| 2015 | 2016 | ||||||
| Price: | 16.88 | EPS | 0 | 0 | |||
| Shares Out. (in M): | 64 | P/E | 0 | 0 | |||
| Market Cap (in $M): | 1,080 | P/FCF | 0 | 0 | |||
| Net Debt (in $M): | -28 | EBIT | 0 | 0 | |||
| TEV (in $M): | 1,052 | TEV/EBIT | 0 | 0 | |||
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Labrador Iron Ore Royalty Corporation (LIF)
I realize going long an iron ore related company may seem like a non-starter for most on VIC, especially given the well thought out short iron ore ideas on this board.
Overview - Basically, the economics of LIF are driven by its relationship with the Iron Ore Company of Canada (IOC), an Eastern Canadian based iron ore pellet and concentrate producer. Specifically, LIF has a 7% gross overriding royalty and $0.10 per tonne commission on Iron Ore Company of Canada’s production and a 15.1% equity interest in IOC.
The thesis boils down to:
- This thesis has a low hurdle: there is upside as long as IOC does not shut down for more than 3 years.
- Getting IOC for free at current valuation. This mine has been running since 1956
- At current valuation, LIF looks attractive to both metal royalty/streaming companies and IOC. As well, activist investors looked at LIF 2 years ago at a price twice as high as currently trading.
- While I generally agree with the iron ore short thesis on VIC, I believe things may not be “as bad” given the big three control ~70% of supply. There are some indications there could be some supply discipline – Bruce Greenwald’s Competition Demystified talks about this possibility in his example of the lead additives industry that was going terminal and yet the oligopoly milked significant profits
- For those looking for short-term catalysts, shareholders may reject LIF proposal to diversify business and issue up to 20% shares. As well, short interest is somewhat high for a relatively high yielding name.
Low Hurdle for LIF
With where LIF is trading and given its 7% royalty in IOC production, it is important to recognize the investment thesis does not require iron ore prices to rebound nor IOC to generate meaningful profits. My arguments for IOC to keep running are:
1) In 1Q15, benchmark iron ore concentrate prices averaged ~US$58/t while pellet prices averaged US$93/t. Doing some simple math, it looks like IOC realized ~C$105/t with operating costs (guesstimated from IOC’s historically disclosed relationship between operating cash flow and net income) in the C$85/t range. For reference, the pellet premium has averaged ~ US$30-US$35/t over the past 5 years. Here the implication is IOC has at least a C$20/t realized price buffer before it may consider shutting down
2) The C$20/t margin of safety may not be sufficient, especially as some may argue the current level of pellet premium will deteriorate. Another cost cushion should come from the fact that IOC has not been producing close to capacity due to a variety of operational and weather related issues. Having spent close to $3 bln in capex over the past 5 years, both production and per unit costs are expected to be lower going forward. In LIF’s 1Q15 report, they already suggested: “The IOC program to restore pellet capacity to 12.5 million tonnes per annum from its current 10 million tonnes capacity will be completed in the second quarter of this year. The completion of this program along with the increase in concentrate production which is expected if the first quarter improvements continue should result in increased sales for the balance of the year.” As a function of higher expected production levels (and at least near-term realization of pellet premiums), the margin of safety probably expands to C$25-$30/t+. Finally, IOC’s implied cost per tonne rose substantially over the past few years from ~C$70/t in 2009 to ~C$95/t in 2013. While part of it can be explained by general cost inflation coming out of the financial crisis, I suspect higher costs in recent years is a result of IOC expensing development costs to increase reserves in anticipation of a sale which did not come to fruition. http://www.bloomberg.com/news/articles/2013-03-01/rio-tinto-said-to-offer-canadian-iron-ore-operations-for-sale
3) IOC is unlikely to shut down in the near to medium term as it just announced 150 layoffs out of an employee base of 2,500. As IOC has previously requested concessions from the union such as wage freezes (and failed), IOC may have pushed much harder for concessions or announced massive layoffs if it were truly contemplating an operate or shut decision. http://www.cbc.ca/news/canada/newfoundland-labrador/labrador-west-dealt-another-blow-as-ioc-announces-150-layoffs-1.3026372
4) IOC has been in operation since 1956. From the historical data I could collect, IOC seems to really only have shut 3 times: 1) 4 week shut in summer 2009 due to market conditions, 2) a ~ 4 week shut due to a strike in 1Q07 and 3) a 5 week shutdown in mid-1980 due to poor market conditions.
5) One of IOC’s key shareholders is Mitsubishi (26.2%). My understanding is they made the equity investment to secure about 1/5 of IOC’s production for its merchant trading operation (which it presumably makes a profit on). Here is another key shareholder (along with LIF) that does not look at IOC in isolation in influencing an economic produce or shut decision (i.e. losses can be offset by merchant trading).
As I will discuss later in the write-up, I think LIF’s current price already discounts about a 3 year shutdown of IOC.
Valuation Base Case $26, Bear Case $18. Getting equity in IOC for free
The mechanics of modeling LIF’s royalty cashflow is pretty straight forward – put in the average expected realize price and expected annual production and then take 7% as LIF’s royalty. Other sources of revenues include a $0.10 commission per tonne of iron ore produced and some nominal interest and income from LIF’s net cash on the balance sheet. On the expense side, royalty taxes are 20% of LIF’s royalties received and there is about a $2 mln administrative expense.
Modeling out IOC’s cashflow takes a bit more guess work on operating costs per tonne and maintenance capex to get to a FCF figure – at which point you would take 15.1% of it and attribute it to LIF.
Using a US$80/t realized price assumption going forward (US$60 concentrate, US$95 pellet), I get an LIF value of $26 per share, $20 per share for LIF’s royalty stream and about $6 per share for LIF’s equity interest in IOC after a 30% holdco discount. In other words, we can value LIF’s equity interest in IOC at zero and still get a reasonable upside to LIF based on the royalty alone.
With a more bearish US$65/t realize priced assumption (US$45 concentrate, US$80 pellet), I get a DCF value of $18 per share, $16 for the royalty and $2 for IOC.
Again, we need not pray for higher iron ore prices merely that either prices stabilize or concentrate prices drop not much below US$45/t.
Assuming IOC shuts down for 3 years (2016 to 2018, with LIF burning $2 mln per year) and a LT realized price of US$65/t (i.e. US$45 concentrate), I get a DCF value of $16 – approximately where LIF is trading at. To oversimplify, if there over/under on LIF is a worse than 3 year shutdown, one should be able to make a clear case for the “over”.
While I would mark this as a very low probability, it is difficult to put a value on a truly LT draconian scenario (other than a value of zero). However, for illustrative purposes, I will note LIF got a takeout bid from Rio Tinto in 2001 for ~$15/share which is $7.50 split adjusted. Back in 2001, iron ore concentrate was ~US$29/t, pellets were US$50/t and IOC realized ~C$42.5/t and an operating cost of ~C$39.5/t.
You will notice I did not include a bull case as I would be hard pressed to forecast iron ore prices being higher in the future but it is a non-zero probability.
Likely Substantial Interest in LIF from Activists, Other Royalty Companies and Rio Tinto
Activist Interest: LIF is a passive investment vehicle where management has not been particularly active in optimizing its balance sheet, removing its implied holdco discount on its IOC equity interest and maximizing value for shareholders. It is highly likely activists are interested in LIF as it was about 2 year ago when Waratah Advisors had interest in LIF and pushed for changes (when LIF was trading 2x where it is trading today).
They also had a (private) detailed LIF slide deck – I encourage you to contact them to get a copy.
Interest from Other Royalty Companies: Due to LIF’s convoluted structure (despite its royalty component), LIF trades at a discount to NAV while many Canadian royalty counterparts trading at a premium to NAV (up to almost 3x in the case of Franco Nevada), such as Royal Gold, Franco Nevada, Silver Wheaton, Osisko Royalty and Altius Minerals. It is rumored that Altius Minerals was in discussions with LIF earlier this year and requested LIF remove its restrictions on not being able to invest in additional royalties/projects and being able to issue up to 20% of shares outstanding to pursue M&A.
I believe the market incorrectly interpreted LIF’s proposal as an indication that IOC is about to shutdown and the likely equity raise and dilution that would result. I believe either the rejection of this proposal in the upcoming AGM or the market’s realization there is takeout interest would be a near-term positive catalyst.
Unfortunately as I am writing up LIF, it was revealed Osisko Royalty has acquired a 9.75% interest in LIF on Friday May 15, 2015. While unfortunate from a price perspective, it does somewhat validate my thesis here and given the valuation upside, does not really change the attractiveness of LIF.
http://ca.reuters.com/article/businessNews/idCAKBN0O023C20150515
Interest from Rio Tinto: As mentioned previously, Rio Tinto attempted to take out LIF in 2001 as its 7% royalty on IOC is clearly an irritant. With the China driven commodity boom since 2001, Rio never really had an opportunity to revisit taking out LIF until now (with a brief window during the financial crisis).
The attractiveness of a takeout to Rio Tinto cannot be understated. With LIF’s current enterprise value of ~C$1 bln, Rio can immediately improve IOC’s cashflow by C$115 mln by removing the 7% royalty (7% on the latest realized price of C$105/t on 16 mln tonnes). There are 3 key points here:
1) At current iron ore prices, Rio can get an easy 10%+ FCF yield (pre-tax) on the takeout. This transaction does not require any forecasting of revenue or cost synergies or another other form of hopeful thinking typical in M&A transactions. Both the math and savings is simple and straight forward
2) With IOC’s capex spend over the past few years, the future annual savings from removing a 7% royalty is even greater (i.e. capacity closer to ~ 20 mln tonnes)
3) Rio gets another 15.1% equity interest in IOC without really paying extra for it.
With Osisko Royalty having made the first move, it is very conceivable Rio is looking even closer at LIF, especially when C$1 bln spent on other capital projects exposes Rio to timing and construction risks, etc.
Iron Ore Market, Potential for Supply Discipline
My LIF thesis assumes currently iron ore prices remain stable or not deteriorate significantly from where we are for a significant period of time (i.e. not more than -25% or below US$45/t).
The above assumptions may be what many readers on VIC may disagree with given the generally correct iron ore short ideas on this board.
Before I explore why I am less bearish on iron ore at this point, it is probably important to review the iron ore bear case and why it is correct so far:
1) China’s infrastructure spending is unsustainable and has to slow down. A review of China’s fixed asset investment as a percentage of GDP on an absolute basis and relative to other developing countries would lead one to this conclusion
2) In theory, the iron ore cost curve would suggest prices should hold in the US$100-$120/t range given the high cost Chinese producers’ marginal costs. In reality, high cost producers don’t necessarily react rationally to market conditions especially when the government may subsidize them in the near to medium term.
3) There is plenty of iron ore in this world and many of it is low cost (as low as US$20-25/t in BHP’s case). Worse, the big three, BHP, Rio Tinto and Value can be expected to continue to bring up significant supply, further crushing the iron ore price.
Clearly points 1 and 2 have played out quite well and there is little to argue with. In fact, the Chinese government is currently subsidizing Chinese iron ore producers to keep on producing by lowering tax structures and will possibly subsidize the industry in other ways in the future. As a result, prices have not held in the US$100-US$120/t and began a precipitous decline to just below US$50/t recently before rebounding to US$60/t.
What I disagree with iron ore bears is on point 3, that the big three BHP, Rio Tinto and Vale, accounting for ~70% of the iron ore supply market would exercise no supply restraint and continue to bring on supply and crush the iron ore market until prices are in the US$20/t to US$30/t range. Before I lay out my analysis, I would encourage readers to read Chapter 15 of Bruce Greenwald’s book competition demystified on cooperation. If you don’t have the book, you can skim this link for some background:
http://csinvesting.org/tag/competition-demystified/
The most relevant part of the chapter is on the lead additives industry which is more or less a commodity business. Despite lead additives being phased out by the EPA (i.e. going to zero), industry players with meaningful market share were able to cooperate sufficiently to generate significant operating profits all the while the industry withered away. (The other examples of Nintendo and Sotheby’s are less relevant as the other studies revolved around companies with significant moats/competitive advantages and how they dealt with competitors).
I contend that the iron ore industry has been playing a repeated game of prisoner’s dilemma where the best result would be for the industry as a whole to exercise supply restraint in maintaining higher prices (price over volume). However, individually, each producer is highly incentivized to produce more to capture market share and incremental margin (i.e. cheat). If every producer did this, everyone is worse off, hence the prisoner’s dilemma.
Back in around 2010, I met with BHP management and I frankly thought they were nuts. They went on harping about being the lowest cost producer in the US$20s and they will continue to bring on as much supply as possible to take advantage of that. I went on to ask them how it isn’t better to realize US$100/t than double your production and realize US$40/t and their answer was that they don’t care and they will not lose market share. I heard a similar message from Rio Tinto although the tone was less aggressive than that of BHP’s. Interestingly, in a meeting with Glencore (who was just going through the Xstrata deal) I brought this up and Ivan Glasenberg laughed and told me to wait until iron ore prices are cut in half and see what they say.
Although BHP and Rio’s rhetoric seemed crazy at the time, I now realize exactly what they were trying to accomplish by sending out these signals: 1) new entrants do not come into our turf (they already had Fortescue embarrass them), and 2) we are not taking the hit when prices fall, the Chinese producers better cut. Just like in a game of chicken, a player can increase its credibility by declaring his intentions and breaking the steering wheel so he can’t swerve (so his opponent has to), the big three were doing the same by sending out that message to market and committing to aggressive capacity expansion projects.
As an aside, I believe BHP tried to do the same thing in the potash industry. Ironically, it was interested in the potash industry precisely because supply was controlled by an oligopoly, yet publically, they announced they would bring on production, be a low cost producer, and not be part of the marketing cartel Canpotex. Even more interesting, when the Russian cartel broke, Blackrock bought Potashcorp aggressively knowing the cartel is unlikely to be broken forever and that the Russians/Belarussians were playing their own prisoner’s dilemma game by punishing oversupply (“cheating”). Not only that, Blackrock immediately turned around and told BHP to stop investment in potash assets:
What I am saying is major shareholders of BHP and Rio Tinto are also likely to be exerting great pressure to stop them from oversupplying and killing the iron ore industry by continuing to spend more capital on iron ore projects.
Despite BHP and Rio Tinto’s clear and committed signals to deter new entrants and their unwillingness to cut production should prices fall (i.e. it’s on you, Chinese producers), they perhaps failed to recognize the Chinese government’s willingness to have Chinese iron ore produce even on uneconomic terms. Further, it is difficult to take such an antagonistic stance when the Chinese are also your biggest customer for your products.
With iron ore price collapse, it is very interesting that what the players are now signalling and gives me a confidence some supplier cooperation could happen and prices should stabilize:
Fortescue’s Andrew Forrest came out and explicitly suggested industry players cap production while in China. Translation: Guys China producers aren’t shutting down, we need to cut production, change of plan.
A month later, BHP signaled even it would defer its port expansion “A planned $600 million project to reduce bottlenecks at Australia’s Port Hedland, the world’s biggest bulk export terminal, will be deferred, meaning BHP will miss a target of raising production to 290 million tons a year by mid-2017, the company said in a statement”
Within 2 weeks, Vale came out explicitly saying it is ready to cut iron ore output. "If the market demands it, we are ready to reduce some production flows in the Southeast to optimise and increase our margins even more," Poppinga said on a conference call Thursday, referring to one of its main producing regions in Brazil.
Although the Chinese were never expected to play ball, even Baosteel announced it is delaying its iron ore project until 2020 being “mindful of the volatility in the iron ore market”.
Now just last week, Cliff Natural Resources CEO presented in BAML’s Barcelona conference. A sales note I received says: “Comes out swinging and says the decline in iron ore prices is not attributable to supply/demand dynamics but rather a deliberate effort by the Australian’s to crush the price with an implication that their actions would be illegal in the US….”
Just 2 days ago, in an even more surprising turn of events, instead of investigating Andrew Forrest for his anti-competitive comments, the Australian Prime Minister wants an inquiry into BHP and Rio’s possible predatory pricing behaviour in iron ore!
Putting this all together, I believe the iron ore industry whether implicitly or being nudged by the Australian government, will likely cooperate more on being “mindful” of supply to support iron ore prices. That is why my base case LIF valuation assumes iron ore prices stabilize at current levels going forward - $26/share target.
If I am wrong on this, my bear case LIF valuation is $18 per share assuming concentrate prices fall to US$45/t. With Vale’s delivered costs in the US$45/t range and its intention to reduce supply as necessary, this should serve as a near to medium term price support level should my expectations for industry supply coordination thesis prove to be optimistic.
http://www.vale.com/canada/EN/aboutvale/news/pages/confira-resultados-quarto-trimestre-2014.aspx
Finally, again, I contend LIF is currently pricing in a 3 year shutdown. While BHP and Rio boasts US$20-US$35/t cash costs, I think one would need to include allocated G&A and maintenance capex costs to see what cost structure and pricing is sustainable in the medium to longer-term even if demands falls off so dramatically that it intersects with the 1st or 2nd quartile of the cost curve long-term (and possibly meaning a price US$40/t+)
Near-term Catalysts
With Osisko Royalty’s almost 10% stake in LIF revealed Friday, it is conceivable LIF could experience a small short squeeze as its short interest is relatively high (when compared to itshistory) at 2.7 mln shares, especially when considering the negative carry this short is paying on the dividends. As it becomes clear IOC is unlikely to shut, I believe the shorts will cover.
As well, LIF’s May 28 AGM will have shareholders vote on its proposal to invest in additional royalties and issue up to 20 % of its equity. I believe shareholders will reject this proposal which could serve as a positive catalyst in the near-term.
Disclaimer: The write-up is only intended for VIC members and not for dissemination.
Not investment advice, no warranties expressed or implied, subject to material and potentially egregious errors. Basically, do your own homework.
Iron ore prices stabilize
Short Squeeze (Osisko Royalty's 10% stake, IOC not shutting down)
LIF AGM where shareholder reject proposal for LIF to acquire additional royalties and/or issue up to 20% shares outstanding
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