Description

Mesabi Trust – MSB 

Mesabi Trust is a royalty pass-through entity with essentially zero operations or variable expenses, which has resulted in a net profit margin of approximately 96% over the past three years. The company receives royalty payments predominantly based upon iron ore mining at the Northshore mine in Northern Minnesota. The revenue stream is variable, and can be highly volatile, based upon mine production, shipments and iron ore pricing. I believe that recent developments will markedly improve the long-term cash flow profile of the Trust (explained in detail below), however current market conditions, which include the temporary closure of the mine (April 13, 2020) have created an attractive opportunity to accumulate shares today.

Due to the price volatility today, I have expedited this for publication today as the shares are down over 10%, likely in response to the mine closure announced yesterday afternoon. 

Background

The Trust was created in 1961 in order to hold the interests of Mesabi Iron Company (“MIC”) in the Mesabi Iron Range, which includes the Peters Lease, Cloquet Lease and Mesabi Lease. MIC hasn’t engaged in mining operations since 1939, hence the conveyance of the land and mineral interests into a Trust. The original leases were granted to the Reserve Mining Company (“RMC”), which operated the mine until its closure in 1986. Cyprus Minerals Company purchased substantially all of RMC’s assets in 1989 and resumed operations, and was purchase by Cliffs in 1994, which renamed the entity as Northshore Mining. 

Cleveland Cliffs Inc. (CLF) remains the owner of Northshore Mining, and has positioned the mine at the center of its long-term growth and profitability strategy, which includes the recent purchase of AK Steel. AK Steel was a primary customer of Cliffs, and generated approximately 29% of CLF product revenue in 2019. AK produces a variety of value-added steel products, primarily for domestic automotive, infrastructure and manufacturing customers. The company operates various steel making and finishing facilities in Pennsylvania, Ohio and Indiana – all in close proximity to Great Lakes ports which are critical for iron ore shipments. AK Steel operates two electric arc furnaces (“EAFs”) as well as two efficient integrated blast furnaces. EAFs have been taking market share in domestic (and global) steel making due to lower operating costs and more efficient operations (lower carbon), but also lack the ability to supply all of the value-added steel needed in the United States for higher end application (i.e. automotive and infrastructure). Cliffs is positioned to supply any or all of these facilities with Hot Briquetted Iron (HBI) feedstock from a new facility that is under construction in Toledo, Ohio. 

The HBI plant will require high quality “DR-grade” pellets, which are 90% pure iron. These pellets can be used to improve steel grades and quality at both EAFs and blast furnaces, while HBI can be used seamlessly (smelter loading) at EAFs and provides ease and efficiency in shipment. Cliffs recently completed a $100 million expansion of its Northshore mine to enable and expand DR-quality pellet production, making it the only U.S. operation of its kind. The recent Northshore expansion, Cliffs/AK merger and HBI facility construction all promote the long-term volumes and pricing of the Mesabi royalties.

Mesabi Trust Estate

The primary assets of the Trust are interests in properties associated with the Peters and Cloquet Lands, which are 9,750 largely contiguous acreages in St. Louis County, Minnesota. The Trust additionally has proportionate fee interests in the land via the Mesabi Land Trust, although the fee-related revenue contribution is generally less than 2% of consolidated revenues per year. 

The Northshore mine is approximately 2 miles south of Babbitt, MN and connected to owned and operated processing facilities and shipping facilities in Silver Bay, MN. The ore is transported along an owned and operated single track railway approximately 47 miles to the port in Silver Bay. Once the finished products are available for barge transport in Silver Bay, the pellets can be delivered cost effectively to various ports, including the HBI facility under construction in Toledo, Ohio. The HBI plant is vital to Cliffs not only because it can supply AK facilities in the region, but CLF has identified 20 EAFs in close proximity to the plant. This HBI plant, as the only supplier in the Great Lakes region, will offer the highest quality product, at competitive costs due to efficiencies in shipment and procurement. Upon completion this facility will have capacity of 2.8mm tons of HBI per annum, solidifying CLF’s position as the dominant pellet producer in the United States (55% market share in 2019).

The competitive advantages of the Northshore Mine are plentiful: highest grade DR-quality pellets, plus owned and operated rail, processing and port operations with direct lake access. Cliffs estimates that the HBI plant will displace a large portion of 3 million tons of ore shipped into the Great Lakes from Russia, Ukraine, Brazil and Venezuela. The impetus for domestic steel supply chains was strong prior to the current COVID-19 pandemic, but I believe that there will be ever stronger tailwinds for domestic supply of critical steel feedstock. This is particularly pertinent to the CLF end markets tailored to U.S. infrastructure and automakers, as being politically important industries. 

The Northshore Mine has a reported annual capacity of 6mm tons, and reported total production of 5.2 million tons in 2019 (this differs from shipments used for royalties, and includes some non-Mesabi land production). This includes 3.5 million tons of DR-grade pellet annual capacity. The most recent reserve estimates for the mine included 816 tons of proven and probable ore, which translates into approximately 265.3 million tons of “saleable product,” based on a 65%-66% pellet standard. This translates into a reserve life of over 50 years based on recent production levels (although this doesn’t include additional expansion on Mesabi lands). 

The mine reserve life is coincidentally aligned with the duration of the Trust, as defined in Section 4.2 of the Article of Trust, which stipulates that the Trust be dissolved 21 years after the death of the last remaining living person named in Exhibit 1. The list of 25 people range in date of birth from 1949 – 1960. If we assume a life expectancy of approximately 90 years, the Trust will be set to be dissolved (likely sold) in 2071, or approximately 51 years.

Royalty Agreements

Mesabi Trust receives two types of leasehold royalties i.) base overriding royalties and ii.) royalty bonuses. The base overriding royalty is an escalating percentage of revenue based on the total tonnage of ore pellets shipped (rate schedule below).

The royalty bonus is calculated based upon the ore shipped which is sold at prices above the Adjusted Threshold Price, which is re-determined annually based upon various measures of inflation and deflation set by the U.S. Department of Commerce (rate schedule below).

The Adjusted Threshold Price has been $55.74 and $56.93 for the calendar year 2018 and 2019, and set at $57.85 for the calendar year 2020. This compares to Cliffs reported pellet selling prices of $105.64 and $99.50 in 2018 and 2019. The pricing is largely based upon the Platts 62% Iron price, in addition to the Atlantic Basin pellet premium. While the Trust noted that 93.2% of product shipped from the Silver Bay facility in 2019 was priced in excess of the threshold price, there is currently an arbitration proceeding regarding a dispute over official selling prices (see risk factors). Cliffs describes their pellet agreements with customers as being subject to “customer requirements and subject to various adjustment factors.” However, objectively, the threshold prices are well below the international iron ore benchmark pricing, even without including pellet premiums (chart below).

The trust also earns a royalty related to the Land Trust, which owns a fee ownership in the Peters Lease and Mesabi Lease. It is not particularly pertinent to the operations of Mesabi Trust, as the revenues are less than 2% in recent years. 

Neither the Trust, nor Cliffs provide specific details regarding the pricing or pellet composition of shipments from Silver Bay, but the following example can be used to impute the rates and royalties for FY2020.

This is an imperfect estimate for the royalties (which are subject to standard adjustments based on differences between shipping dates and amounts). However, the imputed prices appear to reconcile with Cliffs reported realized pricing of $99.50/ton with a slight discount, while the royalty bonus estimate nearly matches reported bonus royalties perfectly. 

Current Market

Mesabi shares have declined approximately 45% this year which can be attributed to three primary (fundamental) drivers:

1. Benchmark 62% Iron Ore prices have declined from approximately $91.53/ton to $84.48/ton, or nearly 8%

2. Cliffs announced that construction at the HBI plant in Toledo was shut down on March 20th following guidelines from the governor of Ohio.

3. Cliffs announced that the Northshore mine will temporarily idle production beginning in mid-April, with an expected resumption of production by August.

While spot iron ore pricing is economically sensitive, hence cyclical and hard to predict, I believe that the long-term fundamentals for domestic, low silica pellets remains very strong. The demand of U.S. automobile manufactures, power generation grids and other infrastructure projects has been disrupted, but has significant latent demand over the next several decades. 

The HBI plant in Toledo had already incurred approximately $700 million in construction costs (relative to an estimated cost of $830 million) and is instrumental to the strategy of the combined Cliffs/AK Steel Company. The original intended operational date for the plant was June 30, 2020 (or earlier), hence it’s likely, or even possible that pellets from Northshore have already been stocked for use in the facility. This is likely a contributing factor to the 3.5 month idling of the Northshore mine, in addition to factory downtime in many steel end markets.

Accordingly, the market reaction to the share price has been vastly overdone in my opinion, offering over 100% upside potential within 12-18 months. 

Valuation 

Investors are inclined to value Mesabi based on a trailing distribution yield, however this often misses many of the nuances of the business. In any event the Trust distributed $2.34/share (including an announced dividend for payment May 20th) over the past fiscal year. This amounts to over an 18% yield based on the current share price. This is not a reliable assumption for the next 12 months given the fundamental changes to the business. If I adjust the previous year’s royalties for the decline in the benchmark ore index, and assume that the company sells 1 million less tons this year (assume 500,000 tons taken from inventory), the distribution can be estimated as follows;

If this cyclically depressed distribution were to be capitalized at a 7.5% rate, the resultant share price is $19.10, or approximately 50% higher than today’s price. However, this also likely understates the economic value of the normalized business, as I expect the company to revert to average annual production of 5 million tons (much of which to the HBI facility in Toledo) over the next 50 years. This product should result in premium pricing based on quality and freight savings, but there is additional upside should the U.S. and its corporations seek to secure domestic supply chains. Under this scenario, the Trust will distribute $2.50 in 2021, and iron ore pricing will improve by 2% (PCE based) per year, for 52-years (to mine depletion). A DCF based valuation ranges from $30.63 (10% discount rate) to $64.88 (5% discount rate). 

Risks

There are obvious risks with regard to a commodity based enterprise, but these are partially mitigated by owning a royalty business. I will note some nuances and unique risks to the Mesabi business below;

• The Trust entered into an arbitration hearing with Cliffs (filed 12/9/2019) regarding pricing for DR-grade pellets and royalty calculations. The accusations include the improper calculation of pellet volumes, as well as isolated pellet sales intended to manipulate pellet pricing for royalties. This relationship may become even more complicated as the HBI facility becomes a major customer of Northshore, and arm’s length transaction prices can be manipulated to favor Cliffs (over Mesabi).

• The Mesabi Trustees include two retired Cliffs employees (who likely have pensions paid by Cliffs), in addition to a retired banking officer and attorney. The Trustees recently failed to gain shareholder approval for a pay increase, and the appointment of a new trustee (filing a retiring trustee spot). However, they used legal maneuvering to adjourn the meeting, and ultimately got the trustee approved (subsequent to proxy soliciting) but failed to gain support for a pay increase. In any event, the pay is modest at $40,000/year, but the trustees may lack expertise or incentive to properly negotiate with Cliffs. The recent arbitration appears to show a certain degree of involvement and participation.

• Cliffs has additional mining interests in the Mesabi Range, but the recent $100 million expansion to Northshore, and captive transport to owned processing and shipment facilities at Silver Bay, makes this asset their most coveted. 

• The logistical challenges of Cliffs integrating AK Steel, while also entering the metallic business with the HBI Facility, cannot be ignored, and are critical to the long-term thesis. 

Catalyst

• HBI facility in Toledo becomes completed and increases demand/pricing for DR-Grade pellets
• U.S. prioritizes domestic supply chains, supporting local ore pricing and volumes
• Government stimulus includes infrastructure bill boosting high grade pellet demand from U.S. mills
• Stimulus results in inflation pressures, which combined with supply chain disruptions, boost pellet pricing 
• Favorable arbitration ruling over Cliffs royalty dispute