An Analysis of Northland Resources & The Iron Ore Market

Copenhagen Business School MSc. Finance & Strategic Management Master Thesis: August, 2012

Author: Daniel Bergman CPR-Nr: 24-08-88-DAB1 Phone: 0046(0)76-3192716 Pages: 78 Characters: 184,330

Supervisor: Ole Risager

Executive Summary
This thesis is written from an investors 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 markets 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 todays 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 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 Northlands 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 years 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. 1

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 1.3.2 1.3.3 1.3.4 1.3.5 1.3.6 1.3.7 Chapter II The Story of Northland Resources ................................................................. 7 Chapter III Strategic Analysis .......................................................................................... 8 Chapter IV Budgeting ...................................................................................................... 8 Chapter V Forecasting ..................................................................................................... 8 Chapter VI Valuation ....................................................................................................... 9 Chapter VII Conclusion ................................................................................................... 9 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 2

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 Porters 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 3

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. Chinas 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 4

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

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 worlds 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 worlds 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.

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 Resources 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 Resources 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 Resources history, organizational structure, and business model. This part presents complete insights about the firms development and organizational structure. The historic

development of Northland Resources provides an indicator of the firms 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
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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 companys 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 investors 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
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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
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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.

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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 Northlands history, organization, and corporate governance. Northland Resources is the worlds fastest Greenfield mining project in the world. The company is publicly listed on stock exchanges in Oslo, Toronto, and Frankfurt. Northlands 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
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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 Socit Gnrale, 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).
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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 Pitkjrvi 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
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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
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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 Ruutijrvi, Salmivaara, and Karhujrvi. 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 1990s; 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.
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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. Northlands 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. Northlands 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).
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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
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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 Northlands 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 Northlands 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 managements 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
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Executive Chairman and CEO & President in the previous 3 years is presented in appendix 2.12. Northlands 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. Northlands 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 todays 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).

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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 Mkel, 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 Northlands large shareholders. In addition the directors are independent from Northlands 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 committees 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 Mkel and Stuart
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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 Mkel 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 Mkel 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 Mkel 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
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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.

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3. Chapter III The Strategic Analysis

This section will provide an extensive analysis of Northlands position for value creation. The single most important factor affecting Northlands profitability is the underlying price of the companys 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 Northlands 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 19061923, 19331953, 19681982, 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
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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 1970s 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

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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).
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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 poors 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

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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 1960s 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 worlds 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
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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. Northlands iron ore concentrate will contain a high Fe grade of 69 percent and low impurities (see appendix 3.9). Northlands 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).

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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).

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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 steels 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). Chinas 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

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industrialization and urbanization of Chinas 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). Chinas 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 Northlands 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

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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 Northlands 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
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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 Northlands 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 Porters 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
34

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 Northlands 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. Metsos products are important to the mining industry and especially to Northland. Switching would not be an option because of the extremely high switching costs. Metsos EBIT margin for mining equipment is about 10-15%, which is an indicator that they could have a relatively high bargaining power (Metso, 2012).
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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 companys 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 Northlands iron ore concentrate will start by trucks on the 150km roadway from the Kaunisvaara mine to a transshipment terminal in Pitkjrvi 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 Pitkjrvi. These trains will then transport the iron ore on the 226 km Malmbanan railway from Pitkjrvi to the Fagernes terminal in Narvik, Norway. Three trains per day are expected to go between Pitkjrvi 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).

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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 Pitkjrvi 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 Metsos 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 Northlands 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 Northlands strategic position.
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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.

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4. Chapter IV Budgeting
This chapter is focused on examining the iron ore price structure and Northlands cost structure. Northlands 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 companys 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 worlds 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 Northlands 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.
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4.2 Cost Structure

The major components of the cost structure for Northlands 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 companys salaries, share based payments, consulting, and auditor fees. Other operating expenditures include write-offs and impairment costs on exploration and mine development assets.
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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 companys 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 companys 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 semiannual interest payments, on March 6 and September 6. The bonds maturity date is on March 6, 2017 (Northland Resources, 2012a).
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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 companys 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 northlands 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.

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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 Northlands 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 Bstable by Standard and Poors and Caa1 by Moodys. 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 markets risk appetite and the risk characteristics of Northlands 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 firms assets are capitalized costs based on the
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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.

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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 worlds 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 worlds 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

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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 todays 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 Canadas total iron ore production. The company that produces the most in North America is Cliffs Natural resources. They produce 12 Million ton annually in Canada and 23 Million ton annually in the U.S. Arcelor-mittal is a multinational

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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 worlds 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).
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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 Billitons 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 Australias iron ore producers are the congested harbors. All the iron ore companies in Australia have fairly easy access to capital and have all

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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. Chinas 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 Chinas state-owned investors and banks when making large capital investments in operationally risky projects (Hurst, 2011).

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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 475575 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 Indias increasing domestic iron ore consumption and taxing of iron ore exports. The largest reserves in India are predominantly located in the countrys 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 regions 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 societys 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
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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 worlds 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 countrys 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.
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This is in line with JP Morgans 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 Chinas 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
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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. Chinas 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 Chinas 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 Chinas 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
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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 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. Chinas 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 Chinas dominance in the iron ore market combined with a saturated demand in developed markets, I
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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 todays 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

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vessels from Narvik to China is estimated to be $36/ton according to Northlands 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 worlds 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 Northlands 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 Northlands 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 companys 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).

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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. Northlands 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
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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. Northlands 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 Hannukainens 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. Northlands 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. Todays 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.

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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 Northlands 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 Northlands 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 Northlands. The life of mine is of today only expected to be 15 years,
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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 Northlands 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. Northlands 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. Northlands market capitalization divided by the total NPV of Kaunisvaara and Hannukainen equals 0.275. This is still higher than Dannemoras 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 Northlands 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 countrys 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 todays 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 years. My fair value of Northland is estimated to be 2.18 NOK. This would represent a 56.4 percent decline from todays 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 Northlands 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 governments 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.

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7.1 Downside Risks

Downside risks are risks that would result in a lower than expected value of Northlands 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.

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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
Northlands 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
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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.

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8. Chapter VIII Perspectives

In this chapter I will reflect on the past of Northlands 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

Northlands 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 managements 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 kesjokisuu, 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
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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).

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Unfortunately the summers 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 Affrsvrlden issued a buy recommendation in October. Their main reason was considering Chinas 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
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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 (Sderlind, 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 Affrer 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 Northlands operations unprofitable should be viewed as very low (Karstrm, 2012). Karl-Axel Waplan expressed his concern about a continued fall in iron ore price in the newspaper, Privata Affrer: It has to occur a complete stop in China, for us to be at risk- Karl-Axel Waplan, (Karstrm, 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.

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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 Northlands 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 Waplans 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 Europes 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) KarlAxel Waplan was questioned about the new supply from African mines. He replied that the quantities are so vanishingly small (Sundqvist, 2011). Northlands 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)
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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 (Brobck, 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). Northlands 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.
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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 companys gigantic stock option plan, where a maximum of 15 percent of the outstanding shares can be reserved for stock options (Northland Resources, 2011b).

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8.2.4 Representativeness, Confirmation & Availability Bias

Representativeness heuristics distorts a managers 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), Northlands 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 years 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.
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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 CEOs view point. Only in fairytales are emperors told that they are naked.- Warren Buffett, (Buffett, 2009) Northlands management is in my point of view characterized as a group of highly homogenous experts. This could lead them to reinforce each others 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. Robertos (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 Northlands 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
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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.

Northlands 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.
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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 companys 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 Northlands 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 Companys 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) Northlands 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.

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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

89

Appendix 2.4 Northland Resources Annual Report, 2012

Appendix 2.5 Source: Northland Resources Annual Report, 2012 Management Team Anders Hvide Karl-Axel Waplan Eva Kaijser Peder Zetterberg Peter Pernlf Manfred Lindvall Petri Peltonen Anders Antonsson Hans Nilsson Jonas Lundstrm Patrick Foster Jukka Jokela Bernt Hedin Willy Sundling Current Position Executive Chairman President & Chief Executive Officer Chief Financial Officer Acting Chief Financial Officer Chief Operating Officer Vice President - Environmental, Health, and Safety Vice President Exploration Vice President Investor Relations Vice President Marketing Vice President Human Resources and Corporate Communications Director, Finance Vice President Finnish Operations Project Manager Project Manager Logistics Joined Northland Jan-09 May-08 Apr-10 Jan-12 Dec-10 Sep-08 Sep-08 Apr-11 Jun-08 Apr-08 May-10 Sep-08 Jun-12 Dec-10

Appendix 2.6 Source: Own Creation, Northland Resources Annual Report, 2012

90

Appendix 2.7 Source: Own Creation, Northland Resources Annual Report, 2012

Appendix 2.8 Source: Northland Resources Corporate Presentation June, 2012

91

Appendix 2.9 Source: Northland Resources Equity Prospectus, 2012

92

Appendix 2.10 Source: Northland Resources Corporate Presentation March, 2012

Appendix 2.11 Source: Northland Resources Corporate Presentation June, 2012

93

Compensation Option Based Compensation Executive Chairman CEO & President Total Salary Executive Chairman CEO & President Total Total Compensation Executive Chairman CEO & President Total

2009

2010

2011

$ 298,580 N/A

$ $ $ $ $ $ $ $ $

327,768 479,128 806,896 392,028 302,290 694,318 719,796 893,632 1,613,428

$ $ $ $ $ $ $ $ $

264,315 311,289 575,604 471,571 531,549 1,003,120 735,886 964,330 1,700,216

$ 277,577 N/A

$ 576,157 N/A N/A

Appendix 2.12 Source: Own Creation, Northland Resource Information Circular 2009, 2010, 2011
3.5 3 2.5 2 1.5 1 0.5 0 2009 2010 2011 2012 Today Weighted Average Exercise Price Northland Stock Price

Appendix 2.13 Source: Own Creation, Northland Resource Information Circular 2009, 2010, 2011

94

Appendix 3.1 Source: Anderlini, 2012

Appendix 3.2 Source: Montier, 2010a

Appendix 3.3 Source: Montier, 2010a

95

Appendix 3.4 Source: Bloomberg, 2012

Appendix 3.5 Source: Montier, 2010a

96

Appendix 3.6 Source: Northland Resources, 2012l

Appendix 3.7 Source: Index Mundi, 2012

Appendix 3.8 Source: Index Mundi, 2012

97

Northland Resources Iron Ore Concentrate Fe Sulphur (S) Silica (SiO2) Alumina (Al2O3) Lime (CaO) Phosphor (P2O5) Magnesium Oxide (MgO) Titanium Oxide (TiO2) Particle size Moisture (H20) 69% 0.05% 1.10% 0.18% 0.04% 0.04% 2.65% 0.08% 40 micron ~6%

Appendix 3.9 Source: Northland Resources Corporate Presentation June, 2012

Appendix 3.10 Source: U.S Geological Survey, 2012

98

Appendix 3.11 Source: U.S Geological Survey, 2012

Appendix 3.12 Source: World Coal Association, 2010

99

Appendix 3.13 Source: Mackenzie, 2012b

Appendix 3.14 Source: Guo & NDiaye, 2009

100

China Fixed Asset Investments

300,000.00 250,000.00 200,000.00 150,000.00 100,000.00 50,000.00 2003 2004 2005 2006 2007 2008 2009 2010 China Fixed Asset Investments

Appendix 3.15 Source: Own Creations, China Bureau of Statistics, 2011

Proportions of Fixed Asset Investments in 2000

Manufacturing Others Real Estate Transport

Proportions of Fixed Asset Investments in 2010

Manufacturing Others Real Estate Transport

Appendix 3.16 Source: Own Creation, China Bureau of Statistics 2011

101

Appendix 3.17 Source: IMF, 2012

Appendix 3.18 Source: IMF, 2012

102

Appendix 3.19 Source: Northland Resources, 2012

Appendix 3.20 Source: Northland Resources Corporate Presentation February, 2012

103

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.

104

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.

105

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

106

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.

107

Apendix 5.13 Source: J.P. Morgan, (2012)

Apendix 5.14 Source: Mackenzie, (2012a)

Apendix 5.15 Source: J.P. Morgan, (2012)

108

Apendix 5. 16 Source: MacKenzie, 2012a

Apendix 5.17 Source: Raw Materials Group, (2011)

Apendix 5.18 Source: Dannemora, 2011

109

Apendix 5.19 Source: Bloomberg (2012)

4000 3500 World Total 3000 2500 2000 1500 1000 500 0 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Moderate Conservative Asia Australia South America CIS North America Africa Europ

Apendix 5.20 Source: Own Creation, using data from annual reports, company presentations and industry reports of Northland Resources and their competitors.

110

Apendix 5.21 Source: Own Creation

Apendix 5.22 Source: Metalytics, (2009)

111

Apendix 5.23 Source: Northland Resources Corporate Presentation June, 2012

112

Appendix 6.1 Source: Own Creation

113

Apendix 6.2 Source: Own Creation

Apendix 6.3 Source: Own Creation

Apendix 6. 4Source: Own Creation

114

Apendix 8.1 Source: Northland Resources, (2012)

Apendix 8.2 Source: Yahoo Finance, (2012)

115

Apendix 8.3 Source: PriceWaterhouseCoopers, (2012).

Apendix 8.4 Source: PriceWaterhouseCoopers, (2012).

116