One way of examining the relative value of an investment is by comparing it against a safe and risk-free investment over time is called a yield spread analysis. In the securities industry, many professional investors will use yield spreads in order to draw a historical comparison between a risky investment and a relatively risk-free investment. Today, I'd like to examine the often volatile Mesabi Trust (NYSE:MSB) relative to the "risk-free" U.S. Treasury 10-year bond. The historical comparison will help determine an appropriate equity risk premium for the trust, and help investors gauge the relative attractiveness of the trust going forward. As the reader will see, based on both a yield spread analysis and a Net Present Value Analysis, the Mesabi Trust is inexpensive and offers substantial upside to investors willing to ride out the stock's volatility.
A Brief Historical Background On The Mesabi Trust
The beginnings of the Mesabi Trust date all the way back to 1870 when a geologist by the name of Peter Mitchell explored the Minnesota wilderness and staked an iron claim, which he believed to be very valuable at the time. The deposit, unlike other high grade iron deposits on Minnesota's Vermillion range, was composed of a low grade iron known as taconite. Despite the low iron grade of the deposit, Mr. Mitchell and a group of investors pushed on, hoping that their taconite deposit would bring them riches, eventually forming the Mesaba Iron Company in 1882. For decades thereafter, the Mesaba Iron Company, which in 1905 became known as the Mesabi Iron Company, was unsuccessful in creating an economically viable iron product for nearby steel mills on the Great Lakes. The two principle assets of the Mesabi Iron Company were the East Mesaba Iron Company and the Dunka River Iron Company, which were later known as the Peters lands and the Cloquet lands. These lands eventually became the principle assets of the Mesabi Trust. Fortunately, the Mitchell group eventually came into contact with two men by the names of Daniel C. Jackling and Edward W. Davis.
Davis and Jackling became convinced that the low grade taconite, which averaged around 30% Fe could be upgraded to a higher iron content of 60% Fe through a process known as magnetic separation. The two scientists worked fervently to prove that their idea could work conceptually, and were able to successfully develop a starter plant in 1920 that helped provide proof of concept. Unfortunately, the cost of producing the concentrate at the time was prohibitively expensive, and the Mitchell taconite mine was delayed for several more decades while the taconite concentration process was further refined by E.W. Davis.
Shortly after the initial taconite plant was shut down for cost over runs, Mr. Davis became convinced that the taconite concentrate produced at the Mitchell mine needed to be more attractive to steel makers than the current iron feed stock, which was hematite fines. After talking to many steel makers, Davis recognized an opportunity. The steel makers were telling Davis that iron fines would often sit at the bottom of a blast furnace and would take a long time to be melted down to iron for steel making. A product that allowed air in the blast furnace to move through the iron ore would help the steel makers use less energy and save money. This eventually led Davis to the idea of creating iron ore pellets, which today are used by steel makers all over the world -- but were first perfected by Davis using ore from the Peter Mitchell mine.
Above, you can see the current high quality product being produced at the Northshore Pellet Plant, the world wide benchmark is 62% Fe Fines. Source: www.epa.gov/ttnecas1/regdata/IPs/Taconite_IP.pdf
Eventually, E. W. Davis perfected the process of concentrating magnetite (i.e., taconite) ores, and the process of concentrate pelletization. These two processes eventually spurred a company by the name of the Reserve Mining Company to strike a deal with the Mesabi Iron Company. The deal outlined that the Mesabi Iron Company would, for all intents and purposes, be replaced by a royalty trust. The end result was the destruction of the Mesabi Iron Company, and the creation of the Mesabi Trust. The Reserve Mining Company, building on the work of Davis, went on to create the first commercial taconite mine and pellet plant in the world. Construction on the Reserve Mining plant, called Northshore in Silver Bay Minnesota, began in 1951, and the first iron ore pellets were shipped from Silver Bay in 1955. After some litigation, the Mesabi Trust began receiving royalties from the Peter Mitchell deposit in 1961. The original trust document was later updated in 1982 and has not been altered since. You can read the 1961 and 1982 revised trust agreement here.
The Reserve Mining Company Taconite Plant, Silver Bay Minnesota: Source Tumblr.com
For the next three decades, the Silver Bay plant produced millions of tonnes of taconite pellets for the Reserve Mining Company on an annual basis. Unfortunately for Reserve Mining, a world wide iron ore glut, combined with low domestic demand for steel, forced Reserve to shutter the Silver Bay plant in 1986. By 1989, a new operator by the name of Cyprus Minerals revived the Northshore facility, but it too struggled to run the plant at a profit. Cyprus eventually sold the plant in 1994 to its current owner, Cleveland Cliffs, today known as Cliffs Natural Resources (NYSE:CLF).
For more information on the history of Silver Bay, visit the Silver Bay historical society webpage.
I also encourage readers to review E. W. Davis's book, Pioneering With Taconite, for rich insights on the history and engineering of the Northshore plant in Silver Bay.
Pioneering With Taconite, Source: Minnesota Historical Society shop.mnhs.org/moreinfo.cfm
A history of the Reserve Mining Company can be found here.
How The Mesabi Trust Works Today
The Mesabi Trust today mostly collects royalty income in the form of base and bonus royalties for iron ore that is mined from the Peters and Cloquet trust lands. As I discussed in a 2010 Seeking Alpha article, base and bonus royalties are derived in the following way:
Base overriding royalties
Base overriding royalties are calculated on the basis of an escalating scale of percentages of gross sales proceeds of iron ore shipped. The applicable percentage is determined by reference to the tonnage of pellets previously shipped in the then current calendar year, as follows:
Tonnes shipped ---Applicable royalty (calendar year)
one million or less ------ 2.5%
1-2 million -------------- 3.5%
2-3 million -------------- 5%
3-4 million -------------- 5.5%
> 4 million -------------- 6%
Royalty bonuses are payable on all iron ore products produced from Mesabi Ore shipped from Silver Bay during a calendar quarter and sold at prices above the Adjusted Threshold Price. The Adjusted Threshold Price was $47.43 for calendar year 2008, $48.48 for calendar year 2009 and will be $48.81 for calendar year 2010 (in 2012, the threshold was $50.54).
Amount by which Bonus sales price exceeds Percentage threshold
$2 or less --------------------- 0.5%
$2-$4 -------------------------- 1%
$4-$6 -------------------------- 1.5%
$6-$8 -------------------------- 2%
$8-$10 ------------------------- 2.5%
>$10 --------------------------- 3%
Historically, over 90% of the iron ore mined at Northshore comes from trust lands, and there is no indication that this will change in the foreseeable future. The current iron ore reserves of these lands is equivalent to 309.7 Million tonnes of iron ore pellets, according to Cliffs' 2011 10-K, dated February, 16 2012. You can read the report here.
Above is a chart created by the author highlighting Cliffs' Northshore mine using data provided from Cliffs' 2011-10K
Unlike most trusts that have a termination date in the near future -- like Great Northern Iron (NYSE:GNI), which terminates in April of 2015 - Mesabi is likely to be around for over 50 years. In exhibit I of the 1961 agreement between The Mesabi Trust and the Reserve Mining Company, 25 individuals are named in order to measure the lifespan of the trust. The Mesabi Trust will terminate exactly 21 years after the last surviving member has passed away. As of Mesabi's most recent 10-K in April of 2012, the youngest member was 51 years of age. Of the group of 25 named individuals, all but three are between the ages of 50-60, and all 25 are between the ages of 50 to 65. If you average out the collective ages of the group, you get an average age of approximately 55 years. Looking at an actuarial table, the average remaining lifespan for a 55-year-old female is 28.27 years and 24.87 for a male. You can review actuarial tables here.
Based solely on averages, that would mean the life of the trust is approximately 46-49 years. However, given that some individuals will likely live a good deal longer than the average, it's fair to assume in the author's opinion that the trust will have a lifespan of over 50 years. Below, you can find the name, age, and birth date of the original individuals listed in the trusts agreement with the Reserve Mining Company in 1961.
Discussion Of Distributions January 2000-December 2012
For this article, the author compiled a very large volume of data going back to 1999, which was then used to examine the trailing twelve month distribution for the Mesabi Trust from 2000 onward. The trailing twelve month distribution was then compared up against the U.S. 10-year Treasury bond, with the difference between the two being the yield spread. The author will discuss the methodology behind the analysis in more detail later. First, let's look at the Mesabi Trust's distributions over the last 13 years.
Below is a list of every distribution Mesabi has made from 2000 through 2012, along with the date the distribution was announced and what the corresponding trailing twelve month distribution became.
Below, you can see what the annual distribution by quarter and by year look like for the period from 2000 to 2012, as well as a chart illustrating the growth in distribution for the same period.
Breaking the data down a little further, you can see the average distribution by quarter for the trust.
Collectively, what these charts and graphs tell us is that Mesabi's annual distribution in this 13-year period has increased by a phenomenal 640%. In the author's opinion, this trend is likely to continue in the coming years as Cliffs' pellet contracts begin to expire in 2015. These contracts will likely be replaced with spot price rates, which would increase the selling price of the Trust's ore significantly from the current below market rates it receives. More on this later.
Additionally, the average distribution by quarter underscores the importance of understanding the seasonality of the Mesabi Trust distribution. As the reader can clearly see, on average, the Q1 distribution is by far the weakest, the Q3 distribution is by far the strongest, and historically speaking, the Q2 and Q4 distributions are approximately equal.
Yield Spread Analysis Methodology
As was mentioned earlier, the author compiled a large volume of data in order to conduct the analysis presented in this article. Market price data for Treasury yield curves were obtained from the U.S. Treasury here. Historical Mesabi Trust stock quotes were obtained from Google Finance. Mesabi Trust distributions and distribution dates were obtained by mining SEC documents to glean the distribution amount and the date of the distribution declaration. The trailing twelve month yield was simply calculated by totaling the four previous quarter's distribution amounts. The trailing twelve month distribution was changed the day after the distribution declaration, since the Mesabi Trust historically declares its distribution in the evening. Lastly, the author painstakingly matched up trading dates between the Treasury and the stock market in order to reduce error in the model to zero.
As an example, during Super Storm Sandy, the stock market was closed on Monday, October 29th and Tuesday, October 30th, but the Treasury was only closed on Monday, October 29th. In this instance, a row was inserted, and the same closing price and trailing twelve month yield were used as the last trading day for the Mesabi Trust (i.e., in this example Friday, October 26th). In this instance, the Mesabi Trust yield and closing price remained the same, since it did not trade on Tuesday, October 30th, 2012, but the yield on the 10-year changed, since it did trade on the 30th of October. If readers would like a further clarification, please feel free to contact the author.
Yield Spread Analysis Results: January 3, 2000-December 21, 2012
Below, the reader can see the results of the yield spread analysis. As previously discussed in the beginning of the article, a yield spread analysis examines the perception of risk in one asset versus that of a "risk-free" asset, which is typically the U.S. 10-year Treasury bond. The difference between the risk-free asset and the risky asset is known as the equity risk premium (i.e., yield spread). In other words, the yield spread is how much an investor wants in return for holding an asset that has more risk than the risk free asset.
As the reader can see from the two charts above, the historical yield spread for the 13-year period is 5.44%, or 544 basis points. The average yield spread is important because it can tell the reader whether or not the Mesabi Trust is over or under valued on a relative basis. As of Friday, December 21st, the 10-year Treasury was yielding 1.77%, the Mesabi Trust trailing twelve month yield was 10.89%, and the yield spread was a historically high 9.12%. The difference between the historical yield spread and the current yield spread is now 3.68%, or 368 basis points. This means that if the trust were to trend back towards its historical average yield spread, the value of Mesabi Trust units would go from $24.17 (price at close of business on Wednesday, December 26th) to $35.99. The math works out like this:
Trailing Twelve Month Mesabi Yield / (U.S. Treasury 10-year yield + historical yield spread between the two assets)
Using the current numbers: $2.595 / ((1.77 + 5.44)/100) = $35.99
As the reader can see, the Mesabi Trust is undervalued by close to $12.00 when using a historic yield spread analysis. If the Mesabi Trust trends back to its historical yield spread average, then an intrepid investor could make nearly a 50% return from the current price levels of $24.17.
But What About NPV? Tough To Say Due To Current Pricing Discrepancy
Many investors will use a Net Present Value or "NPV" analysis in order to evaluate the value of a particular mining company or deposit. For many trusts or companies, this is a completely valid exercise, however, in the opinion of the author, this analysis is less valuable then a yield spread analysis when evaluating the Mesabi Trust. There are several reasons for this, but the primary reason is due to Cliffs' non-disclosed pellet contracts for the Northshore facility.
Earlier in the article, it was mentioned that the Mesabi Trust is likely to continue to see a growing distribution in the years to come. The author believes this to be the case because Northshore is currently receiving below market rates for its pellets due to long-term contracts that Cliffs Natural Resources has with certain off-take partners like Arcelormittal (NYSE:MT), and Essar Algoma. Cliffs' 2011 10-K mentions that these contracts are set to expire in 2015, 2016, and 2018, respectively. Given that many iron ore miners are shifting to spot market pricing as opposed to long-term contracts, it is likely that Cliffs will not renew its contracts, and will instead move to pure spot market pricing system. The terms of the current pellet agreement can be found in Cliffs' 10-Q, filed July 28, 2011: Omnibus Agreement published as Exhibit 10(a).
With all that being said, the results of a Net Present Value analysis using the current trailing twelve month Mesabi Trust distribution are still positive based on conservative assumptions. Below, the reader can see the results of the author's NPV analysis for the Mesabi Trust.
(click to enlarge)
Key assumptions for the net present value analysis were made using reserves of 309.7 million tonnes of pellets, an average production of 6.0 million tonnes per year of pellets, which creates a life of mine of 51.62 years. Reserve figures and the life of mine were discussed earlier in the article. The author used an average annual distribution of $2.595, which is the current trailing twelve month distribution for the trust. Lastly, a discount rate of 9.47% was used. This discount rate was selected because it represents the 13-year average trailing twelve month yield for Mesabi. Furthermore, the 9.47% discount rate reflects the risk-free rate (i.e., the average U.S. 10-year bond yield over the same period), which over the last 13 years has been 4.03%, plus the yield spread between the 10-year bond and Mesabi (i.e., the equity risk premium), which has been 5.44% over the 13-year period. The risk-free yield plus the equity risk premium give us a discount rate of 9.47%.
As the reader can see, using these assumptions gives us a present value of future cash flows of $27.15, and an NPV of $2.98. As a reminder to readers, the net present value reflects the present value of future cash flows minus the initial outlay, which in this case is the price of Mesabi stock (i.e., closing price on December 26, 2012 of $24.17). Using a closing price of $24.17, the NPV upside for investors at this price level is $2.98, not bad, considering you're collecting a 9.47% yield for over 50 years!
The Mesabi Trust has been around for over 50 years, and with sizable reserves and a world that's hungry for iron ore, the trust is likely to be around for another 50 more. This article aimed to give the reader a historical perspective on how the Mesabi Trust came to be, and how it currently operates and provides distributions to unit holders. Based on historical data going back to January 2000, the trust looks undervalued based on both a yield spread analysis and a net present value analysis. Lastly, it is the author's hope that this article provided a new and interesting perspective on an often misunderstood security.
I encourage readers to leave questions and comments below.