Description

Mesabi Trust – Why I see 80% upside to conservative fair value 

“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. Year to date, the situation with Mesabi Trust has improved dramatically, as reflected by:

• A huge boost on ore pricing revealed in the latest royalty report – my calculations indicate implied pricing is up 55%. 
• New royalty pricing due to the expiration of a below-market contract between Cliffs and ArcelorMittal 
• Volume estimated of ore shipped YTD from Mesabi lands are running at 65% above full year 2016 and approaching the mines full capacity (Royalty Reports, tracking at www.marinetraffic.com) 
• Mesabi’s blowout Q2 – earnings up 436% from Q2 2016 
• Mesabi’s Q2 EPS ($.99) was greater than full year 2016 EPS of $.73 

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%, tax advantaged forward yield (using my estimates and based upon the current price)
• Sound interesting? 



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. 
Structure

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).

My Bull Case - new contracts have massively boosted Mesabi Trust’s economics - this is (almost) completely unknown to the market and not factored in to the unit price

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 (good color on this in CLF's last two calls). 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? 

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. A substantial portion of the iron ore from Mesabi Trust lands are sold under one of the April 2002 Agreement with ISG. As of the last time this was disclosed in the 10K (That I could find, Exhibit 13, 2005) the ISG agreement accounted for 74% of iron ore pellets shipments attributed to trust lands. 

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 – earnings were up 412%.

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 2010, a year the share price hit $50 per share. 

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 less than 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. In my view, 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 started December 31, 2016 and expire in 2026 – This contract is the “current” formerly underpriced 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 creates highly 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 $30 per share (2.24 in distributions, 7.5% yield). The 6.2% yield figure is based on what I believe the security should fairly trade at given its unique pass-through nature, long life, and immense positive optionality. 

This type of mispricing 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. 

Trade ahead of the quants 

As all know, a tremendous amount of investor capital is now managed using quantitative investment factors such as earnings growth, value, and momentum. Given the shifting fundamentals in this stock that are not realized in financial statements, I think this quant buying could potentially create share price momentum – a factor that in-itself can trigger additional quant screen based demand. As Mesabi’s market cap climbs (assuming thesis plays out) the stock will filter onto more investor screens, which will in turn create additional demand. While this analysis might seem unusual, in my view this is a consistent pattern that occurs in underfollowed small and micro-cap stocks.

Conclusion: 

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 is still a decent return. 


Supplement: A few Items that help in following and understanding Mesabi Trust

1.) Distributions are three months behind Cliff’s current quarter. Starting in 2015, Cliffs began delaying when they sent the royalty reports to Mesabi Trust. Consequently, the distributions now correspond with the royalty report/distribution from Cliff’s three months earlier than what used to be the case. 

2.) Significant seasonality: Mesabi Trust's cash flows have a great deal of seasonality due to transportation issues at the Soo Locks, which close every winter. This limits shipments and royalty payments in the distribution corresponding with Cliff’s Q1 (ex. Date now in July).

3.) The royalty reports can contain pricing adjustments which can at times boost or detract from the next distribution. The key to understanding these adjustments is that they are based upon Cliff’s contracts with its customers (in this case ArcelorMittal ). These contracts use estimates for the full year to set the current sales price. These estimates are modified each quarter with an updated estimate, and prior payments (if under or over-paid) are adjusted for by adding or subtracting from the current distribution. At the end of Q4 quarter (when full year data is available), the payments are trued up. The key to understanding these adjustments is that they are not systematically biased. These adjustments will balance out over time, and as such can be ignored by longer term investors. 

Catalyst

-Repricing of a below market contract that expired in December 2016 - 91 L/T pricing (vs. 58 /LT 2016, 77 L/T 2010) already implied in latest royalty report from Cliffs 
-Volumes YTD that imply Northshore mine is running at full capacity
- Fundamentals - huge EPS and distribution growth not reflected in "quant screen" numbers yet