Case Synopsis: Baffinland Iron Mines Corporation
Set in 2010 against the backdrop of the global iron ore industry, the case is about Baffinland Iron Mines Corporation, which is caught in a tug of war between Nunavut Iron Ore Acquisition Inc. and Arcelor-Mittal. Both Nunavut and Arcelor-Mittal have their eyes set on Baffinland's Mary River project, which consists of seven deposits and reserves of 865 million tonnes of high grade, direct shipping iron ore in deposits 1-3 alone. The Mary River project has been hailed as one of the best undeveloped iron ore deposits in the world. However, with the onset of the global financial crisis, the project fell on hard times and owing to a lack of financing partners, Baffinland found itself unable to move forward with the project's development. Between October 2007 and September 2010, Baffinland's share price plummeted almost 90% from $4.68 to $0.56 and seeing this as an opportunity to secure ownership of a lucrative asset that was currently trading at a discount, Nunavut made a bid to acquire all shares of Baffinland at $0.8 per share, valuing the company at $274 million. The offer was met with much consternation from Baffinland's board, which set out to look for alternative bidders. High on its list was Arcelor-Mittal and what ensued was a series of competitive bids. As of December 2010, Nunavut had raised its bid price to $1.35 per share for a 50.1% stake in Baffinland and was offering shareholders 2% royalty on the potential sale of iron ore. Pitted against this was Arcelor-Mittal's $1.25 per share bid for at least 50% and 1 share in Baffinland and C$0.1 for each 2007 warrant. Nunavut is now faced with the dilemma of how it should react if Arcelor-Mittal further raises its bid. With the aim of resolving this dilemma, several valuation methods have been applied to determine an appropriate bid price for Baffinland. The results, along with an analysis of Nunavut's and Arcelor-Mittal's strengths and weaknesses were used to recommend a course of action for Nunavut. Problem Statement To determine an appropriate value for Baffinland Iron Mines Corporation and use this as the basis for recommending whether Nunavut should strive to match a potential higher bid from Arcelor-Mittal and/or provide additional benefits to enhance the attractiveness of its offer. Results from Different Valuation Methods Discounted Cash Flow Analysis (DCF): Drawing on the resource, price and cost estimates from Baffinland's 2008 report, three different scenarios, namely base, optimistic and pessimistic were evaluated through DCF analysis. The assumptions of the base case are:  Given the proven and probable reserves of 365 million tonnes in Deposit 1, a mine life of 21 years can be sustained, with annual production of 18 million tonnes in the first 20 years (starting in 2016) and 5 million tonnes in the final year (2036)  Sales of 18 million tonnes will be distributed equally between lumps and fines. Since prices of fines are estimated to drop by 4.68% per year between 2011-15, it has been assumed that this declining trend will continue till 2022, after which prices will stabilize.  Operating costs will increase 2% per year in line with the average annual inflation rate in Canada over 2001-10, while transportation costs will be $22.5 per tonne.
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The capital costs of $4.1 billion will be depreciated, straight line, over the mine's life A 38% tax rate and 9% discount rate have been used, with the latter reflecting a 2% premium over analysts' 2008 estimate in view of the increased volatility of financial markets after the global financial crisis. The results from all three scenarios (assuming iron ore is transported using only rail) is shown in Table 1 (page 3). Notably, the base case estimate of over $632 million places a higher value on Baffinland than that implied by the competing bids, while the optimistic NPV of $2.77 billion is at par with analysts' estimates. Baffinland also had an option to start limited production in 2013 using road haulage, but since this option yielded negative NPVs under both self-management and use of a contractor, only rail transport should be pursued.   Black-Scholes Option Pricing Model: While the DCF valuation shown above is based on the resources already proven to exist in Deposits 1-3, it has not taken into consideration the potential value that may be derived from exploration of Deposits 4-7. The company which acquires Baffinland today will have the opportunity to explore and commercialize these 4 deposits in the future, and hence, the opportunity to invest in Baffinland can be interpreted as a real option. Baffinland shares should therefore trade at a higher price than the calculated NPVs suggest and based on the conservative assumption that Deposits 4-7 will have half the resources in Deposit 1-3, but require the same capital budget, the Black-Scholes Model was applied to determine the value of the option to explore Deposits 4-7. This value was found to be about $417 million (shown in Table 1), and upon adding this to the base case NPV from DCF analysis, it was found that the total value of Baffinland should be $1.05 billion. Comparable Transactions Approach: Using the average enterprise value/resource multiple of precedent transactions for mines in the development stage, a value of $472.68 million was found for Baffinland. On the other hand, using average Price/NAV for precedent transactions and analysts' estimated NAV of $2.7 billion, Baffinland should be valued at $2.56 billion. Insights from SWOT Analysis The comparative SWOT analysis for the two bidders indicates that Arcelor-Mittal, the largest steel-maker in the world, with $2.9 billion net profit in 2010 alone arguably has the higher financial strength. Despite the recent downgrade in credit-rating, the company's times interest earned ratio over 5, reduced debt-equity ratio and strong cash position in 2009 seem to point to an ability to expand freely. Nunavut's strengths include its Canadian origin, backing from Texas based Energy and Minerals Group and strong management team. However, the strategic benefits to Arcelor-Mittal from the acquisition seem to exceed those for Nunavut. First, acquisition of Baffinland will provide a jump start to Arcelor-Mittal in the direction of achieving its iron ore production targets and second, such backward integration will provide a buffer to its steel plants against volatile iron prices. Third, the overall low shipping cost and distance from Canada to Europe would provide cost benefits to Arcelor-Mittal's steel manufacturing operations in Belgium. In contrast, for a company with financial limitations such as Nunavut, continuing the bidding war with Arcelor-Mittal, which is also a huge customer of iron ore, may prove to be a costly option both now and in the future, and the
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company may have far greater difficulty in dealing with uncertainties such as those created by the adverse physical location of Mary River Project and volatile iron prices.
Table 1: Results from Valuation Methods
DCF Analysis Base Case (Rail Only) Best Case (Rail Only) Worst Case (Rail Only) Base Case (Rail and Road With Contractor) Base Case (Rail and Road Without Contractor) Black-Scholes Option Pricing Model Base Case NPV Value of Option to Explore Deposits 4-7 Total Value Comparable Transactions Approach Enterprise Value/Resource Multiple Price/NAV Multiple NPV or Value $632,580,466.63 $2,769,046,534.06 ($541,027,283.12) ($496,565,184.11) ($444,279,816.98) NPV or Value $632,580,466.63 $417,510,019.00 $1,050,090,485.63 NPV or Value $472,675,000.00 $2,556,000,000.00 3.06 Price/Share (Undiluted) 1.38 7.45 2.67 Price/Share (Diluted) 1.20 6.50 Price/Share (Undiluted) 1.84 8.07 (1.58) (1.45) (1.30) Price/Share (Undiluted) Price/Share (Diluted) 1.61 7.04 (1.38) (1.26) (1.13) Price/Share (Diluted)

The Recommendation Results from the overwhelming majority of valuation methods indicate that the bids placed so far by both Nunavut and Arcelor-Mittal have underestimated the value of Baffinland. Given the importance of considering the value of the option to explore Deposits 4-7, we believe that the most reasonable bid price per share is $2.67, which was found by adding the results of the base case scenario from DCF Analysis and the Black-Scholes Option Pricing Model. Now, assuming that the $274 million which the Energy and Minerals Group has agreed to finance is the maximum amount available to Nunavut for bidding, there are two strategic options:  Bid the maximum price possible given the budget available and the desire to acquire 50.1% stake i.e. 162,394,332 shares. This price is calculated as $1.69.  Bid a price of $2.67 per share and acquire 102,647,024 shares for a 26.09% stake in Baffinland. We recommend that Nunavut should proceed with the second option while keeping the royalty offer open for the following reasons. First, raising the bid may confirm the support of the institutional investors who are already showing interest in Nunavut's offer and second, targeting for a smaller portion of Baffinland may cease the bidding war with Arcelor-Mittal, in which the latter will always have an advantage. Nunavut already owns 5.18% of Baffinland shares and acquiring an additional 26.09% will give it a total stake of 31.27%, keeping the option open for Arcelor-Mittal to acquire 66.67% as it originally desired. By taking this approach, Nunavut could avoid the need to bear the majority of the development costs and risks of the Mary River project, while simultaneously retaining the option to enjoy a significant portion of the profits and the synergistic effects of an alliance with Arcelor-Mittal.
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References “How to Value a Mining Stock ” by Paul Vane Eeden, January 16, 2006. Retrieve from: http://www.kitco.com/weekly/paulvaneeden/jan162006.html • “Mining Investing: Deconstructing Mining Asset NAVs” by ADK · in Metals & Mining Investing, January 23, 2013. Retrieve from: http://multistrategy.org/2013/01/23/mining-investing-deconstructing-mining-asset-navs/ • “The Valuation Of Advanced Mining Projects & Operating Mines: Market Comparable Approaches” by Craig Roberts, National Bank Financial. Retrieve from: http://thamdinhgia.org/uploads/218/VALDAYCraigRoberts.pdf • “Valuation of a mining company” By Equity-Research.com ,September 3, 2011 . Retrieve from: http://equity-research.com/valuation-of-a-mining-company/ • “Valuation of Metals and Mining Companies”, Svetlana Baurens, 7.11.2010.Retrieve from: http://www.basinvest.ch/upload/pdf/Valuation_of_Metals_and_Mining_Companies.pdf •

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