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Morningstar | Mineral Sands Cycle Maturing but Still Favourable for Iluka

We maintain our AUD 10.50 per share fair value estimate for no-moat-rated Iluka Resources. The shares have traded sideways since our last report almost three months ago and are close to fairly valued. Second-quarter 2018 production was slightly weaker than expected due to unplanned downtime in Sierra Leone; as a result, group production guidance for rutile was lowered 7.5% to 185,000 tonnes. Total zircon, rutile, and synthetic rutile production guidance for 2018 is down just 2.2% to 690,000 tonnes. However, sales volumes were stronger than expected, with inventory being drawn down faster than our estimate. First-half 2018 mineral sands revenue increased 20% to AUD 607 million. Higher prices were the key revenue growth driver.

Faster inventory drawdown means we’ve increased our expectations for 2018 sales volumes by about 10%. This is the primary driver of our new earnings forecast of AUD 0.57 per share versus AUD 0.49 previously. The benefit to our fair value estimate is offset by the reduction in sales from inventory in 2019 and our 7% lower earnings forecast of AUD 0.81 per share.

Zircon market conditions remain favourable and Iluka continues to boost sales by drawing down inventory. Iluka says demand is solid and the supply response to date is limited. High-cost competitor supply from Indonesia has increased somewhat from low levels, responding to the price incentive. We view this expected development as positive, as it helps support customer needs when demand for zircon is high and lowers demand for substitutes. Indonesian production should fall when demand conditions and prices decline, reducing oversupply risks. The cyclical upturn in demand for titanium dioxide pigment also remains in place, and with it demand for Iluka’s rutile and synthetic rutile. That said, the rate of price inflation for pigment may be slowing as the cycle matures. Pigment is used in products such as paints, paper, and plastics, with demand growth generally correlated to GDP growth.

Iluka is entering a relatively busy period of appraisal and development activity. We think this elevated expenditure and activity is reasonable, given the outlook for demand and the supply headwinds facing the industry due to declining grades. With net debt of just AUD 34 million at end June 2018, Iluka is embarking on these new developments from a position of financial strength.

Development of the new Cataby mine and expansions of Jacinth-Ambrosia in Australia and the Lanti and Gangama operations in Sierra Leone remain on schedule and budget. All are slated to start in 2019--Cataby in the first half, the others in late 2019. A feasibility study is under way on the Sembehun deposit in Sierra Leone with the goal to start production from 2021. The planned unconventional mining of deep zircon and rutile deposits in the Murray Basin, via directional drilling, is contingent on further test mining in 2019. Activity to progress Iluka’s extensive resources in Sri Lanka remains at an early stage.

With operating cash flow supported by strong prices, we think it’s likely Iluka’s balance sheet will continue to improve in the medium term, in the absence of a large cash return to shareholders, or a new acquisition. Given the heightened expenditure and activity on organic options, we think a large new acquisition is unlikely for at least the next couple of years. Maintaining a strong balance sheet is important to protect from excessive swings in prices for zircon, rutile, and synthetic rutile. Iluka needs to be in a strong financial position to allow it to reduce sales and build inventory if required. This is to balance industry supply if/when there is an unforeseen downturn in demand.