In searching for ways to play the potential hard landing in the Chinese economy - I recently came across the shares of Great Northern Iron Ore (NYSE:GNI) - a Royalty Trust which leases 67,000 acres used for the mining of taconite and natural iron ore out of its fields in Minnesota.
The ore that GNI sells is used primarily by steel makers who will be one of the largest impacted sectors if we do see a slowdown in Global Demand - especially from China and Brazil - and the sector has already showed acute signs of slowing. In the chart below - you can see that GNI has outperformed the steel sector by almost 50% when you factor in the $9.25 of dividends paid out over this time period - so if one assumes that the performance of steel stocks is a leading indicator of future dividends - it is highly likely that future payouts will decrease dramatically from the recent $4 dividend.
More importantly - the trust will dissolve in April 2015, at which time, the estimated value (per the company) is only $8, so in determining the current value of the stock - one must take the Present Value of the remaining dividend stream and terminal value to approximate the current share price.
In looking at the dividends, the payout is solely based on the price and quantity of iron ore pellets shipped and can be an extremely volatile number. Weather conditions and macroeconomic supply/demand are the driving factors, with the approaching winter months typically a low-point for dividends as shipping channels freeze up and work stoppages are common. If weather conditions in Minnesota are extreme and shipping channels freeze this winter - we are likely to see the company announce a dividend of $2 or less, which would have a material negative impact on the shares.
Examination of the graph below shows quarterly dividends averaging around $2 per share, albeit the company had an unusually high dividend of $4 last quarter, which seems unlikely to replicate over the long term, especially if one assumes the performance of steel stocks to be a lead indicator.
If we liberally assume a dividend stream of $3 going forward, with 13 payments left, the present value of such a dividend stream at a 5% IRR is $33. Add in the present value of the terminal value ($6) and you have a current value of $39 per share.
With the stock presently trading at $105, that is a GUARANTEED RETURN of 62% over the next 3 years no matter what the overall market does, the return could be even greater if we get a global slowdown or company specific execution problems cause the dividend stream to drop off.
So how can a stock like this trade at $105?
a) Income investors looking for high dividend yielding stocks will see GNI near the top of many dividend screens - and MISTAKENLY assume the dividend is in perpetuity.
b) Most sites extrapolate the latest quarterly dividend of $4 and annualize it - showing a yield of almost 16% - which is completely erroneous. Future payouts are likely to be closer to $2, and if/when we get a dividend announcement closer to this number, the same investors thinking they are holding a 16% yielding stock will likely panic out of the name and cause the shares to trade closer to fair value.
c) Given the cost of shorting a high dividend stock- many professional investors have chosen to ignore the name - but at an annualized return of over 20%, the risk/reward seems too good to ignore.
In summary - GREAT Northern is a "GREAT" short, with a defined catalyst, a defined end date and most importantly - it is a stock that you can feel ultra-safe shorting even if the stock temporarily moves higher and further away from its ultimate and declining value of $39 or LESS, with a good chance for a dramatic price drop this winter, when I estimate a dividend announcement closer to its $2 per share average.
Disclosure: I am short GNI.