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Morningstar | Strong 2018 Result but Weaker Guidance Sees Iluka's AUD 10.50 Fair Value Estimate Unchanged

Iluka’s 2018 adjusted net profit after tax more than tripled to AUD 304 million versus AUD 96 million in 2017. It was a strong result and better than our AUD 254 million forecast with non-production related costs less and revenue better than expected. The impressive uplift was driven by higher prices, which added AUD 265 million to net profit. The realised zircon price rose 41% to AUD 1,321 per tonne and rutile 21% to AUD 952 per tonne. Higher unit costs and lower sales volumes were partial offsets, detracting from net profit by AUD 56 million.

Despite the stronger-than-expected 2018 result, we maintain our AUD 10.50 per share fair value estimate for no-moat rated Iluka Resources. Guidance for 2019 volumes and costs was weaker than we expected. Management is focused on stabilising operations and delivering consistent performance at Sierra Rutile after an unreliable and strike affected 2018. We suspect there may be a touch of conservatism in the guidance for rutile output and unit costs in Sierra Leone. Regardless, the outlook is weaker in the near term than we had previously assumed and Iluka’s original acquisition expectations. As a result, we’ve lowered our 2019 net profit forecast by 16% to AUD 349 million or AUD 0.83 per share.

Longer term we remain confident that continued investment in Sierra Rutile will yield unit cost gains and improved returns. The timing of the acquisition, at the depths of the last downturn, has given Iluka a margin of safety thanks to subsequent price rises. At the moment, that safety margin looks important and valuable. Despite the recent improvement in Iluka’s share price, due to stronger rutile demand and prices, the shares remain undervalued. Successful expansion, stable operations and lower unit costs in Sierra Leone are key to the share price converging to our AUD 10.50 per share fair value estimate.

Like many of its mining peers, Iluka is in strong financial shape. The balance sheet now has modest net cash of AUD 2 million versus about AUD 180 million net debt a year ago. The improvement reflected a 51% increase in net operating cash flow to AUD 627 million driven by higher prices and a modest drawdown of inventories. Lower inventories contributed AUD 86 million to cash flow. Iluka also paid very little cash tax in the period, but this timing issue will resolve in 2019.

The final dividend of AUD 0.19 per share fully franked brought the full-year payout to AUD 0.29 per share, down marginally on 2017’s AUD 0.31 per share payout. Dividends in 2017 were abnormally high, with the outlook for market conditions and prices set to improve and capital expenditure requirements low at the time. Iluka is now in period of elevated capital expenditure, which necessitates a lower dividend payout.

Iluka expects to invest AUD 330 million in 2019, primarily to complete the Cataby mine and Sierra Rutile expansions at Gangema and Lanti. All major developments are on schedule and budget. The feasibility study for the Sembehun deposit in Sierra Leone is also due this year. Early works for the development looks likely to start in 2019.

We look forward to news on the longer-dated development plans this year. Management is advancing and evaluating several potential options. In Australia, the company seeks to unlock its extensive fine minerals deposits with novel processing. A final trial of its unconventional mining technology will be undertaken in the Murray Basin in a bid to unlock high-grade but deep rutile dominant resources. Iluka is also evaluating the restart of a second synthetic rutile kiln in Western Australia and the potential for a large ilmenite deposit in Sri Lanka continues.

Of the longer-dated development options, expansion of synthetic rutile production looks the lowest risk. Capital investment should be relatively low with Iluka able to leverage existing mothballed assets. Our fair value estimate assumes a 50% chance this option will proceed.

Iluka reiterated its recent view on the mineral sands markets with demand overall tracking as expected. Zircon consumption was relatively soft in the fourth quarter of 2019, but the first quarter has stabilised, and management expects a recovery by mid-year. Customer zircon inventories are low, and restocking remains a potential additional demand source. Iluka still sees the zircon market as balanced with the firm’s swing production of zircon in concentrate required to satisfy demand and balance the market. A structural deficit is still emerging longer term due to challenged supply.

Iluka will maintain current zircon prices until the fourth quarter of 2019. We agree with the company’s strategy to slowly increase prices, allowing time for customers to adapt and Iluka to evaluate the impact of price changes on demand. We think avoiding demand destruction where possible and the build of excess inventory downstream are key to avoid the mistakes of the last downturn.

The market for titanium dioxide feedstocks, such as rutile and synthetic rutile, remains strong. Iluka says it is unable to satisfy customer inquiries for high-grade feedstocks, in part a function of the company’s production issues at Sierra Rutile. Management expects strong demand in 2019 and higher-grade feedstocks, as Iluka produces, to do well. As with zircon, Iluka expects medium-term rutile supply to be similarly challenged by the depletion of higher-grade reserves.