Mesabi Trust MSB
January 13, 2005 - 1:44pm EST by
bibicif87
2005 2006
Price: 13.69 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 180 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

To keep things simple, I’ll call this a stand alone long recommendation, but you can also do it as a paired trade, going short GNI, which I wrote up previously, or a marginal US steel company of your choice. More details on that below.

MSB is a passive “grantor trust”. It has no management, no employees, and doesn’t actually do anything other than collect royalties on taconite, a low grade iron bearing ore, mined from its lands. As a trust it is set up in such a way that it owes no taxes, and declares about 100% of earnings as dividends. The mining is all done by the Cleveland Cliff’s (CLF) Northshore mine in Minnesota, and almost all of the ore mined by Northshore comes from Mesabi lands.

The trust, founded in 1961, has a limited lifespan. The Trust will terminate 21 years after the death of the last of 25 people, most of whom were infants in 1961. The youngest of them will be 44 years old this year, so MSB should be around for a good 50 years or so. Reserves of iron ore on the land are estimated by CLF to last at least that long.

The royalties are determined by a formula based on how many tons of taconite ore is shipped, and the actual proceeds to CLF from the sale thereof. The tonnage meter starts at zero at the beginning of each calendar year. For the first one million tons shipped that year, MSB is owed 2.5% of whatever CLF sells them for. The second million tons earns 3.5%. The next million gets 5%. The one after that gets 5.5%, and anything above 4M tons shipped in the year earns 6%. Northshore’s capacity is presently about 4.8M tons per year, and CLF is investing about $29M to move that up to 5.6M tons. Assuming the new equipment is ready to go on schedule in mid year, production should be 5.2M tons in 2005 and 5.6M in 2006. As discussed below, CLF may well expand Northshore’s capacity further in 2007-8.

Since all shipments above 4M tons requires royalties be paid at 6% of the sales proceeds, compared to 4.125% for the first 4M tons, royalties to MSB will grow somewhat faster than the growth in production. But there is another aspect of the royalty deal that provides a much bigger kicker, which I don’t believe investors have fully taken into account. This is the “royalty bonus”, which MSB earns when the price per ton that CLF gets for its ore exceeds a certain target, the “Adjusted Threshold Price.” This ATP was $41.76/ton in 2004, and shouldn’t be above $43/ton, I will guess, in 2005. Changes in the ATP are based upon “the change in a broad based index of inflation and deflation published quarterly by the U.S. Department of Commerce”, according to the annual report.

For many years taconite prices have been well below the ATP, but in Q3 ’04 MSB started to earn royalty bonuses. Based upon CLF’s estimates of taconite prices in 2005 (averaging in the low $50s per ton), the royalty bonus to MSB could be very substantial. If a sale takes place at $2 above the ATP, MSB earns an extra 1% of the proceeds; $4 above earns an extra 1.5%; $6 above earns an extra 2%; $8 above earns an extra 2.5%; $10 or more above earns an extra 3%

To compare 2005 to 2004 in advance, we can say: 1) in 2005 tonnage will go up due to the capacity expansion, 2) higher prices times more volume means the gross proceeds upon which the royalties are paid will be a lot higher, 3) the base royalty percentage will go up somewhat because the extra production gets paid at 6%, and, 4) the biggest difference, MSB will be earning price-based royalty bonuses all year that could put an extra 2-3% of the sales proceeds in MSB’s pocket.

To be more specific, here is a plausible model for 2005, assuming taconite sells for $52/ton, shipments are 5.2M tons, and the ATP is $43/ton:

The base royalty would be 4.56% (1M tons at 2.5%, 1M at 3.5%, etc.). Since $52/ton is $9 over the $43 ATP, MSB would be owed an extra 2.5% bonus royalty, for a total of 7.06%. Multiply 7.06% by the $270.4M proceeds of 5.2M tons times $52/ton, and that equals $19.09M in earnings. Subtract the minimal trust expenses, which we’ll call $0.6M, and divide by 13.2M shares, and you have EPS of $1.40, with dividends approximately the same. It could easily be more—if prices averaged $53 rather than $52, then that would make the bonus royalty an extra 3% vs. 2.5%, which would give us EPS of $1.53, a 9% boost on a 1.9% difference in price.

Obviously, a major factor in MSB’s earnings is the price of taconite. This is largely set up as a contractual formula between CLF and its customers, although the details vary by customer and are confidential. There are three main factors, each weighted about equally:

1. The world price for seaborne iron ore, determined once a year in negotiations between the major iron ore producers and Asian steel makers. These negotiations are occurring right now, and should be decided within the next week. A few months ago the talk was of a 20% increase, then 25%, and now the word is that prices could increase 30%, or even more. The new price will take effect on April 1, the start of the Japanese fiscal year.

2. The PPI all commodities index, put out by the BLS. Lately that has been running up 7%-9%, although it could well decline later this year, depending on the world economy, exchange rates, etc.

3. The prices CLF’s customers get for their steel. Spot prices started out this year well above where they were in early 2004, but have recently been trending down. Contract prices, which probably account for 60% of CLF’s customers’ sales, lagged spot prices on the way up, and will probably show something like 20% Y/Y gains throughout 2005. How steel prices factor into taconite prices is complex. CLF recently filed an 8-K showing changes in its deal with its biggest customer, ISG. The new deal raises the base rate that CLF gets, and gives it more protection if steel prices drop, at the expense of not participating as much if steel prices go up.

For 2005, these factors suggest that the $52/ton average price, and thus my estimate of $1.40 seems reasonable, and with some luck could be a few dimes low. Since all earnings are paid as dividends, MSB is presently priced to yield over 10%, at least based on 2005 estimates. What should it sell for? That depends, obviously, on one’s expectations for 2006 and beyond, but my guess is that, absent a strong downdraft in the world economy and steel stocks, there are plenty of yield hounds who will bid the stock up to something close to $20.

As to post-2005, that depends on many things. The biggest factor will be what happens to the world economy, demand and pricing of steel in the US, etc. There are numerous scenarios out there, from prices collapsing to where they were a few years ago, to prices and demand staying very high for many years, and everything in between. I won’t endorse any scenario. Pick whichever you want and act accordingly. If you are bullish, just buy MSB. If you are bearish, consider a paired trade by shorting the steel company of your choice. Another good pair short, although it is thin and often hard to borrow, is Great Northern Iron Ore. GNI (NYSE-$116) is a similar iron ore royalty trust, but vastly inferior as an investment to MSB. Please see my write-up on VIC from last summer. The main bearish point is that it is on deathwatch. The last of its named beneficiaries died a while ago, and GNI will disappear and be worth nothing in ten years. Under the best of circumstances its dividends won’t exceed by much the amount by which one has to amortize one’s cost basis, as it approaches oblivion. And unlike MSB, so far there have been no announcements of expanded capacity of the mines that pay royalties to GNI.

In considering the post-2005 outlook for iron and steel demand and prices, I’ll add one point that isn’t obvious. The most plausible bearish scenario I have seen for the US steel industry is one based on the idea of a slowdown in Chinese internal demand for steel, followed by them dumping product into the US market. That would certainly be bad for US steel makers, but not necessarily bad for the world iron ore industry. None of China’s steel production is by Nucor style electric furnace mini-mills, which use steel scrap instead of iron ore. That is because, with few cars, there is very little scrap in China. China uses only iron ore, so to the extent that China gains share in world markets, that is good for iron ore demand and prices. No, none of MSB’s ore goes to China, but as discussed above, world iron prices are an important influence on US prices.

Independent of industry conditions, there is excellent reason to expect longer term growth in production at CLF’s Northshore mine; and, if industry conditions do turn very negative, to expect mines other than Northshore to bear the brunt of any production cuts. Of CLF’s six mines, only Northshore is non-union. It has the highest reserves of any of the mines, one of the highest iron ore grades, and is the only one 100% owned by CLF.

Moreover, there is a possibly major change in technology which will be very positive for MSB. Because its iron content is too low, taconite cannot be used in modern electric arc furnaces (mini-mills), which is now the dominant steel making method in the US. Kobe Steel invented a process to convert taconite, which, when mined, has about 32% iron content, into nuggets of about 97% iron content, which can be used in mini-mills in place of scrap. A few years ago a partnership of Kobe, CLF and Steel Dynamics, called the Mesabi Nugget Project, set up a pilot plant at Northshore. The results were excellent, and the partners are now negotiating with Minnesota and Indiana for permits and financing to set up a full 0.5M tons per year commercial plant. A final decision will be made by the second quarter, and the plant should be running by early 2007. CLF, the lead partner, has stated that regardless of where the plant is located, all the ore will come from Northshore. Since processed taconite, when shipped, has an iron content of about 65%, this will increase demand by an extra 0.75M tons. If results continue to be favorable, over time this technology could create many millions of tons of extra demand for taconite, as well as prices.

One complication of owning MSB is the tax issue, which is more like a partnership, in which you are taxed on your share of the earnings, and not the distributions, although they are always about the same. In addition, there is a small depletion allowance. Before April 15 Deutsche Bank, the Corporate Trustee, will send out a tax guide explaining what goes on which tax form. For a copy of last year’s tax guide, call them at (615) 835-2749.

A couple comments on timing. Next week the last dividend of the MSB’s fiscal year will be declared. I will guess that it should be about $0.35, giving the company a total of $0.825 for the year. But dividends for any given quarter are hard to predict, since it depends on actual shipments and transactions. At the current stock price, I think any number much less than this would be considered a disappointment, although it wouldn’t necessarily have any bearing on the outlook for 2005.

Also, around now the Soo Locks that allow iron ore boats out of Lake Superior close for the season due to ice, and don’t reopen until well into April. As a result the next dividend, declared in mid-April, is usually omitted. Last year unusually warm weather reduced the time the Lakes were closed, permitting enough shipments to be made that MSB declared a nickel dividend. This April it might not. Would that bother investors? Not knowledgeable ones, but sometimes they are outnumbered.

Catalyst

1. Higher iron ore prices should produce substantially higher earnings and dividends for MSB in 2005, about 10% at the current price.
2. Longer term, new technology that allows taconite to be used in steel mini-mills could vastly expand the market.
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