Note: all dollar amounts converted to USD unless otherwise noted
Current price: $10.35
Basic shares: 12.5M
Market cap: $130M
Market cap (fully diluted): $131M
Net Cash: $49M
Adjusted run rate EV/EBIT: ~7x
Scully Royalty Corporation is primarily a semi-hidden iron mine royalty company that’s trading at ~7x run rate EBIT (based on mine operator-reported August production data and current iron ore prices) or ~2x EBIT on guided 2021 production numbers. The primary asset is “semi-hidden” as the underlying mine only restarted operations in June of this year. Moreover, SRL has not officially announced current production levels as they only report results on an annual basis despite an NYSE listing (minimum requirement of Cayman companies). I believe the opportunity exists primarily because this company is a complicated hodge-podge of disparate deep value assets and most investors aren’t yet aware of the restart of the mine. I believe SRL has upside potential of $26 (150%) on a 10x EV/EBIT multiple driven by royalty payment increases and downside risk to net cash at $3.75 (-65%).
Snap calculation results in undervalued company on current production numbers, could be a home run on guided numbers:
The key asset here is the royalty on Scully, an iron ore mine in West Labrador in Canada. The terms are 7% net on revenues from iron ore produced through 2055.
SRL has ~$3.75 in net cash (net of a loan payable). At a current stock price of $10.35, subtracting the excess cash on the balance sheet gets us to a price of around $6.60. Assuming August 2019 run rate iron ore production (1.8M tons annualized), we get a EBIT/share of $0.65 (1.8M tons * $80/ton spot iron ore price * 7% net royalty * (1 – 20% royalty tax rate)/13M shares), so on the royalty asset alone SRL is currently trading at nearly a 10% pre-tax yield. The mine operator has guided to 6M tons per year production in 2021, which would result in an EBIT of ~$2/share or an obscene ~30% pretax yield.
You could argue that there should also be some administrative expenses incorporated. Labrador Iron Ore Royalty Corporation, which receives a royalty on an iron ore mine that is basically right next door to Scully, shows 2018 royalty revenues of $105M and $3M in G&A expenses (http://s1.q4cdn.com/337868174/files/2018-Annual-Report-Final.pdf). Or you could just assume SRL’s 2018 operating loss of ~$11M (~$0.10/share) is all attributed to the royalty asset. Regardless the current numbers are great, and the potential 2021 figures make this a potential home run.
Not to mention, there’s still some other assets on the balance sheet to account for that we’ll get to a bit later.
Recent developments at Scully are on schedule, on budget, and impressive:
Tacora is the mine operator that bought the assets in 2017. They have been providing regular updates on their progress, and the most recent one is really impressive: https://www.tacoraresources.com/wp-content/uploads/2019/09/Scully-Mine-update-18-Sept-2019.pdf
The key points:
- Ramp in production (slide 11):
- June: ~23K tons
- July: ~82K tons
- August: ~153K tons <- 1.8M annualized run rate
- Schedule and 2021 guide (slide 15):
- 6MTPA (million tons per annum) guide for 2021
- Almost everything is on schedule if you compare with their November 2018 deck.
- High grade ore with good characteristics (slide 6)
- 65.9% iron, better than industry benchmark of 62%
A bit about the underlying mine economics. Cliffs shut down the mine in 2014 due to high costs. Tacora secured funding from Cargill and a few funds to purchase the asset in 2017 (Cargill also agreed to buy 100% of the produced iron through 2033). They claim to have a cash cost of ~$41/ton (slide 7 here).
Keep in mind the royalties are a percentage of revenues, so cost matters most if prices hypothetically decline to level where Tacora decides to quit producing. As a point of reference, iron ore prices troughed at $63 during the Great Recession and $39 in late 2015, the latter of which is slightly lower than the claimed “cash” cost per ton, so it seems that the mine would produce in all but the worst cases and in at a worst case $40 scenario, your valuation multiples would simply double (since royalty revenues drop straight to marginal operating income) and remain undemanding.
Little idea. Really. But the hellish last 5 years in commodity-land combined with unfortunate Vale issues has me thinking that pricing will more likely go up than down.
Other assets add a bit more value:
Scully Royalty Corporation used to be known as MFC Bancorp (and MFC Industrial previously…and Terra Nova Royalty Corporation before that…). The point is that this was a holding company with a bunch of assets as a consequence of its misadventures ranging from foreign miners (MFC Industrial) to merchant banks (MFC Bancorp). As a consequence of all this, there’s still a bunch of far-flung zombie assets on the balance sheet. By my calculations I’m arriving at another ~$1.50 in value:
Subtracting this $1.50 in addition to the net cash results in a 7x run-rate EBIT multiple and 2x on 2021 guided numbers. Saying this again, this is potentially a 40-50% pretax yield.
Management and Insider Ownership:
Michael Smith is the Chairman and CEO and has been with the company since 1996 with a brief hiatus as major shareholder Peter Kellogg won an activist tilt against the company. Executive compensation seems reasonable to me, with Michael Smith taking in $630K last year and the CFO taking in $300K.
Executive share ownership is a bit of a worry, with Michael Smith only owning 0.9% of the company (~$1M). However, there’s a bunch of well-known microcap investors involved. Peter Kellogg owns 33%, Lloyd Miller’s estate owns 15%, and Nantahala owns 7%. And to reiterate Mr. Kellogg has shown that he is willing to get his hands dirty, going activist and electing himself onto the board in 2014 (before stepping down again in 2015).
Valuation and risks
I view downside as pretty limited since there’s $3.75 of net cash on the balance sheet, so in a bear case I don’t think the stock would go down materially below this level (~65% down). On the other hand, applying a 10x EBIT multiple on the royalty asset and adding in cash and other net assets, we get an upside valuation of $26, an 150% increase from today.
As a point of comparison, Labrador Iron Ore Corporation ($LIF.TO) which was mentioned briefly before, trades at a ~$1B CAD enterprise value ($1.45B market cap with ~$80M in net cash and $380M in equity in its underlying iron ore mine) and did ~$100M CAD in EBIT last year (when iron ore prices were higher than today in 11 of 12 months) for a 10x EV/EBIT multiple.
There’s a litany of other risks, led by commodity price fluctuations. The complexity of the organization also introduces risks (anybody have any clue about Maltese banking laws, Ugandan environmental obligations, or Chinese eye care regulations?). There’s also a strange loan payable at a subsidiary that SRL is fair valuing at $4M despite an undiscounted obligation of $42M. SRL says that this is a non-recourse loan that a former subsidiary owes, so it would seem that the true liability should be even less than $4M.