2023-09-27 17:12:11 ET
Summary
- Labrador Iron Ore Royalty has been consolidating for the past two years.
- Is the investment thesis of this royalty firm, as a high-yield dividend payer, still valid? Is it time to pounce on Labrador Iron Ore Royalty shares?
- In this article, I review Labrador Iron Ore Royalty's business model, dividend policy, and valuation, in an attempt to answer the question above.
As I said in a previous article , Labrador Iron Ore Royalty ( LIFZF )
"is a high-quality income idea, thanks to its long-life royalty interest in one of the leading iron ore mines in the world that is located in a top-ranked mining jurisdiction and being run by Rio Tinto. Although this appears to be a multi-year compounder, it is also true that volatility of iron ore price and variability of equity earnings and dividends from the mine give the share price of LIORC a high beta. There is indeed a silver lining to the share price volatility: investors may load up the high-quality stock at cyclical troughs, expecting to be rewarded in the long run."
Since May 2022 when the aforementioned piece was published, the stock of Labrador Iron Ore Royalty, referred to as LIF hereafter, has spent the past 16 months moving sideways, primarily due to weakness in iron ore prices. Recently, LIF appears to be breaking out, as illustrated in Figure 1. Therefore, it may be a good time to review the investment thesis of this royalty firm as a candidate for high-yield income investing.
The Business
Iron Ore Company of Canada (or IOC) is a joint venture between Rio Tinto (58.7%), Mitsubishi (26.2%), and Labrador Iron Ore Royalty Corp (15.1%). IOC owns a mine with five operational pits, a concentrator, and a pelletizing plant located near Labrador City, Newfoundland and Labrador. IOC is a leading producer of sea-borne, high-quality, low-impurity iron ore products, including premium iron ore pellets that have a clean chemistry - very low phosphorus and low alumina - and are favored by steelmakers because of the relatively low carbon footprint and suitability for producing green steel. It also operates a wholly-owned 418km railway, the Quebec North Shore and Labrador Railway (QNS&L), linking the Labrador operations to wholly-owned port facilities in Sept-Iles, Quebec. IOC has a nameplate capacity to produce 23.0 Mtpa of high-grade concentrate fines, of which up to 12.5 Mtpa can be processed into a range of higher value pellets.
In addition to the 15.1% equity stake in IOC, Labrador Iron Ore Royalty also holds a 7% gross overriding royalty and earns a 10¢ per tonne commission on all iron ore products produced, sold, and shipped by IOC.
These revenue sources mean that LIF's top line is determined by sales volume and iron ore prices. As a royalty firm, LIF enjoys exceptionally high profit margins and rates of return, positioning it as a multiyear compounder.
The Dividends
As a policy, Labrador Iron Ore Royalty traditionally pays out all free cash flow to shareholders through quarterly dividends. The royalty has historically delivered stable after-tax cash flow per share across the commodity cycle, protecting the downside, while the equity interest in IOC has provided additional upside during strong iron ore price periods.
As a result, Labrador Iron Ore Royalty pays highly variable dividends with a typically high yield, thanks to its substantial profit margins, as shown in figures 2 and 3.
On September 15, 2023, Labrador Iron Ore Royalty declared a quarterly dividend of C$0.95 per share for shareholders on record as of September 29, 2023, with payment scheduled for October 26, 2023. The trailing 12-month dividend yield thus comes to 8.55% as of September 22, 2023.
Those who bought LIF at its previous peak around 2012 spent the next decade watching the stock stagnate; nevertheless, they would have received over C$26.90 in dividends per share, making the investment more than worthwhile. On the other hand, those who had the fortitude of buying LIF when iron ore prices crashed would have reaped substantial capital appreciation, in addition to the generous dividends, as seen in Figure 4. When the effects of capital appreciation and dividends are combined, LIF qualifies as a bona fide multiyear compounder. It seems obvious that successful investing in LIF involves buying during iron ore price weaknesses and holding for the long term.
Valuation
The policy of variable dividends as practiced by LIF will inevitably introduce imprecision in the dividend-based estimation of intrinsic value of the stock. Therefore, I attempt to involve as few assumptions as possible in the consideration below.
In the last two years, iron ore prices have crashed down by over 40%, as shown in Figure 5, causing LIF to stop paying unusually generous dividends, and restore dividends to the levels that prevailed in 2017-2020, as seen in Figure 2. Let's consider two cases below, both at a WACC of 7.3%.
- In a not-so-good scenario, if LIF pays a quarterly dividend of C$0.50 per share, as it did in the first quarter of 2023, until the end of the 36-year mine life, the stock is estimated to be worth C$28 per share, implying a downside of 15%.
- In a relatively good scenario, if LIF pays a quarterly dividend of C$0.95 per share, as it did in the second quarter of 2023, until the end of the 36-year mine life, the stock is estimated to be worth at least C$51 per share, implying an upside of 58%.
The greatest risk to LIF continues to be iron ore prices. The collapsing Chinese economy offset by relative resilience of the rest of the world may keep the iron ore prices uncertain.
Investor Takeaways
The investment thesis of Labrador Iron Ore Royalty as the high-yield income investing candidate remains valid. Investors should go long the stock when the iron ore prices crash and hold it for the long term as it has a proven track record of compounding over time.
Weak iron ore prices have forced LIF to consolidate for the past two years. However, the stock appears to be breaking out to the upside. The stock has an advantageous risk-reward profile. Income investors seeking a multiyear compounder with high-yield dividends may consider Labrador Iron Ore Royalty.
For further details see:
Unlocking Opportunity: Labrador Iron Ore Royalty Offers 8.6% Yield And Multiyear Growth Potential