Terra Nova Royalty Corp. (TTT) has become a very diverse business after its amalgamation (last year, 2010) with Mass Financial Corp. One of its main assets (currently accounting for about 21% of its total assets) is a royalty interest in an iron ore mine, the Scully Mine in Wabush, Canada, located in the northern province of Newfoundland and Labrador.
The mine is currently operated by Cliffs Natural Resources (CLF), which will release its financial results for the quarter (and year) this week (February 16) and may provide information regarding the mine production in the fourth quarter of 2010.
Terra Nova has owned the royalty in the mine in various forms since the 1980s, after Michael Smith (the president and CEO of TTT) and his business partners acquired the royalty stream by gaining control of Nalcap holdings. The purpose of this article is to give historical data on the mine and royalty income and its current value to Terra Nova.
A colourful history
Canadian Javelin stock certificate
The story of the Wabush mine begins in the 1950s after entrepreneur John C. Doyle heard of the iron-ore rich lands around the Wabush Lake in Newfoundland and Labrador. Doyle managed to obtain control over the Newfoundland and Labrador Corporation (Nalco) via his company Canadian Javelin. Doyle spent $15m surveying and drilling the area around Wabush lake, commissioned engineers to improve the process of ore benefication and forged the Wabush Mines consortium of international mining and steel companies that operated the mine for the subsequent decades. The Scully mine began operations in 1965. He also built the railway connecting Wabush to the Québec North Shore and the Labrador Railway to transport the ore. By the mid-1960s, Labrador was established as one of the world's largest and most important iron ore producing regions, and continues to export large amounts of iron ore today.
John C. Doyle was a controversial figure. Canadian Javelin stock was suspended from trading more than it was trading, and Doyle spent a lot of time in various courts – investigated for tax evasion, theft, conspiracy, fraud etc. Doyle fled to Panama in the 1970s and conducted the “Javelin International” (Nalcap) business from there. He passed away in 2000. A good summary of his story can be found on the Newfoundland and Labrador heritage website.
The story of Mr. Smith & Mr. Lee acquiring control over Javelin/Nalcap and thus the royalty interest is also quite an adventure, as Mr. Smith and his partners bought up Nalcap shares and then negotiated with the fugitive Doyle to buy his shares that were frozen by the Canadian courts. Some other names tossed their hats in the ring trying to obtain the ownership of the royalty interest, but Smith and his partners prevailed. A summary of the early days of what later became the current companies Mercer International (MERC) and Terra Nova Royalty (TTT) can be found at fundinguniverse.com.
The name game
The company or companies holding the royalty of the Scully mine have changed many times, although the owners (or people involved) did not. In 1992 Asiamerica Equities (the company through which Smith and Lee bought Nalcap) became Mercer International. In March 1996, the royalty interest and other non-paper assets of Mercer were spun-off under the name Arbatax International (the name Nalcap Holdings died in July 1995). Michael Smith became president of Arbatax. The company soon changed its name (in June 1996) to MFC Bancorp. The royalty revenues were profitably reinvested by Mr. Smith in various business opportunities and the company thrived in the subsequent years, growing its book value (pdf) per share from $6.41 in 1996 to $17.91 in 2005 (12% annually). The name MFC Bancorp survived until October 2005 when the company became KHD Humboldt Wedag International, taking over the name of one very successful investment by the company. After spinning off the KHD cement plant operations to shareholders in 2010 (they are now listed under the (KHDHF.PK) ticker in the US), the name again changed, this time to Terra Nova Royalty corporation. The royalty was emphasized as it was the only productive asset remaining with the company after KHD had spun-off the “financial” operations (commodities trading, proprietary investments etc) under the name “Mass Financial corp” in January 2006. However, Mass Financial was reintegrated in the same year, merging with Terra Nova.
The main milestones of the last two decades are summarized in the following picture (events involving the Wabush royalty are highlighted).
Royalty and Mine data
The mine royalty owned by Terra Nova has a lifetime that ends in 2055 (the mine having started its operations in 1965). The current reserves stated by Cliffs (CLF) amount to 72.3m tons of ore as of December 2009. Historically, about 5m tons of ore have been mined annually from the Scully mine (with a decreasing trend over the past decade, see below). Assuming 5m tons of production and CLF’s reserve estimate, the mine would be depleted by the end of 2023, in about 13 years.
From Terra Nova’s (and its predecessor companies’) SEC filings, it is possible to retrieve the data on the production, gross and net royalty revenue from the mine going back to 1993. The following picture shows the yearly shipments of iron ore from Wabush from 1993 to Q3-2010.
Average production was 4.82m tons over the last 17 years, with a clearly declining trend over the last decade, starting in 2001. The 4.82m ton yearly production average gives a 1.21m tons/quarter average. Since trading under the Terra Nova name, the company has also been providing quarterly shipment data going back to 2004. The data is plotted in the following picture.
The 5-year average over the last quarters is 1.04m tons/quarter, below the longer-term average. The averages are also shown in the graph above.
Because of the large increase of iron ore prices, the royalties received have paradoxically increased although the total shipment volume has been decreasing. The following graph shows the gross royalty received as well as the royalty per ton. The royalty per ton started to rise in 2003, and the numbers for 2010 will probably match or come close to the record amounts received in 2008. The gross royalty revenue, however, will be lower because of lower production at the mine. Not included in the graph is the $11.2m settlement the company received in 2010 for under-payment of royalties in preceding years.
The next graph shows the net royalty (after royalty taxes) received by Terra Nova and its predecessor companies in the years 1993-2010.
The graph impressively demonstrates the steady income stream that TTT has derived from the mine, and the large increase in income realized over the past few years despite much lower shipments.
A few years ago, the outlook for the Wabush mine was rather grim. There was even talk of the mine closing down. With Cliffs assuming sole ownership of the mine operation and committing substantial capital for upgrades to the mining equipment and facilities, the future looks much brighter now (see “future so bright” article, The Aurora, 2010). Cliffs will invest $35m to improve the output and the reliability of the mine. Cliffs is also working on a Manganese reduction project, which would extend the mine life by another 10 years approximately. The investment required would be on the order of $30m and one of the eight Manganese reduction lines is currently being tested. Production is forecast to reach 4.5m tons again in 2011 and the goal is to be back at 5.5m tons in 2012 – production levels that were last achieved in the late 1990s. I very much look forward to the Cliffs report later this week to hear about any updates.
The valuation of the royalty interest hinges on a few key variables:
- The production of the mine
- The royalty rate (dependent on iron ore price, but also on the outcome of negotiations with the mine operator about amendments to the royalty rate)
- The remaining life of the mine (depends on iron ore prices [profitability], as well as on investments by the operator [manganese reduction lines] and reserves and depletion)
For a rough valuation, I will use three scenarios for the net royalty income:
- base case: net royalty comes back to the long-term average of about $10m per year
- optimistic case: iron ore prices stay high and net royalty income averages about $20m per year
- extremely bullish case: iron ore prices rise even further and net royalty income reaches $30m per year.
For each scenario, I will use mine lives of 12 years (current estimate), 22 years (assuming 10-year extension from manganese reduction lines) and 32 years (closer to the maximum remaining duration of the royalty, which ends 2055). Each scenario will be discounted at 7.5%, 10% and 12.5% to obtain a value estimate. The discounting was made using the geometric sum (see formula), with D being the discount rate and T the remaining life of the mine in years:
Please bear in mind that this is not an exact science, but merely a method for obtaining estimates of what the asset might be worth under various scenarios. The price of commodities is subject to fluctuations, which might not average out over time. The cash flow from the royalty has been quite stable over the decades, but this might change dramatically (both to the upside as well as to the downside) if iron ore becomes a commodity that is traded on financial exchanges.
The valuations obtained range from around $70m under the most conservative scenario to up to $390 under the most aggressive valuation. At the current valuation of about $187m, the company is already pricing in a fairly optimistic scenario (TTT used a discount rate of 8%).
Every investor will have to come to his or her own opinion about the value that should be given to the royalty asset. I just hope I could clear the picture a little bit with the overview and calculations. Most investors will probably agree that the largest potential value lies not in the royalty itself – but in how the income from this asset will be deployed. Mr. Smith has shown over the past decades that he can do that quite well – let’s hope he delivers as well as he did in the past.
Disclosure: I am long TTT.
Additional disclosure: long KHD Humboldt Wedag International AG.