Baffinland Iron Mines BIM W
May 30, 2007 - 4:27pm EST by
2007 2008
Price: 2.70 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 240 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Baffinland Iron Mines is sitting on mines that should pump out over US$16 BILLION in pre-tax cash flow over 25 years. Never mind the mining should last close to 100 years due to its incredible size. Insiders have bought over C$5 million in stock in the last 18 months (over C$11.2 million in the last 3 years). Mitsubishi has also made a strategic investment in the project. Despite the potential and the heavy insider ownership, Baffinland still only has a C$240 million market cap. This should change over the next six to nine months due to a likely new strategic investor and the definitive feasibility study. The stock could easily double or triple from its current level.

Iron Ore is used in steel
Iron ore is the raw material used to make “pig iron,” which is the main ingredient in steel. There are three types of iron ore: lump, fines and pellets. Paradoxically, fines are actually the lower quality iron ore and must be “sintered” or fused together. Fines can also be processed into pellets which are then used to make steel. Both fines and pellets require extensive processing. Lump can be the better quality iron ore because little processing is needed and it is suitable as a direct feed to making steel. Lump iron ore typically receives a premium to fine iron ore. Currently that premium is about 27%-30%.
Most of today’s mines generally produce a small percentage if any of their output as lump. In fact, the largest iron ore mine in the world, the CVRD mine Carajas, only produces 5% lump and its lump percentage is declining.  (Baffinland’s iron ore deposits are anomalous at 75% lump and 25% fine.)
Cartel Pricing for Iron Ore and Steel Companies Are Getting Squeezed
It is important to note that sea-borne iron ore (iron ore that is not domestically produced and consumed in any one country) is essentially controlled by a cartel of three companies: BHP Billiton, Rio Tinto and CVRD. They control about 75% of the sea-borne iron ore. Every year steel companies negotiate iron ore prices for the following year with these three companies.
And lately due to the demand for steel and thus iron ore, prices have been jumping. In 2005, iron ore prices went up 71.5%. In 2006, prices increased 19% and in 2007 prices increased 9.5%. Iron prices have tripled since 2002 and early predictions are that prices could increase another 10% in 2008.
It’s not hard to understand that steel companies are not enjoying those price increases exacted by the “Big 3” iron ore producers. Chinese steel companies have been trying to get more involved in the price negotiations as the Chinese steel industry explodes in volumes.
China may have some longer term issues beyond the pricing of iron ore. China reported in May their “official” iron ore reserves of 59.4 billion tons. However, most of those reserves are low-grade of 30-35% iron. These reserves are even less impressive when you realize that only 50% of these reserves have been commercially prospected.
Despite these impressive sounding reserve figures, there are rumors in the marketplace that China is mining iron ore grades as low as 8-9% iron. By mining ore at such a low grade, China literally may be running out of domestically produced iron ore. The amount of labor and work involved in trying to get iron ore out for that type of grade is quite high. If China has problems with its domestic iron ore production look out for iron ore prices, they will explode higher.
Luo Bingsheng, deputy chief of the China Iron and Steel Association, has been quoted as saying that Chinese steel companies should buy or jointly develop overseas iron ore mines.  He also said “that in order to guarantee stable supply in the medium and long term China needed to control at least a third of world iron ore resources.” I wonder how many investors have considered this comment.
Further, India recently boosted its export tax on iron ore with a 62% grade or better, as they are trying to keep as much high quality iron ore in the country as possible.
These countries are not the only ones struggling with iron ore prices. The largest steel company in the world, Arcelor Mittal, is starting to struggle with those prices. Arcelor Mittal has been largely protected by its ownership of several iron ore mines and also due in part to supply agreements such as its 25 year preferential supply agreement with Kumba Iron Ore in South Africa that gives Arcelor Mittal 6 million tons of iron ore at cost plus 3 percent. Currently, Arcelor Mittal has 64 million tons of iron ore its 145 million tons needs covered. Its goal is to get to 75% coverage. This is why Arcelor Mittal is actively looking to invest in iron ore mines.
Suffice it to say that supply is tight, and power is increasingly in the hands of just three companies and prices are poised to stay strong and continue to rise as long as demand for steel stays strong.
Baffinland’s 100% owned world class Mary River Deposits
Baffinland sits on world class deposits of iron ore. Compasses don’t work at the deposit as the iron ore grades at 66% iron. Consider that the highest percentage that nature theoretically allows is 69%. The company has five deposits that cover 1,600 hectares.
Baffinland has really only drilled a portion of Deposit #1 and that is what the scoping study and its definitive feasibility study will be based upon. Current estimates of 12.6 million tons per year producing for 25 years are based upon only one of five deposits. Now you can start to visualize how big this operation is going to be.
Baffinland’s initial drilling of Deposit 2 and 3 have showed some spectacular results. For example, just in December drilling of Deposit 3 showed 65.8% iron over 170 meters. In 2004, drilling of Deposit 2 showed 63.5% iron over 107 meters. If these initial drilling results prove accurate, Baffinland could be sitting on a multi-generational iron ore mine, or production of 100 years. More on the deposits can be found here:

Investors wanting further confirmation of the quality of Bafinland’s iron ore deposits should note that BHP Billiton actually staked claims around Deposit #4 at Mary River in 2006.
Scoping Study tripled estimate and Definitive Feasibility Study due in December
Last May, Baffinland through its Scoping Study work was able to triple the resource estimate to 309 million tons iron ore at a grade of 66.1% iron and inferred resources of 28 million tons at a grade of 65.9% iron. The Scoping Study assumed that the mine would produce 10 million tons of iron ore for 34 years.
The initial scoping study produced a cash flow figure of over C$6 billion. However, Baffinland now estimates a higher yearly production number of 12.6 to 15 million tons a year and shortened the time to 25 years from 34 years. And the initial scoping study used figures that are over 43% below current iron ore prices.
The scoping study is kind of like an official “preliminary” resource estimate, and the strict official estimate is called the Definitive Feasibility Study, and that is due on December 15th of 2007. The Study will also be using the improved production estimates and this should provide much higher cash flow and a substantial increase to IRR. The release of this study should provide a concrete catalyst for Baffinland.
Mitsubishi Investment gives credibility
In December of 2005, Mitsubishi Corporation invested C$5.5 million to buy 2.75 million shares at C$2 per share. That price was over a 30% premium to Baffinland’s share price at the time. Further, Mitsubishi added more as part of a follow-on offering earlier this year.
Of interest to note is that Mitsubishi owns 26.2% of Canada’s largest iron ore producer Iron Ore Company of Canada. They also own a 49% stake of Iron Ore Company of Canada’s sales division. Further they own 50% of Compania Minera Huasco S.A. in Chile and Mitsubishi also has a significant global trading presence.
I believe that Mitsubishi’s presence as an investor in Baffinland is a significant positive and validates the potential for Baffinland. Further, their continued participation in financing Baffinland is also very positive.
The potential cash flow numbers are HUGE and the IRR is large as well
The calculations can get a bit complicated, so I will try to keep it as simple as possible. (All figures are in US dollars for the below calculations) Taking out the shipping costs and using the 2007 price of $62.50 a ton for iron ore FOB Baffin Island (not in Rotterdam where the iron ore will be shipped).
If you assume about US$12 to $14 of operating costs, you get an average of around $50 a ton in operating cash margin. At 12.6 million tons a year, that produces $630 million in cash flow and at 15 million tons, that produces $750 million in cash flow. Total cash flow over the course of the first deposit would be $15.75 billion at 12.6 million tons and $18.75 billion at 15 million tons with the second deposit.
I calculate the pre-tax IRR of the mine to be 42% to 46% depending on how much iron ore is produced a year. This is a significant boost to the 15% calculated in last year’s scoping study. This also assumes 100% equity funding the project. If debt is used, the IRRs go even higher. Further this gives absolutely zero value to the fact that there is probably another 75 years of iron ore to be mined.
High valuation numbers based upon recent transactions
Two iron ore companies were recently acquired. Vedanta acquired Sesa Gosa and Anglo American’s purchase of 49% of MMX Minas Rio provides some timely comparisons to the valuations currently being paid for iron ore producers. The EV/tonnage produced a year is $180 a ton of iron ore.
Now if I multiply 15 million tons per year times $180 a ton and I subtract the capital cost of building out the mine (US$1.6 billion, more on this later), you get a valuation of $1.1 billion, which gets you a price of C$13.60 stock price. Again this gives no value to the other deposits or the long life nature of this mine.
Compared to other junior producers trying to build new iron ore mine, Baffinland by far has the highest grades and the highest quality iron ore. The only one close is Mt Gibson Iron which has a much smaller mine that should produce 3 million tons of iron ore at 50% lump 50% fines. Finally, Baffinland also has the second lowest cost of producing iron ore. The only mine that has a lower operating cost than Baffinland is MMX’s Minas Rio, which Anglo American just bought 49% of for $1.2 billion as mentioned above.
Insider Buying
Insiders are rarely stupid with their own money. And the insider trail at Baffinland is telling. Since 2005, insiders have bought over C$11 million worth of stock and in the last eighteen months they have bought over C$5 million worth of stock. To put the insider buying in perspective, name another small cap whose insiders have over 5% of the company recently?
Both the CEO and the chairman have been consistent buyers since around C$1 a share up through C$3 a share. The most indicative pattern of insider buying I have found is when executives are buying as their stock goes up. There is only one reason an executive would do this. This is a significant positive and how I found the company in the first place.
An interesting anecdote is that Gord McCreary (a mining engineer and the CEO of Baffinland) wrote his MBA thesis in the 1977-1978 that someone could develop the Mary River deposits in the right iron ore price environment and produce an excellent return doing so. After working for other mining companies, now he’s making his thesis come true.
The Biggest Risk
The largest risk to Baffinland is the issue of raising the money needed for their large mine, which will require a very large upfront investment of around US$1.8 billion (C$2 billion). The $1.8 billion will be for the mine, rail line and port as the Mary River deposits are in a remote region of Northeastern Canada. So this begs the question: How exactly is a $240 million market cap company going to raise this amount?
First, the company has already proven it can raise equity money, as it has raised almost C$150 million in money to date, including a large flow-through raise of over C$49 million announced on May 16th. (Flow-through common shares are tax credit securities that provide tax benefits to Canadian investors and are only available for junior mining and energy companies.)
Second, the company plans to add strategic investors to help with the financing and facilitate debt financing. Baffinland already has Mitsubishi as a strategic investor and may be able to rely on them for further financing, when the company proceeds with the US$1.8 billion capital raise. Further, Baffinland plans to add additional strategic investors such as steel companies, shipping companies or even a larger mining conglomerate. The more strategic investors Baffinland can get on board the easier it will be to get financing and more importantly debt financing which will significantly raise the IRR of the project.
Third, if raising the money for this project was such a problem, would insiders blow over $11 million buying stock?
Finally, the continuing rise in the price of iron ore, demand for steel, and the tightening of the supply for iron ore in China and India will continue to make Baffinland more and more attractive to partners and financiers.
Shipping Risk
Shipping is the second big risk the company faces. The Mary River deposits are in Northeastern Canada and quite close to Greenland. There is worry about what kind of ice breaking ships will be needed to transport this and the cost involved in building rail lines, a southern port and paying for the ships themselves.
Investors should be assured by the company’s partnering with FedNav, which is the company’s new partner in planning out the shipping solution for the Mary River deposit.
“Fednav has participated in every major bulk shipping project in the Canadian Arctic and has provided innovative and practical solutions that have helped to develop shipping in the Canadian Arctic for over 50 years. Fednav currently provides bulk shipping solutions for CVRD-Inco's Voisey's Bay Nickel operations, Xstrata's Raglan Mine to the south of the Mary River Project and Teck Cominco's Red Dog mine in Alaska. While in operation, Fednav provided bulk shipping services to Breakwater's Nanisivik Mine and Teck Cominco's Polaris Mine to the north of the Mary River Project and was a major provider of ice-class tug and barge shipping services to the petrochemical companies drilling in the Beaufort Sea in the 1970s and 1980s.”
Potential Strategic Partners
The most logical strategic investor at this point would be a steel company and more specifically a European steel company, since Rotterdam is the easiest shipping destination for Baffinland.
The world’s largest steel company, Accelor Mittal, is one company that could very much use Baffinland’s low cost iron ore. As mentioned above, they have a history of locking in pricing and supply and actively investing in iron ore producers. Another potential steel partner is ThyssenKrupp AG, the German steel giant. It’s interesting to note that because of declining availability of lump iron ore from Brazil to Europe, there is a developing shortage of lump into the European steel sector. This bodes well for Baffinland.
Another example of a potential strategic investor is a shipping company, which will then contract on to ship the iron ore. Other potential investors are mining companies such as Anglo American, the world’s second largest mining group, which wants to triple its share of iron ore production.
Why the timing is so good to buy the stock now
By year’s end, BIM should have a new strategic partner and results from their definitive feasibility study. Each of those catalysts should cause the stock to move markedly higher. When Mitsubishi signed on as the first strategic investor, the stock almost doubled in a two month period. The definitive feasibility study will prove to investors that this project can be done and what the official numbers will look like. Both of those major catalysts should serve to drive the stock considerably higher.
In 2008 the company will ship a bulk sample of 250,000 tons to prove the quality and show the world what Baffinland has to offer. By that time, the stock price should be much higher.
Executives of Baffinland have bought over C$11 million of stock. Why? They see a multi-generational iron ore mine that has world class grades of iron. They see substantial IRRs and substantial cash flow. They see a company that could be worth more than $1 billion selling for around $200 million. With new coverage, a definitive feasibility study and a new strategic investor, Baffinland should see its stock price at least double by year end.


-New Strategic Investor
-Definitive Feasibility Study
-Price for iron ore increases again for 2008
-new analyst coverage
-Bulk sample shipment in 2008
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