Terra Nova Dives on Lack of Clarity: Time to Buy?

 |  Includes: CLF, MFCB
by: George Fisher
Terra Nova Royalty (TTT - $10.38) announced first quarter 2010 results yesterday. Many shareholders were looking for management to provide better clarity concerning its restructuring, but instead were given more questions than answers. While most shareholders realize Mr. Michael Smith, CEO, is a bit secretive about such matters, investors were not impressed and share prices sold off hard by 14% on almost four times average trading volume.

Terra Nova is an iron ore royalty income company that has been recently separated from its larger sister, KHD Humboldt Wedag International AG, also known as KID (OTCPK:KHDHF). As with many of Mr. Smith’s dealings, this one is a bit complex.

Terra Nova indirectly owns a royalty income stream from the Wabash ore mine in Labrador Canada, operated by Cliffs Natural Resources (NYSE:CLF). KID provides OEM equipment and services to cement manufacturers in developing countries, mainly India, Russia and China. Terra Nova is a Canadian company whose stock trades as an ADR, while KID is a German company and trades on the Frankfurt exchange. Prior to the disconnection on March 30, the company traded as a single entity as KHD. More information on KHD can be found on my instablog dated February 26.

A few of the important issues either newly raised or left unresolved:

Lack of Detail on TTT Operating Performance

Due to the separation taking place 1 day before the end of the 1st quarter, financial numbers were presented as a combined TTT and KID for the detailed profit and loss statement while TTT alone is presented in the balance sheet. The combined P&L shows revenues of $101 million for the qtr and an operating loss of $0.61 per share. Revenues attributed to TTT were $3.8 million with an operating loss of $0.01. Management stated that Terra Nova’s allocated portion of SG&A was high due to expenses related to the separation, but no details were provided to give clarity on TTT’s cost structure going forward. However, management did promise to provide detailed cost breakdowns in the future.

The major expense categories of a royalty company should be management fees, non-cash adjustments, and taxes, but these were not provided. It is still extremely difficult to develop a proforma income statement and dividend statements without an adequate understanding of these factors.

TTT management projects CLF will mine 4 to 5 million tons of ore in 2010. If CLF mines 5 mil tons and based on 2 different pricing models, royalty revenues could be between $25 and $37 million for the year. Market pricing and volume are the major factors in determining royalty payments. Global prices have been rebounding with the current pricing almost equally to the boom year of 2007. However, the current market price strength may not last throughout the year.

Balance Sheet Still Strong

As of March 31, TTT had cash and securities balance of $108 million, or about $3.56 per share, with no long-term liabilities. Management has stated the cash will be invested in similar iron ore income-generating projects. Book value per share, based on March 31 financials, is $5.42.

Royalty Book Value Rework

Terra Nova currently values the royalty income stream at $27 million. With mine operating partnership changes and a reassessment of ore reserves in 2009, TTT believes the value of the royalty income stream is closer to $200 million. Management plans on stepping up the value on its balance sheet to fully reflect this increase and will add $4.00 to TTT’s book value. After the rework, book value will be $9.42 a share.

KID Spin-Off

As initially developed, the separation plan for TTT and KID involved the distribution by TTT to its shareholders of the 98% of the outstanding KID shares it owned. The first distribution was made in March and consisted of 1 share of KID for every 7 shares of TTT. Additional distribution of shares (1 for 4) will be made in June and again in (1 for 4) in August. TTT will retain a 19% interest in KID for the foreseeable future. With 30 million shares outstanding and a current share price at $6.50, KID has a market cap of $195 million. TTT’s holdings per share of KID stock should be worth $1.63 for the June distribution, $1.63 for the August distribution, and $1.22 for the retained 19% interest, for a total of $4.48.

The distribution of KID shares will be subject to a Canadian 15% dividend withholding tax, and can be taken as a credit against US income taxes as “Foreign Taxes Paid”. However, management has not made a determination as to the tax consequences to US shareholders of KID share distributions.

Rights and Dilution

Management announced a rights offering next month for current shareholders to purchase additional shares at a to-be-determined discount. TTT plans on increasing share count by 24%, diluting future per share operating performance. At today’s price, the rights offering would generate about $72 million. The additional capital will be added to the current cash for further investments.

End Result

Book value calculations for TTT before the June distribution of KID shares and after the rework of the royalty interest would be $13.90, ($9.42 for TTT and $4.48 for KID). However, offsetting this is a lack of clarity concerning TTT’s future royalty performance for earnings and dividends, along with share dilution and tax issues. TTT will have about $170 million to invest in new projects, but none have been identified, albeit a bit early in the game. Future performance of this capital will depend on the ability of management to realize superior returns.

The lack of clarity and uncertainty offset TTT’s book value and investors sold.

TTT currently trades at a 25% discount to its book value and could be considered a bargain. However, it will take at least another quarter before investors have access to detail financials that will alleviate some of the uncertainty. Further share price weakness could provide a very intriguing long term investment for both future cash dividend returns on today’s invested capital and potential capital gains.

Due diligence is very important in this stock as there is not a lot of information available. TTT has no following on Wall Street. As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.

Disclosure: Author has held a long position in TTT since 2008 and in OTCPK:KHDHF since 2010