Labrador Iron Ore Royalty Income Fund (Ticker: LIF-UN.TO)

Thesis:

I am recommending a long position in Labrador Iron Ore Royalty Income Fund (the "Fund") because I believe it represents an attractive value investment and a safe way to gain exposure to iron ore, which is one of the critical commodities demanded by emerging markets.  Based on my intrinsic value calculation, the Fund offers a 27% and 96% appreciation to my mid and high case scenarios respectively and with limited downside risk.  Moreover, the fund offers investors current income while they wait for intrinsic value to be realized. 

Description:

The Fund is a 15.1% equity owner in Iron Ore Company of Canada (IOC) which is the largest iron ore pellet manufacturer in Canada.  The Funds receives a 7% gross overriding royalty on all iron ore sales by IOC.  This structure makes the Fund one of the few true publically traded royalty streams.  The Fund literally gets 7% right off of the top of all of IOC's sales, meaning the fund's main source of income is unaffected by IOC profitability, but instead driven by sales volume and iron ore tonnage price.  In addition to this royalty, the fund earns a pro-rata share of IOC's earnings, dividends from IOC, and a $.10 per tonne commission. 

IOC is owned by three entities, Rio Tinto (58.7%), Mitsubishi (26.2%) and Labrador Iron Ore Royalty Income Fund (15.1%).  IOC was founded in 1954 and has the ability to extract 43 million tonnes of crude ore per annum and convert it into either concentrate or pellets.  In an ideal market IOC aims to produce 13 million tonnes of pellets and about 4 million tonnes of concentrate. The iron ore mines leased by IOC are long life assets, with an estimated life of 30 year at the current consumption rate.  IOC has reserves of 1,369 million tonnes and resources totaling 2,540 million tonnes at a concentration of 38.4% iron.  Reserves plus resources gives the mine an estimated life of about 90 years at current consumption.  The company also owns and maintains its own 418 km railroad which allows it to transfer its product to its port at Sept-Iles, Quebec where it services businesses on the Saint Lawrence Seaway or ships to Europe and Asia.  Historically IOC has sold 35% of its iron ore in North America, 40% to Europe and the remaining 25% to the Asian Pacific market.

Under Canadian tax law, the Fund has the ability to, and has elected to, have its income earned from its investments taxed at the unit holder level.  This is one of the perks of being a Canadian trust.  This structure in effect reduces the Fund's taxable income to zero.  Earnings, under this structure, so long as they are distributed to unit holders, are not subject to Canadian corporate income taxes.   Dividend income from IOC is tax free to the Fund since IOC is a taxable corporation and distributions to the Fund will be paid after tax.  Royalty payments, however, are subject to both Canadian and provincial royalty taxes.  Dividends paid to US holders of the Fund will be subject to Canadian taxes, however, they will receive a foreign tax credit that they can use to offset their US tax liabilities. 

The Fund's favorable tax treatment will be coming to an end on 12/31/2010.  On June 22, 2007 the Canadian Federal Government changed its tax code.  The Fund's earnings will now be taxed like any other Canadian corporation.  However, since dividends from IOC are after tax, these can be distributed to shareholders of the Fund tax free.

Expansion at IOC

IOC has been contemplating an expansion that would bring concentrate production capacity to 22 million tonnes from 18 million tonnes per annum.  IOC will accomplish this production growth by adding a fourth autogenous grinding mill, removing bottlenecks via a new overland conveyor system and adding more rail and mine support equipment.  The total cost of this project will be $539 million Canadian.  However, $104 million Canadian has already been spent by IOC. 

Phase one is anticipated to be completed in 2012, the same year as union negotiations.  Over the last 10 years IOC has experienced two strikes, the most recent of which was in early 2007.  The strike in 2007 was a result of IOC mine employees demanding an increase in their prescription drug coverage benefits, preferential hiring for IOC employee's student dependents and an increase in the signing bonus.  The ten week strike ended with a five year collective bargaining agreement.  Once the strike was resolved, IOC went on to set record production levels and safety records.  A combination of the economic slowdown in 2008 and the 2007 labor strike caused the expansion project to be suspended during late 2008.

The second phase of the project will be to increase concentrate production to 25 million tonnes per annum and increase the pellet plant's output to 14.5 million tonnes per annum.  The total cost of both phases was estimated at about $800 million Canadian, however, this figure has not been updated recently.  While the first phase is underway, the second phase has not yet been approved.  However, given the new tax regime in Australia, Rio Tinto and its partners, are likely to find the IOC shovel ready project a more attractive place to spend on additional capacity.

Liquidity

The Fund has no debt other than some intercompany debt that it has compiled for tax purposes.  IOC is a private company and the only transparency is through the limited information that is available from Rio Tinto's financial statements.  However, to my knowledge, IOC is debt free.  The Fund, moreover, has an undrawn $50 million line of credit and a cash balance of $18.6 million as of its most recent filing.

Assuming IOC continues with its planned expansion, the capital cost will be paid by some combination of free cash flow, a reduction in the dividend, debt on the IOC level or an equity investment from the partners.  In the event that the Fund needs to pay in for the project, it would need an estimated $65.7 million for the first phase and $55.1 million Canadian for the second phase, paid over the construction period.  

Iron Ore Pricing

Historically, iron ore has been priced yearly with a contract set from the miners' port.  However, beginning in early 2010, the price was converted to a quarterly price set on the previous three month's daily averaged spot price plus shipping.  This was done because steel mills had been ignoring their contract and buying on the spot when the spot price had fallen bellow their agreed upon contract price.  Conversely, since the miners have been selling on the contracted price versus the spot price, the industry has calculated that they have given up about 16% in price over the last four years.  The argument from the miners is why would they sell at a lower contracted price if the steel mills are going to ignore the contract when the spot price falls below the contract price and when the spot is above the contracted price we give up margin?

The new quarterly pricing system was designed to alleviate this risk for the miners, however, moving forward, the new quarterly contract starting in July is above the current spot price.  Given the large margin compression amongst Chinese steel mills, it's likely that the mills will renege on the deal and buy from the spot market.  However, this also means that the miners have the pricing power and should be able to negotiate to a spot price only system where mills will just buy at market when needed. 

Since the price security of a contracted price has been thrown out the window by steel mills reneging on the contracts in the past, a spot only price would add upside to the miners at the cost of only marginal increases in volatility.  Another way of looking at this is that the whole premise of doing a quarterly averaged spot price was to align prices more closely with supply and demand.  However, since inherently the calculation takes the last three months and averages them, you're going to have a tendency for the contracted price to either be above or below the current spot price.  From this stand point, a spot only pricing system is best in that it alleviates hostility between buyers and sellers.

A drawback of going to a spot price is the inability to hedge price volatility.  However, a futures and derivatives market is being developed that will allow miners and steel mills to enter into derivative contracts to hedge pricing risks.

Ultimately these changes will allow IOC and the Fund to realize higher revenues and margins on iron ore sales.  This may, however, increase volatility in the interim until a derivatives and futures market is more established.  The main benefit for IOC and the Fund will be the reduced risk of steel mills reneging on their contracts allowing for a potentially more predictable buyer/seller arrangement.   I would expect over time that the quarterly pricing system or a spot only pricing system will result in high margins for the iron ore mills and subsequently higher equity evaluations.   

Argument for Higher Prices

In addition to the transfer to a quarterly pricing system and the potential for a spot only system, there might be upside potential in iron ore pricing as a result of falling Chinese iron ore quality.  As Chinese iron content per tonne falls, Chinese producer's cost to produce each tonne increases.  Moreover, production facilities are designed to handle a fixed quantity of raw ore and process it into an upgraded product.  If iron content falls, output of refined product will fall also.  The Chinese falling iron content will result in an increase in demand for imports. 

Dividend

Year to date the Fund has paid out $1.50 per share via two regular $.50 distributions and two special $.25 dividends.   With the new quarterly pricing system in place IOC should realize higher margins throughout 2010.  Moreover, changes to the price will be acted retroactively and as a result IOC will see upside from Q1's sales.  It's my expectation that in the third or fourth quarter of 2010 the Fund will issue a large special dividend as well as it's usually $.50 per quarter distribution making the year's total distributions at between $4.25 and $5. 

Evaluation

There are several issues with determining an accurate intrinsic value of the Fund.  Firstly, IOC is not a public company and thus financial information is only available via the Fund's annual and quarterly reports and what little information Rio Tinto chooses to disclose in its filings.  Typically Rio Tinto discloses reserves, resources, production, revenue, net income and sometime EBITDA.  Attempting to build a discounted cash flow model off of this little information is extremely difficult.  The second issue with determining intrinsic value is that iron ore is a volatile commodity and prices can change drastically in a short period of time.  The new pricing system of quarterly contracted prices makes things even worse and moving to a spot only price, while more transparent, will further complicate any financial model down the road.  To mitigate these unknowns I used a rather simplistic evaluation method and created a high, medium and low case. 

I determined the value of the Fund's stake in IOC by using a 5X EBITDA multiple.  A 5X EBITDA multiple was chosen to be conservative.  The average EBITDA multiple amongst the three super majors, Vale, Rio Tinto and BHP Billiton, is 11.89X.  However, one needs to account for the minority stake that the Fund has in OIC.  Some discount is needed for the Fund's lack of a controlling interest in IOC and to add further margin of safety I choose 5 times EBITDA.  I believe this to be a reasonable, but conservative multiple, for its IOC stake

To determine the value of the royalty stream, commissions and corporate taxes, I just used a simple perpetuity formula discounting these streams of cash flow at a uniform 8%.  I choose a low discount rate of 8% since the royalty stream comes straight from revenues.  While the transparency and pricing volatility are negatives, I'd rather reflect those risks in my pricing assumptions of the pro-forma 2011 P&L. 

In my pro-forma P&L the high case price is derived from 2008's average Tubarao pellet and the Hamersley fines prices, which is quoted in US cents/dmtu FOB.  I then discounted these prices by 38.1% to reflect IOC's lower iron ore percentage per tonne.  (IOC has an iron content of 38.4% versus the index's standard of 62%.)  The mid case is simply the last three years average spot price discounted for IOC quality.  The middle case is probably the most realistic out come.  The low case is 2009's prices discount for IOC's quality.  2009 was a soft year for iron ore and while this price is in line with 2005-2007 prices, I don't believe that iron ore will return to this level in the long run.  Even if the low case does manifest itself, the downside risk is minimal and you get paid to wait for prices to rebound. 

Buyout Potential

While I am not forecasting this, there is the outside chance for a buyout of the Fund.  If someone wanted to buy IOC they would likely choose to first buyout the Fund.  The Fund's royalty rights limit the IOC's ability to be competitive with higher iron content and more efficient iron ore mines.  While I don't necessarily see a buyout in the near future, there was an attempt to buy the Fund by Rio Tinto on March 30, 2001.  Moreover, given the Australian tax and the shovel ready nature of the IOC expansion project, it is conceivable that Rio Tinto would choose to invest more capital in IOC and perhaps, buy out its partners.  Alternatively, Rio Tinto may consider selling its stake in IOC to alleviate antitrust concerns.  Currently 70% of seaborne iron ore is controlled by three companies, Vale, BHP Billiton and Rio Tinto.  In either case this would create a catalyst for the Fund's price to reach its intrinsic value.

• Potentional for Rio Tinto to either buy out its IOC partners and diversify away from Austrial, or sell its stake in IOC to avoid anti-trust issues with a BHP Billiton/Rio Tinto merger
• A new pricing system for iron ore based only on a spot only price
• Higher iron ore prices as the result of falling Chinese iron content
• Higher iron ore prices as a result of a rebound in the economy