Baffinland Iron Mines (TSX:BIM) Iron Ore – The Dragon is Hungry

Malcolm Bucholtz B.Sc, MBA Analyst

Trading Note

A Domestic Steel Industry is now an Option

A strong domestic steel industry used to be the hallmark of success for any advanced economy. Not so anymore, thanks to tighter environmental regulations, higher wage structures, expensive pension plans and costly health care benefits. Now it is perfectly acceptable for advanced economies to simply import steel from the so called BRIC nations – Brazil, India, China, Russia. Back in 2001, the BRIC nations accounted for 31% of world steel production. In 2007, this figure had increased to 48% as steel output in Japan, the EU and the USA declined. (1)

But what about Iron Ore?

Sourcing steel from developing nations is not as easy as it may appear at first glance. This notion takes on a sharper focus when one stops to consider that China only accounts for 14% of the world’s iron ore reserves and much of this stuff is low grade. This then begs the question, where will the iron ore come from to feed the steel mills in the developing nations? The answer is that this ore will come from places like Canada.

Enter Baffinland Iron Mines Corp (TSX:BIM)

Baffinland Iron Mines is a Canadian company focused on its 100% owned Mary River Iron Ore project in Nunavut Territory, Canada. The above map shows the location of the project. Interestingly enough, this area was explored back in the early 1960’s and 5 high grade deposits were discovered containing 120 million tonnes of iron ore grading 68% iron. Economics were not sufficient enough in the 60’s to justify advancing the project and the project went into dormancy. Today, however, with the Asian Dragon and other BRIC nations making rumbling noises for iron ore, the economics have improved.

Baffinlad has identified a goal of proving up enough resource to justify production of 18 million tonnes of direct shipping ore per year for 20+ years.

Baffinland has established good strategic relationships with Inuit peoples of the local Qikiqtani area, which is a huge positive factor in this day and age where far too many mining companies fail to show respect to the First Nations people.

Baffinland has been focused on what it calls Deposit #1 and it envisions employing conventional open pit mining techniques to extract ore at a stripping ratio of 1.6:1. Given the attractive iron content of the ore, a crushing and sizing operation is all that will be required to prepare product for shipment to market. From the mine site, train loads of product will travel 145 kms to the nearest sea port at Steensby Inlet for loading onto sea-going vessels.

Resources & Timelines

It is anticipated that the regulatory application process will consume much of the next 18 months. Mine site construction should be completed by early 2014 with the first product going to market by Q3 of 2014. Later in Q3 2008, a 250,000 tonne bulk sample of ore will be sent to five European steel mills for trial runs in their blast furnaces. Work is progressing well on this bulk sample exercise with a crushing plant now having been set up. At this time of writing, 47,000 tonnes of ore has been crushed and readied for shipment. The results from these trials when reported towards the end of 2008 will be a major market moving event.

At present, Baffinland has identified a Proven & Probable Reserve at Deposit #1 of 365 million tonnes grading close to 65% iron. At Deposits 1,2 and 3 a Measured & Indicated Resource of 52 million tonnes has been identified along with a further Inferred Resource of 448 million tonnes.

Project Economics

A feasibility study has now shown that the capital cost of bringing this massive project into production will be C$4.1 billion. Based on iron ore prices of US$67 for lump product and US$55 for sintered fines product and operating costs of $14.62 per tonne, on an after tax basis the project will repay capital costs in 4.3 years with an NPV (0%) of C$2.7 billion. With such huge capital costs, Baffinland has now started the search for a minority partner who wishes to take an equity position in the project and share in the capital cost funding.

Baffinland – Do the Math

Baffinland currently has a basic share structure of about 148 million shares outstanding after having just completed a financing to raise C$193 million. Fully diluted structure stands at 160.7 million shares. At the recent price of C$3.36, this equates to a basic market cap of about $497 million.

If I take the NPV of C$2.7 billion and divide by the fully diluted share structure of 160.7 million I arrive at a per share figure of $17. This shows the potential that Baffinland has for future share appreciation.

At The Market Traders we often employ a slightly different methodology where we assign a nominal value to the in situ resource. Taking the stripping ratio of 1.6:1 and applying it to the proven and probable reserves gives me a saleable quantity of iron ore of 228 million tonnes. Assuming that 80% of the measured and indicated resource will eventually end up as proven and probable, this gives a further 32 million tonnes. Lastly I will assume that 50% of the inferred resource ultimately becomes mineable. Using the 1.6:1 strip ratio this gives me 140 million tonnes of saleable product. Now, if I apply a nominal value to the in-situ saleable material of $4 per ton (which is 10% of what I deem to roughly be a longer term average iron ore price) I get a value of $1.6 billion. Dividing by the fully diluted share structure gives me about $10 per share.

Normally the NPV methodology is in close agreement with the nominal value per tonne of resource approach. In the case of Baffinland, there appears to be a divergence. This begs the question, why?

It appears as though what may be happening here is that market players are quite unsure as to how to value Baffinland. Permitting has yet to be completed. Construction has yet to start and 2014 is a long way off. What iron ore prices will be in 2014 is anybody’s guess. Lastly, the capital cost of building the entire project is a staggering C$4.1 billion. Practically all mining projects are suffering from huge cost over-runs right now, so what the ultimate price tag will be is quite unknown.

Add Baffinland to Your List (TSX: BIM)

Gord McCreary and his team at Baffinland have done a substantial amount of work on the Mary River Project. The iron ore market right now is booming as BRIC country steel output grows. The Mary River project hosts a very attractive resource but is not getting proper recognition in the marketplace due to the fact that production is not scheduled until 2014, permitting has not all been completed and the projected capital cost of C$4.1 billion will require a strategic partner which has yet to be identified.

At The Market Traders, we will be watching the Baffinland story with great interest. We are initiating coverage of Baffinland with a “speculative buy” rating on the stock. Fundamentally, the stock should be trading much higher than where it is at right now – closer to $10 per share in our estimation. Progress on the permitting front, the identification of a strategic partner and the current bulk sample program will provide a big measure of confidence for the markets. Technically, the stock is in a broad downward trending channel and has exhibited some excellent trading dips and rallies. Market players should pay strict attention to these dips and rallies and take advantage accordingly. For further information, be sure to visit the Baffinland website at www.baffinland.com.