Red Rock Resources: Red Rock Royalties!

Red Rock Resources (LON:RRR) is somewhat unique amongst value plays. It owns a number of enticing key assets and projects, any one of which could in its own right be a company maker, with arguably enough firepower to blow away the current market cap. Most who follow the company will already know this. For those as yet unfamiliar with Red Rock's extraordinary story, here are someuseful links which bring you up to speed. The potential value of Red Rock's investments is a regular source of investor speculation; there's the 83m or so shares in Jupiter Mines (ASX:JMS), currently worth around 80% of the company's market capitalisation. Then there's the gold project at Migori in Kenya, with its existing 1.2million ounce JORC resource and where the Company could end up with up to a 72% economic interest. And then there's the Columbian gold venture with MFP (Meneras Four Points) which, by the end of 2010, could see Red Rock acquiring a 51% stake in a high grade mining operation producing as much as 50,000 ounces per annum. And of course let us not forget the Company's ASX & TSX listed uranium interests which, if recent revelations in the sector are anything to go by, may themselves be on the cusp of a resurgence of investor interest.

But to paraphrase games show host Chris Tarrant – "we don't want to talk about all that!". We want to talk about another intriguing nugget within the portfolio. One which until last week was modestly hiding its light under a bushel. Namely, the Company's 1.5% GPR (Gross Production Royalty) rights over production at Jupiter Mines Mt Ida Iron Ore prospect.

Here's the story. Back in 2006 the newly listed Red Rock Resources granted Jupiter Mines (ASX:JMS) a 12 month option over its Mt Ida & Mt Hope iron ore licenses. In May 2007, having spent the required $250k on exploration, Jupiter exercised its option and in part consideration also agreed to a 1.5% GPR (with no deductions and no buy outs).

It's not unusual for these license transfer deals to include a Royalty element, but with early stage projects like Mt Ida its seen more as a sweetener "just in case it comes good", rather than any kind of dependable source of future revenue. Given the nature of the exploration business, the odds of any project ever making it through from grass roots to production are extremely slim. And certainly for a company of Jupiter's scale (at that time), driving its Central Yilgarn iron ore prospects up the value curve would have been no mean feat either. That said, explorers tend to be notorious optimists!

Then on the 6th November 2008 something interesting happened. Red Rock announced to the market that they had joined forces with mining investment powerhouse Pallinghurst Resources headed up by Brian Gilbertson, veteran deal maker and founder of BHP Billiton. Together the two companies were poised to take control of Jupiter Mines. The rationale being to development their iron ore and manganese assets and transform the junior explorer into a global contender and linchpin in Pallinghurst's "Steel Feed Corporation" strategy. Red Rock's Chairman Andrew Bell would also join the Jupiter board.

The transaction gained shareholder approval in March 2009 and the Pallinghust/Red Rock team took control of the now reinvigorated and cashed up Jupiter Mines. Drilling completed in December 2009 at Mt Ida identified high-grade magnetite mineralisation which resulted in a conceptual exploration target being modelled with an estimate of between 1.1 to 1.3 billion tonnes of magnetite ore at an expected grade of between 30% and 40% Fe. Needless to say, with high grade mineralisation identified and a conceptual target of such magnitude, commercial production at Mt Ida was steadily becoming less and less of a pipe dream. 

The strategy has been playing out nicely ever since and after gaining approval for the Tshipi Manganese transaction last month, Jupiter Mines has scaled up with a current market cap of around AU$430, some 10 times greater than before Red Rock & Pallinghurst's involvement. So far so good!

But just last week, ambitions of production took a massive leap forward, when the Company released news that the Mt Ida project was now to be fast tracked with an increased exploration budget of AU$3million, dedicated to achieving a maiden JORC in December 2010.

So something which was originally little more than a lottery ticket is now morphing into a potential revenue stream in waiting!

And given the newly condensed timescales, we could soon start to think of the GPR in terms of its stand alone investment potential. But Royalty rights are a very specialised area and given these recent developments, we decided to get a better understanding of how they work, and more specifically what is actually meant by the term Gross Production Royalty (GPR). For our first stop, we found ourselves on the pages of Wikipedia which covers everything you wanted to know about Royalties in general http://en.wikipedia.org/wiki/Royalties. Whilst this page gives a good "from the ground up" view, it is probably of more interest to someone hoping to sign a major recording deal EMI or the like. All good background research anyway!

We eventually found an interesting site providing an overview of various royalty mechanisms as they specifically relate to mining & minerals here. This is more in tune with investor requirements and certainly worth a read.

So to bring everything together, this is where we find ourselves:

The Red Rock Mt Ida Gross Production Royalty (GPR) is a straight 1.5% of all sales achieved from the production of magnetite concentrate from Mt Ida. In other words for every $100 revenue Red Rock will receive $1.50;   The GPR is an absolute fixed percentage payable on all production and is not volume or time limited;   The Magnetite rock will require some processing requiring some plant & machinery, access to water and access to electricity. In the Central Yilgarn, none of these requirements would be considered insurmountable;   The processing will produce Magnetite concentrate grading around 65% and this is currently selling for around $120 per tonne meaning with constant prices the GPR would be around $1.80 per tonne produced;   Tonnage volumes depend on infrastructure capacity limitations, but the initial target seems to be 5 million tonnes per annum, eventually scaling up to possibly 20 million tonnes;   Based on the tonnage targets and current estimated prices, the GPR could be worth between $9 million (£5.7mn) and $36 million (£22.9mn) per annum to Red Rock (at a 1.57 $/£ exchange rate & subject to taxation)   At these production volumes and given a conceptual 1.1-1.3 billion tonne resource the 'mine life' could be many decades;   The precise terms and conditions relating to GPR calculation and payment would be specified in the GPR working agreement or contract, originally forged when the deal was agreed. As this is expected to be a Direct Shipping Operation the terms of the agreement will specify when the Magnetite Concentrate volumes and revenues are determined and when the payments are to be made (and how these should be made).

Mt Ida is by no means a small project, and if our projections are anything to go by then the scale and potential revenues from the GPR are likely to throw up some challenges for the company. After all Red Rock is now in the Gold business, its not a Royalty Management Facility. So at some point the company will be looking at the best way to leverage value form this asset.

Given Management's creative approach and track record for de-risking and building value through deals making, we thought it would be interesting to speculate on a few possible scenarios; 

• Sit back and take the GPR cash: a nice option providing the company with significant annual funds for expansive exploration, growth by acquisition and development; and the levels of incoming cash flow to fund something of a burgeoning dividend as and when production volumes scale up. The down side would be a wait of perhaps two year or so for the first revenues to flow, and the inherent risk associated with delays etc.
• Sell the GPR: naturally to the highest bidder and perhaps yielding a substantial cash lump sum to be used for future work programmes and acquisitions and perhaps return some of cash to shareholders. Another nice option and one that would involve some risk for the acquirer. Naturally a material discount would need to reflect the time value of money and the inherent risks regarding eventual revenues. But companies such as Anglo Pacific Group (LON:APF TSX:APY) who's entire (£250m market cap) business is based natural resources royalty revenues, may find the Mt Ida GPR of some interest.
• Hive off the GPR into a new vehicle: leaving the Red Rock business focused on Gold exploration, development and production. This option could be developed in a number of ways, but all would be likely to include some form of listed vehicle holding the GPR royalty as its principle asset. In essence the listed vehicle would be a Royalty Fund and iron ore play, (like a mini Anglo Pacific) the value of which would be determined by a multiple of projected Royalty revenues. If we use a hybrid of the Resource Star model, then the company may look to hive off the GPR asset in return for an element of cash and shares, thus providing Red Rock with funds for on-going development whilst still maintaining an exposure to the Royalty income stream going forward. If we are right, we can see two significant advantages with this strategy: a/it significantly de-risks the proposition b/ it could be readily fast tracked. Perhaps not straight away, but certainly well in advance of production.

Of course this is pure speculation on our part, but it does give food for thought. If one takes a view that average long term GPR revenues (at $120 per tonne and 12.5million tonnes per annum at 1.5% GPR and 1.57 $/£ exchange rate) could amount to around £14 million per annum, perhaps the issue of how best to  leverage value from this asset is not such a terrible problem to have!

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