Improving Zircon Market A Positive For Iluka

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

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

By Chris Shaw

Commodity prices have struggled in recent months but fundamentals in some cases have improved over the same time, one example being zircon in the mineral sands market.

GSJB Were suggests there are two reasons for the tightening in market conditions. The first is that Chinese import tonnages have been higher than the broker had expected, currently running at record levels year-to-date.

The second positive for the market has been on the production side, as GSJB Were notes output growth in South Africa in particular has been a little weaker than forecast. This has been enough for the broker to lower its forecast zircon market surpluses through 2012. A return to a market deficit is not expected prior to 2013.

Producers are planning to implement price increases this month, but in the view of GSJB Were the key to whether or not these stick will be how much Chinese imports have added to any inventory build. If the Chinese are actually sitting on stocks of zircon, buyers are likely to push back against any proposed price increase.

To reflect this view GSJB Were has not changed its zircon price forecasts, though it notes price risk is at least positively skewed now. The broker's price forecasts stand at US$851 per tonne for this year and US$875 per tonne in 2011. These rise to US$940 per tonne in 2012 and US$1,000 per tonne in 2013.

The major mineral sands exposure in Australia is Iluka Resources ((ILU)), which is the world's largest producer of zircon and the second largest producer of titanium feedstock. The company accounts for about 35% of the global market in both cases.

Iluka's major projects are the Murray and Eucla Basins in Australia, with some other smaller assets in Western Australia and the US. The transformation of the portfolio has taken some time and significant amounts of money, but as BA Merrill Lynch notes the process has now essentially been completed.

The position is now that Iluka has two higher margin assets contributing 80-90% of group output, which should generate solid earnings growth in coming years. Additional earnings come via iron ore royalties from Mining Area C.

BA Merrill Lynch is forecasting earnings per share (EPS) of minus 2.4c this year, rising to 37.2c in 2011 and 52.2c in 2012. This compares to consensus forecasts according to the FNArena database of minus 3.9c this year and 36.3c in 2011.

As earnings improve BA Merrill Lynch expects the significant capex expenditure of recent years to be replaced by free cash flows, to the extent the balance sheet should be in a net cash position within the next 18-24 months. This opens up options for management including the resumptions of dividends, share buybacks or asset spin-offs in the broker's view.

Given BA Merrill Lynch's valuation on the stock is $6.22 the broker has reinstated coverage with a Buy rating as this implies a better than 30% premium to the closing share price yesterday of $4.75. Confidence in the value on offer at current levels is increased by the current tightness in fundamentals in the zircon market.

Effective delivery of recent projects should act as a catalyst for Iluka's share price in BA Merrill Lynch's view, while the major risk is Chinese demand given it represents 40% of global demand. The company is also leveraged to the Australian dollar, so currency movements offer another source of risk to the broker's estimates.

BA Merrill Lynch is not the first to recognise value in Iluka as the FNArena database shows the company is rated as Buy five times, Hold three times and Underperform once. Citi, which rates the stock as a Buy, recently lifted earnings estimates to reflect higher minerals sand prices.

In contrast, Deutsche Bank earlier this week lowered its earnings estimates in 2011 by 25% to reflect changes to its cost assumptions for the company. Deutsche continues to rate Iluka as a Hold, with a price target of $5.10. This compares to BA Merrill Lynch's $6.01 target and an average target according to the FNArena database of $5.27.

Shares in Iluka today are stronger and as at 11.50am the stock was up 8c at $4.95. This compares to a range over the past year of $2.71 to $5.14 and implies about 5% upside to the average price target in the database.

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