Description

TTT - Terra Nova Royalty Corp

I recommend an investment in TTT as a special situation with very limited downside and multiple sources of upside including realizing a higher price on tons produced, proving up reserves, and appreciation of its stake in KHD, each of which I think are highly likely and should be realized over the next twelve months. Catalysts include higher Q3 earnings, a dividend initiation before year end, the last distribution of KHD shares, and marking up of the company's main asset upon adoption of IFRS beginning January 2011.

Brief Background:

Terra Nova was created in early 2010 as the result of the break-up of KHD Humboldt Wedag into two entities-Terra Nova (TTT: US) and KHD Humboldt Wedag International (KWG: DE). Terra Nova is technically the parent and kept the iron ore royalty associated with the Wabush mine in the Labrador Trough of Newfoundland, Canada along with some cash. It is in the middle of distributing its interest in KWG to shareholders. TTT currently retains an approximately 19% stake in KWG and has just done a rights offering to increase paid up capital in order to make the recent distribution of ~30% of KWG shares tax-free to TTT holders.  

Special situation:

I think the rights offering created an overhang and special situation (full disclosure: we purchased a significant amount of the rights to gain access to the oversubscription option). By distributing rights to shareholders and making them transferable, this extra supply created selling pressure that was exacerbated by the market performance in August, especially because the transfer agent sold rights without regard to price on behalf of shareholders that elected that option.

Additionally, the listing of KWG in Germany has created some forced selling as some US funds are not allowed to invest in foreign securities, artificially depressing the value of that component.

Basic Valuation:

I'll start off with a basic valuation to frame the opportunity. Terra Nova has three assets: Cash and similar assets, its stake in KHDHF, and its mine. The value assigned to cash is clear. However management has said they will look to reinvest that in other royalty properties in the resource sector. I generally trust management given their ownership interest and history of value creation. For the value of its KHDHF shares, I use the closing price on 9/21/2010 of $7.60 and multiply by the shares held by TTT (19% of 30.3m). For the mine, I am using the step-up valuation disclosed by the company (see below):

http://www.b2i.us/profiles/investor/ResLibraryView.asp?ResLibraryID=38172&GoTopage=2&Category=1908&BzID=2017

"The royalty assets were revalued because the operator recently updated existing reserves to 75 million tons of iron ore which implies an estimated mine life of at least 15 years based on historical production. As at September 30, 2009, the Company's royalty assets were presented on its historical balance sheet at $27 million. This is reconciled to the pro forma value of $200 million by valuing the royalty interest using a discount cash flow model with forecast revenues to 2023 at a discount rate of 8% p.a., resulting in an upward revaluation of $173 million."

Obviously 50% upside is a nice outcome from the current stock price of $6.80, but I think there are several sources of further upside that I discuss further below.

Wabush Mine:

The Wabush mine is located in the Canada's premier iron ore district, Labrador Trough, bordering Quebec and Newfoundland. There are several large iron ore mining operations in the area (see graphic below). Wabush is owned and operated by Cliff's Natural Resources (CLF) after having bought out Arcelor Mittal and US Steel from a JV that CLF participated in and managed. In fact, CLF was exercising its right of first refusal because Consolidated Thomson had offered to buy out the JV. This is important because it is an endorsement of the mine and streamlines decision making-and makes a manganese reduction circuit investment more likely (more on this later). Production has averaged 4.6m tons over the last 10 years according to CLF (capacity of up to 6m tons). Based on conversations with CLF and TTT's guidance, I expect around 4.5m tons of production this year and 5m tons next year. In 2009, this number was depressed by the severe economic contraction and reduced demand for iron ore and steel.

Importantly, TTT's royalty is well covered by the economics of the mine. CLF would not provide mine specific economics, but they commented on their Q1 conference call: "Our per ton cost estimate in North American iron ore remains unchanged, at$65 to $70 for North American iron ore." (pg 6 of Q1 2010 conference call) and have said that Wabush is their highest cost mine. I estimate that their costs are probably in the $80/ton range, including the royalty to TTT. This should be reasonably conservative because it still significantly higher than CLF's 2005 operating costs (see chart below). Additionally, CLF's CEO made recent comments confirming the attractive economics to CLF who obviously has a subordinated position to TTT.

Source: http://www.nr.gov.nl.ca/mines&en/publications/wabush-memo-v3.pdf

Dec 2009 B of A Conference

Laurie Brlas - Cliffs Natural Resources Inc. - EVP & CFO

"We recently announced the Wabush Mines transaction. What that meant was we have been historically the operator of this mine, but we only own 27% of it. US Steel and ArcelorMittal were our partners in this mine and we managed it for them. And they have elected really not to carry this asset on their balance sheet anymore. They were looking to sell it and we exercised our right of first refusal after they had a transaction. And so for $88 million, we are going to get 4 million incremental tons of pellet capacity. And the important thing about this is these are seaborne pellets. We can and do ship them to China. We ship them all over the world. They aren't landlocked to North America. So we are quite excited about that. Obviously, there is no integration risk because we have always been the operator of this mine. We expect it to close around the end of the year. We are going through the traditional governmental approvals at all different levels."

The chart below provides some more history and is from Leucadia's 2007 annual report which also discusses the pricing mechanism that is now being replaced by a quarterly price and explains why iron ore prices have appreciated so much in the last few years.

Q3 2009 Conference Call:

Michael Gambardella - JPMorgan - Analyst

Thank you. Good morning, Joe, Laurie, Steve. First question on Wabush. My understanding that Wabush had somewhat higher labor costs associated with it compared to the other North American operations. Could you give us an idea of historically what the operating results have been at Wabush, just roughly?

Joseph Carrabba - Cliffs Natural Resources, Inc. - Chairman, President & CEO

Mike, it has been -- it is a high-cost producer. I mean, most of the Eastern Canadian mines are. You are correct, the labor cost and also, one, the weather. Just simply the severe conditions of the weather and transporting the concentrate, the distance from the concentrator all the way down to Sept-Iles, certainly to where the pellet plants are and the loading is certainly makes it a high-cost producer.

I don't have those specific numbers at hand for you, other I can tell you in the last couple of years it has been a profitable mine for us. It has benefited from its ability to export. And people in the export market are quite used to the pellets with the manganese in them. But I don't have specific numbers for you this morning.

Laurie Brlas - Cliffs Natural Resources, Inc. - EVP & CFO

And it does benefit from the international pricing more so, so we are more at market price there. So that creates a better gap for it, and definitely we consider this to be an accretive transaction at the price it's at.

I think this establishes that the mine will continue to be in operation based on the merits of the economics to the manager, CLF. Below is a basic DCF of the mine to back into the $200m valuation. This uses the assumptions disclosed by the company and using a price below realized Q1 (Q2 was higher) which I believe will move materially higher (more on that later). Importantly, this will start to show up on screens next year as the company will adopt IFRS in January 2011, causing them to mark up the asset.

First source of upside: Pricing mechanism

First, regardless of production, Terra Nova is entitled to C$2.65m every year. Using a reduced G&A (bare bones needed in this scenario), I estimate that this minimum payment is worth ~$0.51/share. This along with the cash and KHDHF stock should get you a worst case downside scenario of ~$5.70/share. However, as shown above, I think the mine continues in production for the foreseeable future.

 " The royalty due consists of a base rate per ton of pellets shipped, which is then increased by three escalators related to iron content, pellet prices and the U.S. PPI (Iron & Steel Sub Group)".

http://www.b2i.us/profiles/investor/ResLibraryView.asp?ResLibraryID=38209&GoTopage=1&Category=1908&BzID=2017

The base rate is C$1.685/ton. Of the escalators, the iron content is generally stable, US PPI (table below of YoY changes) has generally recovered to near highs, and pellet prices have recovered but not all been published by the five pricing services. Their investor relations representative said that the three components are about equally weighted and that TTT participates in about half of the pricing changes. Because I don't know the publishers of the pellet components, it's hard to back into the formula and confirm it.

US PPI (Iron & Steel Sub Group)

There are two sources of upside to the price per ton that TTT receives. First, Terra Nova has given notice under the royalty agreement underlying the Wabush Royalty to renegotiate the base royalty rate. The company would not provide any order of magnitude, so this is rather difficult to put parameters around and I'll leave it as a further upside option. However, they said they have the right to seek an increase in the base rate when the operator achieves certain profit metrics. Terra Nova believes these have been achieved so they are seeking an increase.

The second opportunity on the pricing mechanism is the publishing of pellet prices. Below is an excerpt from Terra Nova's Q2 earnings release:

Royalty Rate and Non-Published Price Effect

The Wabush Royalty is paid quarterly and is based on the tonnage of iron ore pellets shipped by the mine operator. One of the major components in the calculation of the Wabush Royalty rate payable is based on the most recently published prices of a basket of five particular iron ore pellets.

Historically, iron-ore benchmark prices were determined in the first quarter of the calendar year through negotiations between the major producers and their most significant customers.  These prices were then generally adopted by the other suppliers when published.

The significant increase in benchmark prices from 2007 to 2008 was resisted by the major Chinese steel mills in particular, who also refused to accept the lowered benchmark pricing offered in 2009. This led major iron ore suppliers to announce a move to quarterly benchmark pricing for 2010, and culminated in the negotiation of proprietary pricing agreements with specific customers that were not published.  As a result, the related royalty rate component for our Wabush Royalty payments for the first half of 2010 was based on 2009 prices.

Increased prices for two of the five component pellets in the pricing basket have been recently published.  If all five component pellets increase their prices to the 2008 levels, our royalty rate will be C$7.74 per ton.

This is important because, as you can see in the PPI numbers and iron ore chart above, prices have been rising but are not yet reflected in the royalty. In Q2, one of the five pricing sources published their iron ore price. This drove the majority of the price per ton from Q1 to Q2 (C$5.163 to C$5.995). Since Q2, a second price has been published in Q3 and the IR expects the remaining prices to be published by year end. Once posted, the price per ton should be approximately $7.50 / ton at current prices.

Below is a DCF showing the upside from a higher price per ton. I highlight $6.75/share and $8.65/share because $6.75 assumes no increase in reserves and isolates the impact of a higher price per ton (using slightly higher G&A too). Again, I'll explain the reserves upside in more detail below. These scenarios result in upside of $1.50-$3.40/share from the base case valuation of $5.28/share for the mine.

Second source of upside: Longer tail of reserves

Next, I think Terra Nova investors will be pleasantly surprised at the duration of reserves. The most recent annual report form CLF reported 73m tons of reserves at Wabush. However, CLF is now discussing the opportunity to increase reserves:

                From CLF Q3 2009 Conf Call:

In other actions, just after quarter ended Cliffs announced its intention to acquire full ownership of the Wabush Mines joint venture by exercising the Company's right of first refusal to buy our partner's 73.2% interest. This bolt-on acquisition is consistent with our strategy to increase our exposure to steelmaking markets outside of North America. The $88 million cash deal which remains subject to regulatory approvals carries no integration risk and is expected to provide approximately 4 million tons of incremental pellet capacity and more than 50 million tons of additional reserves.

Wabush Mines has produced an average of 4.6 million tons annually over the past 10 years. Also, because the port at Sept-Iles can accommodate most capesize vessels, these tons can be 100% exportable to the seaborne market. Cliffs has been the managing partner of Wabush since its inception, and because of our long involvement we are uniquely positioned to benefit from opportunities of the operation.

While overall investors have been extremely enthusiastic and complimentary about the transaction, I want to take a moment to address some of the misconceptions about Wabush in the marketplace.

Because of the mining operation's proximity to several lakes, water infiltration has been an ongoing challenge to some mining areas. To address this challenge, we continue, as we always have as the operator, our successful dewatering efforts of the pit. I have also read some reports that comment about manganese levels in the Wabush pellets and the impact this has on pricing for our product.

In the seaborne market, the manganese content is of little operating consequence from the viewpoint of our customers around the world. We are also exploring a project that would introduce a manganese reduction circuit to our process flowchart that would lower the manganese content. This would have two benefits; it would allow the production from additional areas of the mine while at the same time extending the life of the mine. The ability to consider a project such as this is an example of one of the benefits of being 100% owner, compared to the joint venture partner structure which includes capital committees and differing objectives for the asset.

...

David MacGregor - Longbow Research - Analyst

And then you talked about the capital expenditures up there. Presumably that is the manganese circuit. What is the capital cost? And is it about a 5% discount on the manganese ore?

Joseph Carrabba - Cliffs Natural Resources, Inc. - Chairman, President & CEO

We haven't defined the capital cost. We have got one line up there that has been running in a test production mode, and we've had very favorable results. Again, being in the partnership, if you will, there wasn't a desire to go forward with that. They were satisfied with the manganese results that they had versus the capital output that we had to lay.

We will bring that forward as we get those numbers, David, from there.

The discount that is quoted around is really we sell on iron unit basis. So it is the displacement of iron versus the quality implication. As we have the ability now, again subject to regulatory approvals, as we can move this volume around, particularly to our customers in China, it gets a dilution effect of the ships that go in with the rest of the ores and the manganese. In many of the mills over there, it actually becomes favorable because it just -- it prevents them from having to put manganese into their circuits. So it is more of a displacement of iron units than it is a discount due to quality of high manganese.

...

Wayne Atwell - Casimir Capital - Analyst

Good morning. Can you share your thoughts in terms of how much upside there might be at Wabush; how much you might be able to add to your resource base there?

Joseph Carrabba - Cliffs Natural Resources, Inc. - Chairman, President & CEO

You know, I don't have a number. We are optimistic if we take -- the next step from this test circuit is to install another full line of the manganese reduction circuits. I don't have a number for you, but the reserve base would increase as we went forward.

It wouldn't be huge, Wayne, as far as tripling or quadrupling the reserve, but it would be a nice addition to it, but I don't have the numbers at hand. But it would be a nice enhancement if the numbers play out on the capital and the operating cost versus the gains.

So, clearly there is some upside to the reserve base as a result of the manganese reduction circuit. How much exactly is not clear, but a report from early 2006 published by the Department of Natural Resources for Newfoundland and Labrador using data supplied by CLF implies that there is a significant opportunity.

Below are the sections I thought were most pertinent from the report:

"There are unique circumstances pertaining to the Scully Mine deposits that present obstacles to the production of quality pellets. A major challenge is the high manganese content in the lower units of the geological formation in the stratigraphic column at the Scully Mine. Specifications by the steel industry on the maximum permissible manganese content in pellets have restricted mining to ore units that have less than 2% manganese, which after concentrating results in a similar manganese content in the pellet product. As much as 60% of the production from Wabush Mines, with its high-manganese pellets, has recently been sold in China, as the traditional North American markets are no longer as receptive to this quality of product."

...

"Cleveland-Cliffs had estimated the Scully Mine reserves as of the end of 1996 to have a reserve base that could produce 270 million long tons of pellets over the life of the mine, and then subtracted production over the next five years to arrive at a new pellet reserve estimate of 244 million long tons at the end of 2001".

...

"There remains at the Scully Mine substantial resources of high-manganese iron ore, primarily at

depth below the existing operations, and the emphasis for Wabush Mines must now be to

determine whether or not any of that resource can be incorporated in the long-term mine plans,

while the mine and associated infrastructure are still in operation and operating at a scale to

provide reasonable unit costs."

"Cleveland-Cliffs have previously examined the possibility of installing a manganese reduction plant that would reduce the manganese content of ore processed to allow production of the current pellet products to continue, with their manganese content of either 1.2% or 2.0%, from ores that would contain up to 4.0% manganese. Those studies on manganese reduction in the past have provided some encouragement. The most recent report that we have reviewed was a memorandum prepared by Cleveland-Cliffs staff in June 2005 that suggested favourable economics for the installation of a manganese reduction plant with the economics becoming more favourable if the plant was operational as early as 2008. The capital cost of the manganese reduction plant would appear to result in an additional cost of less than $2 per ton of additional pellets produced over the extended life of the project. The incremental operating costs for the manganese reduction plant were also very modest, and not really significant with reference to the large additional tonnage of pellets produced. The cost factors therefore for the manganese reduction plant do not appear to be an impediment to proceeding with such a project."

...

"Until 2002 Wabush Mines included in their mineral reserves material that graded up to 4%

manganese which resulted in a reserve base sufficient for the production of about 250 million long tons of pellets, which would have been sufficient for about 40 years of mine operations. In 2002 it was belatedly recognized that the mine could no longer mine and produce pellets for sale into the global market starting with material that had such a high manganese content."

CLF's IR confirmed that they think they'll be able to mine reserves that contain up to 4% manganese content. As you can see in the table above, there are substantial resources even after subtracting the subsequent production. If the 4% cutoff used in the 1996 reserve report comes back in play, we could see reserves more than double. Instead, I'm looking for an increase of ~45m tons. This is based on a recent local press account that quoted the vice president and general manager, Gino Levesque as saying, "Further to that, he said, they are still working on the manganese separation project which will extend the life of the mine by another 10 years." (10 yrs at 4.5m tons / year = 45m tons in addition to the roughly 70 there so I use cumulative production of 112.5mt)

Source: http://www.theaurora.ca/News/2010-05-24/article-1565728/Future-so-bright/1

Third source of upside: Appreciation of KHDHF stake

KHDHF is trading near or below net cash depending on how one chooses to calculate it. I believe it is trading where it is because of the distribution of shares to TTT holders who are more interested in the mine than an industrial business and because the shares are listed in Germany with a thinly traded ADR in the US.  

KHD Humboldt Wedag International Ltd. operates as an industrial plant engineering and equipment supply company. The company supplies technologies, equipment, and engineering services for cement and coal and minerals processing industries. The company's products and services for the cement industry include plant design, equipment design and development, engineering services, and automation services; grinding technologies for use in raw material, clinker and finished cement grinding; and pyro-process equipment comprising pre-heaters, kilns, burners, and clinker coolers. Its product and services for the coal and minerals processing industries consist of jigs, centrifuges, float cells, and flocculant products; equipment and plant components for crushing, grinding, and separation of ore and minerals; chemicals for sorting materials by floatation; and coal floatation reagents. KHD Humboldt Wedag has operations in India, China, Russia, Germany, the Middle East, Australia, South Africa, and the United States.

Their core operations are in India, Middle East, Russia, and Eastern Europe. Order intake has been soft (hitting a trough in Q2) because financing dried up for large projects and demand fell, but is quickly coming back (esp in India). However, reviewing cement producers commentary confirms demand for capacity expansion in India, North Africa, and the Middle East and replacement plants in Russia and Eastern Europe. Most orders right now are for repair/replacement of components, not greenfield projects. There is an energy efficiency improvement from upgrades as well.

Given that KHD trades near my estimate of net cash, I think there's limited risk to my valuation of TTT in the base case presented above. Beyond that, we get the industrial business for free. Below is a framework and range of normalized earnings and valuations for the industrial business. As you can see, I believe the KHD stake has an upside of up to $1.10 per share of TTT. However, if the global economy rebounds, especially India and Russia, the upside could be much higher.

I think KHD is attractive in its own right, but I preferred to create it by purchasing TTT and then keeping the distributions because the mine was included very cheaply.

I think the scenarios I outline below are on the conservative side for normalized. For example, order intake in the first half of 2010 was approximately 144m euros. Annualizing it and converting it to dollars results in a revenue run rate of approximately $375m. Revenues from 2005-2009 were $384m, $458m, $580m, $638m, and $576m. Periods before that are likely not comparable because the company was in a period of transition from a merchant bank with a variety of mismatched assets to a more focused industrial company. The company also believes it has the opportunity to expand in the higher margin maintenance and repair side of the business.

Historical operating margins on the industrial business are generally in the high single digits and should have upside as they divested their break-even minerals division and have outsourced more of the production.

Anticipated use of cash:

The company has stated a couple uses of cash. First, they intend to implement a dividend policy to attract a wider shareholder base. This should be in place by year end, and I'd expect it to be $0.30-0.50/share based on the Wabush royalty income. It could be much higher once they deploy the rest of the cash into a cash flow producing property (or if they chose to just return it to shareholders).

The second and larger expected use of the cash is some type of deployment in resource properties. In discussions with the company, they leave their options pretty open. They said they would avoid precious metals and risky jurisdictions, but are open to a number of ideas. They said it does not have to be a North American asset and that they will likely bring in an operating partner. I doubt it will be a pure royalty similar to Wabush, and they expect to deploy it in more than one property.

So what could it be? I believe the transaction they did in Q2 is instructive. When I inquired about the $8m note receivable on the balance sheet, the IR explained that it was a note on an iron ore mine that was not producing but where the owner was looking to raise money in order to restart production since ore prices had risen to a level that makes it economic. Terra Nova bought the note at a discount and moved to foreclose on the property and take control. The owner subsequently raised the capital to pay off the note ($10m-nice little profit). While this transaction didn't result in capital deployment, it shows a shrewd approach to deploying capital. I also find it important that this seemingly attractive transaction was done via Terra Nova instead of another Smith vehicle like Mass Financial (MFCAF) that just as easily could have executed the deal because it shows that Smith is aligned with TTT shareholders and that we will get at least fair value for the cash deployed.

Insider Actions / Michael Smith:

As mentioned in an earlier section, the IR said that insiders would participate in the rights offering (since I first wrote this up, the rights offering results have been disclosed and it was significantly oversubscribed which essentially requires insider participation given their ownership pre-deal). I think this is a strong signal. Some investors have been turned off by the sometimes opaque disclosure that is typical of a Michael Smith (Chairman) company. I don't agree with everything he's done, but he has generally made money for shareholders and has pretty clearly improved the operations of the companies he controls.  I also think it is somewhat telling that he is stepping in as CEO of Terra Nova. As in many spinoffs, it pays to watch their incentives and where the executives choose to go.

Smith has an interesting approach to business. As best I can tell, his modus operandi is to use MFCAF to acquire a business, revamp and restructure the underperforming business, and then spin off MFCAF (and possibly other entities) to shareholders in tax efficient ways. These spins are not always clean separations and often result in cross holdings that can create conflicts, so I think it's important to be on the same side as Smith which I think I am with TTT as discussed above. Previous examples include: Mercer International (acquired and then MFCAF spun out), KHD Humboldt Wedag (acquired, MFCAF spun out, SWA spun out, TTT spun out), Sasamat Capital (holding co with stake in KHD that KHD bought in), SWA REIT (spun off from KHD), Trimaine Holdings (holding co with stake in MFCAF liquidated via distribution of shares), Blue Earth Refineries (spun off from MFCAF and paying out cash flow as dividends), and now Terra Nova.

The last disclosure of Smith's stake was approximately 9%. The IR said he believes the ownership is similar but is held in trusts and therefore no longer disclosed. Additionally, 21% is owned by Peter Kellogg, a long time investor in Smith entities.

Catalysts:

• Dividend initiation
• o "DIVIDEND: It is our Board of Directors intention to establish an annual dividend policy"
• o http://www.b2i.us/profiles/investor/ResLibraryView.asp?ResLibraryID=38209&GoTopage=1&Category=1908&BzID=2017
• o I would guess they pay out most of the income from the Wabush mine as they have plenty of cash on hand for any opportunities that come along. The Wabush income is approximately $0.50/share.
• Distribution of KHDHF shares to clean up the story
• o TTT will likely distribute the remainder of their KWG holdings after the bonding line at KWG is renewed (expected in November)
• Appreciation of KHDHF stake toward value that reflects normalized earnings
• Increase in price per ton of reserves from renegotiated base rate and/or publishing of pellet prices (should be partially a Q3 event and fully reflected in Q4)
• CLF proving up reserves via Manganese reduction circuit
• Possible street coverage

Risks:

• Iron ore pricing declines to the point where CLF stops production
• Production issues at Wabush
• Poor capital allocation of excess cash at TTT (or KHDHF)
• Deterioration of business conditions for KHDHF

Summary:

In short, I think TTT is an attractive investment because it is a high quality asset (well covered economics), has limited downside, has significant upside to the base case, and has even further upside associated with specific catalysts. At the same time, smart insiders are making their opinions clear by staying on board and likely participating in the rights offering.

Catalyst

Catalysts:

• Dividend initiation
• o "DIVIDEND: It is our Board of Directors intention to establish an annual dividend policy"
• o http://www.b2i.us/profiles/investor/ResLibraryView.asp?ResLibraryID=38209&GoTopage=1&Category=1908&BzID=2017
• o I would guess they pay out most of the income from the Wabush mine as they have plenty of cash on hand for any opportunities that come along. The Wabush income is approximately $0.50/share.
• Distribution of KHDHF shares to clean up the story
• o TTT will likely distribute the remainder of their KWG holdings after the bonding line at KWG is renewed (expected in November)
• Appreciation of KHDHF stake toward value that reflects normalized earnings
• Increase in price per ton of reserves from renegotiated base rate and/or publishing of pellet prices (should be partially a Q3 event and fully reflected in Q4)
• CLF proving up reserves via Manganese reduction circuit
• Possible street coverage