Great Northern Iron Ore: Clearly Overvalued; Dividend Stream Will Soon Run Dry

| About: Great Northern (GNI)
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With its 12% dividend yield, Great Northern Iron Ore (NYSE: GNI) frequently shows up in lists of high-income stocks. Yet the company is clearly overvalued, and its dividend stream will soon run dry. Here's why.

As disclosed on the company website, GNI is a trust that is scheduled to terminate on April 6, 2015. That means that GNI will only pay 13 quarterly dividends before it liquidates - 4 dividends in each of 2012, 2013, and 2014, and one final dividend in 2015. After the final dividend, GNI will make a liquidation payment currently valued on the company website at $8.59 per share.

How large are future dividends likely to be? Well, in 2011 GNI paid out $15 in dividends, which was a record. If GNI repeats that performance for the next 3¼ years, then the total of future payments will be something like $57.34 (3¼ X $15 + $8.59). If GNI grows its annual dividends at 11% (which has been the average growth rate since 2007), then future dividends will be $16.65 in 2012, $18.48 in 2013, $20.51 in 2014, and $5.26 in the first quarter of 2015. Including the $8.59 liquidation payment, this implies that total future payments will be $69.50. If you apply even a 3% discount rate, you get a share price of $66.

So why is GNI currently selling for $124 a share? I suspect that GNI's shares are simply misunderstood - bought by people and computers who take the dividend yield at face value and don't understand that the company is nearing termination.

For the sake of argument, though, let's try to make a bullish case.

Since GNI will terminate in April 2015, to pay more than $70 you have to believe that dividends will increase rapidly, and soon. But the company isn't saying that. To the contrary, in its most recent quarterly dividend announcement GNI stated, "we anticipate that 2012 will be another good year for the Trust, though it is not expected to reach the historical record earnings achieved in 2011." That suggests that next year's earnings are going down, not up. And since GNI has a payout ratio of 98%, dividends must decline with earnings.

Maybe the company is being coy, or just wrong, and in fact dividends will rise. After all, iron ore prices have risen rapidly over the past few years. To make that case, you have to believe that you can forecast future commodity prices by extrapolating recent trends, and that's notoriously difficult to do. If you do believe in reading trends, you have to be concerned that the recent trend is not upward. Although iron ore prices are well up from their recession lows, the trend since 2010 is basically sideways; prices today are the same as they were two years ago.

GNI's dividends aren't even that sensitive to iron ore prices. GNI does not make money by selling iron ore on the spot market. Instead, as disclosed in the company's annual report, GNI leases mineral rights to other companies, and collects royalties in return. GNI's royalty stream is much more stable than the spot price of iron ore-so when ore prices rise, GNI's royalties don't rise as far. For example, in 2010 iron ore prices were four times higher than they were in 2007, yet GNI's 2010 dividends ($12.25) were only 24% higher than they were in 2007 ($9.90).

Maybe bulls take heart in the fact that GNI's last quarterly dividend of 2012 was $5.75, a record. But it's unlikely that GNI can sustain that dividend year-round. GNI's dividend history shows a seasonal pattern; in every year since 2005 the year-end dividend has been the highest, and the first dividend of the next year has been 20-60% lower.

At current prices, the bull case for GNI is difficult to make. It's hard to escape the conclusion that GNI is selling for almost twice what it's worth.

Disclosure: I am short GNI.