Baffinland Iron Mines is sitting
on mines that should pump out over US$16 BILLION in pre-tax cash flow over 25
years. Never mind the mining should last close to 100 years due to its
incredible size. Insiders have bought over C$5 million in stock in the last 18
months (over C$11.2 million in the last 3 years). Mitsubishi has also made a
strategic investment in the project. Despite the potential and the heavy
insider ownership, Baffinland still only has a C$240 million market cap. This
should change over the next six to nine months due to a likely new strategic
investor and the definitive feasibility study. The stock could easily double or
triple from its current level.
Iron Ore is used in steel
Iron ore is the raw material used
to make “pig iron,” which is the main ingredient in steel. There are three
types of iron ore: lump, fines and pellets. Paradoxically, fines are actually
the lower quality iron ore and must be “sintered” or fused together. Fines can
also be processed into pellets which are then used to make steel. Both fines
and pellets require extensive processing. Lump can be the better quality iron
ore because little processing is needed and it is suitable as a direct feed to
making steel. Lump iron ore typically receives a premium to fine iron ore.
Currently that premium is about 27%-30%.
Most of today’s mines generally
produce a small percentage if any of their output as lump. In fact, the largest
iron ore mine in the world, the CVRD mine Carajas, only produces 5% lump and
its lump percentage is declining.
(Baffinland’s iron ore deposits are anomalous at 75% lump and 25% fine.)
Cartel Pricing for Iron
Ore and Steel Companies Are
Getting Squeezed
It is important to note that sea-borne
iron ore (iron ore that is not domestically produced and consumed in any one
country) is essentially controlled by a cartel of three companies: BHP
Billiton, Rio Tinto and CVRD. They control about 75% of the sea-borne iron ore.
Every year steel companies negotiate iron ore prices for the following year with
these three companies.
And lately due to the demand for
steel and thus iron ore, prices have been jumping. In 2005, iron ore prices
went up 71.5%. In 2006, prices increased 19% and in 2007 prices increased 9.5%.
Iron prices have tripled since 2002 and early predictions are that prices could
increase another 10% in 2008.
It’s not hard to understand that
steel companies are not enjoying those price increases exacted by the “Big 3”
iron ore producers. Chinese steel companies have been trying to get more
involved in the price negotiations as the Chinese steel industry explodes in
volumes.
China may have some longer term
issues beyond the pricing of iron ore. China reported in May their
“official” iron ore reserves of 59.4 billion tons. However, most of those
reserves are low-grade of 30-35% iron. These reserves are even less impressive
when you realize that only 50% of these reserves have been commercially
prospected.
Despite these impressive sounding
reserve figures, there are rumors in the marketplace that China is mining
iron ore grades as low as 8-9% iron. By mining ore at such a low grade, China literally
may be running out of domestically produced iron ore. The amount of labor and
work involved in trying to get iron ore out for that type of grade is quite
high. If China
has problems with its domestic iron ore production look out for iron ore
prices, they will explode higher.
Luo Bingsheng, deputy chief of
the China Iron and Steel Association, has been quoted as saying that Chinese
steel companies should buy or jointly develop overseas iron ore mines. He also said “that in order to guarantee
stable supply in the medium and long term China needed to control at least a third of
world iron ore resources.” I wonder how many investors have considered this
comment.
Further, India recently
boosted its export tax on iron ore with a 62% grade or better, as they are
trying to keep as much high quality iron ore in the country as possible.
These countries are not the only
ones struggling with iron ore prices. The largest steel company in the world, Arcelor
Mittal, is starting to struggle with those prices. Arcelor Mittal has been
largely protected by its ownership of several iron ore mines and also due in
part to supply agreements such as its 25 year preferential supply agreement
with Kumba Iron Ore in South Africa that gives Arcelor Mittal 6 million tons of
iron ore at cost plus 3 percent. Currently, Arcelor Mittal has 64 million tons
of iron ore its 145 million tons needs covered. Its goal is to get to 75%
coverage. This is why Arcelor Mittal is actively looking to invest in iron ore
mines.
Suffice it to say that supply is
tight, and power is increasingly in the hands of just three companies and
prices are poised to stay strong and continue to rise as long as demand for
steel stays strong.
Baffinland’s 100% owned world class Mary River Deposits
Baffinland sits on world class
deposits of iron ore. Compasses don’t work at the deposit as the iron ore
grades at 66% iron. Consider that the highest percentage that nature
theoretically allows is 69%. The company has five deposits that cover 1,600
hectares.
Baffinland has really only
drilled a portion of Deposit #1 and that is what the scoping study and its
definitive feasibility study will be based upon. Current estimates of 12.6
million tons per year producing for 25 years are based upon only one of five
deposits. Now you can start to visualize how big this operation is going to be.
Baffinland’s initial drilling of
Deposit 2 and 3 have showed some spectacular results. For example, just in
December drilling of Deposit 3 showed 65.8% iron over 170 meters. In 2004,
drilling of Deposit 2 showed 63.5% iron over 107 meters. If these initial
drilling results prove accurate, Baffinland could be sitting on a
multi-generational iron ore mine, or production of 100 years. More on the
deposits can be found here:
Investors wanting further
confirmation of the quality of Bafinland’s iron ore deposits should note that BHP
Billiton actually staked claims around Deposit #4 at Mary River
in 2006.
Scoping Study tripled estimate and Definitive Feasibility Study due in
December
Last May, Baffinland through its
Scoping Study work was able to triple the resource estimate to 309 million tons
iron ore at a grade of 66.1% iron and inferred resources of 28 million tons at
a grade of 65.9% iron. The Scoping Study assumed that the mine would produce 10
million tons of iron ore for 34 years.
The initial scoping study
produced a cash flow figure of over C$6 billion. However, Baffinland now
estimates a higher yearly production number of 12.6 to 15 million tons a year
and shortened the time to 25 years from 34 years. And the initial scoping study
used figures that are over 43% below current iron ore prices.
The scoping study is kind of like
an official “preliminary” resource estimate, and the strict official estimate
is called the Definitive Feasibility Study, and that is due on December 15th
of 2007. The Study will also be using the improved production estimates and
this should provide much higher cash flow and a substantial increase to IRR.
The release of this study should provide a concrete catalyst for Baffinland.
Mitsubishi Investment gives credibility
In December of 2005, Mitsubishi Corporation
invested C$5.5 million to buy 2.75 million shares at C$2 per share. That price
was over a 30% premium to Baffinland’s share price at the time. Further,
Mitsubishi added more as part of a follow-on offering earlier this year.
Of interest to note is that
Mitsubishi owns 26.2% of Canada’s
largest iron ore producer Iron Ore Company of Canada. They also own a 49% stake
of Iron Ore Company of Canada’s
sales division. Further they own 50% of Compania Minera Huasco S.A. in Chile
and Mitsubishi also has a significant global trading presence.
I believe that Mitsubishi’s
presence as an investor in Baffinland is a significant positive and validates
the potential for Baffinland. Further, their continued participation in
financing Baffinland is also very positive.
The potential cash flow numbers are HUGE and the IRR is large as well
The calculations can get a bit
complicated, so I will try to keep it as simple as possible. (All figures are
in US dollars for the below calculations) Taking out the shipping costs and using
the 2007 price of $62.50 a ton for iron ore FOB Baffin Island (not in Rotterdam where the iron
ore will be shipped).
If you assume about US$12 to $14
of operating costs, you get an average of around $50 a ton in operating cash
margin. At 12.6 million tons a year, that produces $630 million in cash flow
and at 15 million tons, that produces $750 million in cash flow. Total cash
flow over the course of the first deposit would be $15.75 billion at 12.6
million tons and $18.75 billion at 15 million tons with the second deposit.
I calculate the pre-tax IRR of
the mine to be 42% to 46% depending on how much iron ore is produced a year.
This is a significant boost to the 15% calculated in last year’s scoping study.
This also assumes 100% equity funding the project. If debt is used, the IRRs go
even higher. Further this gives absolutely zero value to the fact that there is
probably another 75 years of iron ore to be mined.
High valuation numbers based upon recent transactions
Two iron ore companies were
recently acquired. Vedanta acquired Sesa Gosa and Anglo American’s purchase of
49% of MMX Minas Rio provides some timely comparisons to the valuations currently
being paid for iron ore producers. The EV/tonnage produced a year is $180 a ton
of iron ore.
Now if I multiply 15 million tons
per year times $180 a ton and I subtract the capital cost of building out the
mine (US$1.6 billion, more on this later), you get a valuation of $1.1 billion,
which gets you a price of C$13.60 stock price. Again this gives no value to the
other deposits or the long life nature of this mine.
Compared to other junior
producers trying to build new iron ore mine, Baffinland by far has the highest
grades and the highest quality iron ore. The only one close is Mt Gibson Iron
which has a much smaller mine that should produce 3 million tons of iron ore at
50% lump 50% fines. Finally, Baffinland also has the second lowest cost of producing
iron ore. The only mine that has a lower operating cost than Baffinland is
MMX’s Minas Rio, which Anglo American just bought 49% of for $1.2 billion as
mentioned above.
Insider Buying
Insiders are rarely stupid with
their own money. And the insider trail at Baffinland is telling. Since 2005,
insiders have bought over C$11 million worth of stock and in the last eighteen
months they have bought over C$5 million worth of stock. To put the insider
buying in perspective, name another small cap whose insiders have over 5% of
the company recently?
Both the CEO and the chairman
have been consistent buyers since around C$1 a share up through C$3 a share.
The most indicative pattern of insider buying I have found is when executives
are buying as their stock goes up. There is only one reason an executive would
do this. This is a significant positive and how I found the company in the
first place.
An interesting anecdote is that
Gord McCreary (a mining engineer and the CEO of Baffinland) wrote his MBA
thesis in the 1977-1978 that someone could develop the Mary River
deposits in the right iron ore price environment and produce an excellent
return doing so. After working for other mining companies, now he’s making his thesis
come true.
The Biggest Risk
The largest risk to Baffinland is
the issue of raising the money needed for their large mine, which will require
a very large upfront investment of around US$1.8 billion (C$2 billion). The $1.8
billion will be for the mine, rail line and port as the Mary
River deposits are in a remote region
of Northeastern Canada. So this begs the
question: How exactly is a $240 million market cap company going to raise this
amount?
First, the company has already
proven it can raise equity money, as it has raised almost C$150 million in
money to date, including a large flow-through raise of over C$49 million announced
on May 16th. (Flow-through common shares are tax credit securities that provide
tax benefits to Canadian investors and are only available for junior mining and
energy companies.)
Second, the company plans to add
strategic investors to help with the financing and facilitate debt financing.
Baffinland already has Mitsubishi as a strategic investor and may be able to
rely on them for further financing, when the company proceeds with the US$1.8
billion capital raise. Further, Baffinland plans to add additional strategic
investors such as steel companies, shipping companies or even a larger mining
conglomerate. The more strategic investors Baffinland can get on board the
easier it will be to get financing and more importantly debt financing which
will significantly raise the IRR of the project.
Third, if raising the money for
this project was such a problem, would insiders blow over $11 million buying
stock?
Finally, the continuing rise in
the price of iron ore, demand for steel, and the tightening of the supply for
iron ore in China and India will
continue to make Baffinland more and more attractive to partners and
financiers.
Shipping Risk
Shipping is the second big risk
the company faces. The Mary River deposits are in Northeastern Canada and quite
close to Greenland. There is worry about what
kind of ice breaking ships will be needed to transport this and the cost
involved in building rail lines, a southern port and paying for the ships
themselves.
Investors should be assured by the
company’s partnering with FedNav, which is the company’s new partner in
planning out the shipping solution for the Mary River
deposit.
“Fednav has participated in every
major bulk shipping project in the Canadian Arctic and has provided innovative
and practical solutions that have helped to develop shipping in the Canadian
Arctic for over 50 years. Fednav currently provides bulk shipping solutions for
CVRD-Inco's Voisey's Bay Nickel operations, Xstrata's Raglan Mine to the south
of the Mary River Project and Teck Cominco's Red Dog mine in Alaska. While in operation, Fednav provided
bulk shipping services to Breakwater's Nanisivik Mine and Teck Cominco's
Polaris Mine to the north of the Mary River Project and was a major provider of
ice-class tug and barge shipping services to the petrochemical companies
drilling in the Beaufort Sea in the 1970s and 1980s.”
Potential Strategic Partners
The most logical strategic
investor at this point would be a steel company and more specifically a
European steel company, since Rotterdam
is the easiest shipping destination for Baffinland.
The world’s largest steel
company, Accelor Mittal, is one company that could very much use Baffinland’s
low cost iron ore. As mentioned above, they have a history of locking in
pricing and supply and actively investing in iron ore producers. Another
potential steel partner is ThyssenKrupp AG, the German steel giant. It’s
interesting to note that because of declining availability of lump iron ore
from Brazil to Europe, there is a developing shortage of lump into the
European steel sector. This bodes well for Baffinland.
Another example of a potential
strategic investor is a shipping company, which will then contract on to ship
the iron ore. Other potential investors are mining companies such as Anglo
American, the world’s second largest mining group, which wants to triple its
share of iron ore production.
Why the timing is so good to buy the stock now
By year’s end, BIM should have a
new strategic partner and results from their definitive feasibility study. Each
of those catalysts should cause the stock to move markedly higher. When
Mitsubishi signed on as the first strategic investor, the stock almost doubled
in a two month period. The definitive feasibility study will prove to investors
that this project can be done and what the official numbers will look like.
Both of those major catalysts should serve to drive the stock considerably
higher.
In 2008 the company will ship a
bulk sample of 250,000 tons to prove the quality and show the world what
Baffinland has to offer. By that time, the stock price should be much higher.
Summary
Executives of Baffinland have
bought over C$11 million of stock. Why? They see a multi-generational iron ore
mine that has world class grades of iron. They see substantial IRRs and
substantial cash flow. They see a company that could be worth more than $1
billion selling for around $200 million. With new coverage, a definitive
feasibility study and a new strategic investor, Baffinland should see its stock
price at least double by year end.