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Morningstar | Iluka's 1H a Mixed Bag, But Underlying Fundamentals Remain Strong

Iluka's first-half 2018 net profit after tax of AUD 126 million was more than double the adjusted net profit of AUD 53 million in the first half of 2017 and slightly ahead of our expectations. The uplift was entirely due to higher prices with mineral sands revenue increasing 21% to AUD 607 million despite 3% lower combined zircon, rutile and synthetic rutile sales volumes of 439,000 tonnes. Adjusted group EBITDA was up 80% to AUD 279 million, driven by the higher prices. The contribution to EBITDA from the Mining Area C iron ore royalty was basically steady at AUD 29 million. Iluka's realised zircon price rose 46% to USD 1,240 per tonne while rutile was up 20% to USD 906 per tonne versus a year ago. Pricing momentum remains strong with the rutile price up 14% for the second half of 2018 while zircon will rise 11% from the fourth quarter of 2018.

We maintain our AUD 10.50 per share fair value estimate for no-moat Iluka. The unchanged fair value estimate reflects several negative and positive factors which broadly balance out. On the negative side, Iluka expects the cost to develop the Sembehun mine and expand the processing plant at Sierra Rutile to cost 40% to 60% more than the prior estimate of USD 300 million. In addition, the company will also incur higher operating costs at Sierra Rutile following unplanned outages in the first half. Iluka expects its unit costs of goods sold for the group to increase to AUD 725 per tonne from AUD 710 previously. The capital cost increase is an unpleasant surprise, a result of a prior estimate from Sierra Rutile's previous management team.

Offsetting those negatives are several positives. Further near-term zircon and rutile price increases are the key positive. Iluka has continued to sell inventories to support customer demand and faster than we expected. Inventories are now close to normal levels. Iluka has increased its 2018 zircon production guidance by 10% to 330,000 tonnes to help satisfy robust customer demand.

Iluka says demand for zircon is strong across all major regions and the market is tight, reflecting challenged supply, a hangover from the period of poor prices the industry recently emerged from. Iluka notes some customers are sacrificing product quality by using lower amounts of high-priced zircon. Management sees no evidence of zircon substitution yet given the price of substitutes such as alumina are also high. In titanium dioxide feedstocks, demand for pigment and pigment plant capacity utilisation remains high. This continues to favour Iluka's high-grade rutile and synthetic rutile feedstocks.

Near mine exploration in Sierra Leone is also positive and brings potential to extend the life of the existing mines. This may allow some of the capital required for Sembehun to be delayed. Exploration at Sembehun has also increased the resource by 14% to 5.0 million tonnes of rutile. This could facilitate greater production rates or longer mine life in future, or both. At Jacinth-Ambrosia, Iluka has scrapped plans to expand the processing plant by 30% to offset the decline in grade. Management believes it can now achieve similar zircon production rates for the next few years without the associated expansionary capital expenditure.

With the faster-than-expected drawdown of inventory, and robust first-half free cash flow of AUD 232 million, the balance sheet continues to improve. Net debt is now just AUD 34 million, down from AUD 305 million a year ago. This sees Iluka well placed for the planned period of elevated capital expenditure starting from the second half of 2018. Given the upcoming capital expenditure, Iluka paid out a lower-than-expected AUD 0.10 per share interim dividend. We've reduced our full-year 2018 dividend forecast to AUD 0.30 per share from AUD 0.40 previously as a result.