As Rio Tinto's sale process for its stake in a Labrador iron ore mine gets into gear, the spotlight falls on Labrador Iron Ore Royalty Corp., which also owns a stake in the same mine.
The Rio Tinto sale, if it comes off, will make it easy to draw a line to the value of Labrador's equity stake in the mine, and may show people there's more value than thought in Labrador Iron Ore. That might explain why the shares have been trading strongly since Friday when the Rio Tinto news broke.
But on top of that equity stake, Labrador Iron Ore gets a 7 per cent royalty on all iron ore sales. The discussion is ramping up regarding what that is worth.
An activist shareholder who is pressing Labrador Iron Ore to look at splitting the royalty from the equity stake argues it's a lot more than the market and sell-side analysts realize.
The evidence is where shares of other precious metal royalty companies trade. With metal prices high, but operating costs rising, owning a chunk of the top line at a metals company is more attractive than owning a chunk of the bottom line, the argument goes. The market has reflected that. There's no doubt that royalty stocks have been hot, while mining stocks have been anything but.
If you start to value the royalty that Labrador Iron Ore has at a level even close to precious metals royalty stocks, the value of the company surges.
Some analysts value the future cash flows of the Labrador royalty stream using a discount rate at 8 per cent to 10 per cent.
But what happens if you start to move the discount rate down toward the levels where precious metals royalty stocks trade? Franco-Nevada and Silver Wheaton shares trade at levels that imply a discount rate in the 1 per cent to 2 per cent range.
Do that and the value of Labrador Iron Ore skyrockets. Now, there's no suggestion that an iron ore royalty from one mine should be worth the same as a precious metals royalty from diversified sources. But take the royalty valuation even a little ways in that direction and the numbers get bigger fast.
At $75 (U.S.) per tonne for iron ore, RBC Dominion Securities estimates the royalty is worth $13.11 (Canadian) a share at a 10 per cent discount rate, and $20.99 at a 6 per cent discount rate. RBC splits the difference and says the royalty stream is worth $16.25 a share at an 8 per cent discount rate.