MFC Industrial (NYSE:MIL)

As someone who tries to pay close attention to unusual situations in the stock market, I have had Terra Nova Royalty (TTT) on my radar screen for a while. It jumped right off the page at me yesterday when I was looking at my watchlist. The company was one of the day's biggest losers, closing down 14%. Ouch. Add to that the 3% that the stock is down today and that's quite a whack.

For those of you who aren't familiar with Terra Nova, it is a mineral royalty company that was recently spun-off from KHD Humboldt Wedag International. Specifically TTT currently owns the rights to royalty income from the Canadian Wabush ore mine that is operated by Cliffs Natural Resources (CLF). Terra Nova expects to earn between $25.8 and $37.5 million in gross royalty income from the property in 2010. The company's revenue will obviously fluctuate depending upon the price of iron ore. Part of the reason why this stock has come under tremendous pressure lately is the fact that the price of iron ore has dropped by 15% in the past several weeks.

Adding to the stock's problems, Mr. Market did not like either the company's recently published results or press release yesterday. Terra Nova actually managed to lose money last quarter, which isn't easy to do when your business mainly consists of collecting income from a royalty stream. Granted, costs associated with the company's recent spin-off were a significant one-time expense, but apparently people have little confidence in management's ability to increase shareholder value in the future.

The recent implosion in this stock has dropped its current share price below what many are estimating to be its real book value.

Also weighing upon the stock is a rights offering that the company recently announced. TTT plans to raise approximately $70 million by increasing its share count by 24%. Rights offerings for companies that are trading below book value are highly dilutive and the market usually frowns upon them.

Here's the official announcement on the issue from TTT's recent press release:

"RIGHTS ISSUE: In the next month we intend to undertake a rights issue where our existing shareholders may purchase additional shares at a discount to market. We believe that there are significant opportunities to expand our business through opportunistic acquisitions. Because of the inherent risks associated with the mineral business, we believe any acquisitions should be conservatively financed. The additional capital we believe can be successfully deployed. The major features of the issue will be as follows:

Number of shares issuable: 7,250,000 common shares, representing approximately 24 percent of Terra Nova's issued and outstanding common shares "

Rather than paying out a revenue stream from an undervalued asset, TTT plans to add risk to the situation by actually raising money to buy new unknown assets in the future. Mr. Market doesn't like this sort of uncertainty. Hence the discount to book value.

So what exactly is Terra Nova's book value? As of March 31st, the stated book value of Terra Nova's iron ore royalty stream was $5.42/share. However, the company believes that this number is significantly understating the true value of this asset. It plans on increasing the book value of the stream by $200 million to around $9.50 per share in the near future:

"As of January 1, 2011 Terra Nova intends to change its Financial Reporting Standards from Canadian GAAP to International Financial Reporting Standards. Pursuant to IAS.16, Property, Plant and Equipment, we expect to increase the value of the royalty asset to its fair value. If this were implemented as of December 31, 2009, based upon our current valuation including current royalty rates and forecasted demand, we estimate it would result in a value for the existing royalty of $200 million and we estimate the effect on such an increase would be as follows:

All amounts in U.S. Dollars in Thousands, Except per Share Data

Carrying value Dec. 31, 2009 $27,150

Valuation increase $172,850

Revised book value* $200,000

Long-term income tax provision ($51,850)

Increase in Shareholders' equity $121,000

Shares outstanding (000's) 30,285

Increase in shareholders' equity per share $4.00

* note: the increase in the value has been calculated using a 8% discount rate "

On top of the value of the royalty assets we need to add the value of the remaining shares of the other portion of KHD Humboldt Wedag's business that has not yet been spun off to shareholders, around 70% of the industrial plant technology, equipment and service company KID (KHDHF.PK).

KID has 30 million shares outstanding and they are currently trading at around $6/share. That adds up to a total market cap of $180 million. 70% of 180 million is worth $126 million. Divide $126 million by 30 million TTT shares outstanding and we're talking about $4.16/share worth of KID that has yet to be distributed or will be retained by TTT. Now KID probably isn't worth that entire amount to U.S. shareholders because it will only be traded OTC here and it will not be very liquid, but that's still a lot of hidden value.

Using these rough, back of the envelope numbers Terra Nova has an approximate book value of $13.66/share, while it is currently trading at only $10.10/share.

One of the reasons that spin-offs often unlock value in companies is because they make it easier for investors to see the true value of an assets. To me, the KHD spin-off looks like a complicated mess. Not surprisingly, the few investors who followed this obscure company seem to be frustrated by the complex nature of this transaction and they are selling the stock. I'll admit, this situation is a little too opaque for me to make a real money investment in at this point, but it's perfect for CAPS.

Here's a link to the company's recent investor press release for anyone who's interested:

Terra Nova Reports First Quarter Results for 2010

I'd love to hear others' thoughts on this situation. All of the above calculations were quick and rough back of the envelope sort of stuff. If I planned on taking a real position in this company I definitely would dig into this matter a little deeper.

Deej

No position in TTT