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Bram de Haas
Bram de Haas
Articles (348)  | Author's Website |

Value Idea Contest: Scully Royalty Is Undervalued Because of Underappreciated Royalty Asset

A look at the deep-value situation Scully Royalty, which owns a 7% royalty interest on the Tacora Resources Scully Iron Ore Mine

July 11, 2019 | About:

Company history and business

Scully Royalty (SRL) used to be called MFC Bancorp but just underwent a name change, as it is on the cusp of a transformation in character.

The company is led by CEO Michael Smith who appears to be a deep value investor buying up distressed assets all over the globe. These assets are currently collected within Scully Royalty. The name change has been affected because one of its previous dormant assets is a royalty on the Scully iron ore mine in Canada, however. This mine was shut down by its previous owner but is currently being restarted by current private owner Tacora Resources. As the mine ramps up production, the 7% royalty held by Scully Royalty will dwarf any of its other potential cash flows.

Financial strength

Scully Royalty is in superb financial shape. In fact, one of the things that initially attracted me to this name is its pristine balance sheet with no debt whatsoever but numerous assets that offer upside optionality. The company should have around $60 million in cash depending on how the turnaround of its legacy merchant banking business is progressing.

Management

Michael Smith has been heading Scully Royalty since about 1987. He’s also on the board of Drummond Financial Corp. Dr. Clemens Scholl wrote a terrific piece to construct Smith’s track record and concluded that it is quite impressive with 15% returns over 15 years. That was a while ago, but Scully Royalty or MFC Bancorp shares have significantly increased since then. They also remain undervalued, in my view. More about that in the next paragraph.

Valuation

My preferred fishing grounds for value ideas, like this GuruFocus Value Investing Idea Contest winner that appreciated over 100% within 12 months, are deep value in nature. Often that means asset plays, and Scully Royalty is no exception.

This is actually a multi-asset play put together through the years by Smith. Some of the purchases have turned out really bad. So far at least. The company acquired a Cypriot bank with a European banking license, an African power plant, Eastern European metal facilities, several mines (both shut down) and a Canadian gas plant. It is easy to miss the forest for the trees.

Until a recent name change into Scully Royalty, this company was called MFC Bancorp and its focus was on its turnaround merchant banking services. These operations are now at a breakeven point regarding cash. It has been moving in this direction for a couple of quarters, and the restructuring looks like it is nearing completion. You could argue that this division by itself is a valuable component, but I’m disregarding it entirely and embracing a “show me the money” attitude.

For simplicity's sake and to communicate the value proposition clearly, I’m going to discount all those disparate value investments to zero even though technically they represent embedded optionality.

What I’ll focus on instead are two things:

  • Balance sheet or more specifically the cash balance and debt.
  • Scully royalty.

Let’s look at the balance sheet (pictured above) and simplify things a little bit. There are a lot of debatable line items (as well as assets of questionable value that aren't immediately visible), but what stands out to me are:

1) The absence of debt.

2) The presence of around $60 million dollars in cash and equivalents.

This sets a floor for the stock. The market cap is about $177 million. It shouldn’t ever trade much below cash levels. The enterprise value is about $117 million.

The true value here and the reason for recent strong stock performance is the Scully Royalty. I’ve explained the royalty in the intro briefly but will attempt to put a conservative dollar value on it here. The Scully iron ore mine in Canada was shut down by its previous owner, Cliffs Resources. At the time, iron ore prices were much lower, and Cliffs entirely withdrew from Canada.

Currently, it is being restarted by current private owner Tacora Resources. For the time being, Tacora resources is a private company. It doesn’t have to report publicly and releases very little information about the progress it is making through press releases (this contrary to how a public company usually operates).

Because the royalty is not producing much revenue for Scully Royalty yet, we can’t value it based on the company’s historical numbers. Instead, I did some digging to find out more about the potential value of this stream.

The royalty interest has been renegotiated by Scully and Tacora, and it is now a 7.0% net revenues royalty interest on iron ore produced from the mine and 4.2% net revenues royalty interest on iron ore produced from tailings and other disposed materials. Under the terms of the sub-lease, there is a minimum royalty payment of $3.25 million per year

The upper range of production capacity is about six million tons of high-quality Canadian iron ore (this quality is more valuable) per year. Target figures have not been disclosed by Tacora Resources directly. Canadian premier of Newfoundland and Labrador, Dwight Ball, luckily talked about 260 jobs and 6 million tons here. This article also speaks of 6 million tons.

I can’t be sure Tacora is going to succeed long term, but it did a few things right and because of these steps, I’m optimistic it will succeed in running this mine (at least for some time):

  • Tacora renegotiated royalty with Scully Royalty (previously, MFC Bancorp).
  • Tacora renegotiated the CBA with the steelworkers union even before buying the asset.
  • It lined up Cargill to take off production until 2033.
  • Tacora closed on financing.
  • Tacora had a Town Hall meeting (see Wabush Town Meeting Nov. 27, 2018).
  • Tacora has been hiring since November 2018 and continues to put effort into this front through LinkedIn, for example.
  • Tacora will install a manganese reduction circuit, which enables it to mine from areas that were previously off limits.
  • Tacora can start with a downhill haul from an easy and profitable part of the mine.
  • The mining district here matured; firms around this area are providing essential services. This decreases the cost of on-staff specialized personnel.
  • The mine life should be extended to between 20 and 50 years (note the royalty only runs until 2055).

Relative value

If I assume that the company produces 5 million tons annually, achieves an iron ore price half the current spot price for the lower benchmark quality ($60), with an annual 2% increase and 20% royalty tax rate, this means the company today effectively trades at a 6.8x forward EV/Ebitda.

Here are several important valuation examples of royalty companies (focused on the  streaming and royalty space) with royalties on commodities:

  • Altius Minerals trades at a 17x EV/Ebitda.
  • Franco Nevada trades at 30x EV/Ebitda.
  • Wheaton Precious Metals trades at 30x EV/Ebitda.
  • Anglo Pacific Group trades at a 10x EV/Ebitda.

Altius (ATUSF) is a diversified base metals royalty company and likely the best comparable. Anglo Pacific group trades at the lowest multiple, at 10x, but it derives most of its revenue from coal. Which is not where investors want to be currently. Franco Nevada and Wheaton Precious are focused on precious metals. There is more optionality within the precious metals space. Theoretically, the ceiling is much higher, and therefore these deserve to trade at a premium.

However, from comparative analysis, it is clear that the company would deserve a re-rate of between 46% (to the Anglo Pacific valuation) and 150% (to the Altius valuation).

Discounted cash flow

I have also created a discounted cash flow model to gauge the value of this royalty. It starts with the same assumptions, with one addition:

  • Produces 5 million tons annually.
  • Achieves an iron ore price of half the current spot price for the lower benchmark quality ($60), with an annual 2% increase.
  • Has a 20% royalty tax rate.
  • Has 20 years of production, conservative estimate.
  • Has a discount rate of 11%.

This very conservative DCF suggests this stream is worth $183 million. Compared to the current enterprise value, we are looking at 56% upside.

These evaluations are not meant to be precise measures of value. Instead, I want to illustrate that this company owns a tremendously valuable asset that should drive further upside over the coming months as the value becomes apparent to the market.

Risks

One of the key risks is that management will reinvest the cash flow from the royalty in additional deep value investments that fail to perform. If the cash is destroyed in such a fashion, ultimately shareholders don’t benefit.

A severe crash in iron ore prices could also derail the bull case. But with iron ore prices at $120 per ton, that seems very far off.

There could be significant delays or accidents at the mine site.

The market could turn out not to agree that this deserves a multiple in excess of 7x EV/Ebitda.

The company's merchant banking organization could turn out to lose money instead of breaking even or adding to cash flows.

There are always unexpected things that can happen to derail an investment thesis.

Outlook

After the recent name change and taking into consideration MFC Bancorp’s history of spinoffs and financial engineering, it seems logical the company will execute a corporate transaction. This may take the form of a spin-off or spin-out transaction of some sort to isolate the royalty asset. Once it trades as a pure play, the market will more readily attribute a correct multiple, and it may also help incite an acquisition by a larger royalty company.

Because Tacora resources is actively recruiting, it publishes regular LinkedIn updates about key events. Updates like the recent one above indicate the company has shipped its first load by train to Pointe Noire where it can access the seaborne market. Tacora has a long-term contract with Cargill to offtake its production in place, which seems to indicate that cash will start to flow soon and eventually will reach Scully Royalty as well. As Scully Royalty SEC filings start to reflect the presence and magnitude of this royalty, I expect the re-rating will be set in motion.

Above, I laid out valuation cases that are reasonable but conservative estimates of the value that can be created. I would not be surprised if things turn out significantly better than my estimates of between 46% and 150% upside.

Disclosure: Long Scully Royalty andAltius Minerals.

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About the author:

Bram de Haas
Bram de Haas is managing editor of The Special Situations Report and Founder of Starshot Capital B.V.

Visit Bram de Haas's Website


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