Summary

  • Mesabi Trust’s income and distribution levels are set for a massive increase in 2017 – and the current market price is not factoring this in.
  • I estimate that the one-year forward yield is 14%, vs. an average 15-year yield of 7.3% – this will become visible when the next distribution is announced.
  • Mesabi Royalty trust will benefit from the long-term turnaround at Cliffs Natural Resources – while the market fixates on less-relevant Chinese ore prices.
  • My price target for Mesabi Royalty trust is $25 per unit, which creates 66% upside from today’s price.

Mesabi Royalty Trust – 66% upside to fair value

“The best business is a royalty on the growth of others, requiring little capital itself.” – Warren Buffett, 1978

Buffett’s quote perfectly describes the situation at Mesabi Royalty Trust (NYSE:MSB) which over the coming years will benefit massively from the turnaround at Cliffs Natural Resources (NYSE:CLF). My calculations indicate that Mesabi Trust will have an upward explosion in its earnings and distributions over the next twelve months. This will be the catalyst that alerts the market to its severe undervaluation. My short-term price target for the stock is $25, which creates 66% upside from today’s price.

I am going to keep this article tightly focused on the present opportunity. Those who want a simple introduction to the trust and its operation can read the first article that I wrote on the stock way back in June 2013, which can be found here, or Konrad Lisowski’s more in-depth article found here. (Just a note: Mesabi receives royalty payments from Cliffs slightly later than it used to, so the comments on seasonality in my earlier article are no longer relevant).

The present opportunity

My calculations indicate that Mesabi will (conservatively) pay out approximately $1.80 per unit in distributions in calendar year 2017, and approximately $2.08 in distributions over the next twelve months. At the current price, this means that the calendar-year 2017 forward yield is 12%, while my estimate based of the 12-month forward distribution is 14%. This is very significant relative to Mesabi’s 15-year average yield of 7.3%, which I believe will trigger a revaluation in the shares.

Mesabi Royalty Trust

Here is the basic calculation for this quarter’s (likely) distribution:

In the last reported quarter (10/31/2016) Mesabi had $7.6 million in unallocated reserves. Since October 31 st, Mesabi paid out $1.88 million in distributions, and received from Cliffs an additional $9,791,421 in base and bonus royalty payments. This leaves Cliffs with about $15.5M in unallocated reserves from which it can pay distributions.

If Mesabi’s Trustee chooses to keep the same level of unallocated reserves and pays out the entire recent distribution from Cliffs, the next distribution payment (which should be announced within the next two weeks) will be right around $.75 per share (13,120,010 shares outstanding).

However, based on the successful turnaround at Cliffs Natural Resources and improved longer term prospects for domestic iron ore and steel production, I believe that the trustee is likely to release a healthy portion of the excess reserves that were built up as a cushion when the operating environment was less certain. This will bring reserve levels in line with historical norms.

Historically, the trustee chose to leave around $1 million of unallocated reserves at the end of both the fiscal year (1/31) and the first quarter (4/30). Even if we assume the trustee maintains a surplus of twice this historical norm, the next distribution to Mesabi unitholders goes from $.75 per unit to $1.03 per unit.

Regardless of how much (if any) of the excess reserve the trustee chooses to release in the next distribution, the magnitude of the next distribution payment should wake the market up to Mesabi Trust’s severe undervaluation. If excess reserves are not paid out this quarter, it is very likely they will be in a payment later this year.

The easiest way to see the big picture is to look at Cliffs Natural Resources

While the huge distribution bump should be a catalyst, it is hardly the full story. Mesabi is reliant upon the success of Cliffs Natural Resources, as suggested by the Buffett quote that I started this article with.

I am currently putting together notes for a Cliffs Natural Resources article that should be ready for publication later this month. As such, my intent here is to summarize what the market is missing that is also relevant to Mesabi Trust. My price target for Cliffs Natural Resources (which I also view as severely undervalued) will not be revealed until this second article is published.

The Turnaround of Cliffs under CEO Lourenco Goncalves has been spectacular

I consider Cliffs CEO Lourenco Goncalves to be among the greatest industrial CEOs in the world. Under Goncalves, Cliffs has:

  • Refocused on its crown jewel Great Lakes assets – sold all of the cash flow negative assets acquired by prior management
  • Reduced debt by $1.3B, including capturing over $500 million in market discounts by purchasing debt for less than face value – and this is before an equity raise this year which reduced net debt by an additional $550 million
  • Substantially reduced both fixed operating costs and costs per ton Put in place long-term sales contracts that cover 80 to 90% of Cliffs production volume

In other words, the company is well positioned to take advantage of better conditions in the domestic iron ore and steel markets, which in turn is good for the Northshore mine and Mesabi Trust (which has a royalty interest in Northshore’s production).

Improving conditions:

  • While the market is fixated on short-term gyrations in Chinese iron ore index prices, Cliffs US operations (USIO) have no direct exposure to this index. USIO contracts combine steel and iron ore prices based upon Cliffs unique position within the great lakes region. This allows both Cliffs and the steel producers (Cliffs customers) to hedge against movements in the spread.
  • The market is underrating the bullish implications of Secretary of Commerce Wilbur Ross and the other steel veterans recruited by the administration. Ross made a large portion of his fortune in the steel industry and benefited massively from the Bush administration’s steel policies – perhaps no one is more qualified to boost the US steel economy via the enforcement of fair trade policies.
  • Investors soured on the “Trump trade” when it became clear that legislation will be more difficult than early investor euphoria anticipated. Fortunately, tariffs that will benefit domestic steel over the next four years are already in place – they were passed under the Obama administration. All that is needed is proper enforcement, which the administration has indicated is a top priority. Any additional action will be a bonus built upon what already exists.
  • Inventory build in China is of overstated relevance – most commentators are not differentiating between different grades of ore. Due to a major crackdown by the Chinese government, it is becoming harder for the highly polluting, lower grade ore to find buyers, causing it to pile up in inventory. This is documented by the price spread between 58% and 62% Fe ore, which has blown out from as little as $10 per ton in 2016 to a recent spread of around $35 per ton. In other words, the huge inventory build mostly reflects the lower grade ore.
  • Cliffs is running at full capacity for full-year 2017 and has new long termcontracts for 80-90% of its volume going forward – This should assure a very strong 2017 for Mesabi, and stable earnings and distributions going forward.
  • Mesabi Trust’s land contain low Silica ore, which is ideal for the manufacture of the DR-Grade pellets that are used in Electric Arc Furnaces to make ultrahigh grade steel.
  • In the Q4 2016 call, Goncalves stated that DR-grade pellets are the future for Cliffs, and that they will continue to develop the product. This is important, as it suggests that Mesabi’s royalty interests are well positioned for the future.

Conclusion

The future for Mesabi Trust is far brighter than its current unit price suggests. The catalyst for Mesabi’s revaluation will be a massive increase in Mesabi’s distribution, which will become visible when the next distribution is announced within the next few weeks. My price target for Mesabi is $25 per share, which creates 66% upside to fair value from today’s price. I see it hitting this level at some point in 2017, with more upside in 2018 and beyond.


Disclosure: I am/we are long MSB, CLF.

Additional disclosure: Mr. Stewart is Portfolio Manager of the Opus Active Opportunity Strategy. The Active Opportunity strategy is a “go anywhere” concentrated value strategy that focuses on under-followed and misunderstood securities. The objective of the strategy is to maximize investor returns while minimizing the risk of permanent capital impairment. Qualified Investors are invited to contact Opus Capital Management in order to learn more. Opus Capital Management reserves the right to make investment decisions regarding any security without further notification except where such notification is required by law.

Article by Opus Capital Management