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Since my last article on Mesabi Trust (MSB), the stock has slipped by 20%. The slide tells us something about the expectations for the stock and probably iron ore prices too. In my last article, I used a table to illustrate the fair value of MSB under hypothetical discount rates and iron ore prices. At the time, I believed $75 per ton was reasonable, and a fair discount rate was 7% while the market thought the stock was worth $30, likely implying a higher normalized iron ore price. Since then, expectations have sunk as illustrated in the sensitivity table from my last article shown below.
Source: author’s own estimates.
It looks like there is reason to trim expectations of iron ore prices in the near term after a spectacular 27% slide in spot prices in August. Though futures already pointed towards declining prices for the years ahead, this is a setback that adds to another disappointment in its Q2 earnings report. In the first half of the fiscal year, the iron ore production and shipping volumes from Mesabi Trust lands have dropped substantially as you can see in the table below. This in turn affected the royalty payments heavily because royalties as a percentage of revenue rise with the increase of volume.
Source: 10-Q, red square added by author for emphasis.
Per Mesabi’s own reading, the decline is due to anticipated weak demand. This is interesting given the bullish narrative surrounding Cleveland Cliffs' (CLF) new HBI plant that is to come online in early 2020. It is because of the lower production coupled with the weakening pricing outlook that the boom I spoke of didn’t come, while the bust showed itself early.
Another issue is the narrowing spread between the global market and the Minnesota market for iron ore pellets. In my previous article, I used the chart below to show this. Since, I have added 2020e that shows how I estimate the premium to contract. From CLF’s data, it looks like the prices are converging, as CLF realized the same price per ton ($112.6) in Q2 this year as it did in Q2 last year.
Note that years on the x-axis refer to MSB fiscal years e.g. 2019 is from Feb 2018 to Jan 2019. Prices are USD per ton. Source: author’s own calculations; 2020e are author’s estimates.
The bonus royalties that MSB booked were also disappointing and confirm this pattern.
The YoY drop in production at Cleveland Cliffs was in anticipation of slowed client demand, not because of actual sales being down because they were up. Inventories explained the difference as these were down YoY.
Analysts are still divided over where the iron ore price will go. Some forecast a rebound to $115, citing fundamental supply/demand imbalances in this market, others say a weakening Chinese housing construction market could send prices as low as $50. For my estimates, I stick to futures and these haven’t changed materially since my last article. That Cleveland Cliffs scaled back production is nevertheless a disappointment that will hit Mesabi’s results. To account for this, I have adjusted my volume estimate for this year down by 10%.
As I set out in my previous article on MSB, an optimistic long run price level would be $75 per ton. It is unrealistic to assume that North American pellet producers can enjoy sizeable premiums over productions costs forever as this is a commodity business. Even in a scenario where import restrictions remain in place, domestic supply and demand will balance towards a reasonable price to cover the cost of capital.
Volume upside comes from the new HBI plant which will use production from Mesabi’s mine located in Babbitt, Minesota. This was once again clarified by CLF management in its Q2 earnings call.
And as far as quality, one thing that we're going to have, we're going to have HBI being produced from iron ore -- from one mine that's the Babbit mine, and the one pellet that’s the Northshore plant.
Lourenco Goncalves – CEO Cleveland Cliffs
The current production capacity for DRI pellets (those that can be used to feed the HBI plant) is 3.5m tons, of which 2.7m to 2.8m will be used for the HBI plant, while the remainder is expected to find its way to third parties.
However nice this may be, CLF hasn’t signalled it plans to increase production capacity at the Northshore mine, it only upgraded the facility so it can produce DR iron pellets along with blast furnace pellets. The upside for MSB is probably a more stable off-taker for the ore of its mine. To be clear, CLF owns the mine but leases mineral rights from MSB.
Because the annual production nameplate capacity of the mine remains 6 million tons, we should not count on major gains from the production level of calendar 2018 and 2019, which were described as full capacity production by CLF. A production level of 4.5 million tons is what I see as a cautiously optimistic normalized level, which is roughly ~10% below what the company calls full production. Also, the 4.5m tons level fits well with an average expected price of $75/ton as there will be years with low prices and low demand (like 2016), as well as years with high pricing and volumes.
Interest income is excluded from net income. Volume (tons) is in thousands. Source: author’s own estimates using MSB fiscal years. Annual average iron ore spot prices are sourced from Index Mundi, futures quotes are from CME group.
As in my last article, I argued that MSB was structurally undervalued in the past, as the average dividend yield was 8.9%, quite high for a stock with such a low bankruptcy risk and zero leverage, even considering its cyclicality. I still think that a discount rate of 7% is fair, but the market is probably closer to 8%. My fair value calculation is shown below.
Source: author’s own calculations. Net cash consists primarily of government securities not allocated for dividend distributions.
As you can see in the table above, I maintain that the normalized dividend should be the only input along with net cash. We are at a high point in the cycle, which affects the psychology of us all. However, there will also be swings down and my discount rate is maybe on the bullish side as well. The table below shows how a different price per ton in my ‘normalized’ calculation would affect the fair value estimate of MSB.
Source: author’s own estimates.
Depending on the discount rate used, it looks like a value of $24 to $27¼ per unit is about right. This puts the optimistic upside at 11%, but it doesn’t leave a wide margin of safety.
In my opinion, Mesabi Trust has been structurally undervalued in the past but it will see a strong net profit in this fiscal year, albeit a lower one than last year. An investor with a long term horizon and optimistic view on iron ore markets may take a position in MSB to profit from the high dividend payments and added stability from the HBI plant. At this point in time, however, it looks like there is not too much upside as valuation caught up while long-term prospects are still moderate. It is probably better to await slower times and a sub-$20 share price and then consider to strike.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.