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An Analysis of Northland Resources & The Iron Ore Market
Copenhagen Business School Author:
MSc. Finance & Strategic Management Daniel Bergman
Master Thesis: August, 2012 CPR-Nr:
24-08-88-DAB1
Phone: 0046(0)76-3192716
Supervisor: Pages: 78
Ole Risager Characters: 184,330
1
Executive Summary
This thesis is written from an investor’s perspective to determine the fair value of Northland Resources
share price as of the 20th of July, 2012. The valuation is supported by a fundamental analysis of the iron
ore market’s forecasted supply and demand capacity.
For a long time the iron ore price has, been set in secretive meetings, not widely followed by banking
analysts, and not been included in major commodity indexes. The iron ore price is highly leveraged
towards the urbanization and industrialization phase of China. The economic prosperity of China has
caused an exponential increase in commodity prices. This has led many people to believe in a new
paradigm or a so called super cycle with sustained high commodity prices in the future.
Northland Resources is one of the largest industrial projects in Sweden at the moment. The company will
start production of a high quality iron ore concentrate in Northern Sweden by the 4th quarter of 2012. The
project has required a colossal investment of more than 5 Billion SEK and serves as a very important part
for the socio-economic development. This project has the potential to reverse the declining population
trend and generate economic growth for the greater region.
Many private investors have been amused by Northland Resources fantastic growth story. Private
investors on internet forums have consistently been arguing in favor for investing in the company.
Banking analysts and newspapers are also enthusiastic about Northland. The average target price for
Northland by banking analysts is 15.67 NOK, which is more than a 200% upside to today’s price of 5
NOK. Analysts expect the iron ore price to remain high in the future. Despite that in the last 100 years,
the iron ore price has only been above $100/ton in the last 2 ½ years.
According to my conservative analysis, the iron ore supply entering the market from 2013 to 2016
combined with a restructuring of the Chinese economy will gradually phase out the Chinese high cost
producers to set a new price floor at $100/ton. My prediction of the iron ore price and valuation of
Northland is contrarian to many analysts’ recommendations. I consider a fair value of
Northland’s share price to be 2.18 NOK or a 56.4 percent decline from the current market price of 5
NOK. I believe that there are strong indicators that Northland Resources will prove to be a value trap.
Many investors rely on simple P/E ratios on next year’s earnings or intuitive DCF valuations. A more
reliable DCF valuation backed by fundamental supply and demand requires more details and is far less
intuitive. Investors relying on simple DCF and P/E ratios are also probably less likely to understand the
composition of GDP growth that drives the demand for iron ore and are thereby deluded to invest in
Northland Resources.
2
Executive Summary
1. Introduction – Chapter I ......................................................................................................................... 6
1.1. Problem Identification .................................................................................................................... 6
1.2. Problem Statement .......................................................................................................................... 7
1.3 Structure of Thesis ........................................................................................................................... 7
1.3.1 Chapter II – The Story of Northland Resources ................................................................. 7
1.3.2 Chapter III – Strategic Analysis .......................................................................................... 8
1.3.3 Chapter IV – Budgeting ...................................................................................................... 8
1.3.4 Chapter V – Forecasting ..................................................................................................... 8
1.3.5 Chapter VI – Valuation ....................................................................................................... 9
1.3.6 Chapter VII – Conclusion ................................................................................................... 9
1.3.7 Chapter VIII – Perspectives ................................................................................................ 9
1.4 Methodology .................................................................................................................................... 9
1.5 Delimitations .................................................................................................................................. 10
1.6 Source Criticism ............................................................................................................................ 10
2. The Story of Northland Resources – Chapter II ................................................................................... 12
2.1. The History of Northland Resources ............................................................................................ 12
2.1.1. The Exploration Phase 2005-2010 ........................................................................................ 12
2.1.2. The Development Phase 2010-2012 ..................................................................................... 13
2.2. The Kaunisvaara Project ............................................................................................................... 14
2.3. The Hannukainen Project ............................................................................................................. 16
2.4. The Organizational Structure ........................................................................................................ 17
2.5. Corporate Governance .................................................................................................................. 18
2.5.1. Ownership Structure ............................................................................................................. 18
2.5.2. Executive Compensation ...................................................................................................... 19
2.5.3. Management Team ............................................................................................................... 20
2.5.4. Board of Directors ................................................................................................................ 21
2.7. Chapter II – Conclusion................................................................................................................. 22
3. Strategic Analysis – Chapter III ........................................................................................................... 24
3.1. Commodity Prices ........................................................................................................................ 24
3.2. Commodity Cycles ....................................................................................................................... 24
3.2.1. Historic Commodity Cycles.................................................................................................. 25
3
3.2.2. The Current Commodity Cycle ............................................................................................ 25
3.3. The Iron Ore Market ..................................................................................................................... 27
3.3.1. The Iron Ore Industry ........................................................................................................... 27
3.3.2. The Iron Ore Product ............................................................................................................ 28
3.3.3. The Iron Ore Supply ............................................................................................................. 30
3.3.4. The Iron Ore Demand ........................................................................................................... 31
3.4. Northland Resources Strategic Position – PESTEL Analysis ...................................................... 32
3.4.1. The Political Factors ............................................................................................................. 33
3.4.2. The Economical Factors ....................................................................................................... 33
3.4.3. The Social Factors ................................................................................................................ 33
3.4.4. The Technological Factors.................................................................................................... 33
3.4.5. The Environmental Factors ................................................................................................... 34
3.4.6. The Legal Factors ................................................................................................................. 34
3.5. The Industry Analysis – Porter’s Five Forces .............................................................................. 34
3.5.1. Threat of New Competition .................................................................................................. 34
3.5.2. Threat of Substitute Product ................................................................................................. 35
3.5.3. Bargaining Power of Customers .......................................................................................... 35
3.5.4. Bargaining Power of Suppliers ............................................................................................. 35
3.5.5. Intensity of Competitive Rivalry .......................................................................................... 36
3.6. The Internal Analysis – Value Chain Analysis ............................................................................ 36
3.6.1. Logistics ................................................................................................................................ 36
3.6.2. Operations ............................................................................................................................. 37
3.7. Chapter III – Conclusion .............................................................................................................. 37
4. Budgeting – Chapter IV........................................................................................................................ 39
4.1. Reference Price & Value Premiums ............................................................................................. 39
4.2. Cost Structure ............................................................................................................................... 40
4.2.1. Operating Expenditures ........................................................................................................ 40
4.2.2. SG & A Expenditures ........................................................................................................... 40
4.2.3. Capital Expenditures ............................................................................................................. 41
4.2.4. Financial Income & Expenses .............................................................................................. 41
4.2.5. Depreciation and Tax Rate ................................................................................................... 42
4.3. Balance Sheet Risk ....................................................................................................................... 42
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4.4. Risk Analysis ................................................................................................................................ 43
4.5. Chapter IV – Conclusion .............................................................................................................. 43
5. Forecasting – Chapter V ....................................................................................................................... 45
5.1. Future Production Trends ............................................................................................................. 45
5.1.1. Europe ................................................................................................................................... 45
5.1.2. North America ...................................................................................................................... 46
5.1.3. South America ...................................................................................................................... 47
5.1.4. Australia ................................................................................................................................ 49
5.1.5. Commonwealth of Independent States (CIS) ....................................................................... 49
5.1.6. Asia ....................................................................................................................................... 50
5.1.7. Africa .................................................................................................................................... 51
5.2. Future Consumption Trends ......................................................................................................... 51
5.2.1. The Transportation Sector .................................................................................................... 52
5.2.2. The Real Estate Sector .......................................................................................................... 52
5.2.3. The Manufacturing Sector .................................................................................................... 53
5.2.4. China’s Five Year Plan ......................................................................................................... 54
5.2.5. Indian Demand ..................................................................................................................... 55
5.2.6. Developed Markets ............................................................................................................... 55
5.3. Estimation of Forecasted FOB Price ............................................................................................ 56
5.4. Chapter V – Conclusion ............................................................................................................... 56
6. Valuation – Chapter VI ........................................................................................................................ 58
6.1. The Absolute Valuation ................................................................................................................ 58
6.1.1. Discussion of Valuation Model ............................................................................................ 58
6.1.2. Assumptions ......................................................................................................................... 59
6.1.3. Valuation............................................................................................................................... 59
6.1.4. Sensitivity Analysis ............................................................................................................. 61
6.2. The Relative Valuation ................................................................................................................. 61
6.2.1. Dannemora Mineral .............................................................................................................. 61
6.3. Chapter VI – Conclusion .............................................................................................................. 62
7. Conclusion – Chapter VII ..................................................................................................................... 63
7.1. Upside Risks ................................................................................................................................. 64
7.2. Downside Risks ............................................................................................................................ 65
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7.3. Recommendation .......................................................................................................................... 66
8. Perspectives – Chapter VIII ................................................................................................................. 68
8.1. The Behavioral Story .................................................................................................................... 68
8.1.1. The Winds of Change ........................................................................................................... 68
8.1.2. The Year of Confidence ........................................................................................................ 69
8.1.3. The Inconvenient Truth ....................................................................................................... 70
8.2. The Behavioral Aspects ................................................................................................................ 71
8.2.1. Overconfidence and The Illusion of Control ....................................................................... 72
8.2.2. Optimism ............................................................................................................................. 73
8.2.3. Internal vs. External Locus of Control & Self Attribution Bias .......................................... 74
8.2.4. Representativeness, Confirmation, & Availability Bias ...................................................... 75
8.2.5. Polarization .......................................................................................................................... 76
8.2.6. The Sunk Cost Fallacy ......................................................................................................... 76
8.3. What to expect next? ................................................................................................................... 76
Reference List ....................................................................................................................................... 79
Appendix .............................................................................................................................................. 90
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1. Chapter I – Introduction
This chapter serves to present the disposition and synopsis. It will provide the reader with the
following parts: problem identification, structure, methodology, delimitation, and source
criticism.
1.1 Problem Identification
Almost all (95%) of all iron ore is used for steelmaking. Steel is an essential part in everything
from infrastructure project to everyday goods. Despite being one of the world’s most salient
commodities, the iron ore price has been settled in secretive meetings between miners and steel
producers for more than 40 years (Blas, 2009). Flourishing emerging markets, have driven many
commodity prices to highs never seen before. The explosive growth of China has made many
people to believe that the turn of the millennium was the start of a new paradigm or a so called
super cycle (Rogers, 2004).
The undergoing expansion of the largest iron ore projects is likely to take decades (Geoff, 2012).
The three largest producers of iron ore control 62 percent of the world’s iron ore market. This
gives room for new junior miners to enter the iron ore market. Northland Resources is a junior
miner about to enter the iron ore market with a production start in the 4th
quarter of 2012
(Northland Resources, 2012l).
The aim of this thesis is to carry out a valuation of Northland Resources based on an analysis of
the iron ore market and a forecast of the future demand and supply capacity. Northern Sweden
enjoys a long history of iron ore mining with good access to existing railways and low political
risks. This makes Northland Resources an ideal candidate to be analyzed and to determine
whether the risks and future earnings reflect the current stock price. However, a valuation of a
non producing cash flow company is always a difficult task. The analysis of the iron ore market
will be a crucial factor in determining the profitability of Northland Resources.
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1.2 Problem Statement
The problem statement of this thesis is the following question:
“What is the value per share of Northland Resources?”
The following five questions will be essential to recognize a fair value per share of Northland
Resources and will be answered throughout this paper.
“What is Northland Resource’s strategic position relative to other miners?”
“Is there a new paradigm in commodity prices?”
“What is the source for supply and demand of iron ore?”
“What is the forecasted costs, iron ore price, and price premiums?”
“What is the correct discount rate to reflect Northland Resource’s financial and business risks?”
1.3 Structure of Thesis
This thesis is divided into eight chapters to cover all the essential perspectives by an orderly
method. The first two chapters will serve to explain the subject and give background information
about Northland Resources. In chapter three the main focus is the fundamental analysis of the
iron ore market and the strategic situation of Northland Resources. The fourth chapter is a
forecasted budget for Northlands Resources presented of costs and expenses, as well as an
estimation of the discount rate. Chapter five will provide a forecast of the iron ore price based on
fundamental supply and demand. Furthermore, in the sixth chapter, a valuation will be presented
based on a discounted of cash flow model of free cash flow to equity. The report is tied together
with a conclusion in chapter seven. The last chapter named perspectives is to discuss whether the
market valuation reflects an accurate price of the share. More detailed information about the
chapters is shown below.
1.3.1 Chapter II – The Story of Northland Resources
This chapter will provide an overview of Northland Resources. This chapter will tell the story of
Northland Resource’s history, organizational structure, and business model. This part presents
complete insights about the firm’s development and organizational structure. The historic
8
development of Northland Resources provides an indicator of the firm’s future ability to generate
value for shareholders.
1.3.2 Chapter III – Strategic Analysis
The overall objective with the strategic analysis is to determine Northland Resources potential
for future value creation. This is to a large extent dependent on the market for Northland
Resources product, primarily the iron ore market. The chapter will begin with a macro analysis
of the iron ore market. This macro analysis will cover the fundamental factors affecting the
supply and demand for iron ore and examine the historical trends. The macro analysis is
followed by an industry analysis. Northland Resources strategic position regards to competitors
will be examined in the industry analysis to determine whether Northland will enjoy an
competitive advantage. The industry analysis is followed by an internal analysis of the specific
activities that create value for Northland Resources. Lastly, this chapter will be summarized in a
SWOT analysis. The main purpose of this chapter is to assess whether Northland Resources will
achieve a competitive advantage in the iron ore market with their product. A strong strategic
support will facilitate the forecasting process to let us see into the future with a high degree of
visibility (Penman, 2010).
1.3.3 Chapter IV – Budgeting
This chapter will elaborate on the forecasted cost structure that will serve as an input in the
valuation of Northland Resources. The cost structure includes operating costs, capital
expenditure, financial expenses, and depreciation. This chapter will also include a description of
calculating the correct iron ore price incorporating price premiums and freight costs obtained
from the port of Narvik. In addition, this chapter will also assess a fair risk measure for
Northland Resources.
1.3.4 Chapter V – Forecasting
The assessment of the strategic position in chapter two, will provide a strong support of
fundamental sources of supply and demand in the iron ore market. The supply capacity will be
forecasted up to the year of 2020 by researching major potential iron ore production in the world.
The demand capacity will be assessed by a qualitative study of the potential sources for future
9
demand capacity. The growth rate of supply and demand will be assessed in both a conservative
and moderate scenario. These growth rates will be used to calculate a surplus or shortage of iron
ore in the future market. These scenarios will then be used in the valuation section.
1.3.5 Chapter VI – Valuation
The absolute valuation to be used is based on a discounted cash flow model, namely the free cash
flow to equity model (FCFE). The cost and price estimates from previous sections will serve as
important input into the valuation. The first year for Northland Resources to generate a cash flow
is 2013. Therefore the forecast horizon to be used starts in year 2013 and ends in 2020. Then the
year 2021 will serve as the terminal period. A relative valuation will also be conducted based on
a qualitative comparison to a peer company. A relative valuation will reflect the expectations of
investors in the market.
1.3.6 Chapter VII – Conclusion
This chapter will serve to conclude my valuation of Northland Resources. This chapter will
present a brief summary of my results from my analysis that motivates my forecast and valuation.
The conclusion will present potential upside and downside risks of investing in Northland
Resources. The conclusion will end with a final recommendation on whether the company’s
share is under or overvalued.
1.3.7 Chapter VIII – Perspectives
This chapter will discuss the resulting share price of my valuation and why it might not be
efficiently priced by the market. In the event of a large deviation from the prevailing market
valuation, a rationalization from the behavioral school of finance might help to explain the
market inefficiency.
1.4 Methodology
The thesis is written from a private investor’s point of view and relies on publicly available
information. The secondary information about Northland Resources is obtained from academic
articles, Canadian Securities Administrators SEDAR filing system, Northland Resources website,
and annual reports. The secondary information about the iron ore market is obtained through
10
researching the largest mining companies in the iron ore market as well as the largest consuming
nations of iron ore. I will analyze forecasts and analysis made by the World Steel Association,
World Steel Dynamics, IMF, among other research institute specialized in commodities or global
trade. Additional information will be obtained from different newspapers and online databases
such as the Financial Times, and Bloomberg.
The strategic analysis and valuation techniques are obtained from the “Financial Statement
Analysis” book written by Christian V. Petersen & Thomas Plenborg (2012). The corporate
governance framework is based on the book “An Introduction to Corporate Governance,
Mechanisms and Systems” by Steen Thomsen (2008). The behavioral analysis of management
and investors is based on the book “Value Investing” by James Montier (2010) and “Behavioral
Corporate Finance” by Hersh Shefrin (2007).
Various theories are applied to form a structured and properly assessed, quantitative and
qualitative valuation of Northland Resources. This report follows a case study approach in the
way the research is focused on the iron ore market and the valuation of Northland Resources.
1.5 Delimitation
The cutoff date for this report is set to 08:00 am Central European Time, on July 20th
, 2012. No
information published after this date will be used. The resulting share price from this thesis is to
be compared to the current market valuation on July 20th
, 2012. A major part of this thesis will
be to research the iron ore market. The iron ore market is a subject that could deserve a thesis by
itself. Therefore the extent of researching the iron ore market will be focused on the price setting
mechanism of supply and demand for price forecasting.
1.6 Source Criticism
An ideal valuation is a valuation based on unbiased information. (Plenborg, 2012) However most
information published about Northland Resources could potentially be biased in one way or
another to manipulate the stock price. That being said it is important to address the validity,
reliability, and robustness of the obtained sources. The annual reports and press releases by
Northland Resources are valid, but could potentially open up for interpretation and when that is
present the trustworthiness is at stake. The qualitative information obtained from Northland
11
Resources could be “selling-biased” to present a favorable story of Northland Resources (Shefrin,
2007). The quantitative data obtained in annual reports, industry reports, and statistics is less
likely to be at risk of misinterpretation because of its validation by independent accountants. The
sources of major research institutes for the iron ore market is also less likely to be at risk of
manipulation. Major research institutes are large organizations with a credible reputation.
12
2. Chapter II – The Story of Northland Resources
This chapter will outline an overview of Northland as a company. The chapter presents a detailed
description of Northland’s history, organization, and corporate governance.
Northland Resources is the world’s fastest Greenfield mining project in the world. The company
is publicly listed on stock exchanges in Oslo, Toronto, and Frankfurt. Northland’s main activities
are in the development of iron ore deposits. The mining sites are located in an established major
iron ore province on both sides of the border between Sweden and Finland. The locations of the
two mining projects are shown in appendix 2.1. These sites lie more than 100 km north of the
Arctic Circle. (Northland Resources, 2012a) The two mining projects are:
Kaunisvaara, Sweden
Hannukainen, Finland
2.1 The History of Northland Resources
The original company was established in 1987, as a biotechnology company under the name of
Genprobe Technologies Ltd. Ten years later the company conducted an initial public offering on
the Vancouver stock exchange. Over the years, the company underwent a series of changes in
name and strategy. In 2003 the company became a junior Canadian exploration company under
the name North American Gold Inc. and started to conduct business in Sweden. The original aim
was to look for copper and gold deposits. The company acquired 60% of an iron ore project in
the Barsele region of Northern Sweden through an option agreement. A year later, in 2004 the
company acquired certain properties in the Pajala area including Tapuli and Sahavaara through
an option agreement with the Anglo-American corporation (Northland Resources, 2012l).
2.1.1 The Exploration Phase 2005 - 2010
The year of 2005 was the birth year of the company we see today. This year the company
changed name and became Northland Resources Inc. At this time they also decided to broaden
its exploration and acquired the Hannukainen properties in Finland. The following years
Northland conducted a series of right issues of a total of $170 Million and were subsequently
listed on the Oslo stock exchange. In the same period Northland exercised its option to acquire
13
full ownership of the Barsele and Kaunisvaara project. The funds obtained were directed to take
the project through initial exploration and feasibility study stages. In 2008 Northland switched
from the Vancouver stock exchange to the Toronto stock exchange. This was also the year
Northland announced the results of the preliminary assessment of the economic viability study
for Sahavaara, Tapuli, and Hannukainen deposits (Northland Resources, 2011a).
2.1.2 The Development Phase 2010 - 2012
The year of 2010 was a ground breaking year for Northland. The company received the final
environmental permit for the Tapuli deposit and announced the results of the definitive
feasibility study for the Tapuli and Sahavaara deposits. In 2010, Northland announced a revised
decision for the logistical route, to use trucks and then trains to transport the iron ore concentrate
to the deep water port of Narvik, Norway. The ice free port can handle larger vessels than the
previously proposed port of Kemi, Finland. In late 2010 Northland raised $242 Million through
a rights issue to invest in infrastructure and development of the Kaunisvaara site. December 20th
,
2010, was an historic day for Northland as it was the official ground breaking ceremony for the
start of constructing the mine (Northland Resources, 2012a).
The construction of the Kaunisvaara project speeds up during 2011. The Barsele project is
divested and all focus is directed towards the Kaunisvaara and Hannukainen projects. Northland
signs important contract with suppliers throughout 2011. Peab was appointed to construct all the
civil works for the Kaunisvaara project including detailed engineering, earthworks, foundations,
buildings and related works. Metso is the supplier of mineral processing equipment and services
for the two process lines at the Kaunisvaara project. Vattenfall will provide two new over-head
power lines, one of 130kV and one of 40kV which will supply the mine with sufficient electrical
power (Northland Resources, 2012a).
During 2011 there was no final agreement signed for the logistical solution. Northland led a
discussion to initiate a joint venture to finance the logistics and signed a letter of intent with
Grieg Logistics, Savage Services Corporation, and Peab for the logistical solution. The final
project financing would be a syndication of a senior loan led by three banks Société Générale,
WestLB AG, and UniCredit Bank of up to $400 Million. The syndication was planned to be
finalized during the second quarter of 2011, but was then delayed (Northland Resources, 2012a).
14
The senior loan syndication was never finalized in 2011 and Northland received a bridge
financing from Standard Bank of South Africa of $50 Million that would be replaced by the final
project financing in the first quarter of 2012. On February 2nd
, 2012, Northland unexpectedly
announced an equity and bond offering. The total amount of $675 Million was directed to ensure
the development, construction and completion of the Tapuli mine to December 31st, 2014. The
equity and bond offering was $325 and $350 Million respectively. Northland expects to generate
sufficient cash flow after 2014 point to service its debt and finance the development of the
Sahavaara mine (Northland Resources, 2012a).
In early 2012, the construction for the transshipment terminal in Pitkäjärvi as well as the
Fagernes terminal in Narvik port commenced. Northland took the decision to finance the
logistical solution entirely by Northland and not by a joint venture, but will fully outsource the
logistical solution to Savage, Peab, and Grieg. On March 19th
, 2012 Northland announced the
project is on schedule and will be fully operational by the fourth quarter of 2012 with the first
shipment in the beginning of 2013 (Northland Resources, 2012a).
2.2 The Kaunisvaara Project
The Kaunisvaara project is located in Norrbotten County, Sweden in the municipality of Pajala
near the village of Kaunisvaara (see appendix 2.2). The project area lies 15 kilometers south of
the Swedish/Finnish border, and within 150 kilometers from the two largest iron ore mines in
Sweden, the Kiruna and Malmberget mines both operated by LKAB. Geologically, the
Kaunisvaara deposits have similarities to the two LKAB mines in terms of iron ore quality. The
Kaunisvaara project will be a high grade iron ore open pit mine. The Kaunisvaara project is a so
called a Greenfield project, which means that the area has never been mined before (Northland
Resources, 2012l). The company has focused on developing three iron ore deposits:
Tapuli
Sahavaara
Pellivuoma
The Kaunisvaara area has a long mining history from as early as 1641. The modern prospecting
of the iron ore field began by the discovery of ironstone occurrences by geologist V Tanner in
15
1918. Since then it has been various discoveries of iron ore deposits in the Kaunisvaara iron ore
area. The ironstone occurrences of the Kaunisvaara Ore field has been described and researched
in numerous geologic investigations by the Swedish Geological Survey (SGU) sponsored by
LKAB. The Finnish mining company Outokumpu has also explored parts of the area for iron ore,
copper, and gold potential in the mid-1990s. The most extensive exploration was conducted by
Anglo American from the year 2000 to when Northland took over the Pajala exploration in 2004.
Northland has compiled an extensive database of available historical exploration information for
the Kaunisvaara deposits. The mineral reserve is shown in appendix 2.3. This mineral reserve
excludes the Pellivuoma deposit due to the lack of economic assessment. The Pellivuoma
feasibility study is expected to be released by the second half of 2012 (Northland Resources,
2012l).
A mining company needs to obtain three permits in order to start mining operation in Sweden.
The three permits are exploitation concession, construction permit, and environmental permit.
The Tapuli deposit is fully permitted and the Sahavaara is expected to receive its final
environmental permit by the third quarter of 2012. The Pellivuoma deposit has of today no
permits. The Tapuli and Sahavaara deposits are classified by the SGU as being of national
interest for mineral production. The title of being of national interest could strengthen Northlands
future applications for environmental permits and exploitation concessions (Northland Resources,
2012l).
The construction of the process plant started in December, 2010 and mining is expected to
commence in the 4th
quarter of 2012 from the Tapuli deposit. The Sahavaara deposit is planned
for mining in 2017. The Pellivuoma deposit is about 15 km from the mill and will be mined in
the latter part of the Kaunisvaara project. Pellivuoma is expected to prolong the mine with 10
years at 6 Million ton per annum. The mine will be operated as a conventional open pit mine
with truck and shovel operations and state of the art mineral processing techniques. The mineral
processing technique involves crushing, grinding, flotation and magnetic separation (Northland
Resources, 2012l).
The logistical solution of the project is to transport the iron ore with trucks from Kaunisvaara to
Svappavaara and from Svappavaara to Narvik with existing railway (see appendix 2.4). The
Kaunisvaara project has a potential to produce up to 5 Million ton iron ore concentrate per
16
annum with a 69% Fe content. The product will be sold to steel makers in Europe and Asia.
Northland has entered into long term agreements for 100% of the first 7 years of production with
Standard Bank Plc, Tata Steel UK Limited and Stemcor UK Limited (Northland Resources,
2012l)..
Northland is actively engaging in exploration projects to extend the potential life of mine of
Kaunisvaara. The company believes that regardless of good exploration indications, the area is
underexplored by too little drilling data. The most advanced exploration object is the Pellivuoma
deposit. The ongoing exploration around the Kaunisvaara area currently in the drill testing phase
includes Ruutijärvi, Salmivaara, and Karhujärvi. Further exploration results of the drill testing
areas may be revealed along with the DFS report for the Pellivuoma deposit in the 4th
quarter of
2012 (Northland Resources, 2012l)..
2.3 The Hannukainen Project
The Hannukainen project is located in the Kolari district of northern Finland, 30 kilometers
North East of Kaunisvaara (see appendix 2.2). The Muonio River marks the boundary between
Sweden and Finland. The Kolari district is an area of developed infrastructure with paved roads,
power lines and railroad all nearby. The Hannukainen project will be an iron oxide, copper, and
gold (IOCG) open pit mine. Northland is planning to produce about 2 million ton per annum of
high quality iron ore concentrate. A preliminary economic assessment (PEA) study was
completed in the second quarter of 2010. The definitive feasibility study (DFS) is expected to be
completed by the end of 2012. Hannukainen permitting is an ongoing project for the company. In
June 2012, the tentative plan was to start mining operations in 2016 (Northland Resources,
2012l).
The mining area from Kolari to Rautuvaara is an historical mining camp that has not been used
since the early 1990’s; the infrastructure is in place, but needs to be refurbished. The first
exploration of the area was conducted during and after the Second World War. The first
feasibility study was completed in 1967 and the mine opened in 1975. Nevertheless the mine
closed in the late 1980s due to low commodity prices. The latest exploration has been conducted
by airborne and ground geophysics, bedrock mapping and drill testing between 1976 and 1987.
Drilling programs were completed in 2010 and 2011 at Rautuvaara and Rautuoja Deposits.
17
According to Northland the drilling results were promising to increase the resources at depth.
(Northland Resources, 2012l)
The project is a brownfield project, which means that the area has been mined before. Last time
Hannukainen was in operation were during the 1980s by Rautaruukki Oy and is reported to have
produced a low grade iron ore of 4.5 Million ton annually. The mine was closed in 1988 after not
being profitable enough at the preceding iron ore price (Northland Resources, 2012l)..
Northland acquired the deposit in 2005 and has since focused on exploring the area for additional
iron, copper and gold reserves. In addition to claims adjacent to the Hannukainen project, the
Company holds extensive exploration claims covering the most prospective areas in the Kolari
region. The PEA modeled the development of the Hannukainen deposit but did not include any
nearby resources. It is anticipated that as the Company identifies suitable adjacent resources,
they will be developed to provide additional feed to the processing facility located near the
Hannukainen deposit. The PEA indicates that the total project life will be 14 years. However this
PEA excludes potential satellite deposits that are currently being explored. The upcoming
Hannukainen DFS may reveal substantial new IOCG mineralization reserves. The exploration
areas currently in drill testing are Kuervitikko, Rautuvaara, Rautuoja, and Mannakorpi
(Northland Resources, 2012l).
2.4 The Organizational Structure
Northland Resources S.A. is a public limited liability company, domiciled in the Grand Duchy of
Luxembourg. Northland’s corporate governance structure is based primarily on Luxembourg
corporate law. Northland Resources S.A. is the parent company, which in turn holds operating
subsidiaries, which are subject to relevant laws and guidelines in Sweden, Finland, and Norway
(Northland Resources, 2012a).
Shareholders, board of directors, and management team of Northland Resources has slowly been
changed over the recent years, as the firm has moved from exploration, to development, to a
production company. Northland’s current organizational structure is illustrated in appendix 2.5.
The company has a one tier board system where the board of directors is in charge of
management control and decision. The chairman of the board Anders Hvide is also part of the
executive management team as an executive chairman (Northland Resources, 2012a).
18
Northland has 6 directors and 13 persons in the executive management team according to the
June, 2012 company presentation. The management team has extensive expertise in exploration,
engineering, development, finance, communications and international business relations. As at
the end of the fourth quarter 2011, Northland had 15 full time employees, 18 consultants and 329
contractors. The management team and board of directors are illustrated in appendix 2.6 and 2.7
respectively (Northland Resources, 2012a).
2.5 Corporate Governance
In this corporate governance subchapter I will examine the control mechanisms that Northland
has set in place to ensure they are satisfying the desired direction by the majority shareholders.
The corporate governance is aspects of ownership structure, board of directors, committees,
incentives, company law and other mechanisms (Thomsen, 2008).
2.5.1 Ownership Structure
The ownership structure has changed dramatically over the recent years. Frode Teigen, Skagen
Kon-Tiki, and Skagen Vekst have all been large shareholders up to 2010. All together they
owned 15.1 percent of the firm (Mining Journal, 2009). However these shareholders sold out
during 2010 and new shareholders came in.
Today the largest shareholders by June, 2012 are presented in appendix 2.8. The management
and board own approximately 0.4 percent of the outstanding shares according to the March
corporate presentation (2012). Insider holdings of options and shares, as of February 24 2012,
according to the equity prospectus (2012) are presented in appendix 2.9. The executive chairman
Anders Hvide has the largest insider holding of 1 750 800 stocks. The management team does
not own a substantial share of the firm, but are included in an extensive stock option plan, where
a maximum of 15 percent of the issued shares can be reserved for officers, directors, employees
and consultants (Northland Resources, 2012b).
The largest shareholder is Avanza bank, which is a custodian bank for people in Scandinavia.
The largest institutional shareholder, Deans Knight Capital Management is an investment firm
for high net-worth individuals. Deans Knight Capital Management participated fully in the rights
issue of 2012. The third largest shareholder is Henderson Global Investor, which is an
19
institutional investor that has been invested in Northland in the previous years. The top 15
shareholders own 47.4% according to the June, 2012 presentation. The geographical locations of
the participants in the rights issue of 2012 is presented in appendix 2.10. Norway represents 40
percent of the participating shareholders. Northland is followed by 15 analysts as shown in
appendix 2.11 (Northland Resources, 2012c). The average target price by analysts is 15.67 NOK.
This would be more than a 200 percent up-side to the July 20th
, 2012 share price of 5 NOK.
(Holter, 2012)
Northland has a low concentration of ownership. The dispersion of ownership combined with a
low share of insider holdings exacerbates the type 1 agency problem of power between
shareholders and management. No single shareholder has a significant influence on Northland’s
operations. The dispersion of ownership among institutional shareholders reduces the type 2
agency problem between majority and minority shareholders. However, a company without a
majority owner has a tendency to make all shareholders weak (Thomsen, 2008).
In early 2012 the company issued $350M in corporate bonds. A high level of financial leverage
can put pressure on managers to work efficiently to pay off the debt or risk going into
bankruptcy. (Thomsen, 2008) The Bond Trustee (“Norsk Tillitsmann”) control Northland’s draw
downs of the bond facility based on the independent consultant Turgis Consulting Ltd (“Turgis”),
Turgis is required to ensure that the Kaunisvaara Project passes a defined “cost-to-complete” test
as well as to certify that the project is progressing according to schedule (Northland Resources,
2012j).
2.5.2 Executive Compensation
The aim with the executive compensation is to offer contracts that combine rewards and
penalties with three goals in mind. First goal is to offer contracts that are at least as attractive as
the executive management’s second best alternative. Second goal is to induce executive
management to represent the interests of the shareholders. Third goal is to offer contracts that are
not unduly generous to the executive management (Shefrin, 2007).
Northland has implemented a stock option plan; the allocation of stock options (see appendix
2.9). Michael C. Jensen (2000) argues that stock options do not play a major role in aligning the
interests of executives and investors, when shareholder power is weak. The compensation for the
20
Executive Chairman and CEO & President in the previous 3 years is presented in appendix 2.12.
Northland’s share price has appreciated from 5 NOK in 2009 to peak at 20 NOK in the spring of
2011, and then it fell dramatically during the summer to end the year to about 11 NOK
(Northland Resources, 2012b). The option based compensation developed in a similar fashion to
the share price. On the other hand the fixed salary increased sharply over the period. Overall the
total compensation increased 5.4 percent in the period the share price dropped. In my opinion
there is a lack of variability in compensation.
Performance based pay should be based on the value added by the management and not the
inherent economics of the business. We should consider how much the management improves
the underlying economics of the business. Not how much the underlying economics enhances the
perceived performance of the management (Buffet, 2009). Once the mine is constructed the
stock options will be more sensitive to the iron ore price and less to the contribution by the
management. Northland’s stock option plan will not be rewarding the management for adding
value but rather reward the management based on the inherent economics of the business.
The share price has been higher than the weighted average exercise price of the stock options for
some time (see appendix 2.13). In the last few years management has been paid very well for
their options, but with today’s low share price in relation to the weighted average exercise price
of the stock options helps to reduce the type 1 agency problem. Lazonick et al. (2000) research
concludes that stock option plans might direct management to only focus on profits and forgo
important risk measures which can reduce their long term value. Lastly stock option plans
increases the inclination to take part in accounting fraud (Shefrin, 2007).
2.5.3 Management Team
The management team has undergone a series of changes as the company has been in transition
from being an exploration, to development, and to a producing company. In the period after the
Oslo listening and securing $170M financing for exploration in 2006 and 2007, the firm was lead
by Ardean Morrow as President and Director, William S. Wagener as COO, Aurelian Bukatko as
CFO. All of them resigned or retired before the company entered into the development phase and
the rights issue in 2010 (Northland Resources, 2011a).
21
Anders Hvide is the executive chairman (see appendix 2.6). Mr. Hvide joined Northland in
January, 2009 after serving as a partner and managing director of metals and mining, as well as
corporate finance for Pareto Securities A/S. Mr. Hvide has a long history from M&A
transactions and corporate advisory services (Northland Resources, 2012a).
The President and CEO is Karl-Axel Waplan. Mr. Waplan joined Northland in 2008 and became
President and CEO in January, 2010. Previously he was the President and CEO for Lundin
Mining from April 2005 to January 2008. In this period he successfully three folded the share
price from about 30SEK to 90 SEK (Yahoo Finance, 2012). Mr. Waplan has worked more than
33 years in the mining industry at Boliden, Ferro Alloys & Noble Alloys and among others
(Northland Resources, 2012a).
Overall the executive management team is highly educated and has an extensive experience from
leading international companies. Many have previously worked for Boliden, Lundin Mining,
LKAB or other highly prestigious industrial companies (Northland Resources, 2012a).
2.5.3 Board of Directors
Tuomo Mäkelä, Stuart Pettifor, and Birger Solberg have all been in the board since 2007 (see
appendix 2.7). Anders Hvide joined the board as chairman in January, 2009. The board has a
broad international experience from exploration, development, and production of minerals. All
the directors are independent from Northland’s large shareholders. In addition the directors are
independent from Northland’s management, except Anders Hvide, who serves as Executive
Chairman. Only independent Directors serve as Committee members (Northland Resources,
2012a). The following committees are established by Northland:
The Audit Committee
The Compensation Committee
The Nomination Committee
The Environmental, Health, and Safety committee
The audit committee’s responsibility is to review the internal and external audit process. This
includes also Northland whistleblower line for anonymous submission of questionable
accounting or auditing matters. Matti Kinnunen is the chairman with Tuomo Mäkelä and Stuart
22
Pettifor as members. Mr. Kinnunen has extensive experience from the financial industry. Mr.
Kinnunen joined the board of Carnegie in 1991 and thereafter served on a number of leading
positions. He held the position as chief operating officer for Carnegie from 2003 to 2007 and
then deputy CEO of the Carnegie group until they went into bankruptcy in 2008 (Hammar, 2008).
The compensation committee responsibility is to supervise the compensation of executive
officers and directors. The committee also makes recommendations regarding the stock option
plan and bonuses. Tuomo Mäkelä is the chairman of the committee with Stuart Pettifor and
Birger Solberg as members (Northland Resources, 2012a).
The Nomination committee responsibility is to propose and review candidates for board
positions. Birger Solberg is the chairman of the committee with Tuomo Mäkelä and Stuart
Pettifor as members (Northland Resources, 2012a).
The environmental, health, and safety (EHS) committee was established in 2011. The main task
of the committee is to advise the board of directors and the company on EHS strategy, policies,
and programs. The committee should support Northland in developing and implementing best
practice EHS standards and systems. Stuart Pettifor is the chairman of the committee with
Tuomo Mäkelä as member (Northland Resources, 2012a).
Moreover, the board of directors is characterized as a highly homogenous group in the sense that
there are no women and all members has a high level of expertise in the mining and steel making
industry.
2.7 Chapter II – Conclusion
This chapter informs about the development of Northland Resources. The company is working
towards becoming a Scandinavian mining company with production start in the 4th
quarter of
2012. The company has two projects in progress the Kaunisvaara and Hannukainen projects.
The Kaunisvaara project is considered to be one of the fastest greenfield mine project in the
world with less than 24 months of construction time. The project life is estimated to be about 15
years for respective project with a high potential for further expansions.
The second part of this chapter examined the organizational and corporate governance structure.
The highly dispersed shareholders in combination with a low degree of insider holdings pose to
23
cause a severe agency problem between shareholders and management. The enormous stock
option plan and lack in variability of salaries could be a result of the agency problem. A large
stock option plan increases management propensity to act in a fraudulent manner. Moreover the
management team and board of directors have a high level of expertise.
24
3. Chapter III – The Strategic Analysis
This section will provide an extensive analysis of Northland’s position for value creation. The
single most important factor affecting Northland’s profitability is the underlying price of the
company’s product, namely the iron ore product. The iron ore market is a highly complex and
dynamic market. Therefore this section will be a thorough examination of the iron ore market.
The second part of this section concerns Northland’s strategic position in the mining industry.
3.1 Commodity prices
The performance of an investment in a commodity stock is dependent on the underlying
commodity price which is driven by the fundamental supply and demand story of the commodity.
Jim Rogers (2004) argues that the twentieth century has experienced three long commodity
boom periods 1906–1923, 1933–1953, 1968–1982, the average period lasted a little more than 17
years. The current boom in commodities started with the new millennium. In order to estimate
the future iron ore price, we need to understand the commodity cycle of boom and busts.
3.2 Commodity Cycles
Commodity cycles could either be supply driven or demand driven. A supply (demand) driven
boom is caused by a change in supply (demand). A change in supply could be caused by either a
physical constraint where deposits become depleted or technological innovations which allows
for higher production. A change in demand occurs when there is a higher or lower need for a
commodity (Schumpeter, 1934).
The start of a commodity cycle is characterized as a period with a long period of historically low
commodity prices. The first signal of an emerging commodity boom is declining inventories. If
supply is not steadily increasing at the same rate as demand, then supply will not match demand
which would lead to higher prices. (Rogers, 2004) This is called the displacement period and is
recognized by investors seeking to profit from new opportunities (Montier, 2010). During this
period demand exceed supply and extraction for a commodity is forced on to the less productive
margins and thereby setting a higher price floor for a commodity (Schumpeter, 1934). High
commodity prices encourage investors to invest in mining and drilling projects. The boom
generally ends after discoveries of new reserves and new mines coming online leading to a
25
higher supply capacity. A clear sign that the boom period ended is a buildup in inventories. The
resulting bust is associated with declining prices and extermination of inefficient projects.
(Rogers, 2004)
3.2.1 Historic Commodity Cycles
The mid twentieth century commodity boom was to a large part an agricultural boom. The
interesting feature with this boom is that there was not a significant change in fundamental
supply and demand. Higher commodity prices were due to a perception of supply shortages
which led to a buildup in inventory (Farooki and Kaplinsky, 2012)
The 1970’s commodity boom was mostly a supply driven boom in oil price (IMF, 2008). Prior to
the boom, the price for oil had been low for a long term making investors less eager to invest in
oil projects. Eventually inventories of oil began to disappear with nothing to replace them. But
the shift in purchasing power of oil from the United States to the OPEC was the monumental
shift to have caused the oil price boom. This led investors to stumble over one another in an
effort to profit from higher prices. Investments in oil projects to build infrastructure and drilling
platforms eventually encouraged new supply to satisfy demand. Companies began drilling for oil,
and opening up new mines. Gold dropped from $850 in 1980 to $300 in 1982, oil collapsed to
less than $10 a barrel in 1986. Then the cycle began to repeat itself. With excess supply
combined with low prices leading investors to search for other profit opportunities (Rogers,
2004).
The important commonality in previous boom periods is the belief in a new paradigm of
sustained demand growth or constrained supply. In neither case was there a sustained structural
imbalance between supply and demand. Consequently in both periods the boom was short lived
with prices falling rapidly once supply came in balance with real (as opposed to perceived)
demand (Farooki and Kaplinsky, 2012).
3.2.3 The Current Commodity Cycle
The current commodity boom started around the year 2000. Prices of many commodities like oil,
nickel, tin, corn, wheat, and iron ore have reached record highs. The difference between the
26
current commodity boom and the one in the 1970s is that the current one is demand driven and
the previous boom was supply driven.
U.S. investors were too distracted by their own booming economy and stock market in the years
leading up to the current boom in prices. There was very little money allocated in increasing
productive capacity of natural resources. The 1990s was characterized with high stock market
returns and low commodity prices. Then things changed with the start of the new millennium.
The emerging markets transformation created a high demand for commodities. The boom in
commodity prices is due to a combination of rapid industrialization, urbanization, a higher
commodity intensity of growth, and rapid population growth. The slow supply adjustment to
rapidly increasing demand is also a main reason for higher commodity prices (Rogers, 2004).
The Chinese dominance in world commodity markets is shown in Appendix 3.1. Between 2000
and 2010, China imports of iron ore in value terms increased 42.5 times (Anderlini, 2012). The
iron ore price has seen a percentage increase that beat most other commodities.
The iron ore price has surged around 1000 percent, while gold has increased by around 400
percent in the last decade (Index Mundi, 2012). This has made many mining companies
enormously profitable. The earnings trend for iron ore is illustrated in appendix 3.2. This is a
worrying trend that suggests an iron ore price bubble has emerged. The earnings deviation from
the trend is shown in appendix 3.3. This shows that the recent earnings deviation from the trend
is larger than for the previous commodity bubble (Montier, 2010). Unfortunately, this data is
only for the period up to 2007. There was a slight drop in 2008, but most commodity prices
continued to reach highs never seen before in 2011.
Another reason to believe there is a bubble is because of the increase in inventory since 2008.
The Bloomberg China Inventory Index has doubled since 2008 (see appendix 3.4). The total
amount of iron ore in Chinese inventory surpassed 100 Million ton in June, 2012 (China Daily,
2012). A reason for this could be that investors and steelmakers anticipate they can sell the iron
ore for a price higher in the future.
In spite of the worrying scenario analysts and investors believe the growth will continue. The P/E
multiple cyclically adjusted on past earnings is depicted in appendix 3.5. The current price
implies very high growth rates for the foreseeable future (Montier, 2010).
27
The emerging markets demand for commodities are most notably India and China. These two
countries have undergone a transformation to open up to the world economy. The transformation
of these emerging markets has made many people to believe that there is a new paradigm
emerging (Farooki and Kaplinsky, 2012).
3.3 The Iron Ore Market
Almost all iron ore mined are used in the production of steel. After the iron ore is mined it is sold
to steel companies for further processing. Steel represents as much as 95 percent of all the metals
used each year, because of its countless applications. Steel is used in the construction of
infrastructure, and production of consumer goods from cars to washing machines (Blas, 2009a).
The demand for infrastructure is most important; it is ten times more steel intensive than the
production of consumer goods (Steel Dynamics, 2011). The iron ore price is one of the key
drivers in global inflation. According to a mining analyst at Barclays Capital says:
“Iron ore may be more integral to the global economy than any other commodity, except
perhaps for oil.”- Christopher LaFemina, (Blas, 2009a)
Despite this it is not followed by as many analysts as other important commodities like oil and
gold. The price is difficult to find and is not quoted on any news websites. Oddly the iron ore
price is often not included in major commodity indexes like the standard and poor’s commodity
index, Thomson Reuters CRB Index, and Dow Jones-UBS commodity Index, among others.
3.3.1 The Iron Ore Industry
The iron ore industry is highly consolidated where the three largest producers represent 62% of
the world iron ore production for 2009. Economies of scale have been an important reason for
the high level of consolidation in the iron ore industry. In periods of low iron ore price, mining
would require large and cost efficient operations to satisfy shareholders required return. A large
capital investment upfront for processing plant, infrastructure like ports and railways are
necessary and has caused high entry barriers. The outcome of these factors is that Vale accounts
for about 80% of the Brazilian production, and Rio Tinto and BHP Billiton accounts for over
about 80% of the Australian production (Northland Resources, 2012l). The consolidated iron ore
28
industry is a clear indicator that the iron ore price has been low for a long time prior to the
current boom period.
On the other hand the steel industry is highly fragmented, where the top three producers only
account for 12% of world production (see appendix 3.6). Historically the price for iron ore has
been set in secret meetings between the top producers and steelmakers, where the first agreement
each year was set as a benchmark for the rest of the industry to follow throughout the year. The
benchmark price was adjusted for differences in the quality of the ore and freight costs. This
historical monopolistic pricing system introduced in the 1960’s has come to an end. The iron ore
was the last critical commodity whose price was set by annual negotiations. Similar changes in
pricing power have occurred during the last commodity boom for crude oil and aluminum in the
1970s and early 1980s respectively. (Blas, 2009a)
The move to spot pricing for iron ore has positively impacted producers. An iron ore price chart
for 30 and 10 years are illustrated in appendix 3.7 and appendix 3.8 respectively. Near the end of
the benchmark pricing era, China overtook Japan as the key price negotiator for the world’s steel
mills. Today the China Iron and Steel association would probably have hoped to preserve the
benchmarking system. China is the largest importer of iron ore in the world, the rejection of
accepting a benchmark deal in 2009, led to higher prices (Blas, 2010). The price setting moved
swiftly into quarterly contracts and spot prices. The spot market has gained increased importance
since 2009, as the major suppliers have decided to sell an increasing share of their production at
the spot price. The change of the pricing system has changed in the favor of the miners
considering the large price appreciations after the shift (Northland Resources, 2012).
3.3.2 The Iron Ore Product
The most important factor to consider when investing in an iron ore project is to know the price
of the iron ore product that the project will deliver. This product can differ in quality and
therefore also in price. Iron ore can differ in types with a variety of different qualities (Duade,
2011). The two most common types of iron ore are:
Hematite
Taconite
29
Hematite has a red crusty color and is most common in the Southern Hemisphere in the Pilbara
region of Western Australia, and the Carajas region of Brazil. Other large areas of hematite could
also be found in Africa. Hematite has a high Fe grade of between 40-70 percent. This ore is
typically not rigorously processed further. Hematite can be mined by using a simple crushing and
screening process before it is shipped off to a steel producer. This kind of ore is called “DSO” or
direct shipping ore. The simple mining procedure also results in a higher degree of impurities,
which can be costly for steel producers to remove. The final end product is either in the forms of
lumps or fines with iron ore content between 40-70 percent Fe. The lumps are larger than the
fines and are preferred since it can be more easily used in the production of steel. (Duade, 2011).
Taconite is by contrast most common in the Northern Hemisphere in the Labrador though in
Canada, Northern Sweden, Russia, and China. Taconite has a finely dispersed magnetite with a
low Fe grade of about 25-35 percent. Because of the low Fe grade the taconite ore requires
rigorous complex processing to create an end product in the form of a magnetite concentrate with
50-70 percent Fe. The magnetite concentrate could be processed further into pellets or sintered
pellets. These pellets could in turn be fed into a direct reduced iron (DRI) plant to create a DRI
product that could be used for steel making. The positive aspect of taconite is that the final end
product is superior to the hematite product with fewer impurities and a higher Fe grade. This
final product can receive a price premium when sold both for the quality and the value in use
(VIU) (Duade, 2011). Nevertheless it could be very expensive for the mining companies to
acquire the equipment and processing facility necessary.
Northland’s iron ore concentrate will contain a high Fe grade of 69 percent and low impurities
(see appendix 3.9). Northland’s magnetite concentrate generates heat during oxidation, a
favorable feature for pellet producers that reduces pellet plant energy consumption. Northland is
likely to receive a premium for both the high Fe content and low impurities. The premium for the
69 percent Fe concentrate has varied from $4 to $7 per percentage above 62 percent Fe in recent
years. This premium for low impurities is estimated to be about $5 per ton for Northland.
Additionally a high quality concentrate has less waste and thus saves money on freight
(Northland Resources, 2012l).
30
3.3.3 The Iron Ore Supply
The Chinese consumption of iron ore setoff large production increases since the year of 2000.
The production number for the world iron ore producers is not easily obtainable. One
organization to provide a world production estimate is the U.S Geological Survey. The world
production in the year of 2000 is estimated to have been 1,060 Million ton annually, not taking
the different qualities into account. This amount more than doubled to 2,590 Million ton annually
in 2010 (see appendix 3.10). The U.S Geological Survey estimated the world iron ore production
for 2011 to have reached 2,800 Million tons. China had the highest production increase both in
percentage and absolute terms. Worth noticing is that the producers in China produce at a very
high operating cost often about $100-140/ton and a low quality of 20-30 percent Fe. The
professor Magnus Ericsson (2012) director at the Raw Materials Group argues that the
equivalent amount of high grade iron ore production should be 350 Million ton annually by
China (Dipak, 2012).
Despite being the largest producer, China is also the number one importer of iron ore in the
world. The second largest country in percentage increase in production is India. India introduced
an export tax on iron ore in 2011 of 20 percent. This was later raised to 30 percent by the end of
the year. Iron ore exports from India are likely to diminish in the future as India will be using the
iron ore for domestic demand. The countries with above 50 percent production increases are
Australia (157%), Brazil (90%), and South Africa (90%). The countries with the slowest increase
in production are Russia, Ukraine, Kazakhstan, Sweden, and Canada with an average of 26
percent for the decade (World Coal Association, 2010).
Iron ore is one of the most abundant mineral on earth. The U.S Geological Survey has estimated
the world iron ore reserves except for African reserves (see appendix 3.11). The top 5 countries
with the largest remaining reserves are Ukraine, Russia, China, Australia and Brazil. The largest
producers today have also access to massive reserves to extract iron ore from. This means that
there is no reserve constraint for iron ore like there is for oil. The world total remaining reserves
and resources amount to 180 and 230 Billion tons respectively. The life of the reserves and
resources are estimated to have a life of 80 and 102 years respectively at 2009 production level
(Northland Resources, 2012l).
31
The monumental challenge preventing iron ore producers to expand production capacity is the
construction of logistical infrastructure like ports and railways. Other challenges include
environmental permitting, political risks, and financing. The major iron ore regions for future
production capacity are examined in chapter 5.
3.3.4 The Iron Ore Demand
During the last two decades, China and India have attained extraordinarily high levels of
economic success by any standard. China and India are the only countries in the world with
sustained rapid growth rates since 1980. This is a result of their market oriented reforms that
were geared towards integration into the global economy (Farooki and Kaplinsky, 2012).
The iron ore demand is closely followed by the demand for steel, almost all iron ore produced is
used in steel production. The world coal association has estimated the steel consumption in the
world for both 2000 and 2010 (see appendix 3.12). This figure shows that there has been a
dramatic increase in demand by China but not by India. Many industrialized countries have
experienced a declining steel demand. According to Wood Mackenzie (2012), China accounts
for the entire growth in seaborne trade for the last decade (see figure 3.12). The growth averaged
7.8% annually for the last decade. Regardless of extraordinary success from these two countries
only China contributed to a greater demand for steel. In order to understand the source of iron
ore demand we need to understand the composition of the GDP growth.
Considering steel’s various applicability in infrastructure projects like the construction of roads,
buildings, railways and airports, the demand for steel is highly correlated to investments in fixed
assets. About 58 percent of Chinese steel is typically used for construction (Mackenzie, 2012).
China’s share of investment driven growth has increased to about 50% of GDP in 2010. This is
very high compared to other countries (see appendix 3.14). Many economists argue that this
level is unsustainable over the long run (Anderlini, 2012).
Countries with high fixed asset investments are countries that are going through an urbanization
and industrialization process. The Chinese Fixed asset investments have grown significantly. The
total fixed asset investments have increased from about 70,000M RMB in 2003 to 280,000M
RMB in 2010 (see appendix 3.15). Hence, iron ore demand is highly leveraged towards
32
industrialization and urbanization of China’s economy and their path along the steel intensity
curve (Northland Resources, 2012l).
The three largest sectors of the Chinese fixed asset investments are manufacturing, real estate
and transportation, the only major increase in proportion has been in manufacturing (see
appendix 3.16). The manufacturing sector in turn consists of textiles, equipment, and electric
machinery (see appendix 3.17). This sector is mainly driven by export-led industrialization (J.P.
Morgan, 2012).
The financial crisis hurt many countries with a severe recession in 2008. This led to rapid falling
exports which China to a great extent depend on by its large manufacturing share. China had to
introduce a massive stimulus package to save the economy from a hard fall. The stimulus
package included massive investments in infrastructure to build railways, roads and airports
(Roubini, 2011). The stimulus package rapidly increased the amount of investments to GDP (see
appendix 3.18). China’s steel production has increased by 230 million tons a year since the 2008
stimulus program was introduced. This is more than 50% increase in total demand and
equivalent to nearly 2.5 times the U.S.’s annual consumption (Mackenzie, 2012).
3.4 Northland Resources Strategic Position – PESTEL Analysis
The current commodity boom has sparked large investments in new and existing iron ore
projects. Northland is set to start their mining operations in the fourth quarter of 2012. The
framework I use to determine Northland’s strategic position is by the use of the PESTEL
analysis. The factors in the PESTEL analysis are the following:
Political factors
Economical factors
Social factors
Technological factors
Environmental
Legal factors
33
3.4.1 The Political Factors
Scandinavia is well-known for their stable political system. However many mining regions in the
world have a high political risk. The greatest political risk for many mining companies is
nationalization. This kind of risk is especially high in South America or Africa. The logistical
solution is often a bottleneck for many miners since they have to produce millions of tons
annually to be profitable. The Swedish government has shown a willingness to support
Northland to achieve a smooth logistical solution by improving road and railways.
3.3.2 The Economical Factors
The profitability of mining companies is dependent on the iron ore price premium and costs.
There are good reasons to believe the iron ore price will fall in the future. This will be further
looked into in chapter 5 the forecasting section.
Northland will produce a superior product that will receive a premium (see appendix 3.19). The
operating cost adjusted for Fe quality compared with a peer group is also positive (see appendix
3.20). Worth mentioning is that these graphs are taken from Northland’s company presentation
and excludes some of the largest mining companies and could potentially be biased.
The access to capital is often an obstacle for many miners. The capital costs for mining
infrastructure, buildings and equipment are often very large. Northland has obtained financing
solutions through an equity and bond issuance.
3.3.3 The Sociocultural Factors
Mining companies are dependent on a skilled and motivated work force to work in often harsh
environments. The relative high unemployment rate has incentivized many people to relocate to
Northern Sweden. Northland received several thousands of applicants for the few hundred of
jobs they need to fill. The employment situation does not seem to be an obstacle for Northland
(Northland Resources, 2012a).
3.3.4 The Technological Factors
New technological innovations have enabled higher production and lowered costs of production.
The improved technology has also enabled more mining companies to produce a product of
higher quality. Northland has decided to use state of the art equipment. The equipment is
34
supplied by Metso and is according to Metso, close to “guarantee” a 69 percent iron ore product
with low impurities (Metso, 2011). A downside risk is if more mining companies upgrade to the
latest technology, then the supply of high grade iron ore will increase.
3.3.5 The Environmental Factors
Environmental impact has become one of the top concerns for many mining companies
especially for Vale in Brazil. The large size of many mining operations and the long distance
transportation has a negative impact on the environment. Northland was considering using
electrified truck transportation, but this option was later abolished (Sunqvist, 2011).
The size of Northland’s operations cannot be compared to the large operations in Australia and
Brazil. Northland has fulfilled the current requirement for mining in the Tapuli deposit. However
the Sahavaara deposit has not received a final environmental permit. One of the reasons for the
Hannukainen DFS to be delayed was to ensure that the mine will meet future environmental
requirements. The environmental regulations are most likely to be more stringent in the future.
3.3.6 The Legal Factors
The legal factor to consider is property rights and taxes. The property rights in Sweden are
strongly governed by Swedish legal system. A tax for fuel is a concern for Northland as it is a
large part of the transportation costs. This is a relative small concern compared to Vale, where
the government is imposing higher taxes especially for mining companies (Vale, 2012).
3.4 The Industry Analysis – Porter’s Five Forces Analysis
The industry analysis will determine the attractiveness of the iron ore industry and to assess
whether Northland has a competitive advantage. A competitive advantage is crucial to achieve a
return that is higher than the cost of capital.
3.4.1 Threat of New Competition
The most portentous threat for mining companies is the threat of new competing mines or
expansion projects of existing mine enabling more iron ore supply to reach the market. In the last
decade the iron ore production doubled. Iron ore supply has the potential to double in the current
35
decade as well. The major obstacles of entering the iron ore market is of investments for
infrastructure, buildings, and equipments. These can be very large, but can be overcome by
financing. Therefore access to finance is a vital need to enter the iron ore market.
The access to iron ore reserves is also a barrier to enter the iron ore market. The size of
Northland’s reserves in comparison to a sample of mining companies is illustrated in appendix
3.21. The relatively small reserves with a low quality make Northland an unattractive takeover
target.
3.4.2 Threat of Substitute Product
The durability of steel is difficult to match with any other raw material. Mining companies are
facing the threat that steelmakers will be able to use more recycled steel in their production of
new steel. Steel is 100 percent recyclable and can be recycled an infinite amount of times. Steel
is one of the most recycled materials in the world and as a country advances past the industrial
phase the supply of scrap metal increases (Worstall, 2012).
3.4.3 Bargaining Power of Customers
The bargaining power of customers is limited considering that the steelmaking industry is highly
fragmented. The customers Northland has signed off take agreements with are Standard Bank,
Stemcor, and Tata Steel. Standard Bank will buy 60% of Northlands iron ore production and this
iron will most likely be sold to steel mills in Asia. Tata steel and Stemcor will each buy 20% of
the production. It is however unclear how much will be sold to Europe respectively Asia.
Northland has an attractive product that is currently sought after by many steel makers
(Northland Resources, 2012a).
3.4.4 Bargaining Power of Suppliers
Northland has chosen Metso as a supplier of mining equipment. Metso is a well known for their
sophisticated mining technology especially for complex mining operations. Metso’s products are
important to the mining industry and especially to Northland. Switching would not be an option
because of the extremely high switching costs. Metso’s EBIT margin for mining equipment is
about 10-15%, which is an indicator that they could have a relatively high bargaining power
(Metso, 2012).
36
3.4.4 Intensity of Competitive Rivalry
The iron ore industry is characterized by high fixed cost and exit barriers. The trend of growing
numbers of competitors could have the impact of making the competitiveness even more intense.
The main advantage Northland has over competitors is their superior product. Unfortunately as
competition gets tougher, more miners will feel the pressure to improve their position by
upgrading their equipments to produce a better quality product.
3.5 The Internal Analysis – Value Chain Analysis
The internal value chain analysis strives to identify the activities in and around the organization
that combined create the company’s product. The essence of value creation is explained by the
underlying business activities. This qualitative analysis examines the core competencies and
competitive strengths contribution to value for Northland Resources. I have chosen to only
examine the primary activities of logistics and operations as those are of the highest concern.
3.5.1 Logistics
The logistical route is completely outsourced to Savage, Peab, and Grieg logistics. The current
agreement reaches to the year 2021 and is worth about $900M USD in total. The transportation
for Northland’s iron ore concentrate will start by trucks on the 150km roadway from the
Kaunisvaara mine to a transshipment terminal in Pitkäjärvi outside the town Svappavaara (see
appendix 2.4). The railroad transportation and construction is outsourced to Peab. The trucks are
expected to be 90 ton trucks with a capacity of 55 ton net load. The trucks are expected to be
going day and night all year around. The trucks will leave in a 5 to 7 minutes interval, once
Northland reaches full production in 2015 (Northland Resources, 2012m).
The iron ore will then be loaded on to trains in Pitkäjärvi. These trains will then transport the
iron ore on the 226 km Malmbanan railway from Pitkäjärvi to the Fagernes terminal in Narvik,
Norway. Three trains per day are expected to go between Pitkäjärvi and the port in Narvik. After
upgrading the railway Green Cargo have capabilities to run four trains per day with 40 rail
wagons per train. (Northland Resources, 2012m).
37
The Fagernes terminal will de-ice the concentrate, and then it will be stored and reloaded on to
cape size vessels for shipment to Europe or China. The Narvik port is ice-free all year around.
The Fagernes terminal is operated by Grieg logistics and has a capacity of 10+ MT per annually.
Both the Pitkäjärvi and the Fagernes terminal is currently under construction by Peab and are
expected to be completed in the 4th
quarter of 2012 (Northland Resources, 2012l).
3.5.2 Operations
The mining operation is conducted through over 40 subcontractors on site. The first step to
extract the iron ore is by traditional open pit, drill and blast techniques. The iron ore will then be
crushed and screened before entering the process plant.
The processing will be conducted with the use of a comprehensive equipment package from
Metso. The processing is a complex operation with processing is primary and secondary grinding,
and magnetic separation. The secondary grinding equipment will include Metso’s popular
Vertimill™ vertical grinding mills. A total of 7 Vertimills™ will make Kaunisvaara, the mining
site in the world with the most vertical grinding mills. The mining equipment will ensure a high
quality product according to Metso (Metso, 2011).
3.6 Chapter III – Conclusion
Iron ore is one of the most important commodities to the human civilization. Despite this it is not
followed by many analysts, used to be traded in secretive meetings up until recently, and not
included in major indexes for commodities. The recent surge in demand from China has created
a sharp price increase and many people argue for a super-cycle with high sustained commodity
prices for this decade.
The core belief of the capitalist system is that firms that earn abnormal profits will face
competitive pressure. The competitive pressure will tend to reduce profitability unless the
company has a robust competitive advantage. I do not consider Northland’s iron ore product to
have robust enough advantage to earn higher margins than other producers over the long term. In
my opinion the barrier to enter the high-end iron ore market is simply of a financial concern.
Below is a SWOT analysis to summarize Northland’s strategic position.
38
Strengths
Premium product
Management has a high level of expertise
Good access to a skilled workforce
Low political risks
Off-take agreements
Financing in place
Near production start (Q4, 2012)
Confident logistical solution by Grieg,
Savage, and Peab
State of art processing equipment
Weaknesses
Relatively low reserve makes it an
unlikely takeover target
No futures market for hedging the iron
ore price.
Long and complex logistical route.
Complex operations
Management possibly influenced by
behavioral biases.
Poorly aligned incentives
Dispersed Shareholders
Low insider ownership
Opportunities
Could become more environmentally
friendly and save money on fuel for truck
transportation by using electrified trucks.
Low bargaining power of buyers; well
sought after product.
A depreciating Norwegian Krona.
Threats
Highly competitive industry; more
producers seeking to produce a
premium product.
Not an adequate high barrier to enter
the iron ore market
Potential bubble in the iron ore price.
Threat of substitutes; more steel being
recycled
Hazardous weather conditions
High bargaining power of suppliers;
high exit barriers.
An appreciating Norwegian Krona.
39
4. Chapter IV – Budgeting
This chapter is focused on examining the iron ore price structure and Northland’s cost structure.
Northland’s cost structure consists mainly of operating expenditures, capital expenditure,
depreciation, financial income and financial expenses. The final section of this chapter will be a
risk analysis to derive an appropriate discount rate reflecting the riskiness of the company’s
business activities.
4.1 Reference Price & Value Premiums
The pricing of iron ore has developed into a complex subject. This has made it more difficult to
compare prices of products from producers, because of their varied product specification. A few
years ago the world’s iron ore market shifted from annual contracts towards quarterly contracts.
The trend is moving towards a spot price for iron ore. Singapore and China are today in the
process of setting up a spot market for iron ore. The spot price has gained in popularity and is
expected to become the most common pricing method in use. The turnover on the spot market
has accelerated, as the major producers have started to adopt the practice of selling iron ore on a
spot market (Blas, 2009b).
There are three sources available to follow the spot price, namely Metal Bulletin Inc., Steel
Business Briefing Ltd and Platts. Platts and Metal Bulletin has created two daily spot indexes for
iron ore named “IODEX” and “MBOI” respectively. The index I will use for a reference price is
the Platts “IODEX” index. This index tracks the price for the Chinese spot market with a Fe
content of 62 percent. Iron ore products with a higher Fe content is sold at a premium and lower
Fe content is sold at a discount. The premium is about 4-7 USD per percentage above 62 percent.
The price index has a normalized the level of impurities. Products with low levels of impurities
will obtain a value in use (VIU) premium. The iron ore price is for the delivery from the Chinese
port of Qingdao in Northern China (Platts, 2012).
In order to obtain freight on board (FOB) price for Northland’s iron ore from the port of Narvik,
the Fe and VIU premium will be added and the freight cost has to be deducted from the index
price. The freight on board price is the price that Northland will receive for its iron ore
concentrate from the port of Narvik. The freight on board price is forecasted in the next chapter.
40
4.2 Cost Structure
The major components of the cost structure for Northland’s operation are the operating, sales
general and administration, and capital expenditures. The operating expenditures and capital
expenditures have been estimated in the published definitive feasibility study (DFS) for
Kaunisvaara and updated in 2012 prior to the equity and bond offerings (Northland Resources,
2012l). The costs for Hannukainen are less certain and could potentially be changed in the DFS,
which is planned to be released in the fourth quarter of 2012. The final decision to invest in
Hannukainen has not been taken. The tentative plan is for Hannukainen to be in production by
2016 according to the June corporate presentation (2012).
4.2.2 Operating Expenditures
The operating expenditures comprises of mining, processing, transportation and other costs.
These costs are estimated on a cost per ton basis for each mining project. The largest portion of
operating expenditures is allocated for the transportation of the iron ore, to the port of Narvik.
About 50 percent of the total operating expenditures are allocated to transportation by trucks and
railway. Northland has found contractors to manage the entire logistical solution for the
Kaunisvaara project. I assume the operating expenditures to remain constant throughout the life
of the projects. The operating expenditures are projected to be $55.6/ton and $54.7/ton including
a 5% contingency cost for the Kaunisvaara and Hannukainen respectively according to the
annual report (2011). A definitive decision for the logistical route of the iron ore from
Hannukainen has not been taken and could potentially impact the operating expenditures for
Hannukainen.
4.2.3 SG&A Expenditures
The sales, general, and administrative expenditures are considered as operating costs as well but
are calculated for the company as a whole and not independently for each mines cost per ton.
The sales expenditure refers to marketing activities. General and administrative expense involves
the company’s salaries, share based payments, consulting, and auditor fees. Other operating
expenditures include write-offs and impairment costs on exploration and mine development
assets.
41
The sales expenditure was $752,000 in 2011 (Northland Resources, 2012a). I expect the sales
expenditure to be slightly less than $1,000,000 annually for future years. I therefore assume a
sales expenditure for future years to be $1,000,000 annually. The general & administrative
expenditures are likely to fluctuate in the future as salaries, wages and performance based
payments change. I expect a drop in general & administrative expenses for 2013 due to a lower
need for consulting services in the future. I estimate an average general and administrative
expense of $14,000,000 annually for future years. I assume the other operating expenditures to
be stable at $9,000,000 annually.
4.2.4 Capital Expenditures
The capital expenditures have been estimated for the life of mines. The Kaunisvaara and
Hannukainen life of mine are estimated to 17 and 14 years respectively. These expenditures
projected by Northland includes the cost for constructing buildings, process plant, filtration plant,
power supply, tailings & water ponds, owners costs, and a 5% contingency cost. The total capital
expenditures for Kaunisvaara and Hannukainen are $1,085,000,000 and $474,500,000
respectively (Northland Resources, 2012a).
4.2.5 Financial Income & Expenses
The financial income is the interest earned on the company’s interest bearing assets. For the year
2011, the financial income amounted to $2,300,000 (Northland Resources, 2012a). I assume that
the future cash flow will be saved to either finance Hannukainen or pay back its debt. I assume
an average of $50,000,000 of interest bearing assets. This would yield $1,250,000 annually at a
2.5% interest savings rate.
The financial expense is the interest paid on the company’s interest bearing assets and fees
related to fund raising. The financial expense for 2011 was $11,880,000, this relates almost
entirely to fees for fund raising. In early 2012 Northland issued 5 year bonds of $350,000,000
and equity of $325,000,000. The fees for the bond and equity issue is expected to be around 8%
of the total issued amount. The interest rate for the corporate bonds is 13% annually with semi-
annual interest payments, on March 6 and September 6. The bonds maturity date is on March 6,
2017 (Northland Resources, 2012a).
42
I expect that the company will issue new bonds to replace the current bonds. These new bonds
could have a slightly lower interest rate due to the de-risking of the company’s business activities
and an improved market climate. I assume an interest rate of 10% after 2017 and an issue cost of
$28,000,000 for the new bonds in 2017.
4.2.5 Depreciation and Tax Rate
Concerning depreciation, I used a 5% straight line of the capital expenditures. The buildings are
estimated to have a life time of 20 years. The tax rate is assumed to be 28% throughout the
project. The company has unused tax loss carry-forwards for a total of $107,810,000. This
amount will offset the tax to be paid for the year 2013, 2014, and 2015 which would be
approximately $106,100,000 according to my calculations.
4.3 Balance Sheet Risk
The balance sheet for the year end of 2011, convey that northland’s largest non-current asset is
mines under construction. This is capitalized exploration and construction costs on the balance
sheet, which is a total of $236,794,000. Besides this Northland has also another asset category
for exploration and evaluation assets. The company follows the reporting standard IFRS 6 for
exploration and evaluation of mineral resources. This standard allows the company to capitalize
all costs directly related to exploration and evaluation like consulting fees, salaries, drilling, and
travel and accommodation costs. The exploration and evaluation assets amount to a total of
$64,165,000. Moreover the property, plant, and equipment have a book value of $9,345,000
(Northland Resources, 2012a).
Determining the amounts to be capitalized requires management own estimate and assumptions
regarding the expected future cash flows of the assets, discount rates, and the expected period of
benefits. In a scenario of sharply falling iron ore price, the value of these assets is highly
questionable. A worst case scenario could mean that liquidation value of assets may not be
substantially more than zero.
43
4.4 Risk Analysis
Mining exploration and development involves a high degree of uncertainty. Very few areas
explored are subsequently developed into producing mines. Northland has not yet generated a
positive cash flow, which makes it inherently difficult to quantify uncertainties based on past
performance. The iron ore production and quality projected by the management is also at risk to
disappoint investors due to humans’ belief system of overconfidence, optimism, and wishful
thinking (Barberis & Thaler, 2002). There is no assurance that Northland’s exploration activities
will result in new discoveries of mineral reserves for continued mining activities in perpetuity.
The economic feasibility of the deposits is also dependent on factors that are out of management
control such as iron ore price volatility, and political risks. Quantifying uncertainties of this
complex matter is inevitable impractical and will therefore be based on my objective analysis.
Northland issued corporate bonds to finance its mine development. These bonds are rated B-
stable by Standard and Poor’s and Caa1 by Moody’s. These corporate bonds were issued with an
interest rate of 13% and will mature on March 6, 2017 (Northland Resources, 2012h). Northland
could either payoff these bonds with internal cash flows or issue new bonds. Northland will most
likely issue new bonds and use the generated cash flows for the startup of Hannukainen. These
new bonds interest rate depends on the market’s risk appetite and the risk characteristics of
Northland’s business operations.
Instead of using the capital asset pricing model, I focus on the acceptable level of risk to satisfy
equity holders. The required return on equity has to be higher than the return on the debt. I would
consider an appropriate cost of equity to discount future free cash flows to equity in the long
term to be 20 percent.
4.3 Chapter IV – Conclusion
This Chapter began with an explanation of how to calculate the iron ore price from the port of
Narvik (FOB), which is the price Northland will receive for its product. This price will be
forecasted in the next chapter. The following part of this chapter stated my estimations and
expectations of the different costs that will be inserted into the valuation. An examination of the
balance sheet showed that a substantial part of the firm’s assets are capitalized costs based on the
44
management judgment. The chapter ended with a risk analysis to obtain an appropriate discount
rate. In my option the discount rate for the cash flow to equity has to be 20 percent to satisfy
investors risk tolerance. These inputs will serve as a foundation for my valuation in chapter 6.
45
5. Chapter V – Forecasting
This section will focus on the fundamental factors affecting the iron ore price, namely the supply
and demand. The supply and demand forecasting will rest on the future consumption and
production trends globally. These trends will then be analyzed to estimate an approximate
outlook for the iron ore price.
5.1 Future Production Trends
Iron ore is one of the world’s most abundant mineral. The largest known iron ore reserves today
can be found in Brazil, Ukraine, Russia, China, Africa, and Australia (U.S Geological Survey,
2012). The factors limiting the mines for higher production are logistical infrastructure,
environmental permitting, tax issues and financing. In this section I will analyze a major part of
the world’s iron ore production to estimate a growth rate for future production potential. Data on
the world annual production is very difficult to obtain and different organizations estimate
materially different production numbers. The United Nations Conference on Trade And
Development (UNCTAD), estimated the world production to be 1,800 million ton in 2010. This
is contradictory to the United States Geological Survey estimation of 2,590 million ton for 2010.
These production calculations could be adjusted for different quality and therefore differ. The
future production capacity is obtained through analyzing and researching companies annual
reports and corporate presentations.
I have divided the world into seven regions, which are Europe, North America, South America,
Australia, Commonwealth of Independent States (CIS) (Ukraine, Russia, & Kazakhstan), Asia,
and Africa.
5.2.1 Europe
The only notable iron ore region in Europe is in Northern Scandinavia (see appendix 5.1). The
main port for iron ore shipment is the port of Narvik. The port of Narvik is a deep water port that
is ice free year around and suitable for cape size vessels. The railway for iron ore transportation
is the 500km long Malmbanan that reaches from the port of Narvik in Norway. The type of iron
ore mined in this region is mostly the taconite type that after processing produces a high quality
46
magnetite concentrate or pellet. The companies with a current or potential production of above 2
Million ton annually are presented in appendix 5.2.
The largest iron ore company is the Swedish state owned company LKAB. They control the
largest iron ore reserve in Scandinavia, which is about 1,500-2,000 Million ton of 45 percent Fe.
LKAB produce the majority of the iron ore in the Scandinavian region of about 26 Million ton
annually, still far from the 35 Million ton they produced by the end of the last commodity boom
period. LKAB is also the company with the longest history of mining with an establishment in
the 1890s (LKAB, 2012).
The other two companies with a current production are Northern Iron and Rana Gruber.
Northland Resources and Nordic Iron Ore are two mining companies with plans to be in
production in the near term. The Scandinavian total production has a potential to double by 2020,
from today’s 30 Million ton to 60 Million ton annually. All companies except Nordic Iron ore
have secured financing for startup of production. The major bottleneck for higher production in
the region is the Malmbanan railway, which is currently being upgraded.
5.2.2 North America
North America has a long mining tradition. The iron ore is very similar in quality compared to
the Scandinavian iron ore. The most common type is taconite, although some hematite deposits
can also be found. The largest iron ore areas are in the Labrador region in Quebec, Canada and
the Michigan, Missouri and Minnesota region in the United States (see appendix 5.3). The U.S.
region has experienced a decline in production from 2000 to 2010. The largest reserves are in
Quebec, Canada and have the highest potential for future production expansions. I have
identified ten iron ore companies with a current or potential production of above 2 Million ton
annually (see appendix 5.4). The major challenges for iron ore producers in the region are of
logistical infrastructure and access to capital.
The company with the highest production capabilities in Canada is the Iron Ore Company of
Canada. Alone they produce half of Canada’s total iron ore production. The company that
produces the most in North America is Cliff’s Natural resources. They produce 12 Million ton
annually in Canada and 23 Million ton annually in the U.S. Arcelor-mittal is a multinational
47
mining company with a large production in the U.S through joint ventures. The company has
also extensive exploration projects in Canada. Considering the development projects in North
America, the region has the potential to more than double their production of iron ore by 2020.
The most interesting mining companies in development are Adriana Resources and New
Millennium Corporation. Combined their iron ore resources reaches over 10 Billion tons of iron
ore. However the geographical locations of the mining projects require colossal investments in
logistical infrastructure.
Adriana Resources is estimated to invest a total of $12.9 Billion in capital expenditures and
would then still need to transport their iron ore 850 Km on railway. On the other hand their
operating expenditures would amount to only about $30/ton. Adriana Resources has no project
finance in place, but are backed by the Chinese Steel and Iron Corporation.
The New Millennium Corporation is situated slightly better, but considering the limitations of
the Canadian railways the company considers building a 600 Km slurry pipeline to the nearest
port. The pipeline could make the New Millennium Corporation have the lowest operating
expenditure in North America, less than $30/ton. Then again the capital expenditures are
estimated to $4.4 Billion. They have no project finance in place for this project, but have
successfully financed another mining project through a joint venture with Tata Steel.
5.2.3 South America
South America is home to the world’s single largest iron ore producing company, Vale. Brazil is
dominating iron ore production in South America with the second largest known mineral reserve
in the world. The iron ore is transported on the 892 Km Carajas railroad. The characteristics of
the iron ore in South America are more similar to the Australian than the North American or
Scandinavian iron ore. The Carajas mine in Brasil consists predominantly of high quality (66.7%
Fe on average) hematite iron ore. Hematite ore is a so called DSO, direct shipping ore, which do
not have to be rigorously processed. The major challenges for iron ore producers in the region
are of harsh weather conditions, logistical infrastructure, political risks, and environmental
permitting. The mining companies in the region have the potential to double iron ore production
by 2020 (see appendix 5.5).
48
Vale is a diversified mining company. Besides iron ore, Vale produces nickel, coal, copper,
potash, and energy. Currently with the high iron ore price they receive 68 percent of their
revenues and a return on equity of 28.2 percent from their iron ore mining. Since the start Vale
has up to this year produced a total of 5 Billion ton iron ore (see appendix 5.6). Their current
reserves of iron ore are up to 17 Billion ton. Vale has a capital investment budget of $21.7
Billion to construct new processing facilities, railway and port infrastructure. Vale put
considerable efforts on low costs and carbon emissions to create long term value. The main
challenge is like many other mining companies the logistical infrastructure, except from that the
government of Brazil has raised corporate income taxes to 39 percent (Vale, 2012). This poses a
risk for shareholders to profit from investments in Vale.
5.2.4 Australia
Australia produces the most iron ore with the highest quality in the world. The largest iron ore
deposits are found in the Pilbara region of Western Australia (see appendix 5.7). The iron is of
the direct shipping ore type and vast reserves of several tens of billions tons exist in the area. The
Pilbara region is home to the two mining companies with the longest history, namely BHP
Billiton and Rio Tinto both founded in the 19th
century. Australian mines enjoy a considerable
advantage over Brazilian, Canadian, and European mines with their closer proximity to Asia.
Currently around $60.8 Billion of investments are planned for new iron ore mines and to expand
current capacity. The major challenges are harsh weather conditions and logistical infrastructure.
The two largest BHP Billiton and Rio Tinto are both diversified mining companies. Due to the
high iron ore price, 50 percent of BHP Billiton’s revenue came from the iron ore business at a 65
percent EBIT margin (BHP Billiton, 2012). Rio Tinto is in same position with a 70 percent of
EBITDA margin for its iron ore business (Rio Tinto, 2012). Rio Tinto has exponentially
increased production since the year 2000 (see appendix 5.8). Fortescue Metal Group, one of the
top ten largest iron ore company in the world is also Australian. Fortescue will commit $1.8
Billion in 2012 to ramp up production to 155 million tons annually by 2014 (Fortescue Metal
Group, 2012). The most common bottleneck for Australia’s iron ore producers are the congested
harbors. All the iron ore companies in Australia have fairly easy access to capital and have all
49
committed substantial amounts of money to harbor expansion projects. If all goes as planned the
total production will close to double by 2020 (see appendix 5.9).
5.2.5 Africa
Africa is the big new player in global iron ore supply. Africa is undergoing massive exploration
and the reserves found up to now are mainly of high-quality DSO hematite ore that are estimated
to match those in Australia and Brazil. The total iron ore reserves in Africa are estimated to 34.9
Billion ton of hematite and 17.3 Billion ton of magnetite. Over 200 iron ore projects across the
African continent have been identified. The biggest impediment for mining companies in Africa
is access to capital, to build infrastructure (Hurst, 2011).
Traditionally, Africa has never been seen as a major competitor in the iron ore market. Typically
African projects require huge capital investments to bring them to market. On the other hand
many African projects will have a very low cash cost. For a long time Western banks have been
reluctant to finance these projects because of high political and economic risks. The current
boom in commodity prices is likely to make African iron ore projects more attractive in terms of
risk and reward for investors (Hurst, 2011).
Recently there has been a surge of Chinese investments. The Chinese government seems to be
the most willing to take the risks in Africa. Chinese direct investments to Africa have increased
19-fold, from $491.2 Million in 2003 to $9.3 Billion in 2009. China’s Ministry of Commerce
announced in 2012 that over the next five years it will encourage direct investments globally to
increase to $560 Billion. Today about 14 percent of the total Chinese direct investments are
allocated to Africa. If this persists then Africa can expect $78.4 Billion in investments over the
next five years. Then this would be sufficient to meet the $52-54 billion capital expenditures
reported by RBC Capital Markets (2011) to develop 32 mines across the continent by 2016.
China has established strong ties with many African countries through its non-interference
approach to international engagement. This state-level engagement provides assurance to
China’s state-owned investors and banks when making large capital investments in operationally
risky projects (Hurst, 2011).
50
According to Luke Hurst (2011) analysis of 17 mines African iron ore projects, production has
the potential to add 481 Million ton annually to the world iron ore market by 2018. This figure is
aligned with estimates by RBC Capital Markets (2011) that 475—575 Million ton annually of
iron ore export capacity will become available from Africa by 2016. This analysis by RBC
Capital Markets is based on data from 32 mines. Another analysis by Ocean Equities (2011)
based on 16 mines concluded that African production capacity could reach 300 Million ton
annually by 2018. My analysis of the African continent based on reports by Hurst (2011), RBC
Capital Markets (2011), and Ocean Equities (2011) conclude that Africa iron ore production
could potentially reach 585 Million ton annually by 2020 (see appendix 5.10).
Most disclosed estimates of operating costs for west and central African iron ore projects are low.
In view of the fact that the high grade ore requires little processing, west and central African iron
ore projects will have operating costs on average including shipping of around $50-80 per ton.
5.2.6 Asia
The major iron ore producing countries in Asia are mainly China and India. China is the largest
producer of iron ore in the world with 1070 Million ton annually (U.S. Geological Survey, 2012).
The problem is that the Chinese iron ore is of poor quality and high operating costs. The
equivalent amount of a high iron ore quality would be about 350 Million ton annually. The iron
ore industry in China is highly fragmented with over 5,000 iron ore mines. Many of them
produce less than a hundred thousand tons annually, while the largest iron ore mine in China
produce less than 5MT annually. A large share of iron ore mining is conducted through
underground operations with Fe grades less than 20 percent (Raw Materials Group, 2012). The
size of the Chinese iron ore reserves is not publicly known.
India is the third largest exporter of iron ore after Australia and Brazil. This might change due to
India’s increasing domestic iron ore consumption and taxing of iron ore exports. The largest
reserves in India are predominantly located in the country’s north and west side, consequently
making transportation costly to steel mills. Most steel mills are located mainly in industrialized
coastal southern provinces.
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The Chinese production has undergone an exponential expansion phase from producing 224
Million ton annually in the year 2000 to producing 1070 Million ton annually in 2010. This
production is at very high operating costs and of low quality. I expect China to focus more on
costs and quality over the next ten years, while increasing investments in Africa to extract
enormous volumes. I do not expect iron ore production to increase significantly in China over the
next decade. In my calculation I adjust the amount of Chinese iron ore production to one of high
quality. My projections up to 2020 for China and India are that they will increase their
production capacity by a rate of 5% annually (see appendix 5.11).
5.2.7 Commonwealth of Independent States (CIS)
The iron ore producing companies in the CIS region are mainly Russia, Ukraine, and Kazakhstan.
The CIS region has seen a slower growth in iron ore production relative to main iron ore
producing regions in the world during the previous decade. This could be contributed to the
region’s slightly higher risk characteristics of political, corruption, and property rights risks
combined with barriers for foreign investments.
The total past iron ore production for the full region is easy to obtain. Nonetheless, the individual
companies’ production targets for the future are more difficult to find. Many iron ore producers
are owned by the state in the respective country and are not particular transparent with their
production targets. In order to provide an estimated production to 2020, I assume the production
growth rate will be similar to the previous decade (see appendix 5.12).
5.2 Future Consumption Trends
In this section I will scrutinize the future consumption of iron ore in emerging and developed
markets by estimating the future composition of GDP growth. Steel is an integrated component
to a modern society’s high standard of living and a measure of economic progress. This makes
steel consumption a major part in countries industrialization and urbanization phase. The
urbanization phase is most dependent on investments in infrastructure, real estate, while the
industrialization phase is more dependent on investments in manufacturing.
The consumption trend for the last decade has been dominated by a sharp increase in demand by
emerging markets especially by China. I will start this forecasting by first examine the current
52
state of the sectors, that achieved high investments in fixed assets over the last decade to estimate
potential investments for the future. The sectors with a high degree of investment in fixed assets
are the transportation, real estate, and manufacturing sectors.
5.2.1 The Transportation Sector
China has the world’s single largest high-speed railway network. The network will exceed
13,000 Km in 2012, which is the approximately the same distance between Hong Kong and New
York. The plan is for the network to reach 16,000 Km by 2015. At the same time China is part of
the Trans-Asian Railway Network that is expected to be completed by 2015 (Anderlini, 2012).
The Trans-Asian railway is a 100,000 Km railway network through 28 countries. Since 2010
China is investing about $106 Billion per year on railways (Law, 2011). According to a China's
Ministry of Railway (2010) report passenger traffic reached 1.52 billion people in 2009.
In the period from 2005 to 2010, China invested $40 Billion to build 33 new airports bringing the
total number of airports to 175. The total investment in aviation infrastructure during this period
is equivalent to the total amount invested in aviation projects for the previous 25 years. China
has planned to invest $228 Billion in the aviation industry to 2015 (Kuchler, 2011). Investments
will bring the total number of airports to 220. There are fears of over investment in the aviation
industry, 130 out of the country’s 175 airports in 2011, where loss making according to Li
Jiaxing the vice minister for transport (Dyer, 2011). Building competing high-speed railways
could potentially make the airports even less profitable.
5.2.2 The Real Estate Sector
The Chinese real estate sector is up for a sharp decline according to many analysts. Home prices
fell in 46 of 70 cities in April 2012 compared to the previous year. Analysts at Nomura argue
that housing starts and sales is a leading indicator for iron ore production (Mackenzie, 2012a).
Housing starts reached an all time high in early 2011 (see appendix 5.13), at the same time the
iron ore price peaked. Housing starts began to decline later in the year and the year to year
completion rate rose (see appendix 5.14). This graph shows year to year changes in starts and
completions of commodity housing; which includes both private and government sponsored
housing. A looming real estate bubble is worrying private investors to invest more in real estate.
53
This is in line with JP Morgan’s predictions that real estate investments would decline hefty in
2012 (see appendix 5.15). In March 2012, the central government approved a budget of $70
Billion for social housing. This could to some degree offset the 2012 downtrend in real estate
investments. The social housing investment is not a comforting sign either; it will be less than
the level of 2011 (see appendix 5.16) (Mackenzie, 2012b).
5.2.3 The Manufacturing Sector
The manufacturing sector in China is going through a transformation of labor force. A Deloitte
(2011) survey on the manufacturing sector reports that the next ten years will see a higher
demand for high labor quality industries, like information technology, mechanical, and chemical
engineering. The traditionally labor intensive industries, like clothing, footwear, and simple
manufactured items will endure problems by a shortage of labor and rising labor costs. The trend
towards high-end manufacturing has been persistent since 2004 (see appendix 3.14). Tax costs
are the most critical cost for manufacturers. According to data from the World Bank, China is in
the top 15 percent of countries with the heaviest taxation. The Chinese taxation system
encourages companies to invest in less steel intensive assets, like technological innovation, and
research and development (Deloitte, 2011).
5.2.4 China’s Five Year Plan
The current five year plan (2011-2015) for national economic and social development was
approved in October, 2010. The key themes of this five year plan are economic restructuring,
social equality, and environmental protection (APCO, 2010).
The economic restructuring is aimed to change the growth composition of GDP to rely more on
domestic consumption and less on investments & exports. The financial crisis made Chinese
officials aware of the importance of creating a sustainable growth model. The reason for the shift
is to reduce income disparity, fixed asset overinvestment, reduce dependency on exports and thus
reducing the current account surplus. The government wants to raise household income to boost
consumption, and facilitating expansion of the service sector (IMF, 2012). Increase in household
income is most likely to be through raised minimum wages and increased social safety nets, like
health care and social welfare payments. Increased minimum wages could also pose as a threat to
54
the manufacturing sector. Chinese experts are expecting consumption to rise from the current
35.1 percent to around above 50 percent of GDP by 2015 (APCO, 2010).
A swift restructure is likely to result in high unemployment as the population takes time to adjust
and in turn a lower GDP growth. High unemployment and social unrest is the last thing the
Chinese central planners would like to experience. China’s GDP growth rate target for 2012 is
set at 7.5 percent. This growth is said to ensure employment levels remain on target for the
government to reach its 2020 GDP-per-capita goal. The previous target of 8 percent has been
greatly exceeded by actual growth since the target was set in 2005. A lower target rate would
give officials room to set in policies that will slowly increase consumption without having to
excessively focus on high growth targets (APCO, 2010).
Minimum wages and increased social safety nets is planned to contribute to social equality by
closing the income gap. The separation in quality of life indicators between China’s urban and
rural residents is large. The inequality is a cause of growing social unrest, which is a major
problem for the government. Improving the quality of life in rural areas is in turn expected to
boost consumption. This restructuring would ultimately create a more lasting transformation that
would increase the welfare of the Chinese people and contribute significantly to sustainable
global growth according to the IMF (2012).
The Chinese composition of GDP growth is expected to change in the future, which would cause
a lower iron ore demand and a lower GDP growth. The 13th
five year plan is likely to include a
significantly lower budget for fixed asset investments.
5.2.5 Indian Demand
The Indian economic growth is driven by a large service sector and domestic demand, unlike
China’s export and investment led growth. This has led India to run a large trade deficit for many
years, while China has been running a large trade surplus. India has not undergone an
industrialization and urbanization phase compared to China (Farooki & Kaplinsky, 2012). The
low standard of infrastructure in India combined with political risks has refrained foreign direct
investments in manufacturing. The data on fixed asset investment in India is opaque and not
easily obtainable. The rising export tax of iron ore is an indicator of greater demand by India as
55
they will slowly enter an industrialization and urbanization phase similar to China. The stage of
India compared to other emerging and developed markets in the steel intensity phase is
illustrated in appendix 5.17.
5.2.6 Developed Markets
In the last decade the developed markets demand for steel has been stable. The developed
markets need for steel is likely to be saturated with a stable or declining outlook. This is
associated to greater uncertainty, deleveraging, and credit tightening in many developed markets
and suggest that the growth in fixed investment is likely to be slow (IMF, 2012).
5.3 Estimation of Forecasted FOB Price
The Chinese reference price for iron ore as of today July 20th
, 2012 is trading at $125/ton. It has
dropped about 30 percent, since the peak in February 2011. This has still not caused a real panic
for investors. It seems that investors and analysts still believe that the iron ore price will be above
$100/ton up to 2015 (see appendix 5.18). The near time price is also expected to be high
according to some prominent banking analysts (see appendix 5.19). Despite the fact that out of
the last 100 years the iron ore price has only been above $100/ton for 2 ½ years.
I believe that my sample of iron ore producers represents more than approximately 90 percent of
future production capacity. The global iron ore production has the potential to double by 2020.
The likelihood of doubling production is impossible to quantify. Therefore, I have constructed
two scenarios for future growth rates. In my conservative scenario, I assume that half of the
production capacity will come online. My moderate is slightly more optimistic with 75 percent
of production capacity to come online. According to my forecast the production growth will
remain low for 2012, but will accelerate rapidly in 2013 and 2014 (see appendix 5.20).
The demand outlook for China looks weak. Another stimulus package to boost investment would
only exacerbate the overcapacity in infrastructure, real estate, and manufacturing. This would
likely intensify an inevitable economic slowdown once further fixed asset investment growth
becomes impossible. China’s expected growth rate for iron ore demand is expected to be 5
percent for 2012 with a 7.5 percent GDP growth (MacDonald, 2012). Considering China’s
dominance in the iron ore market combined with a saturated demand in developed markets, I
56
would reasonably assume the world demand growth to be in a range of 3-4 percent. India could
potentially pick up a slacking iron ore demand by China in the future. I expect the world demand
growth for iron ore to be an average of 3.5 percent per annum up to the year 2020.
Based on my forecasting, both my moderate growth and conservative growth scenarios will
greatly exceed the probable world demand growth in the period from 2013-2016 (see appendix
5.21). The total surplus in this period is likely to be somewhere between 300-600 Million ton.
Today, the price floor for iron ore is set by Chinese high cost producers (see appendix 5.22). The
surplus iron ore, predominantly from Australian and African mines would phase out the high
cost producers and set a lower iron ore price.
I will use my conservative scenario; in this scenario a total of 370.8 Million ton would phase out
all Chinese high cost producers by 2017, if world demand growth averages 3.5 percent. I expect
this would cause the iron ore price to gradually decline to an average $100/ton by 2016. This
would represent a fall of 20 percent from today’s price of $125/ton. A sharper drop should not be
taken as a surprise. Many of the Chinese iron ore producers are state owned and might still
produce at a loss. Another factor to exacerbate the problem would be the large size of inventories
in China. These inventories at about 90 Million ton could cause a panic, if sold in a rapid fire
sale.
The trend for the iron ore price and Fe quality premium is shown in appendix 5.23. This is taken
from Northland Resources June corporate presentation (2012) and is only based on data from
January, 2010, when the iron ore price has been high. The Fe quality premium is today at $4 per
percentage above 62 percent, this would give Northland a total of $28/ton. The iron ore price has
dropped 30 percent since the peak in 2011. The premium is more volatile and has dropped 60
percent in the same period. Therefore I expect the premium to gradually decline to $16/ton by
2016. This would represent a decline by 40 percent or twice the expected percentage fall in the
iron ore price. The value in use premium is today $5/ton (Northland Resources, 2012c). I expect
this premium to remain at $5/ton, assuming they can produce the promised quality.
Northland has signed off take agreements with Standard bank, Stemcor, and Tata Steel. It is
however unclear how much will be sold to Europe and China. The Freight rate for cape size
57
vessels from Narvik to China is estimated to be $36/ton according to Northland’s calculations
(Northland Resources, 2012c). I will assume that all production will be sold to China
5.4 Chapter V – Conclusion
In this chapter, I have taken on the challenge of forecasting. We simply do not know the future,
but we can get a good understanding of where we stand in the commodity cycle. In my
conservative scenario where only half of the majority of the world’s iron ore production comes
into reality, would generate a surplus of 370.8MT in the period from 2013 to 2017. This would
be enough to wipe out all Chinese high cost producers and set a new iron ore price floor of
$100/ton.
A worse scenario should not be ruled out. China might slow down more than expected due to
their economic restructuring. In this event I do not expect China to introduce a stimulus package
as in 2008. More stimulus to boost investment would only worsen the overcapacity problems in
infrastructure, real estate, and manufacturing and intensify an inevitable economic slowdown
once further fixed asset investment growth becomes impossible.
Another case could be that more production than the conservative scenario comes into reality. If
production follows my moderate growth scenario, then a total of 600MT could cause a
significant dent in the iron ore price. Furthermore a drop in price could be exacerbated by a panic
in selling inventories.
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6. Chapter VI – Valuation
Previous chapters focus has been to elaborate on supporting arguments for a final valuation of
Northland. In this chapter I will combine these arguments to estimate Northland’s fair value
through an absolute valuation. The absolute valuation will be based on a DCF methodology of
free cash flow to equity described by the book Financial Statement Analysis and Security
Valuation written by Stephen Penman (2010).The estimates will be taken from the budgeting and
forecasting sections of this thesis. The final part of this chapter will be to compare Northland to a
similar mining company, to arrive at a relative valuation.
6.1 The Absolute Valuation
This valuation is supported by my analysis of the iron ore price, price premiums, and costs from
previous sections. The price, premium and freight cost for the periods was projected in the
forecasting chapter, while costs and discount rate for the periods were projected in the budgeting
chapter. This chapter will start by a discussion of the chosen valuation model.
6.1.1 Discussion of Valuation Model
I chose to use the free cash flow to equity model to estimate Northland’s share. The value of any
stock is the present value of the free cash flow to equity per year for the forecasted period plus
the present value of the terminal period. The free cash flow to equity is calculated in the
following way: Net Operating Profit After Tax + Depreciation and Amortisation +/- Changes in
Net Working Capital +/- Net Investments in Fixed Assets +/- New Net Financial Obligation –
Net Financial Expenses After Tax (Penman, 2010). Once the equity value is calculated, it is
divided by the number of outstanding shares to conclude a company’s final value per share.
The FCFE model is a popular amongst professionals and academics. The reason for this is
because it relies only on free cash flow rather than on accounting based earnings, providing a
more accurate result as companies’ accounting policies do not interfere with the valuation.
The drawback of the model is that it is very influenced by the numbers estimated on assumptions.
These estimations and underlying could potentially be wrong. Then the final valuation will be
biased and thereby provide an incorrect value of the company (Penman, 2010).
59
6.1.2 Assumptions
Production will start on time with the specified product quality.
Northland will receive environmental permit for Sahavaara.
Northland will receive permit to use 90 ton gross weight trucks.
Hannukainen will be operational by 2017, financed by internal cash flows.
No value assigned to Hannukainen gold and copper production.
Railway to mine by 2021.
Production will remain stable at 7 million ton per annum past 2021.
Iron ore price will gradually decline to settle at $100/ton by 2016.
Price premiums will decline to $16/ton for Fe quality premium by 2016.
Value in Use premium will be stable at $5/ton.
Freight costs will be stable at $36/ton, assuming all production will be sold to Asia.
Capex and Opex will be as budgeted.
Sales, General and administrative expenses will be stable at $24,000,000.
A NOK/USD exchange rate of 5.75.
Depreciation: 5 percent straight line.
New corporate bonds will be issued at a 10 percent interest rate and an 8 percent issuance
cost, when the current corporate bonds expire.
Stable tax rate of 28 percent.
Cost of equity of 20 percent.
No changes in net working capital.
6.1.3 Valuation
The valuation is presented in Appendix 6.1. Northland’s plan is to deliver 1.4 Million ton iron
ore concentrate in 2013 and in sequence increase to reach 4.4 Million ton annually by 2017. I
have no reason to believe any production increase, once Northland reaches full production of 7
Million ton per annum by 2021. This is supported by the logistical solution of PEAB, Savage,
and Grieg (Northland Resources, 2012c). These companies give Northland a credible position to
meet their goal of delivery. The truck contract is valid for 9 years to 2021. I assume that a
60
railway will be operation to the mine by 2021 that would allow 5 Million ton to be mined
annually from the Kaunisvaara project.
The company has not taken an investment decision for the Hannukainen project. This will likely
occur after taking the result from the coming DFS study into consideration. Northland’s tentative
plan is to have Hannukainen in operation by 2016, but in my valuation I have considered
Hannukainen to be in operation by 2017. This will enable Northland to finance Hannukainen’s
capital expenditures through internal cash flows. The capital expenditures will be paid during the
construction of the mine, which is estimated to take two years. Northland’s tentative plan is for
Hannukainen to produce 2 Million ton per annum. Hannukainen will also produce copper and
gold as a byproduct. I have chosen to exclude the copper and gold production in my valuation
due to the high level of uncertainty.
The valuation results with a market value of equity of $ 195M. In Norwegian Kronor this is
equal to NOK 1,121M using a NOK/USD exchange rate of 5.75. Finally the share price is
calculated by dividing the market value of equity with the number of shares outstanding. The
resulting share price is equal to 2.18 NOK (see appendix 6.2). This would represent a 56.4
percent drop from July 20th
, 2012, share price of 5 NOK.
My valuation shows that Northland will show a loss for 2013. The first profitable year for
Northland would be 2014, where Northland would make 0.3 NOK in earnings per share. Today’s
market value of 5 NOK would give it a forward P/E ratio of 16.67 on 2014 earnings.
In my scenario Northland will enjoy high profit margins in the year 2014 and 2015 (see appendix
6.3). However as we know companies without a significant competitive advantage will not be
able to maintain high margins over a long period of time. Northland will be able to sustain their
business even with a lower iron ore price of $100/ton at a net profit margin of about 10 percent.
Nevertheless if the iron ore price would fall to $80/ton due to a hard landing by China, then
Northland will have a very difficult time to pay interest payments on their bonds and a
bankruptcy should not be ruled out.
61
6.1.4 Sensitivity Analysis
The sensitivity analysis of Northland is designed to show the effect of changes in the discount
rate and iron ore price on Northland’s share price. The price scenarios are for the Chinese 62
percent reference price and I have chosen to include the following price levels 80, 100, 120, and
140. I have also chosen to have a fixed Fe Quality premium of $28/ton and a value in use
premium of $5/ton. The freight rate is assumed to $36/ton. The two discount rates I have chosen
are 15 and 20 percent. The resulting sensitivity analysis is shown in appendix 6.4. Evidently
Northland’s share price is highly sensitive to changes in iron ore price. A 20 percent increase in
iron ore price from $100/ton to $120/ton would increase the share price more than 100 percent.
6.2 The Relative Valuation
A relative valuation is aimed to support the DCF analysis. The aim with the relative valuation is
to take investors opinion into account. Importantly to be aware of is that profit potential per
resource varies considerably from company to company. Therefore, it is in my view that a strict
multiple valuations for iron ore mining companies seldom make meaningful sense, there are just
too many adjustments required. There are only a couple of mining companies that have similar
enough firm characteristics to Northland Resources. I will focus to examine investors’ opinion
by doing a more qualitative comparison.
I have chosen a mining company with close enough characteristics to Northland Resources. This
company is Dannemora Mineral. The commonalities are that they operate in Sweden, have
secured financing, and production start in 2012.
6.2.1Dannemora Mineral
Dannemora is a junior mining company in Sweden with startup of production in 2012. The
expected production for 2012 is 0.5 Million ton, 1 Million ton for 2013, and subsequently it will
increase to reach 2 Million ton per annum by 2016. Dannemora produces lumps and fines of 55
and 50% Fe content respectively with no value in use features and will therefore sell at a
discount to the 62% reference price. The operating cost is estimated to be about $30/ton, which is
considerably lower than Northland’s. The life of mine is of today only expected to be 15 years,
62
significantly lower than Northland. The situation near Stockholm with sales to Europe grants low
freight rates. The small size and lower complexity of operations would reasonable give
Dannemora a lower characteristic risk.
The NPV for Dannemora is calculated in the same fashion as for Northland’s Kaunisvaara NPV
with a reference price of $120/ton. The Dannemora NPV is estimated to be $416M after tax and
financing. The current market capitalization for Dannemora is $97M. The market capitalization
divided by the NPV equals 0.23. Northland’s Kaunisvaara NPV is $800M and the market
capitalization is $350M. The market capitalization divided by the NPV equals 0.43 for Northland.
This is considerably higher because of the better growth prospects for Northland.
The NPV for Hannukainen is $471M based on conservative price estimates in the PEA study.
Northland’s market capitalization divided by the total NPV of Kaunisvaara and Hannukainen
equals 0.275. This is still higher than Dannemora’s MCAP/NPV. In order for Northland to be
priced in the same level as Dannemora, the NPV for Hannukainen would have to be $721M. An
NPV of $721M is not unlikely to be announced in the upcoming DFS for Hannukainen, if
Northland decides to use the same level of reference prices as for Kaunisvaara NPV.
6.4 Chapter VI – Conclusion
I conducted a free cash flow to equity valuation in this chapter with the cost and price input from
previous chapters. The resulting share price with a 20% required return on equity is 2.18 NOK.
This excludes the gold and copper byproduct from Hannukainen. The price of 2.18 NOK is a
56.4 percent drop from the current price of 5 NOK. My sensitivity analysis shows that Northland
is highly sensitive to changes in iron ore price. The chapter ended with a simple comparison of
Northland and Dannemora. The comparison of net present values shows that investors expect
either Northland to be of considerably lower risk or higher growth potential. If investors price in
the same risk for the two companies the NPV of Hannukainen is expected to be $721M.
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7. Chapter VII – Conclusion
This thesis undertook the challenge to analyze the iron ore market and Northland’s position to
subsequently conduct a valuation of Northland Resources. Northland will start their iron ore
production in the 4th
quarter of 2012. Pajala is full of optimism; Northland has contributed to
reverse the trend of a declining population. The mining renaissance will give jobs to thousands of
people directly and indirectly (Sundqvist, 2009). The recent surge in demand of iron ore from
China has caused many to believe in a new paradigm of continued high commodity prices or a so
called commodity super cycle. My analysis shows that this is an incorrect belief and that the iron
ore price is expected to fall in the coming years.
In my strategic analysis I found that the fixed asset investment composition of GDP growth
determines a country’s demand for iron ore. This was of vital importance for the forecasting of
future supply and demand. The forecasted demand was scrutinized to discover that the high level
of fixed asset investment is unsustainable and will likely be lower in the future. The forecasted
supply was based on my analysis and judgment of the major iron ore producing regions future
potential. The future supply is likely to be very large in the period from 2013 to 2016. In my
conservative scenario I estimate the iron ore price will gradually decline to an average of
$100/ton past 2015.
My prediction of the iron ore price and resulting valuation of Northland is contrarian to many
analysts’ recommendations. The average analyst target price for Northland is 15.6 NOK, which
is 200 percent higher than today’s share price of 5 NOK. These valuations are based on a long
term iron ore price of at least $120/ton. Despite that in the previous 100 years the iron ore price
has only been above $100/ton in the last 2 ½ years.
My fair value of Northland is estimated to be 2.18 NOK. This would represent a 56.4 percent
decline from today’s market value. Northland is highly sensitive toward the iron ore price, which
in turn is highly leveraged towards the industrialization and urbanization of China. Furthermore,
there are both upside and downside risks in Northland that should be considered.
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7.1 Upside Risks
Upside risks are risks that would result in a higher than expected value of Northland’s share price.
These risks are the following:
Positive DFS for Hannukainen
Lower operating costs
Supply setbacks in the iron ore market
Higher demand in the iron ore market.
The final DFS study for Hannukainen is set to be released in the 3rd
or 4th
quarter of 2012. The
company has invested a substantial amount in exploration around the Hannukainen area. The
previous PEA study granted a positive NPV for Hannukainen. The price estimates used in this
calculation was conservative compared to the Kaunisvaara DFS. The NPV has the potential to
double by only using higher price estimates. On the other hand, my valuation of Northland in
comparison to Dannemora showed that a doubling of NPV could already be priced in.
Lower operating costs could be possible by either a lower fuel price or a different transportation
method. A railway or a slurry pipeline could lower the operating costs, but are not likely to be
constructed in the short term; the truck transportation contract is valid to 2021.
Supply interruptions could possibly sustain a high iron ore price. African iron ore are in
particular exposed to political uncertainties. Vale of Brazil has encountered hardship from
environmental protection agencies. Stricter environmental requirements in many countries could
limit the expansion of many iron ore producing companies.
A demand shock that would increase the demand for iron ore could be caused by a new stimulus
package by China. China needs high GDP growth to ensure social stability. A significant drop in
GDP growth could escalate the government’s intensions to introduce another stimulus package.
Conversely, another stimulus package could prove to be unsustainable and will only intensify a
coming downturn. Another source of greater demand is from India. India has shown a
willingness to move towards a higher degree of fixed asset investments. This is could act as a
cushion to prevent the iron ore price from falling rapidly.
65
7.1 Downside Risks
Downside risks are risks that would result in a lower than expected value of Northland’s share
price. These risks are the following:
Significant lower demand in the world iron ore market
Significantly higher supply entering world iron ore market.
Additional financing
Logistical Problems
Inferior Quality
Higher Operating Costs
Negative DFS for Hannukainen
Accounting Fraud
A commitment by the Chinese government to restructure the economy could significantly lower
the demand for iron ore. Further investment could be very costly and the government might not
be willing to generate GDP growth at any cost. China will go through a leadership change in
2013. The commitment to the restructuring by the next central planner is highly uncertain.
My forecasting is based on a conservative scenario for future production potential. In this
scenario I assume that only half of the planned future production will be attained. This could
prove to be an overly conservative scenario and cause a severe drop in the iron ore price.
In my valuation I assumed that Hannukainen would be financed through internal cash flows. A
favorable DFS on Hannukainen could make the management more inclined to invest in
Hannukainen before a potential drop in commodity prices. This would pressure the shareholders
by another massive rights issue to finance the capital expenditures of about $400M.
The logistical solution with trucks and trains is another worrying factor. The road is in an
immediate need for improvements. The work to improve the road is currently undertaken, but the
road will need a constant maintenance once production has started. The weather in Northern
Sweden could also lead to greater than expected interruptions in delivering the iron ore.
66
Northland is using state of the art equipment to produce their iron ore of the highest quality. The
equipment supplier Metso has closed to “guaranteed” the product quality. I do not think we
should take the product quality for granted. Metso holds no responsibility that the mine will
produce iron ore of highest quality. The planned quality requires a rigorous and complex
production process and not that many mines have aimed to produce this high quality from the
very start. No assurance is given that the anticipated tonnages and grades will be achieved
(Northland, 2012l).
The risk for higher operating expenditures could materialize if the oil price increases or the road
needs more than expected improvements.
The Hannukainen preliminary study showed a positive NPV of $421M. There is no assurance
that the upcoming DFS will verify the PEA results. The Hannukainen DFS has been postponed
for over a year since the original release date. Northland wrote the following in the equity
prospectus released in February 2012:
“A delay in finalizing the DFS could also mean, due to changes beyond the control of the
Group, that it is no longer viable to open new mining operations.”
(Northland Resources, 2012l)
The stock option plan combined with a high degree of agency problem between shareholders and
management increases the propensity to commit accounting fraud.
7.2 Recommendation
Northland’s profit margin is likely to be high in the short term, but the iron ore mining industry
is like any other competitive industry. I do not consider Northland to have an adequate
competitive advantage with their high quality iron ore concentrate to maintain a high profit
margin when new supply enters the market. The Chinese growth cannot go on forever. This
reminds me of what one famous economist once said:
“If something cannot go on forever, it will stop.”- Herbert Stein. (Stein, 1997)
Northland may make you quickly rich or poor, but would not be recommended for long term
wealth accumulation. In the long term the downside risks outweigh the upside risks and
67
considering humans’ belief system of overconfidence, optimism, and wishful thinking investors
might be in for a real disappointment. Personally, I would not touch it even if I wore an hazmat
suit. For long term value creation I would recommend the two diversified mining companies
BHP Billiton and Rio Tinto, because of their close proximity to Asia and that they are more cost
conscious and positioned for long term value creation throughout commodity cycles.
68
8. Chapter VIII – Perspectives
In this chapter I will reflect on the past of Northland’s share price trend to provide guidance for
future share price changes. It is often said that the most important factors are also the most
difficult to measure. I will look into the decisions taken by the management and how the
investing public reacted. This chapter will end with an elaborate story of what I think we can
expect next.
8.1 The Behavioral Story
Northland’s share price has fallen by 75 percent since the peak in 2011 (see appendix 8.1). Many
mining companies have experienced a slight turmoil, according to the S&P Metals and Mining
ETF named XME. The XME has fallen by 20 percent since 2011 (see appendix 8.2). First we
need to understand the complete story of the management’s actions leading up to this crisis. The
top people at Northland are Anders Hvide and Karl-Axel Waplan. Mr. Waplan achieved
tremendous success as a CEO for Lundin Mining before he joined Northland. In the news Mr.
Waplan is often characterized as very optimistic. (Sundqvist, 2009) He is also known for making
bold statements regarding continued high commodity prices for a long time in the future.
(Samuelson, 2011)
8.1.1The Winds of Change - 2010
The original plan was to ship the iron ore from the Kemi port in Finland via the railroad in
Äkesjokisuu, Finland which is 18 Kilometers from Kaunisvaara. The company announced in a
press release in February 2010 that Northland and the Swedish Rail Administration have signed a
memorandum of understanding regarding the co-financing of a rail line (Northland Resources,
2010b). A month later, Northland announced the appointment of three lead investment banks for
the syndication of the senior loan (Northland Resources, 2010c).
In April 2010 the management from 2007 sold a large part of their stocks and exercised stock
options at the peak of 19.5 NOK. The stock drops to a low of 10 NOK in June. Nevertheless the
stock starts to recover gradually after the announcement of the PEA study for Hannukainen in
the end of June. In July, Northland announced they are studying the possibility of using the port
of Narvik (Northland Resources, 2010e). The final decision for logistics was revealed in the
Kaunisvaara DFS in September. The company chose Narvik as the best solution and anticipated
69
they would receive a permit for 170 ton trucks (Northland Resources, 2010d). The stock market
reacted negatively despite a positive NPV in the DFS study, the stock dropped by 16 percent to
14.5NOK. The year ended with Northland completing a rights issue of 250M USD at 13.5 NOK
and started the construction of the Kaunisvaara mine (Northland Resources, 2010f).
8.1.2 The Year of Confidence – 2011
The start of 2011 was very optimistic. Karl-Axel Waplan was interviewed several times by the
media. One newspaper gave him the title “the iron ore king” (Hammar, 2010). In one interview
by the Business Excellence Magazine, Karl-Axel Waplan made the following statement:
"From a mining point of view, the project holds no insurmountable obstacles. The major
challenge we face is the tight schedule we have set ourselves." – Karl-Axel Waplan, (Business
Excellence, 2011)
Northland received a credit approval of 175M USD out of the total 400M USD expected as a
senior loan (Northland Resources, 2011c). The company also started to work on a DFS for
Hannukainen with completion date by the end of the year. The stock reached a high of 19 NOK
in January. In the corporate presentation April (2011), the company aimed to achieve the
following goals:
Target production of 6-7 Million ton annually by 2015.
Hannukainen target production by 2014
Senior Loan Syndication finalized by Q2 2011
Pellivuoma DFS completed by Q3 2011
Hannukainen DFS completed by Q4 2011
Shortly thereafter in May, the company updated their Kaunisvaara DFS by doubling the NPV.
The stock rose about 8%. The doubling of NPV was a result of raising the reference price from
$101/ton to $137/ton FOB price. This was supported by an analysis made from the Raw
Materials Group, an “independent” consulting agency where Karl-Axel Waplan is a director.
This DFS update also anticipated a joint venture for the logistical solution (Northland Resources,
2011e).
70
Unfortunately the summer’s economic turmoil made the stock drop astonishingly 38 percent.
The drop was further exacerbated by a fall in the iron ore price, the stock reached a bottom of
slightly below 6 NOK in November. Despite a fall in the iron ore price, people were still
optimistic about Northland Resources. Carnegie issued a buy recommendation with a target price
of 92 NOK based on a discounted cash flow analysis in September. The Swedish Newspaper
Affärsvärlden issued a buy recommendation in October. Their main reason was considering
China’s strong demand for commodities (Elofsson, 2011). Like most valuations of Northland the
recommendation is to buy, but is also commonly associated with a high risk rating.
The three lead banks for the senior loan syndication where all severely affected by the financial
turmoil during the summer. Karl-Axel Waplan was interviewed by the Swedish National Radio
on October 20th
concerning the senior loan. Karl-Axel Waplan first acknowledged that the
company would need a financing solution in place by the first quarter of 2012. Then the
interviewed unfolded following:
Karl-Axel Waplan – We are currently negotiating and discussing the final syndication with these
banks and they confirm their interest and their willingness to make this financing. We have no
reason to doubt it because they drive the project forward and will syndicate with other banks at
present so I have no reason to doubt it
The Interviewer - What would happen if one of these banks goes bankrupt?
Karl-Axel Waplan – Well, then there are other banks that have shown interest in the project so I
believe there are other banks that we can count on in that case.
The Interviewer – What do you think the risk is that you are without these financiers?
Karl-Axel Waplan – That I consider to be extremely small today, if not to say entirely
nonexistent. (Martinsson, 2011)
Despite these optimistic statements, the stock dropped 6.1 percent on the day of this interview.
8.1.3 The inconvenient Truth – 2012
Northland did not receive a financing deal from the banks in the fourth quarter of 2011. Instead
Standard bank provided Northland with a short term bridge loan of $50M that would be
converted into the long term financing deal later. The bridge financing gave the impression that
Northland would be able to secure a long term financing deal. Standard Bank is one of the
71
stakeholders with the best insight into the company and its projects. The average analyst target
price of Northland was 21.47 NOK on January 4th. That would mean a 154% price increase from
the price of 8.46 NOK (Söderlind, 2012). On January 10th
SEB organized an investor seminar
with Northland Resources among other companies. Karl-Axel Waplan confirmed that the project
is on time and budget, but most importantly reiterated confidence in financing.
On January 23rd
, the Swedish newspaper Veckans Affärer issued a buy recommendation with a
target price of 15 NOK. The main reason was that the probability of a price fall in iron ore that
would make Northland’s operations unprofitable should be viewed as very low (Karström, 2012).
Karl-Axel Waplan expressed his concern about a continued fall in iron ore price in the
newspaper, Privata Affärer:
“It has to occur a complete stop in China, for us to be at risk”- Karl-Axel Waplan, (Karström,
2012)
Anders Hvide was interviewed by the business news network in Canada on January 24th
. Mr.
Hvide was asked about the financing that the network estimated to be $500M. Mr. Hvide
commented that the financing would be not all equity by all means (Business News Network,
2012).
The stock reached 11.45 NOK on February 2nd
, when the stock was abruptly stopped from
trading. The inability of Northland to obtain financing from the syndication of banks in the
economic climate forced them to execute an enormous stock and bond issuance of $675M in
total, $350M in bonds and $325M in Equity (Northland Resources, 2012m). The share price has
declined to 5 NOK as of July 20th
, 2012.
8.2 The Behavioral Aspects
There might be important lessons to be learned from this story by examining the behavioral
aspects of management and the reaction of investors. The integration of these behavioral concepts
could present a rich explanation of what might happen next.
72
8.2.1 Overconfidence & The Illusion of Control
A key attribute of overconfident managers are the tendency to make bold statements (Shefrin,
2007). The actions taken by Northland’s management can strongly be characterized by
overconfidence. Overconfident managers seem to have all the right answers, impressing people
with the speed and decisiveness with which they can deal with challenging issues. They also treat
intimidating and difficult obstacles as temporary issues. My interpretation of Karl-Axel
Waplan’s statements in the press would characterize Mr. Waplan as highly overconfident.
Moreover the annual report includes the following bold statements:
“We aim to develop our company into one of Europe’s leading iron ore producers”, “Our mines
will produce high-grade, high-quality iron magnetite concentrate”, “Prices will remain at
historically high levels.”- Annual Report 2011, (Northland Resources, 2011a)
Overconfident managers are overly convinced that their views are correct and that they do a
better job than they actually do. This in turn leads to a poor capital discipline and demands of
high salaries and bonuses (Shefrin, 2007).
Research shows that overconfident actions are a result by long periods of results above
expectations. Overconfidence creates biases in the analysis of external factors like the business
cycle. This jeopardizes their observation and understanding of both threats and opportunities.
Sometimes it makes the managers ignore the threats altogether. (Linda M. H. Lai, 1994) Karl-
Axel Waplan was questioned about the new supply from African mines. He replied that the
quantities are so vanishingly small (Sundqvist, 2011).
Northland’s management has an impressive resume in the metals and mining industry. Their
success of over a decade with high commodity prices could have led them to become
overconfident. Karl-Axel Waplan previously CEO for Lundin Mining accomplished to more than
threefold the stock price from 2005 to 2008. Long periods of success could lead to an illusion of
control during periods of growth. The illusion of control leads managers to keep working with
the same strategies, which made them successful in the first place, without regard for changes in
the business cycle. This results in an insufficient adjustment of strategies, which in turn makes
the company struggle behind the business cycle, instead of working towards the threats and
opportunities. (Montier, 2010a)
73
8.2.2 Optimism
Northland Resources investment in Pajala has generated great optimism and people have been
given a hope for the future. It has been described as the most revolutionizing investment in
Pajala for the last 100 years (Brobäck, 2011). Mining operations around the world has fueled
optimism in the current commodity boom.
Excessive optimism by management and investors can lead to bad decision making by excessive
risk taking. One classic sign of excessive optimism is the level of mergers and acquisitions in the
industry. Mergers and acquisitions (M&A) are often made on the basis of optimistic expectations
about the future (Roll, 1993). The level of M&A activity in the mining industry has been
measured by Pricewaterhouse Copper (PwC) and is shown in appendix 8.3. The fall in
commodity prices in the second half of 2011 did not stop M&A activity and was described by
PwC as defying gravity. The year of 2011 was the second busiest year of mining M&A activity
in history. The total value of M&A deals in 2011 was $149 Billion, only 2 percent lower than the
peak year of 2006. The major difference between the year 2006 and 2011 is that in 2011, there
was considerably less canceled M&A deals, as shown in appendix 8.3. A reason for this could be
that shareholders of the targeted companies, where more eager to sell or that the shareholders of
the acquiring company where more eager to pay a high premium.
Excessively optimistic managers will overinvest and underestimate risks and costs. As a result
they pursue projects that they perceive to have a positive NPV based on overly optimistic price
estimates, but in reality have a negative NPV. Research on the mining industry by Brian W.
Mackenzie (1981), shows that the NPV of the average mining project turned out to be negative.
Excessively optimistic projects forecasts belong almost entirely from agency conflicts between
shareholders and management (Montier, 2010a).
Northland’s management has shown to constantly be overly optimistic in their projections. The
company has failed to achieve the promised goals of the April, 2011 company presentation. In
particularly the long promised syndication of the senior loan. Additionally the doubling of the
Kaunsvaara NPV by raising the reference price is another sign of over-optimism. The company
has promised to deliver the highest quality iron ore in 2013 and that the iron ore price will
remain at high levels. There are reasons to believe that the management might disappoint
investors again with optimistic goals.
74
8.2.3 Internal vs. External Locus of Control & Self Attribution Bias
Warren Buffet often talks about the importance for management to have an internal locus of
control. Management with an internal locus of control believes they are in control of the outcome.
When failing they would blame themselves and internal factors in the company for not achieving
their goal. These managers are truthful about their mistakes and more likely to learn from them.
On the other hand, management with an external locus of control does not believe they can
control the outcome of their actions. When failing they blame everyone else and external factors
beyond the company control for not achieving their goal. Managers that are not truthful about
their mistakes are more likely to lie to themselves about other important things as well. (Buffet,
2009)
Managers with an external locus of control are more likely to exhibit the self attribution bias.
Management with a self attribution bias will attribute the success to their skills or internal factors,
while attributing their failures to someone else or external factors. These managers will resist a
low reward for poor performance and seek a high reward for good performance, regardless of
whether the performance was due to luck or skills (Buffet, 2009). Moreover the agency problem
of weak shareholders magnifies the self attribution bias. (Montier, 2010a)
The management of Northland Resources has shown to exhibit the self attribution bias by not
commenting of their failures. The management has never admitted any mistakes and said the
financial solution is both a good and strong solution for the company (Northland Resources,
2012m). Karl-Axel Waplan was asked in July, 2012, why the share price is low. He answered
that it will be higher once the company is in production (Hannu, 2012). The company has weak
shareholders that intensify the self attribution bias in the form of the company’s gigantic stock
option plan, where a maximum of 15 percent of the outstanding shares can be reserved for stock
options (Northland Resources, 2011b).
75
8.2.4 Representativeness, Confirmation & Availability Bias
Representativeness heuristics distorts a manager’s perception of risk for an event to occur. Most
times they overestimate their own ability to accurately predict the probability of an event. One
reason for this is because they are struck by the confirmation and availability bias. The
confirmation bias is the tendency for managers to search for information that agrees with them,
rather than look for information that would prove them wrong. These managers interpret
information and act in a manner to support their original belief. This is closely related to the
availability bias. The availability bias is the tendency for managers to judge the probability of an
event based on how easy it is to recall similar occurrences. These biases lead managers to
overweight recent, readily, available, and intuitive information that agrees with them (Shefrin,
2007).
In the February corporate presentation (2012), Northland’s operating costs adjusted for Fe
content placed them in the middle of their peer group. But for the next month, Northland
changed their peer group to be placed among the top three miners with the lowest operating cost.
In the recent June corporate presentation (2012) the management included a graph of the iron ore
price (see appendix 5.25). This graph is only showing the recent period, where the iron ore price
has been above $100/ton. Additionally in the presentation, Northland was placed with the second
best operating expenditure in their peer group. There are strong reasons to believe that the
management is influenced with these biases and thereby neglecting the risk of a severe fall in the
iron ore price.
It has shown that individual investors also rely on simple heuristics when making an investment
decision. Simple heuristics could for example be simple P/E ratios on next year’s earnings, or
simple DCF valuations. A simple EPS estimate could be as high as 2.5 NOK giving Northland a
favorable P/E ratio of 2 for 2014 earnings. However, a simple EPS estimate would neglect
depreciation, financial expenses and a fall in the iron ore price. Karl-Axel Waplan said himself in
an interview, that their cash flow calculation is not an entirely simple calculation (Hammar,
2010). A more reliable DCF valuation requires more details and is far less intuitive. Additionally
individual investors relying on simple DCF and P/E ratios are probably less likely understand the
composition of GDP growth that drives the demand for iron ore. Northland Resources should
therefore be recognized as a value trap.
76
8.2.5 Polarization
Many managers like to think they know the best and surround themselves with people who are
happy to strengthen their viewpoint (Shefrin, 2007). Then if a CEO is enthused about a thing like
continued high iron ore price, both internal staff and external consultants will come up with
whatever projections that are necessary to justify the CEO’s view point.
“Only in fairytales are emperors told that they are naked.”- Warren Buffett, (Buffett, 2009)
Northland’s management is in my point of view characterized as a group of highly homogenous
experts. This could lead them to reinforce each other’s belief about continued high iron ore price
to end up in an extreme position.
8.2.6 The Sunk Cost Fallacy
The sunk cost fallacy is the tendency by managers to overly commit to a course of action after
substantial prior investment of money, time, and other resources. These managers believe they
have passed the point of no return. Michael C. Roberto’s (2002) research has shown that
climbers have passed away attempting to conquer Mount Everest, because of their inability to
ignore sunk costs even if their life dependent on it.
Karl-Axel Waplan and Anders Hvide have both invested a lot of money and time into Northland.
Their personal reputation is also at stake. They are likely to believe that the point of no return has
passed especially after the colossal equity and bond issuance. This means that they are overly
eager to build this mine, even if the iron ore price would start to decline. It also increases the
management inclination to believe that the iron ore price will be high in the future.
8.3 What to expect next?
Enthusiastic stories about Northland’s Billion Kronor profits based on sky high iron ore prices
and continued dominance of China affect us emotionally. Unfortunately we typically make bad
investment decisions based on our emotions (Montier, 2010b).
In my point of view Northland is a perfect short candidate for three reasons. The iron ore price
outlook is unfavorable. The management is influenced with behavioral biases that ultimately
77
results in a poor capital discipline. The investing public is enthusiastic about it which has
resulted in an overvaluation.
My analysis of the iron ore price takes fundamental factors of supply and demand into account.
However these factors cannot justify a high iron ore price in the future. The large expansion of
inventories combined with an unusual large price increase may suggest that investors and
steelmakers buy iron ore with the belief that it can be sold for a higher price in the future. As one
renowned economist put it
“If the reason that the price is high today is only because investors believe the price will be
higher tomorrow, then a bubble exists.”- Joseph, Stiglitz (Stiglitz, 1990)
There are good reasons to believe the iron ore price is in a bubble territory. Some of the most
common signs of a price bubble are the following:
Some people are aware of it.
The problem gets worse over time
Eventually the problem explodes into a crisis.
Northland’s leverage on the Chinese urbanization & industrialization makes it a ticking time
bomb in the event of a sharp slowdown. In that event, I would believe the management will
confidently state that the price drop is just temporary. Subsequently I would suspect the
management to change accounting policies or simply overstate accounting statements. The
managements have demonstrated a willingness to fiddle with numbers and a determination to not
give up. As one famous investor once said:
“Managers that always promise to 'make the numbers' will at some point be tempted to make up
the numbers." – Warren Buffett, Buffett (2009)
Earnings contain a large number of highly subjective estimates that could be altered. This could
for example be a more aggressive capitalization of costs. This could potentially already be the
case as Northland capitalizes most of their exploration costs. Management might change the
depreciation costs by changing the estimate of useful asset life. Additionally the other operating
asset is an asset that is unexplained in the balance sheet. A substantial unexpected increase in
other operating assets should be seen as an early warning signal.
78
In the event of a sharp price decline, the problems would eventually become inevitable to hide
and shock remaining investors. The impact of a sharp fall in the iron ore price could result in a
crisis of biblical proportions by a large socio-economic impact on the regions of Northern
Sweden. Thousands of people are directly or indirectly relying on the current mining renaissance.
In a true Graham manner, when I research a company’s financial reports, I start by reading on
the last page and slowly work my way toward the front. The last page of important information
in Northland’s annual report is a page concerning forward looking statements.
“These statements reflect our current belief and are based on currently available information.
Accordingly, such forward-looking statements involve known and unknown risks, uncertainties
and other factors which could cause the Company’s actual results to differ materially from those
expressed or implied by such statements. We undertake no obligation to update or advice in the
event of any change, addition, or alternation to the information contained in this Annual Report,
including such forward-looking statements”- Northland Resources Annual Report 2011
(Northland Resources, 2011a)
Northland’s management has shown to form beliefs that are overly optimistic. Beliefs could
move iron ore, but the monumental question is whether it will be profitable. Investors too often
accept the reality of the world with which they are presented.
79
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Appendix
Appendix 2.1 Source: Northland Resources Annual Report, 2011
Appendix 2.2 Source: Northland Resources Annual Report, 2011
Appendix 2.3 Source: Norhtland Resources Annual Report, 2011
90
Appendix 2.4 Northland Resources Annual Report, 2012
Appendix 2.5 Source: Northland Resources Annual Report, 2012
Management Team Current Position Joined Northland
Anders Hvide Executive Chairman Jan-09
Karl-Axel Waplan President & Chief Executive Officer May-08
Eva Kaijser Chief Financial Officer Apr-10
Peder Zetterberg Acting Chief Financial Officer Jan-12
Peter Pernlöf Chief Operating Officer Dec-10
Manfred Lindvall Vice President - Environmental, Health, and Safety Sep-08
Petri Peltonen Vice President – Exploration Sep-08
Anders Antonsson Vice President – Investor Relations Apr-11
Hans Nilsson Vice President – Marketing Jun-08
Jonas Lundström
Vice President – Human Resources and Corporate
Communications Apr-08
Patrick Foster Director, Finance May-10
Jukka Jokela Vice President – Finnish Operations Sep-08
Bernt Hedin Project Manager Jun-12
Willy Sundling Project Manager – Logistics Dec-10
Appendix 2.6 Source: Own Creation, Northland Resources Annual Report,
2012
91
Appendix 2.7 Source: Own Creation, Northland Resources Annual Report, 2012
Appendix 2.8 Source: Northland Resources Corporate Presentation June, 2012
92
Appendix 2.9 Source: Northland Resources Equity Prospectus, 2012
93
Appendix 2.10 Source: Northland Resources Corporate Presentation March, 2012
Appendix 2.11 Source: Northland Resources Corporate Presentation June, 2012
94
Compensation 2009 2010 2011
Option Based
Compensation
Executive Chairman $ 298,580 $ 327,768 $ 264,315
CEO & President N/A $ 479,128 $ 311,289
Total $ 806,896 $ 575,604
Salary
Executive Chairman $ 277,577 $ 392,028 $ 471,571
CEO & President N/A $ 302,290 $ 531,549
Total $ 694,318 $ 1,003,120
Total Compensation
Executive Chairman $ 576,157 $ 719,796 $ 735,886
CEO & President N/A $ 893,632 $ 964,330
Total N/A $ 1,613,428 $ 1,700,216
Appendix 2.12 Source: Own Creation, Northland Resource Information Circular 2009, 2010,
2011
Appendix 2.13 Source: Own Creation, Northland Resource Information Circular 2009, 2010,
2011
0
0.5
1
1.5
2
2.5
3
3.5
2009 2010 2011 2012 Today
Weighted Average Exercise Price
Northland Stock Price
95
Appendix 3.1 Source: Anderlini, 2012
Appendix 3.2 Source: Montier, 2010a
Appendix 3.3 Source: Montier, 2010a
96
Appendix 3.4 Source: Bloomberg, 2012
Appendix 3.5 Source: Montier, 2010a
97
Appendix 3.6 Source: Northland Resources, 2012l
Appendix 3.7 Source: Index Mundi, 2012
Appendix 3.8 Source: Index Mundi, 2012
98
Northland Resources Iron Ore Concentrate
Fe 69%
Sulphur (S) 0.05%
Silica (SiO2) 1.10%
Alumina (Al2O3) 0.18%
Lime (CaO) 0.04%
Phosphor (P2O5) 0.04%
Magnesium Oxide (MgO) 2.65%
Titanium Oxide (TiO2) 0.08%
Particle size 40 micron
Moisture (H20) ~6%
Appendix 3.9 Source: Northland Resources Corporate Presentation June, 2012
Appendix 3.10 Source: U.S Geological Survey, 2012
99
Appendix 3.11 Source: U.S Geological Survey, 2012
Appendix 3.12 Source: World Coal Association, 2010
100
Appendix 3.13 Source: Mackenzie, 2012b
Appendix 3.14 Source: Guo & N’Diaye, 2009
101
Appendix 3.15 Source: Own Creations, China Bureau of Statistics, 2011
Appendix 3.16 Source: Own Creation, China Bureau of Statistics 2011
-
50,000.00
100,000.00
150,000.00
200,000.00
250,000.00
300,000.00
2003 2004 2005 2006 2007 2008 2009 2010
China Fixed Asset Investments
China Fixed Asset Investments
Proportions of Fixed Asset Investments in 2000
Manufacturing
Others
Real Estate
Transport
Proportions of Fixed Asset Investments in 2010
Manufacturing
Others
Real Estate
Transport
102
Appendix 3.17 Source: IMF, 2012
Appendix 3.18 Source: IMF, 2012
103
Appendix 3.19 Source: Northland Resources, 2012
Appendix 3.20 Source: Northland Resources Corporate Presentation February, 2012
104
Appendix 3. 21 Source: Own creation
Apendix 5.1 Source: Own creation, Raw Materials Group, 2011
Apendix 5.2 Source: Own Creation, using data from annual reports and company presentations
of Northland Resources and their competitors.
105
Apendix 5.3 Source: Haywood, 2010
Apendix 5.4 Source: Own Creation, using data from annual reports and company presentations
of Northland Resources and their competitors.
Appendix 5.5 Source: Own Creation, using data from annual reports and company presentations
of Northland Resources and their competitors.
106
Apendix 5.6 Source: Vale Annual Report, 2011
Apendix 5.7 Source: Rio Tinto Annual Report, 2011
Apendix 5.8 Source: Rio Tinto Company Presentation, 2012
107
Apendix 5.9 Source: Own Creation, using data from annual reports and company presentations
of Northland Resources and their competitors.
Apendix 5.10 Source: Own Creation, using data from Hurst, (2011) RBC Capital Markets (2011),
and Ocean Equities (2011).
Appendix 5.11 Source: Own Creation, using data from annual reports and company presentations
of Northland Resources and their competitors.
Apendix 5.12 Source: Own Creation, using data from annual reports and company presentations
of Northland Resources and their competitors.
108
Apendix 5.13 Source: J.P. Morgan, (2012)
Apendix 5.14 Source: Mackenzie, (2012a)
Apendix 5.15 Source: J.P. Morgan, (2012)
109
Apendix 5. 16 Source: MacKenzie, 2012a
Apendix 5.17 Source: Raw Materials Group, (2011)
Apendix 5.18 Source: Dannemora, 2011
110
Apendix 5.19 Source: Bloomberg (2012)
Apendix 5.20 Source: Own Creation, using data from annual reports, company presentations and
industry reports of Northland Resources and their competitors.
0
500
1000
1500
2000
2500
3000
3500
4000
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
World Total
Moderate
Conservative
Asia
Australia
South America
CIS
North America
Africa
Europé
111
Apendix 5.21 Source: Own Creation
Apendix 5.22 Source: Metalytics, (2009)
112
Apendix 5.23 Source: Northland Resources Corporate Presentation June, 2012
113
Appendix 6.1 Source: Own Creation
114
Apendix 6.2 Source: Own Creation
Apendix 6.3 Source: Own Creation
Apendix 6. 4Source: Own Creation
115
Apendix 8.1 Source: Northland Resources, (2012)
Apendix 8.2 Source: Yahoo Finance, (2012)
116
Apendix 8.3 Source: PriceWaterhouseCoopers, (2012).
Apendix 8.4 Source: PriceWaterhouseCoopers, (2012).
