Thanks to a landmark deal and a healthy set of H1 2018 results, Anglo Pacific Group (LSE:APF), London’s only listed mining royalty business, has shot up by more than a fifth over the last month to 150.5p. Through its unique model, which sees it provides financing to miners in low-risk jurisdictions for a portion of their revenues, the firm has built a portfolio of royalties highly diversified by both commodity and geography. Here, CFO Kevin Flynn explains why Anglo Pacific’s ability to self-fund growth thanks to strong performance in its portfolio and the commodity market could trigger a re-rate in its shares and allow this upside to continue.
Anglo Pacific’s portfolio of royalties, which stood at 12 investments as at 31 December 2017, is split between producing (6), development (4) and early stage (2) assets. This approach aims to accelerate income growth and pay a substantial dividend out to shareholders while maintaining opportunities that could yield significant returns in the future.
Although the royalty model is well-known in North America, particularly in the precious metals space, Flynn says Anglo Pacific’s focus on base metals and bulk material royalties is globally unique. In the UK specifically, he believes that it offers investors one of the lowest-risk ways to gain exposure to commodities on the market. To him, this is mainly down to the way royalties are paid:
‘Royalties tend to come off the top line of production, so there is much less sensitivity to operating costs, inflation, or capex blowouts on projects that might restrict the free cash flow of an underlying operation. These factors do not impact on our right to royalties. In terms of a de-risked way of getting commodities exposure, a royalty model is probably a good starting point.’
Flynn adds that the scalability of royalty investment also offers superior diversification to the operatorship model used by many AIM resource players. Indeed, Anglo Pacific’s commodity exposure is spread between coal, iron ore, vanadium, gold, and uranium in locations as geographically diverse as Australia, Brazil, Spain, and Canada:
‘We can meaningfully grow our resource base without having that drag along on costs which you would expect to have with an operator. For example, over the last couple of years, we have grown our income from £4m to over £40m, and our cost base has virtually remained flat. That is the virtue of the model. Mining is a cyclical industry but what we like to do is to diversify and reduce the concentration risk we have on any one particular commodity, geography or counterparty. We tend to look for companies that can make money throughout the entire cycle.’
The last few months have been busy for Anglo Pacific. In June, it bought a 0.5pc net smelter return royalty in the Cañariaco Copper Project in Peru for $1m. The site, owned by Candente Copper, has a projected average production of 262MMlbs of copper per annum. The purchase was in line with Anglo Pacific’s ongoing strategy to invest smaller amounts in development stage opportunities which it hopes to have the potential for higher returns along with significant growth potential.
Arguably, the firm’s most significant transaction came last month, when it purchased a 4.25pc stake in Labrador Iron Ore Royalty (LIORC) for c.US$50m (C$65.5m), . LIORC is a passive flow-through entity for a 7pc gross revenue royalty and a C$0.10p/t commission on all iron ore products sold by the Iron Ore Company of Canada (IOC), in which LIORC also owns a 15.1pc equity stake.
Operated by Rio Tinto, IOC is one of Canada’s largest iron ore producers, with mining and processing operations located in the area of Labrador City. It is also among the top five global producers of seaborne iron ore pellets and sells an iron ore concentrate product based on the 65pc Fe index. Its reserves and planned production are expected to last around 25 years, and it has sufficient mineral inventory to support future expansion options.
According to Anglo Pacific, LIORC pays quarterly cash dividends to the maximum extent possible, declaring payments of C$169.6m in 2017 with a historical 2017 dividend yield of c.11pc. As a result, the business expects its deal to immediately enhance adjusted earnings and cash flow per share as well as further diversifying its sources of income and commodity exposure.
The real kicker, however, was the premium quality of IOC’s product, which contain low levels of pollutants like aluminium, silicon, and phosphor. According to Flynn, environmental policy in China is driving structural change in the country’s steel industry, which currently produces half of the world’s supply. With demand for high-quality iron ore product in turn increasing, Anglo Pacific sought to ensure its investment in a product that will meet these evolving requirements:
‘What attracted us was the premium product that is produced by the underlying operator. A big part of our focus over the last couple of years has been on the premium product area of the mining sector, which we have observed to command more and more weight, especially over the last six months or so. This is being driven by environmental clampdowns in China, where we are seeing the authorities get serious about environmental issues. For us, LIORC ticked all of the boxes. It has a good initial yield in a safe jurisdiction and is operated by a tier one player. We think there is considerable upside to come from this investment too, as these premiums are likely to continue. Broker consensus for the income from that royalty over the next 12 months suggests it could produce $C4.7-5.7m for us. That represents a running yield of about 8-9pc.’
Another important update last month was Anglo Pacific’s H1 2018 results. The well-received figures showed a 12pc year-on-year increase in revenues to £19.1m and a 20pc jump into total income generated from royalties to £20.8m, from £17.3m in H1 2017. Elsewhere, the business revealed a 15pc increase in adjusted earnings per share to 8.56p and a net cash balance of £5.2m as at 30 June 2018, after investing £13.8m and dividends of £7.2m.
A notable exception to these across-the-board gains was a c.30pc drop off in volumes. However, Flynn tells us he expects some particularly meaningful volume growth to come through soon, driven in particular by the firm’s royalty at Kestrel, an underground coal mine in Australia. Rio Tinto sold its 80pc interest in Kestrel last month to a joint venture between EMR and Adaro for $2.25bn, and Adaro has publicly indicated that it will look to double production in the next two to three years. With virtually all output from Kestrel in this period coming from within Anglo Pacific’s private royalty land, Flynn said the deal is likely to have a significant positive impact on group revenues.
Notably, the LIORC transaction was funded entirely from Anglo Pacific’s balance sheet. Aside from its strengthening portfolio, Flynn puts the company’s ability to grow without necessarily diluting shareholders through a placing down to macro improvements:‘The commodity price outlook has increased as we have gone throughout the year, and that has dropped down into our cash balances to help us self-fund acquisitions. All things being equal, we expect to be debt-free by the end of the year, so we will have plenty of liquidity to go forward and continue to acquire more royalties.’
He believes this could soon be a vital catalyst in a re-rating of the firm, which he thinks is undervalued with a current market cap of £272.1m and a p/e ratio of 26.45x: ‘We plan to continue growing. We do want to put another one or two royalties into the portfolio in H2 2018, and those would be financed from the balance sheet. Anglo Pacific in the past has generally relied on the market to fund its acquisitions and growth, and that is no longer the case for us, absent a really transformational deal. We think that in its own right should be a catalyst for some share price re-rating.’
What’s more, Flynn says the areas of the commodity market where Anglo Pacific has most exposure are continuing to thrive as others suffer from ongoing macro threats like a trade war between the US and China. For example, he points out that the current 2019 price expectations for coking coal, to which the business’s portfolio was nearly 50pc weighted at the end of last year, are 34pc ahead of where they were this time last year. If this continues, he believes it could be another potential trigger for a re-rate in the firm’s shares:
‘The fundamentals are really in place for us to meaningfully grow. We think that we are undervalued on most metrics at the moment, certainly compared to what royalty companies in the northern American market seem to attract. Organically, we think these market fundamentals are triggers that should naturally result in a re-rating, representing value that our share price doesn’t currently reflect.’
The bottom line
Anglo Pacific’s model provides a high degree of commodity exposure, geographical diversification, and cost certainty, and the firm’s recent results seem to suggest that its approach is working. The interesting thing now is that the current combination of ideal macro conditions and reliable performance is allowing the business to fund its growth without repeatedly going to the market to demand funds. Although it will always be sensitive to changes in the commodities market, Anglo Pacific could be worth a punt on the expectation it will deliver on Flynn’s plans for more royalty acquisitions over the near-term.