Iluka’s Iron Ore Upside

This story features ILUKA RESOURCES LIMITED. For more info SHARE ANALYSIS: ILU

The company is included in ASX200, ASX300 and ALL-ORDS

By Greg Peel

When one thinks of Iluka ((ILU)), one thinks specifically of mineral sands mining, with the company's two main products being zircon and titanium. Both are highly refractory elements used in coatings such as paints and ceramic glazes with a multitude of domestic and industrial applications. Zircon oxides come in many colours while titanium oxide is starkly white.

Iluka has long been a struggler in the Australian resources sector due in a large part to its high inverse leverage to the Aussie dollar, such that earnings in the commodities boom have been decimated by the related Aussie dollar appreciation. However, in recent times management has sought to protect earnings upside through medium-term currency hedging.

But what the investment community may often overlook is that Iluka also enjoys iron ore mining royalties from its Mining Area C. Morgan Stanley describes iron ore as Iluka's secondary driver of earnings.

Secondary it may be, but this week's news that Brazilian leading iron ore producer Vale is asking 114% over last year's contract price for this year's iron ore has finally given analysts the gumption to lift their price increase expectations above the earlier consensus level of 60%. Morgan Stanley is currently forecasting a 90% increase for the benchmark.

Benchmark annual (or this year probably quarterly) iron ore price increases are being driven by this year's spot price movements and while contract prices will settle at a slight discount for size and maturity, the world's large producers are pushing for that gap to be a lot closer this year. Morgan Stanley is nevertheless forecasting that 45% of Iluka's iron ore royalty stream will be priced on spot in 2010, rising to 90% by 2018.

Morgan Stanley suggests iron ore price settlements will be the trigger for analysts to begin upgrading consensus earnings estimates for Iluka.

But returning to Iluka's primary source of earnings, Morgan Stanley notes demand for the company's industrial minerals is also improving and the analysts expect prices to reflect stronger demand from around mid-2010, thus skewing Iluka's earnings into the second half. Zircon and titanium are typically late-cycle movers, lagging price hikes in the more heavily traded base metals.

As a result, the stockbroker has upgraded Iluka from Equal-weight (Hold) to Overweight (Buy) and increased its price target by 28% from $4.28 to $5.49 suggesting 33% upside from yesterday's trading price. The analysts suggest the “risk” of this call is further skewed to the upside.

FNArena's broker database currently shows a Buy/Hold/Sell ratio on Iluka of 4/3/2 and an average target of only $4.02.

Current consensus estimates assume Iluka's net profit this year (Jan-Dec 2010) will dive by some 23% from last year (deeper loss), but 2011 should see a more than doubling of earnings for shareholders (finally a profit again). If Morgan Stanley is correct, these numbers are about to change materially.

Iluka rates a relatively low 0.2 on the FNArena Sentiment Indicator.

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