% of its NPAT as dividends; therefore, as there is no reinvestment, the share price growth has a ceiling.

Two Reasons why we are Downgrading Deterra

1. Deterra Shares are trading at high levels despite subdued Iron Ore Prices

The Deterra share price has rallied quite a bit in the past two months. The primary narrative driving this action is the China reopening play that has lifted the iron ore price from the depths of around US$80 a tonne to around US$110 a tonne at the time of writing. This is a 37.5% increase in under a month, while DRR shares are up ~15%.

As good as the MAC asset is, as we just said, we already know the production capacity and the percentage (1.232%) of revenues Deterra receives as royalty from BHP. This has thus been baked into the DRR share price.

What we don’t know is the future iron ore price. The fluctuations in the commodity price can increase or decrease the royalty payments to Deterra. This is only partially responsible for Deterra’s profitability and dividends. Therefore, the DRR share price does not trace the peaks and troughs of the iron ore price. It is often relatively moderate when it comes to movements, which is evident in the chart below.


Source: Tradingview.com

When Deterra listed on the ASX at about $4.5 a share in October 2020, iron ore prices were around US$125 a tonne. About 6-7 months in, iron ore had skyrocketed to over $225 a tonne. At the same time, in May 2022, Deterra shares peaked at around $4.77 a share.

Fast forward to now, iron ore prices have come down about 50% off their highs due to decreased demand, easing supply, low global growth forecasts. While the China reopening play has boosted iron ore prices to over the three-figure mark, global growth concerns should keep a lid on the price.

Deterra shares, on the other hand, are currently trading at levels it was last seen when iron ore prices were at record highs, that is, $4.73 a share. MAC is expected to ramp up production to 145 Mwmt by mid-2024. This forecast has not changed and has been priced into DRR.

We are confident that Deterra will meet profit expectations and payout 100% of NPAT as dividends. However, when it comes to pricing, it is relative. Our analysis points to the fact that DRR is richly priced, given the current iron ore prices.

2. Deterra’s Push for Growth is a Double-Edged Sword

BHP’s Mining Area C is one of the largest iron ore mines in the world. It is responsible for 2/3rd of BHP’s Iron Ore production. The quality and production ramp-up on this asset makes Deterra a quality stock pick. There is minimal operational risk, and it is safe to say Deterra will always receive royalty revenue from BHP.

This characteristic has made Deterra a low-risk cash cow for investors, particularly dividend-chasing investors. It is also a reason why Deterra shares continue to trade at elevated levels despite iron ore prices falling off a cliff recently.

If the process of just operating the MAC could continue, DRR would continue to be a fantastic stock for income investors. But Deterra’s management has clarified that they are looking for more diversification and expansion. Why disrupt a cash cow?

If Deterra doesn’t add to its asset portfolio, it will become a takeover target, given the cashflow generative property that is underpinned by arguably the best iron ore royalty asset (MAC). To avoid becoming a target, Deterra’s management has to seek the acquisition of additional royalty assets.

While new acquisitions may bring growth to revenues and profits, the quality and reliability of those revenues and profits will be reduced. Therefore, the quality of Deterra’s dividends will also be reduced unless the company can find an asset that is better than BHP’s Mining Area C, which is a long shot. Deterra is thus stuck between a rock and a hard place.

Recommendation

Royalty companies often trade at a premium due to the reliability of their dividends. However, iron ore prices have halved since the last time DRR shares traded at current levels of ~ $4.7 a share. Our analysis indicates that it is richly priced, especially given the outlook for iron ore prices.

Deterra is also looking to expand its asset portfolio; however, finding an asset that is of a higher quality than MAC is next to impossible. Any potential acquisition would reduce the quality of Deterra’s profits and dividends.

Currently, Deterra continues to be a cash cow that will continue to pay dividends with minimal operational risk. We thus recommend investors with exposure to ‘Hold’ positions.

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