When most people are young children and becoming familiar with money, at some point, our parents explain to us that nickels are less valuable than dimes. Many small children may at first assume that nickels are more desirable, since they are larger, but as our parents explain, nickels are worth only 5 cents while dimes are worth 10 cents. Every now and again, there is a kid who never received such an explanation or just doesn't quite get it. Often the more financially astute children in a group may take advantage by trading their nickels to him for his dimes.
Although rare, such opportunities also sometimes appear in the financial markets. Today I will make an argument that Great Northern Iron Ore Properties (NYSE:GNI) is one such opportunity. But in this case, GNI shareholders are the ones trading in their dimes and getting nickels in exchange. As such I believe that GNI presents shareholders with major downside potential in the months ahead.
As stated in its own 2011 Annual Report of the Trustees to Certificate Holders:
"Great Northern Iron Ore Properties is a conventional nonvoting trust organized under the laws of the State of Michigan pursuant to a Trust Agreement dated December 7, 1906. The Trust owns interests in fee, both mineral and non-mineral lands, on the Mesabi Iron Range in northeastern Minnesota. Many of these properties are leased to steel and mining companies that mine the mineral lands for taconite iron ore.
The major source of income to the Trust is royalty income derived from taconite - a type of iron ore - production and minimum royalties. The terms of the Great Northern Iron Ore Properties Trust Agreement, created December 7, 1906, state that the Trust shall continue for twenty years after the death of the last survivor of eighteen persons named in the Trust Agreement. The last survivor of these eighteen persons died on April 6, 1995. Accordingly, the Trust terminates twenty years from April 6, 1995, that being April 6, 2015.
At the end of the Trust on April 6, 2015, the certificates of beneficial interest (shares) in the Trust will cease to trade on the New York Stock Exchange and thereafter will represent only the right to receive certain distributions payable to the certificate holders of record at the time of the termination of the Trust. Upon termination, the Trust is obligated to distribute ratably to these certificate holders the net monies remaining in the hands of the Trustees (after paying and providing for all expenses and obligations of the Trust), plus the balance in the Principal Charges account (see Note 6 to the Financial Statements). All other Trust property (most notably the Trust's mineral properties and the active leases) must be conveyed and transferred to the reversioner (currently Glacier Park Company, a wholly owned subsidiary of ConocoPhillips Company) under the terms of the Trust Agreement."
As one can see, the trust has an April 2015 date for termination, and after the final distribution, the delisted shares will be completely worthless. Yes, this stock is a guaranteed zero by the end of 2015. As I will illustrate, GNI is extremely overvalued based on several misconceptions in the market and poor diligence by shareholders. It also faces several risks to the yields enjoyed by investors over the last two years.
Misconception #1: GNI is a Value Stock
One of the reasons that people are putting money into GNI is no doubt that screeners like Yahoo Finance and Google Finance list the company as paying a high dividend and having a very low price to earnings ratio. Yahoo Finance currently lists the dividend as $14 and the yield as 18.9% and the P/E as 4.98. The yield figure is simply incorrect based on the price of the stock. At $78.91, a yield of $14 is equal to ($14/$78.91), or 17.7%. Google Finance agrees on the P/E ratio, but also ascribes an incorrect yield of 18.38%. Investors that invest in GNI based on information provided by these two popular finance portals may think that they are getting a high-yielding bargain. Only after conducting deeper due diligence into GNI will they realize they are greatly overpaying for this deceptively high-yielding trust.
A number of articles touting the stock, which appear based on cursory computer screens without any significant due diligence by the authors, have also been released in recent months. Examples of these pieces can be found here, here, here, here and here. Despite these articles, GNI is not a value stock, principally because as of April 2015, the trust will wind down and after a final distribution as such, within 2.5 years, just ten more regular dividend payments, the shares will have a terminal value of zero.
Misconception #2: Shareholders Will Receive Anything Beyond the Final Distribution for the Trust's Current Royalty or Land Rights
Shareholders in the trust may have some misconceptions regarding what is owed to them upon the dissolution of the trust. The 2011 Annual Report of the Trustees clearly lays out the terms for the dissolution of the trust with Page 3 stating:
The Trust terminates twenty years from April 6, 1995, that being April 6, 2015.
At the end of the Trust on April 6, 2015, the certificates of beneficial interest (shares) in the Trust will cease to trade on the New York Stock Exchange and thereafter will represent only the right to receive certain distributions payable to the certificate holders of record at the time of the termination of the Trust. Upon termination, the Trust is obligated to distribute ratably to these certificate holders the net monies remaining in the hands of the Trustees (after paying and providing for all expenses and obligations of the Trust), plus the balance in the Principal Charges account (see Note 6 to the Financial Statements). All other Trust property (most notably the Trust's mineral properties and the active leases) must be conveyed and transferred to the reversioner (currently Glacier Park Company, a wholly owned subsidiary of ConocoPhillips Company) under the terms of the Trust Agreement.
Note 6 on Page 17 elaborates on this stating:
Pursuant to the Court Order of November 29, 1982, the Trustees were directed to create and maintain an account designated as "Principal Charges." This account constitutes a first and prior lien of certificate holders on any property transferable to the reversioner and reflects an allocation of beneficiaries' equity between the certificate holders and the reversioner. This account is neither an asset nor a liability of the Trust. Rather, this account maintains and represents a balance that will be payable to the certificate holders of record from the reversioner at the end of the Trust.
The trust holders will therefore receive nothing beyond the final distribution paid by the company. Furthermore, examination of the historical record of the Principal Charges account dispels any hope that this figure should increase meaningfully from the 2011 figure of $4,961,873:
2011 Principal Charges account - $4,961,873
2010 Principal Charges account - $4,839,748
2009 Principal Charges account - $4,930,558
2008 Principal Charges account - $4,962,052
2007 Principal Charges account - $5,036,930
As we can see looking at the Annual Reports of the Trustees from 2007 to 2011, which are available as exhibits to each respective 10-K filing, the principal charges account has remained extremely stable over the past 5 years and we can assume this will likely continue to be in the range of $5 million upon the wind-down of the trust.
Net monies have also stayed remarkably stable and the overall total per share estimated wind-down value of the trust, as reported in the 10-Ks from 2007 to 2011, has experienced very little volatility:
Shareholders that think they are going to get a distribution figure that is meaningfully larger than the $8.59/share reported in the most recent 10-K are simply mistaken and believing this could cost them dearly.
Misconception #3: As a High Dividend Payer, GNI Makes a Poor Short Candidate Because the Cost of the Dividend Payment is a Borrow Cost
In the case of a normal stock, the dividend can often be considered to be a perpetual borrow cost. If you go short a stock like Coca-Cola (NYSE:KO), you can reasonably assume that the dividend will be the same or higher in three years than it is today. Technically speaking, when looking at the intrinsic value of a stock which is a perpetual earnings generator, like Coca-Cola, when the company goes ex-dividend, it might immediately lower the value of the stock by the amount of the dividend since the company is paying out some of its assets. However, with a perpetual earnings generator, the value lost in the payout is constantly replenished through new internally generated cash flow. Therefore, assuming that the dividend payout ratio is below 100%, future earnings power is intact and interest rates remain stable, from a Net Present Value ("NPV") perspective the company will remain at least as valuable one quarter later as it is today.
Based on today's actual situation, the mathematical intrinsic value of any stock before its Q4 2012 dividend record date should be:
Value of Stock (pre-Q4 2012 ex-dividend date) = DQ4 + D2013-2015 + Dn + RCV
DQ4 = Present Value of Q4 2012 Dividend
D2013-2015 = Present Value of all dividends paid from 2013 through to the end of 2015
Dn = Present Value of all dividends from 2016 and beyond
RCV = Residual capital value above and beyond dividend payouts
If a company is a perpetual earner, Dn will not shrink from quarter to quarter, so long as a company's earning power does not shrink. This is because for a perpetual earnings company the dividend going forward should remain the same, all else being equal. So in this case:
Dn = PV of Dividend from 2016 to infinity
Under a zero-growth scenario, as a fiscal quarter passes in time, the present value of Dn should increase. This is because as time passes, future dividend payouts become nearer-term dividend payouts and their present value increases as a result. Also, residual earnings beyond what is paid out are added to RCV. Under this zero-growth scenario, as time passes, the value of Dn + RCV increases to offset the value lost from any quarterly dividend payout.
Assuming that nothing changes, by the end of 2015, the value of the stock will be equal to:
Value of Stock (End of 2015) = Dn + RCV
Assuming a perpetual earner, no changes to the earning power of the company, expected dividend payouts and overall interest rates, the present value of Dn should have increased by an amount at least equal to (DQ4 + D2013-2015).
This is an important point, because it means that for most companies, even assuming a scenario of zero growth, the dividend paid out is a very real cost to borrow a dividend paying stock. It will continue into perpetuity and earnings replenish its ability to pay future dividends. This is not the case with GNI as I shall illustrate.
Why the Payout of GNI's Dividend Does Not Represent a True Cost to Borrow the Stock
GNI is a trust which is scheduled to wind down on April 6, 2015. Under the terms of the wind-down, the trust's only money generating asset - royalties from leasing properties for iron ore mining operations - will be transferred to the Glacier Park Company, a division of ConocoPhillips (NYSE:COP). This transfer will take place without any additional consideration beyond that outlined in the Principal Charges account. This has important implications for the mathematical valuation of GNI shares. GNI has declared December 31st, 2012 as the dividend date of record for Q4 2012; therefore, before December 26th - the last day for trade settlement in 2012 - the Q4 dividend should be included in the NPV of the stock. As outlined earlier, the value of any stock before its Q4 2012 dividend date of record should be:
Value of Stock (pre-Q4 2012 Date of Record) = DQ4 + D2013-2015 + Dn + RCV
But in the case of GNI because the trust is scheduled to wind down in April of 2015, the Q1 2015 payout and the final distribution are the last dividend payments that stockholders will receive from this stock; that's all that shareholders will ever receive. The royalty stream will no longer belong to stockholders and the company will have no additional earning power. Therefore in this case:
Dn = 0
RCV = 0
Since in GNI's case:
Dn + RCV = 0
Value of Stock (End of 2015) = Dn + RCV
Value of GNI Stock (End of 2015) = 0
In this case, assuming that the final payout has occurred by the end of 2015, the value of GNI shares at the end of 2015 will be zero. This is one thing that can be 100% absolutely guaranteed.
Unlike a normal perpetual earning stock where, assuming no growth in dividends and no changes in interest rates, the present value of Dn + RCV should increase with time's passage, when a quarter passes for GNI and it pays out its dividend, the value of Dn + RCV is still zero and does not increase whatsoever. The dividend paid out is now gone from the equation; it will never be recovered and it can no longer be considered in the NPV calculation which determines the mathematical and intrinsic value of the stock. In GNI's case, with every dividend out the door, GNI is one step closer to being worth zero. Although the stock's movement may not exactly track payout dates, the payout does in reality reduce the NPV of the stock by the exact amount of the payout. A mathematical projection of GNI's intrinsic value can be expressed as follows:
After Q4 2012's dividend record date, GNI will have an intrinsic value of:
Value of GNI Stock (post-Q4 2012 Dividend Date of Record) = D2013-2015 + 0
D2013-2015 = Present Value of all dividends paid from 2013 through to the end of 2015
At the beginning of 2014, GNI stock will have an intrinsic value of:
Value of GNI Stock (post-Q4 2013 Dividend Date of Record) = D2014-2015 + 0
D2014-2015 = Present Value of all dividends paid from 2014 through to the end of 2015
At the beginning of 2015, GNI stock will have an intrinsic value of:
Value of Stock (post-Q4 2014 Dividend Date of Record) = D2015 + 0
D2015 = Present Value of all dividends paid through to the end of 2015 (assuming wind-down payment is distributed in 2015)
And by the end of 2015, GNI stock will be totally worthless:
Value of Stock (post-2015 Final Dividend Date of Record) = 0
In 2015, GNI's Trailing Dividend Yield Will Eventually Approach or Exceed 100%, the Trailing P/E Will Approach or Break Below 1x and It Still Won't be a Good Buy
As the trust approaches the end of its life, assuming the earnings and payouts remain constant, these figures will appear more attractive on a cursory level, because the remaining value in the trust will decrease, translating into a lower price for the stock. After the Q1 2015 dividend is paid out and there is only approximately $8.50 in value left in the stock - based on the estimated final distribution - it is likely the stock would trade for $10 or less. In this case, it is conceivable that by assuming a payout and earnings in 2014 consistent with today's, then on a trailing basis, the dividend yield at that point would be listed at over 150% and the P/E would also be below 1x.
This will not mean that buyers will or should be lining up to purchase the stock, although foolish touters who write based solely on a computer screen may still recommend it. At $10, it would still not be a good buy, despite the headline figures because the future value of the stock will be exactly equal to the price of the final payout, not a penny more, and then the stock will cease trading and disappear.
Downside Risk #1 for GNI: Iron Ore Prices
Over the last two years, iron ore prices have been high on a historical basis, underpinned by strong infrastructure and real estate demand from China. At this juncture, there are risks to iron ore prices as Chinese real estate markets remain in a relatively weak state, with excess capacity of real estate units/infrastructure and government property controls unlikely to ease in the near future. The Chinese economy has shown marked signs of slowdown in 2012, and the Chinese government has openly indicated it is willing to accept slower growth going forward, so iron ore demand in China is unlikely to be as robust in the coming years as it has been over the past several years.
Despite a recent run-up in prices, it seems unlikely that prices for iron ore in 2013 and 2014 will be meaningfully higher than in 2011 and traders are reportedly turning cautious on the metal. While GNI's royalty payout scheme is not fully leveraged to iron ore prices, if prices decline, there are risks to GNI's future payouts. Because of this, shorting GNI makes a good hedge against a general economic slowdown because of the iron ore price's positive correlation with growth in the global economy.
Downside Risk #2 for GNI: Tax Loss Selling
Despite the recent run in the stock, today GNI stands at $78.91, which is 29% below its price of $111.10 as of the end of 2011. Prudent shareholders in GNI will use the recent upswing as an opportunity to sell their stock and potentially realize a real capital loss which can be applied against capital gains in other stocks. We could see this starting to put pressure on the stock around and leading up to December 26th, which is the last trade date that will settle in 2012.
Downside Risk #3 for GNI: Interest Rates
Prevailing interest rates on risk-free investments, e.g. US 10-year government bonds, are near historic lows with 10-yr US treasuries yielding 1.76% as of the close on December 17, 2012. The fed funds rate is currently at 0.25%. These figures are significant because they illustrate that the rates can't really go down that much more.
All else being equal, low rates reduce the cost of capital for companies and lower the appropriate discount rate used to calculate the net present value ("NPV") of an income stream like that generated by GNI. I don't view the risk of materially higher interest rates as a likely short-term scenario, given the Federal Reserve's current stance, but a non-zero risk still does exist here in this respect. Therefore, there is some risk in assuming that the appropriate discount rate used to calculate the NPV of GNI's dividend stream will not increase over the next 3 years. If the discount rate increases, the NPV of GNI's future dividend payouts will be inversely affected and will decrease, and should negatively impact the stock's value. Given that interest rates have barely any room to fall before actually reaching zero, and the federal reserve has already seemed to abandon lowering interest rates in favor of direct asset purchases, the chance of materially lower interest rates over any extended basis seems implausible and therefore there is unlikely to be any major upside surprises in this respect.
Downside Risk #4 for GNI: Business Risk
Although historically the trust has been fairly stable with regard to its production and payment of dividends, there is always the risk that some sort of disruption to production takes place based on natural factors (e.g. a severe winter blizzard) or man-made factors (e.g. contract dispute among the owners/producer and workers). These risks are not particularly troubling, but they do exist and should therefore be accounted for as non-zero risk factors.
Arriving at a Fair Value for GNI Today
Looking at statements from GNI's trustees in their most recent dividend distribution release saying that fiscal 2013 is not expected to reach earnings achieved in 2011 or 2012, it is unlikely that profits and therefore dividends in 2013 will exceed the figures in 2011 and 2012. Distributions in 2011 totaled $15/share and declared distributions through Q4 of 2012 total $14.00.
From a historical perspective, looking at the last 5 years, GNI has declared average annual dividends of $12.19 as illustrated below
It is worth noting that the 5-year historical average is significantly below the payout figures attained in 2011 and 2012. If the economy were to slow down in a meaningful way, then we could expect the trust's earnings and distributions to approach lower figures, potentially even 2009 levels of $8.00 share. The possibility of such events presents a material downside risk to GNI's current payout scheme.
For argument's sake, I have modeled out three scenarios regarding GNI's future dividend payouts:
Under the Optimistic Scenario, for the remainder of the trust's life, GNI pays out more than it ever has historically, paying the equivalent of a $16 annual dividend in 2013 and 2014. Taking into account the typical seasonality exhibited by the trust's payouts, dividends are projected at $2.50, $3.00, $4.00 and $6.00 per share for Q1-Q4 respectively. The final distribution associated with the winding down of the trust is estimated at $9.00, also larger than estimated figure has been at any point over the last five years.
The Base Scenario, which is quite generous given the current economic environment/risks, projects payments for the remaining quarters as equal to those achieved during 2012. The final distribution is assumed to be $8.59, which is the most recently reported estimate contained on page 6 of the most recent 10-Q.
The Pessimistic Scenario assumes economic/business problems or a decrease in the price of iron ore. This scenario assumes that payouts in 2013 equal those made in 2009 and a reversion to the average quarterly dividend payment over the last five years in 2014 (i.e. $12.34 annual dividend) and a winding down payment equal to $8.46, the average estimate over the last five years.
Looking at all of these figures, it should be clear that even under the most Optimistic Scenario, shareholders only recover a total return of $48.75. Based on an investment at the current price of $78.91, this represents a loss of $30.16 or 38.2% per share. Essentially, this is a guaranteed loss if one were to buy the stock today and hold it until the trust is wound up.
But even this figure is inflated in terms of a current fair price for GNI stock because it does not take into account the time value of money, i.e. dollar for dollar, the same money tomorrow is worth less than money today. I have modeled out the net present value of the dividend streams of the three scenarios using three different discount rates as shown below:
Based on this, we can determine that even under the most optimistic scenario, the shares should be worth no more than $45.69 today and could be worth less than $30 if things don't go so well. I believe that a realistic fair value today for the shares is probably in the range of $39 per share based on the generous Base Scenario and a discount rate of 10%, which is still low considering all the attendant risks to holding the shares. This represents over 50% downside from the current stock price.
During my tenure writing for Seeking Alpha, I have devoted significant time and effort into warning readers about various scams, bubbles and general market irrationality. My track record is shown below.
Readers should note that to date my track record is flawless, with companies that I have written about declining by 84% on average. I am very comfortable adding GNI to this list based on all the reasons presented.
It is an absolute certainty that by the end of 2015, assuming payment of the final distribution, shares in GNI will be completely worthless; they will be delisted from the exchange and will be worth zero. At a closing price on December 17, 2012 of $78.91, GNI is currently trading anywhere from 73% - 163% above the net present value of the dividends which will be received between now and wind-down of the trust. Conversely, this means that for every $1 of investment, shareholders are receiving only $0.38 - $0.58 in return. Even on an undiscounted basis, shareholders in the trust are looking at guaranteed losses of at least approximately $30 per share, or 38.2%.
At current prices, shareholders in GNI are clearly trading in their dimes for nickels. What would their parents have to say about that?
Additional disclosure: I am short GNI and/or hold derivative positions which will benefit from a decline in the stock price.