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Morningstar | Tight Supply Underpins Positive Outlook for Iluka Resources, AUD 11 FVE Maintained. See Updated Analyst Note from 15 May 2019

No-moat-rated Iluka's share price is down almost 30% since May 2018 highs above AUD 12 per share. The sell-off reflects concerns that prices of zircon and titanium dioxide feedstocks will decline and came despite a modest rise in the S&P/ASX 200 Resources index. We generally see global metals and mining firms as overvalued, but not Iluka. The market is too pessimistic on the outlook for prices. Demand growth for zircon and titanium dioxide feedstocks is only likely to be steady, but supply constraints underpin our optimism. Producing mines are depleting and grades in decline. Also, the bench of replacement deposits are generally of lower quality and prices will need to remain favourable to incentivise supply.

Cost increases and disruptions at Sierra Rutile also weigh on investor sentiment and see concerns Iluka's planned expansions in Sierra Leone will destroy value. But Iluka has a strong operational track record. It's also unreasonable to extrapolate recent issues at an aging mine, now finished, to new capacity being built. With the shares at more than a 20% discount to our unchanged AUD 11 fair value estimate, we think shareholders are being compensated for the risk.

The zircon and rutile price recovery lagged other commodities and has further to go. Both are late-cycle commodities. Zircon is primarily used for tiles, ceramics and porcelainware. About 90% of titanium feedstocks--rutile, synthetic rutile, upgraded slag and ilmenite--are used to make pigments for paint, plastics, and paper. The market is too pessimistic on the outlook for zircon and rutile prices. Depletion of higher-grade orebodies and a weaker bench of replacements mean prices should sustain around current levels. Industry dynamics are favourable and likely to support attractive returns. The three largest producers of zircon and high-grade titanium dioxide feedstocks account for about 70% of supply global.

Iluka's medium-term developments should underpin modest volume growth. The firm's inventory of undeveloped projects and execution record mean it's unlikely production will fall longer term. The market underestimates the value of the Mining Area C iron ore royalty. It brings a stable and growing source of cash flow with no costs. BHP is nearly tripling output. This low-risk cash flow is worth around AUD 3 per share, more than one fourth of our AUD 11 per share fair value estimate.