“The best business is a royalty on the growth of others, requiring little capital itself.” – Warren Buffett, 1978
In my opinion, Mesabi Trust is one of the most absurdly undervalued securities I have ever seen. While Mesabi’s share price is up 10% from my April 13th article, the underlying business has improved dramatically since then, as reflected by:
- Fund of funds Business Keeps Dying
- Baupost Letter Points To Concern Over Risk Parity, Systematic Strategies During Crisis
- AI Hedge Fund Robots Beating Their Human Masters
- A huge boost on ore pricing revealed in the latest royalty report – my calculations indicate implied pricing is up 55%.
- This new pricing is based upon the expiration of a below-market contract between Cliffs and ArcelorMittal, creating a specific catalyst
- Volume estimates for ore shipped YTD from Mesabi lands are running at 65% above full year 2016 and approaching the mines full capacity
- Mesabi’s blowout Q2 – earnings up 436% from Q2 2016
- Mesabi’s Q2 EPS was up substantially (412%) as I anticipated in the tweet below
As such, I’m raising my conservative target up to $30 (+80% upside) with a bullish target of $46 (+180% upside).
With no analyst coverage and no management to tell the story, there is almost no information flow and next to zero investor awareness of what I believe will be the coming - a long-term surge in Mesabi Trusts earnings and distributions. My estimate of the one-year forward yield now stands at 17%.
Imagine a business with the following attributes:
- 96% profit margins
- Exists solely to collect royalty payments and distribute cash to shareholders
- No dilution risk, no debt, no potential for bad acquisitions, and no changing of the core business
- Benefitting from BOTH record volumes (+65% in 2017 vs. 2016) AND record pricing (+55% in 2017 vs. 2016)
- Price increases driven by the expiration of a 15-year-old, massively below market contract - meaning the price increases will not be reverting to the prior range
- A 17%, forward yield (using my estimates and based upon the current price)
- Sound interesting?
One of the best risk-reward situations I have found
Though the potential revaluation might not be as rapid as what occurred with RMR Group Inc. (up over 200% within one calendar year of my article) and the total appreciation might not match National Beverage (up over 400% from my last article), I believe the Mesabi Trust situation offers investors a remarkable risk-to-reward opportunity. If the market does not recognize the underlying value through appreciation, investors should still earn a handsome return from the 17% forward yield (based upon my estimates and projections).
Mesabi Trust basics: One of the world’s most unique publicly traded assets
Mesabi’s sole revenues are mining right royalty payments from the Northshore iron ore ("IO") mine in Minnesota operated by Cleveland Cliffs (CLF) - it is a low-cost, long life, non-unionized mine with wholly-owned rail and port facilities. As such, Northshore represents one of Cliff’s USIO (U.S. Iron Ore) crown-jewel assets. Northshore ore contains low silica content, which makes it even more strategic as Cliffs moves forward with its strategy of producing the Hot Briquetted Iron (HBI). HBI is used in Electric Arc Furnaces, which are the future of the U.S. steel industry. HBI production requires low silica ore such as is found on Mesabi Trust’s land, which is why to-date, Cliff’s production of HBI has taken place at the Northshore mine.
The royalties paid to Mesabi Royalty Trust are determined by a formula that factors in how many tons of taconite are shipped and the sales price received by Cleveland-Cliffs during the current payment period.
The royalty schedule is as follows:
- For the first one million tons shipped that year, Mesabi is owed a 2.5% of what CLF sells them for
- The second million tons earns 3.5%
- The next million gets 5%
- The one after that gets 5.5%
- anything above 4M tons shipped in the year earns 6%
In addition to this distribution schedule, Mesabi Trust is also entitled to bonus payments if the price per ton that Cleveland cliffs gets for the ore exceeds a target price, which is called the adjusted threshold price (currently $54.74 per ton).
The schedule for these bonus payments is as follows. If a sale takes place at:
- $2 above the threshold price, Mesabi earns an extra 1% of the proceeds
- $4 above the threshold price earns an extra 1.5%
- $6 above the threshold price earns an extra 2%
- $8 above the threshold price earns an extra 2.5%
- $10 or more above the threshold price earns an extra 3%
As you can see, the royalty payments are heavily leveraged to both the volume and the price. Throughout the course of one year (as volume accumulates beyond the various threshold levels) the profitability of the royalty increases as volume breaks through the various threshold levels.
The trust has a limited lifespan defined in the trust agreement this way:
“The Trust shall continue until twenty-one (21) years after the death of the survivor of the persons named in Exhibit I annexed herto and hereby made a part hereof”
Exhibit one of the governing documents show that six of the 21 individuals named were born in 1960 and one (the youngest) was born in 1961. If we use 1960 as our benchmark and assume at least one of these individuals' lives to be at least 80 years old, the trust would terminate after the year 2061, or something around 44 years from now. However, per the Trust Agreement section 4.6, at termination the royalty rights are sold and the proceeds are distributed to shareholders. This pushes value out beyond 2069, or effectively the end of Northshore’s useful mine life (Estimate derived from 2016 10K 261m LT Saleable Product / 5M average annual production). With an effective useful life of +52 years, Mesabi is (For valuation purposes) effectively perpetuity.
Four key investor questions answered
I have noticed that investors and analysts new to Mesabi Trust tend to ask the same questions. I have answered these questions in my supplementary article, “Four Weird Tweaks That Confuse Mesabi Trust Investors and Analysts.” You might want to read these brief notes before continuing.
My Bull Case - new contracts have massively boosted Mesabi Trust’s economics
In December 2016, contracts signed by Cleveland Cliffs in 2002 (and modified in 2004) with International Steel Group (ISG, now part of ArcelorMittal) expired and were replaced with a new contract that updated the pricing formula. Over the years, the original contract fell behind market prices and forced Cliffs to sell ore at substantially below market prices. The new contract remedies this, and we are already seeing the impact on current year pricing. This is obviously great news for Cliffs, but what is the significance for Mesabi?
It is simple. Mesabi ore is the primary source of ore used to fulfill this contract. This means that Mesabi’s royalty will benefit massively from this step-up in pricing. The last time this was disclosed (to my knowledge) was in Exhibit 13 of Mesabi Trust’s 2005 annual report:
I highlighted the parts that are most relevant. In brief, the highlighted areas state that a substantial portion of iron ore from Mesabi Trust lands are sold under one of the April 2002 Agreement with ISG. It goes on to state that the ISG agreement accounted for 74% of iron ore pellets shipments attributed to trust lands in 2004.
Impact of the new contract on pricing is already visible
The impact of the new contract is already visible in Mesabi pricing: Reverse engineering a sales price based upon the July 31st royalty report (corresponding to Cliff’s Q2, the first quarter with no holdover contract pricing) suggests an average ore price of $91 per share. In 2016, the Mesabi’s royalty income was based upon an average price of $58/LT. This huge 57% price increase has massively boosted Mesabi’s earnings potential, as reflected by the recent quarter.
It is hard to over-emphasize how important this average price is
In my opinion, the best way to understand the significance is to compare this year’s pricing with a prior banner year for Mesabi, the fiscal year ending January 31, 2011. That year, the 62% Iron Ore Index traded above $150 per ton and Domestic Hot Rolled Coil went as high as $700 – yet because of contract stipulations, Cliffs (and Mesabi) were stuck selling at the vastly below market price of just over $77 per ton. In other words, Cliffs is now selling Northshore ore at almost $15 per ton higher that the banner year of 2010 (Mesabi’s fiscal year 2011).
Recency bias at work
After periods of poor performance, investors tend to anchor on the recent past and forget what is possible. Let’s look at Mesabi Trust’s share-price performance in 2010. Make sure to expand the image so that you can read my notes.
What does this mean for Mesabi’s Royalty?
Very simple – Mesabi distributions could go higher than the year when Mesabi’s share price almost hit $50 per share.
In fact, my best estimate is that Mesabi’s distributions will total $2.86 per share, while my conservative estimate is $2.24 per share. The $2.86 estimate uses the July 31st royalty report pricing ($90.7) for the full period, while my conservative estimate uses $80 per share and a lower volume figure. I consider the 90.7 value reasonable because the contracts are priced on an estimate of the full year sales price – meaning that each quarter, the new pricing is the “best guess” for full year pricing. I don’t have any basis for the reduced figures, they were created simply to add a margin of safety to the forecast.
Full year 2016 vs. 2017 - Running the numbers through Mesabi’s royalty schedule
Mesabi Trust 2016 EPS = $0.73
- CLF shipped 3.3m long tons (LT) of Northshore Iron ore at $58/LT
- Base Overriding Royalties of $7.4m = $1.4m on the first 1m LT (2.5% x 1m LT x $58) +$1.9m on 1-2m LT (3.5% x 1m LT x $58) + $2.7m on 2-3m LT (5.0% x 1m LT x $58)
- $1.5m on 3-3.3m LT (5.5% x 0.3m LT x $58)
- Bonus Royalties of $2.9m = 1.5% x 3.5m LT x $58 (over $53.80 threshold)
- Mesabi earnings = $7.4m base + $2.9m bonus - $0.7m everything else = $9.6m / 13.1m Mesabi shares = $0.73.
Mesabi Trust 2017 EPS = $2.86 (estimate)
- CLF shipments, at an annualized 5.5m rate and $91 per long ton pricing
- Base Overriding Royalties of $23.2m = $2.3m on the first 1m LT (2.5% x 1m LT x $91) $3.2m on 1-2m LT (3.5% x 1m LT x $91) + $4.6m on 2-3m LT (5.0% x 1m LT x $91)
- $5.0m on 3-4m LT (5.5% x 1.0m LT x $91) + $8.2m on 4-5.5m LT (6.0% x 1.5m LT x $91)
- Bonus Royalties of $15.0m = 3.0% x 5.5m LT x $91 (Greater than $10 over the $54.74 threshold)
- Mesabi earnings = $23.2m base + $15.0m bonus - $0.7m everything else = $37.5m / 13.1m Mesabi shares = $2.86
My full year estimate implies a forward P/E of 6 and a distribution yield of 17%. This is for a security with 96% profit margins, no debt, long life, and 100% pass through of income to investors. I believe Mesabi Trust’s income is much higher in quality than the average MLP (no dilution risk, management risk, capex, or leverage) and as such should trade at a yield below the Alerian MLP Index (currently 7.7%). At Mesabi’s 10-year average yield of 7.3%, the implied share price (using my forward EPS estimate) is $39 per share.
(Note: the full year 2017 reflects pricing derived from the most recent royalty report sent from Cliffs. FY 2017 volume is based on YTD estimates).
Demand picture looks solid for years to come
- Cliff’s Empire (17% of 2016 production) was closed in 2016 – this will increase utilization at Northshore and Cleveland Cliff’s other mines going forward.
- New ArcelorMittal Contracts until 2026 – This contract is the “current” ISG contract which utilizes a large percent of Mesabi’s lands
- Steel mills thrive on consistency of inputs – Mills are often tied to ore from specific mines, and as such I believe this contract continue to be fulfilled using a large portion of Mesabi’s ore.
- Demand From Cliff’s planned HBI plant – The Northshore mine was used to create the first HBI pellets because of its low silica ore and significant operating advantages (long life, wholly owned rail and port facilities). In my view, this creates massive future optionality for the Mesabi Trust, as the HBI plant could potentially create a new, higher-value source of demand for the Trust’s ore.
- The “Wilbur Ross” factor – Commerce secretary Wilbur Ross made a large part of his fortune anticipating and influencing steel tariffs. He knows exactly what it takes to stoke demand and pricing for the domestic steel industry. While investors tend to lose hope on things that requires even a modicum of patience
- Both political parties have an enormous incentive to promote economic activity in new swing-states such as Minnesota (location of the Northshore Mine). At the very least, the potential for new trade restrictions on steel create extraordinary positive optionality for Mesabi Trust.
Simple Value framework
I believe that Mesabi Trust, like most pass-through vehicles, is most often valued on a yield basis, or as a simple perpetuity. Given the trust’s long life and pass-through nature, this makes perfect sense.
My bullish upside fair value target is $46 per share (2.86 in distributions, 6.2% yield), while my base or conservative case for fair value is raised to $30.1 per share (2.24 in distributions, 7.5% yield). The 6.2% yield figure is based what I believe the security should fairly trade at given its unique pass-through nature, long life, tax advantaged distributions relative to most other “yield” vehicles, and immense positive optionality.
My fair value range is deliberately wide. Anyone who believes that valuing this security is an exact science is fooling themselves. For example, slight changes to the discount rate (reflecting investor sentiment) wildly impact present value. The good news for Mesabi Trust investors is that my conservative or floor price target currently implies 80% capital appreciation potential. Add in my estimate for the next four distributions and the potential one-year total return approaches 100%.
This is possible because this security is almost completely under the radar– not only is there no analyst coverage, there is no management team or Investor relations department with an interest in getting the word out.
“Front Run” the quant bots – wild card appreciation optionality
A tremendous amount of investor capital is now managed using quantitative investment factors such as earnings growth, value, and momentum. By understanding the specific facts of this article that will shift future fundamentals, I believe investors have an opportunity to invest before quant buy signals are triggered over the next year. This quant buying could potentially create share price momentum, which is itself a quantitative factor that can trigger additional share demand. As Mesabi’s market value climbs, the stock will filter into more investor screens, which will in turn create additional share demand. While the above analysis might seem unusual, in my view it is a consistent pattern that occurs in small and micro-cap stocks as improving fundamentals gain recognition.
If my conservative bull case plays out, investors will see close to 100% total return upside. If Mesabi’s share price doesn’t budge, my estimate of the forward yield still implies a 17% return – nothing to sneeze at! Regardless, I believe long term Mesabi Trust investors will be rewarded. I see substantial total-return upside over the next 12-18 months.
My brief report, “The four weird tweaks that confuse Mesabi Trust investors” can be found here.
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. Accredited 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.