Great Northern Iron Ore GNI S
August 10, 2004 - 3:30pm EST by
bibicif87
2004 2005
Price: 100.75 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 151 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT
Borrow Cost: NA

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Description

This a short sale idea. On the surface GNI, a nonvoting trust, might appear to be an attractive long for income-oriented accounts. Dividends have been steadily rising in recent years, the stock is priced to yield over 7%, and, due to the trust’s tax situation, the owner gets substantial tax deductions. One critical item has evidently been ignored by the buyers: GNI has an unusual charter that requires it to go out of business in less than 11 years, at which point dividends will cease and the shareholders will receive a final payment unlikely to be much more than $10 per share. The total of the dividends over that time period, plus the liquidating payment in 2015, is unlikely to even equal today’s $100.75 stock price, and may be far less. If money has any time value, GNI should be selling for something closer to half its current price.

GNI, formed in 1906, was designed to have a limited lifespan, to match that of the resource being exploited, namely, the right to mine iron ore on some large land holdings in northern Minnesota owned by legendary tycoon James Hill’s Great Northern Railway. Estimates at the time were that the iron ore would last about 50 years, so the trust was set up to do the same. Rather than pick a specific date for the trust to liquidate, the founders named as beneficiaries a pool of 18 children ranging from infants to six years old, all relatives of Hill, and declared that the trust would cease business twenty years after the death of the last of them. With life expectancy in 1906 under 50 years, that surely seemed reasonable at the time. But as any statistician could have told the founders, the chances were good that at least one of those 18 kids would be long lived, and that is what happened, with the last one not dying until 1995. Thus was calculated the April 6, 2015 termination date, at which point all remaining cash gets distributed, and all other assets, minus some deductions, get turned over to the “reversionary beneficiary”, Burlington Resources, a corporate descendant of Hill’s railroad. The 1906 prediction about the life of the iron ore reserves was quite good, with the last of the high quality ore being mined in the 1950s, but necessity breeding invention, the steel industry learned how to make use of taconite (tough pellets with a much lower iron content), of which there remains vast quantities on trust lands.

GNI’s income is derived from royalties paid by companies mining taconite on its lands. There are 14 different leases from mining companies, with varying production levels. Industry consolidation has put those leases into two hands, US Steel and Cleveland-Cliffs. GNI’s trustees meet quarterly and declare as dividends approximately 100% of the trust’s net income, which is a function of how much ore gets mined and the royalty rate, a function of taconite prices, which are based partially on steel prices. In addition, the leases contain provisions for minimum annual royalties, which are credited against future production. There are about $2 per share in credits existing, which are being worked off at the rate of about $1 per share; if we assume that production and royalty rates remain unchanged, in about two years customers who are utilizing those credits will have to start writing checks, adding a bit more than a dollar per share to GNI’s cash flow.

Other than that, it is hard to see what can cause GNI’s income to rise much from current levels. Existing mines on GNI’s land are essentially working at capacity. There are no announced capacity expansion plans, although there is some possibility that a newly formed company may have a small operation up and running on GNI’s land in a few years. If steel and taconite prices stay high, it is possible that over the next year or two another new mine or two gets announced, but it would take several more years for them to be up and running. Most of the existing leases expire after the trust does, so no major favorable changes in lease terms are likely to have much impact on GNI’s results before 2011 at the earliest, when two of the larger leases expire. There is no reason to think at this point that any renewal of those leases will be on terms much different than at present. If there is no capacity expansion on GNI’s lands, and taconite prices are stable, then I don’t see how dividends can get much higher than the present rate, plus an extra buck per year when the built up minimum royalty credits are consumed in two years.

Iron ore prices have zoomed in recent years, as the boom in China has gobbled up steel capacity around the world, increasing production of steel in the US and thus demand for taconite, and even creating demand for US taconite to be exported to foreign steel makers. To give the benefit of doubt to the bulls, let us assume that the boom in Chinese demand for buildings, infrastructure, cars, and everything else, continues unabated until 2015. In that environment US taconite demand and prices might stay high, and there probably would be some new leases and an expansion of capacity on GNI’s land. Nevertheless, given the time lags for creating and expanding new mines, it is unlikely that dividends could possibly average more than $10 (last 4 quarters were $7.10) per share between now and when the trust terminates. Moreover, a nonstop worldwide boom for the next 11 years associated with such strong prices would certainly bring with it sharply higher interest rates, which would reduce the appeal of an income security such as GNI. A recession in US steel demand and pricing (perhaps caused by a slowdown in China that again makes the US a dumping ground for foreign steel) would obviously reduce dividends. For example, in 2002 GNI paid only $5.40 in dividends.

I don’t claim any expertise on the Chinese economy, and am actually long term optimistic on its outlook, but there is plenty of reason to believe that its growth rate could cool a bit over the next year or two. Meanwhile, the three biggest iron producers in the world, Rio Tinto and BHP Billiton in Australia, and Vale in Brazil, are engaged in massive iron ore capacity expansion projects in their home countries, both of which have cheaper access to Asian markets than does taconite from Minnesota. These expansion projections include not just increased production, but improvements in rail transport, material handling, and dredging at ports to increase export opportunities.

For a long term perspective on the Chinese market, I recommend checking the BHP Billiton website (www.bhpbilliton.com), where various presentations by its corporate officers are posted. One particularly relevant to this discussion is “Will China’s Demand Overwhelm Supply?” from June 7, 2004 by BHP’s chief commercial officer. Discussing all minerals, he points out that there is a lag between when demand and prices rise and suppliers increase capacity and delivery capabilities enough to meet that demand. For iron ore, that lag is listed as two to four years, and he says that the big three iron ore producers have “an absolutely enormous amount of latent capacity available”, and that their share of the total market will rise because “they are capable of meeting the market demand.” In other words, there is no shortage of iron ore in the world, or ability to supply it from places other than, and much cheaper than, Minnesota. To the extent that this keeps a lid on steel prices, it keeps pressure on US taconite prices, and thus GNI’s earnings.

Again, I am not predicting a collapse in iron ore and steel prices. But it would take a surprising surge in demand above what is already expected to move prices much higher, and that would probably be associated with higher interest rates. Meanwhile, I recommend you take out your present value tables, make your own assumptions—anything remotely reasonable, and GNI is worth a lot less than $100.75 .

One complication worth noting is the tax situation. GNI is taxed like a limited partnership, in that the holder is taxed on a share of the income, not on the cash distributions. In fact, the trustees try hard to match dividends with income, so that part makes little difference to shareholders. In addition, because the shares will definitely be worthless on April 7, 2015, the IRS lets the holder amortize the investment between whenever they buy it and that date. This reduction in value produces a loss on a taxpayers’ income statement that, at the current price and dividend rate, makes the dividend tax free. I suspect that one reason why the stock is so overpriced is that many long term holders have by now a cost basis close to zero, and it isn’t worth their while to sell and report such gains. As we get closer to termination date, that viewpoint should change.

What is the tax treatment to the short seller? My brain melts trying to figure out what a mirror image of being long would look like on the tax forms. My accountant, admittedly not the world’s most sophisticated, said he will treat it like any other short sale of a dividend paying company. If the IRS thinks otherwise, I am sure it will eventually let me know. This is a risk to consider.

If you agree that GNI is very overpriced and want to short it, but are concerned with the risk that iron ore demand and prices could still go way up from here, you could hedge by going long Mesabi Trust, a similar but smaller trust. MSB has the advantage that it was formed much later. Of its 25 named beneficiaries, the youngest is 43, and the trust does not terminate until 21 years after the death of the last of that pool, so it will be around long after GNI is gone.

Finally, I’ll mention that GNI is not easy to borrow, as one would expect with only 1.5M shares outstanding. I’ve had no luck with E*Trade or Ameritrade, but have found shares at a full service firm. This is just a guess, but perhaps firms with offices in Minnesota might have shares available.

Catalyst

1. Time: GNI will go out of business in less than 11 years, with a final liquidating dividend of about $10 per share.

2. Any developments in the economy that reduce demand for and price of steel, and thus iron ore.
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