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Morningstar | Temporary Production Headwinds for Iluka Sees Value Emerging

A couple of clouds have gathered around Iluka in the form of a strike and worse than expected mining performance at the company’s operations in Sierra Leone. More importantly, the underperformance of the dredge at Sierra Leone, set to decommission in early 2019, sees some investors questioning Iluka’s substantial investments to expand production at Sierra Rutile. The new production issues build on unpleasant news in August. Unplanned first-half outages at Sierra Rutile raised the expected fiscal 2019 unit costs of goods sold for the group to AUD 725 per tonne from AUD 710 previously. In addition, Iluka said the capital cost to develop the Sembehun mine would be 40% to 60% above initial estimates.

The ongoing issues at Sierra Rutile seem the key driver of the decline in Iluka’s share price. From a peak of around AUD 12 per share in May 2018, the shares have fallen about 30% to AUD 8.50, wiping about AUD 1.5 billion from the market capitalisation of Iluka. The price reaction greatly exceeds the headwinds to the fundamental valuation and the shares now screen as undervalued. Despite the current round of production issues, we’ve maintained our AUD 10.50 per share fair value estimate. For now, the evidence says Iluka can improve the performance of Sierra Rutile and right the ship.

Weaker near-term production sees our fiscal 2019 earnings forecast decline 12% to AUD 0.57 per share. However, this is not enough to drive a change in our fair value estimate or to explain the decline in the share price. The market appears to be extrapolating these concerns into future years, but this discounts Iluka’s ability to effect management changes and improve productivity. These actions are already underway. In addition, market conditions for mineral sands generally remain strong and the decline in the AUD/USD exchange rate to 0.71 is a modest benefit. The Australian operations, which produce virtually all of Iluka’s zircon, continue to perform strongly.

Market conditions for mineral sands remain favourable. Iluka has increased the reference price for zircon by 12% starting October, and it will be in force for six months. The company’s approach to manage the price increases in consultation with customers should help to mitigate the risk of excess inventories building in the supply chain. In the last boom, rapid appreciation of the zircon price and speculative buying by customers ahead of real demand caused problems. High prices led to demand destruction and a material inventory overhang, which sowed the seeds for the ensuing bust.

This time around, we think the slower appreciation of the zircon price, a growing customer preference for higher quality tiles and a weaker outlook for zircon supply should see more of the price gains retained through the cycle. Iluka upgraded its guidance for zircon production in August to help ensure continuity of supply. The aim was also to dissuade customers from reducing the quantity of zircon used or from seeking poorer quality substitutes out of perceived necessity. Zircon remains a small single-digit percentage of the price of a finished tile, and price appreciation has been needed to incentivise longer-term supply. By extension, some of the price gains since the last trough should be sustainable. We think the current reference price of USD 1,580 per tonne is likely close to the peak. Our fair value estimate factors in an approximate 26% decline to our unchanged midcycle assumption of USD 1,250 per tonne.

The market for titanium dioxide feedstocks is also still positive with pigment producers maintaining high rates of plant utilisation. This sees continued strong demand for high-grade feedstocks, like the rutile and synthetic rutile Iluka produces, to maximise pigment plant productivity. Iluka says some of its customers are concerned if there will be enough high-grade feedstock available in 2019, suggesting potential for the market to further tighten in 2019.