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Iluka Resources and its lucrative BHP iron ore royalty

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One mining company not frequently mentioned despite being in the ASX 100 is Iluka Resources (ASX:ILU).

The company owns a significant asset known as the "MAC royalty" receiving an extremely lucrative royalty rate on iron ore revenue generated from BHP's Area C mine.

Iluka is also involved in mining and processing mineral sands deposits, producing titanium dioxide products such as rutile, synthetic rutile and ilmenite that are primarily used in pigments and paints.

The company also produces zircon, which is primarily used in tiles and ceramics. In terms of global significance, it is a top-three producer in both titanium dioxide and zircon production.

Not often mentioned despite being in the ASX100, Iluka Resources receives an extremely lucrative royalty rate on iron ore revenue generated from BHP's Area C mine.

And now to the MAC royalty. Entered into in 1994, it entitles Iluka to receive a royalty rate of 1.232% of iron ore revenue generated from BHP's Area C mine, as well as a step up in payments for an increase in production capacity from the mine.

The royalty is extremely lucrative for Iluka given the long reserve life of the Area C mine, and no exposure to operating costs (being a royalty on revenue - not profitability).

For those who follow ASX mining companies, you would already be aware of the recent spike in iron ore price caused as a result of the tragic tailings dam spill at the Corrego do Feijao mine in Brazil.

For Brazil - and mine owner Vale - it is the second incident of its kind in four years.

The incident has unsurprisingly caused significant disruption to Vale's operations and global iron ore supply, leading to higher iron ore prices.

While higher iron ore prices benefit iron ore producers (as well as the Australian government), Iluka also stands to benefit through its MAC royalty.

The amount Iluka Resources will receive is likely to step up this year given the move in iron ore prices, with the year to date average being US$88 per tonne (A$124/t). Assuming the averages hold, this would lead to an additional 20 to $25 million of cash flow to Iluka.

Regardless of your view on the value of the MAC royalty, there are arguably benefits for ILU in keeping the royalty over the next few years.

The royalty helps to buffer the unpredictable nature of the mineral sands commodity cycle, while still providing a benefit to shareholders longer-term.

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Roger Montgomery is founder, chairman and chief investment officer of Montgomery Investment Management. Following a successful career as an analyst and public company chairman, Roger published the first edition of his stock market guide, Value.able, in 2010, becoming an Australian best seller in just 16 weeks. He holds a Bachelor of Commerce and is a senior fellow of the Financial Institute of Australasia.
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