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Mesabi Trust, A Good Protection Against The Coming Inflation

|About: Mesabi Trust (MSB)

From Autumn 2018:

Mesabi Trust (MSB) is a royalty trust that distributes its profits to unit holders from an iron ore mine. Northshore Mining Company, a subsidiary of Cleveland-Cliffs (CLF), mines the ore and processes it into pellets which are then used by steel producers. Cleveland-Cliffs is the largest producer of iron ore pellets in North America. Northshore pays royalties to Mesabi based on the amount of ore extracted at the mine and the pellets’ selling price. The Trust agreement will last until 21 years after the death of the last of 25 individuals named in the Trust. All individuals are alive so the Trust will continue in its current form for at least two or three decades to come.

Trust Versus Master Limited Partnership

Mesabi Trust is a pass-through entity. This means that its profits, unlike a corporation, are not taxed. The unit holders are responsible for paying Federal taxes on the distributions they receive from Mesabi. A trust cannot engage in any other activity besides collecting and distributing revenues after its expenses. The structure is similar to a master limited partnership (MLP). Both investments typically distribute most of their profits directly to their shareholders and focus on natural resources. They are also exempt from paying federal taxes. Many MLPs are oil and gas producing companies that aimed to grow through acquisitions. Yield hungry investors invested in MLPs after the 2008 downturn. Unfortunately, with the decline in energy prices many MLPs declared bankruptcy. Many used debts to finance their acquisitions and when energy prices dropped they could not service their debt. Their legal structure forced them to distribute at least 90% of their profits when times were good. This left them little cushion for bad times. Once profits declined they not only had to halt their distributions to shareholders, but could not even keep current on their debt payments.

Corporations like Exxon (XOM) and Chevron (CVX) can more easily weather the fluctuations in energy prices since they retain some of their earnings. There was a catch to MLPs high dividend yields in 2011 that many investors chose to ignore. Many risk averse investors invested in MLPs without appreciating the risks they were undertaking. Two examples of MLPs that failed recently are Linn Energy and EV Energy. Both companies declared bankruptcy after the fall of energy prices in 2014. Eventually the companies had to be restructured and the debt holders became the majority holders and the unit holders were almost 100% wiped out. Linn Energy today has split into two corporations, Riviera Resources (OTCQX:RVRA) and Linn Energy (LNGG). Linn Energy will soon form into a new company, Roan Resources. EV Energy emerged from bankruptcy recently as Harvest Oil & Gas (OTCQX:HRST), a corporation. To add insult to injury to MLP unit holders, many can actually end up owing taxes to the government after bankruptcy due to debt write offs. This is known as cancellation of debt income (CODI). While stock holders in corporations are only at risk of losing 100% of their investment, MLP unit holders’ liability may exceed 100% of their original investment due to Federal tax laws.

Royalty Trusts have similar tax advantages as MLPs but are not in growth mode. Trusts’ primary purpose are to distribute all their assets efficiently to unit holders. They have a finite life and are not loaded with debt. They may not appear as attractive to many investors because they lack growth. The taxes that trust unit holders pay are complex since part of the income is considered a return of principal. This is akin to buying a twenty-unit apartment building. Every year you sell one of the units and collect rent from the rest. The income from the building is partially from the sale of the unit and partly from the rent. After twenty years you will get no income since all the units are sold. In the case of Mesabi, we know we are at least 21 years away from depleting all the trust’s earning potential since the mine has ample ore to keep it going for decades and the agreement is in effect 21 years after the last surviving individual dies. While Mesabi has no growth opportunities, it also has none of the risks that drove many MLPs to bankruptcy.

Mesabi Trust Fundamentals

As discussed above Mesabi is a very simple entity. It collects revenues from its mine, pays expenses and distributes the remainder to its shareholders. The two primary determinants of the distributions are the amount of ore the mine operator extracts and the price of the iron ore pellets. Below is a table of Mesabi’s key numbers going back to the year 1999.

Units

Revenues

Net Income

Income per unit

Income as a % of Revenues

Stock price on 4/1

PE

2018

13,120,010

34,567,557

33,495,567

2.55

97%

25.75

10.1

2017

13,120,010

10,736,534

9,613,112

0.73

90%

15.00

20.5

2016

13,120,010

9,721,508

8,558,841

0.65

88%

5.99

9.2

2015

13,120,010

26,080,115

24,767,848

1.89

95%

13.33

7.1

2014

13,120,010

22,045,153

21,056,289

1.60

96%

21.06

13.1

2013

13,120,010

31,562,945

30,654,737

2.34

97%

22.76

9.7

2012

13,120,010

34,158,326

33,237,332

2.53

97%

30.64

12.1

2011

13,120,010

33,341,871

32,463,194

2.47

97%

41.14

16.6

2010

13,120,010

13,241,669

12,423,662

0.95

94%

24.46

25.8

2009

13,120,010

35,469,105

34,669,785

2.64

98%

7.41

2.8

2008

13,120,010

18,866,511

18,232,360

1.39

97%

25.41

18.3

2007

13,120,010

17,902,988

17,146,666

1.31

96%

23.50

18.0

2006

13,120,010

21,579,833

20,734,877

1.58

96%

22.96

14.5

2005

13,120,010

13,575,548

13,017,587

0.99

96%

15.00

15.1

2004

13,120,010

7,270,517

6,771,340

0.52

93%

9.10

17.6

2003

13,120,010

5,100,759

4,694,531

0.36

92%

4.49

12.5

2002

13,120,010

3,984,721

3,644,406

0.28

91%

3.45

12.4

2001

13,120,010

5,753,650

5,346,145

0.41

93%

3.00

7.4

2000

13,120,010

5,359,893

4,970,428

0.38

93%

2.88

7.6

1999

13,120,011

5,988,143

5,634,757

0.43

94%

3.00

7.0

Avg

13,120,010

17,815,367

17,056,673

1.30

96%

16.02

12.9

Key observations from the data:

- Units are constant as expected. No dilution has happened and is unlikely to happen.

- Revenues and Income move together as expected. They also are not correlated with the economy’s cycles. For example, in the 2008/2009 downturn, they were above average. They plummeted in 2016 with the fall in commodity prices.

- Revenues and Income are volatile.

- Income as a percent of collected revenues is fairly consistent and has never dipped below 88%.

Mesabi Trust, a Good Protection Against the Coming Inflation

Based on historical prices and metrics, Mesabi Trust is not particularly cheap nor is it expensive as you can see in the table above. However, if you believe that inflation is coming, Mesabi offers a great protection. As Warren Buffett stated:

“In an inflationary world, a toll bridge would be a great thing to own because you’ve laid out the capital costs. You built it in old dollars, and you don’t have to keep replacing it.”

Mesabi’s costs will not increase significantly in an inflationary environment since on average over 90% of revenues turn into income. However, commodity prices will rise with inflation. Like a “toll bridge”, revenues will rise while costs stay about the same.

The signs of rising inflation are becoming more prominent. To be sure predicting macroeconomic factors like inflation is a fool’s errand. Investors still need to make decisions based on the available information and the odds of inflation are rising due to several reasons. First, years of loose monetary policy by the Fed and other central banks have dramatically increased the money supply. Furthermore, short sighted US fiscal policy often motivated by political rather than long-term goals have sown the seeds for a dramatic increase in prices. The US Federal deficit as depicted below is close to a trillion dollars despite record low unemployment rate and a vibrant economy. Deficits are supposed to fall or even turn into a surplus during times of prosperity as they did in the late 90’s. How will the government service its debt when times really get bad? The two choices are increasing taxes or printing money to pay off debt obligations. The US government will not default on its debt obligations. Raising taxes in a downturn is unacceptable and will only lead to prolonging the downturn as it did in Greece. Fortunately, the US is in control of its own money supply, unlike Greece or other countries in Euro Zone. It will likely continue issuing more debt which will lead to high inflation.

The second reason to believe upcoming inflation is rising wages not just in the US but in China, the world’s biggest labor market. Inflation has supposedly been under 2% according to the Fed. In the past I have argued that the government’s methodology for calculating inflation may underestimate the true rate of inflation. For example, wages may have not been rising but increasingly healthcare costs imbedded in employment contracts have risen far above inflation rates. Today nearly 20% of the US GDP is spent on healthcare. Looking at wages alone without considering healthcare costs does not accurately reflect labor costs.

The third reason for inflation is increasingly the rejection of globalization. The US imposed tariffs and Brexit are two examples of this trend. For the past several decades globalization has put a downward pressure on prices. Hundreds of millions of Chinese were able to enter the labor market allowing them to escape poverty, a great feat for humanity. This trend is now ending. Some companies hope that other countries can replace Chinese low-cost labor. For example, some auto manufacturers are betting on Africa. However, no other region can replace what the Chinese labor force did in the past three decades.

Conclusion

In this frothy asset environment, there are few bargains left. Investors are reluctant to hold cash due to low interest rates. Cash is not merely a defensive option but provides a way to take advantage of declining asset prices that will inevitably occur in the next recession. Despite increasing risks, many investors have continued to buy stocks. Bonds are also extremely overvalued and will suffer a fall with rising interest rates.

Mesabi Trust is currently trading at around $27 and is not cheap by historical standards. However, with rising inflation Mesabi’s prospects are much better than many other alternatives. In an inflationary environment Mesabi’s costs will hardly increase while its revenues will likely rise due to rising commodity prices like iron ore. When investors finally realize that inflation is a major threat, “toll bridges” like Mesabi will outperform many other investments whose businesses will be impacted with rising prices.