Fabrice Taylor is a chartered financial analyst.
ftaylor@globeandmail.com
Royalties are hot commodities these days. Look at Franco Nevada. Look at the oil patch, where feeble gas producers are selling a pound of their flesh in the form of an overriding royalty.
Most notably, look at the Labrador Iron Ore Royalty Income Fund. It’s doubled since hitting a rocky bottom 12 months ago. With dividends, it has done even better. And it’s still going up.
This is a little baffling at first glance. For an income fund, the stated yield looks low at less than 5 per cent. On top of that, the fund couldn’t cover its distributions from cash flow in the past year; it had to dip into its cash pile.
And finally, the high dollar has to hurt where it counts.
But scratch beneath the surface and you can make a case for owning this thing.
First, an explanation of the assets: Labrador owns a 7-per-cent gross overriding royalty on the production of the Iron Ore Company of Canada, whose claim to fame may be that it was once run by Brian Mulroney. But I’m digressing.
Royalties are wonderful things. You get paid before anyone else: before the workers, before the bond holders, before the tax man and before the shareholders. You don’t worry about expenses, in other words, because as far as you’re concerned there are none. You only worry about volumes and prices.
And worry you did in the past year, as Iron Ore didn’t operate at full capacity and didn’t earn great prices for its iron, hence the need for distributions from cash.
The fund also owns a 15-per-cent equity stake in IOC and earns a small amount of commissions – 10 cents a tonne – on what IOC sells.
There’s no leverage in a royalty stream, yet the swings in Labrador’s revenue are breathtaking. In 2007, Labrador earned royalties of $53-million (after paying a 20-per-cent tax to the Province of Newfoundland and Labrador). In 2008, it soared to $129-million. On 32 million units out, that’s a big move.
And the value of the equity stake, which is affected by leverage (meaning that because of fixed costs a change in revenue leads to a much bigger change in profits), would have soared in similar fashion. Indeed, IOC paid dividends to shareholders.
This year’s recession brought the opposite effect. Royalty income in the first nine months of the year fell by more than half and adjusted cash flow per unit was a mere third of what it was the year before. Even royalty owners get burned by drastic price swings.
It looks like the old pendulum is moving the other way now though. Demand is back. IOC was back to full production in the third quarter – and spot prices are firming up. India, one of the biggest producers in the world, will import iron this year. Although some say that’s temporary as it fires up supply, it’s still a sign of rising demand.
Steel demand historically peaks at about 1000 kilograms per capita in industrializing nations. Neither China nor India are close to that yet. With about two billion people between them, that’s a lot of demand. It won’t happen tomorrow, but it takes a while for new supply to come on stream.
The hair in the soup is the Canadian dollar. Part of the drop in Labrador’s financials, mentioned above, is because of volumes and pricing, but a good part is also from foreign exchange. Some pundits see the dollar going to par with the greenback. That’s only another nickel or so but it would hurt.
Iron ore prices are, for the most part, set annually early in the year by producers and consumers. Given the rise in price of exchange traded commodities like copper, negotiated iron prices will likely be a lot higher next year than this.
Labrador units have done well, but they once changed hands for $60 before being interrupted by an inconvenient financial catastrophe.
In 2008, the distribution was almost $5 per unit.
That could happen again if the dollar behaves as it should. And don’t forget that stocks that do well tend to keep doing well.
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