Iluka Staring At More Downside

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

– Zircon/titanium prices continue to fall
– Price floor may be 6 months or more away
– Iluka looking at cash burn
– Deutsche downgrades to Sell
 

By Greg Peel

Last year when the rare earth metal market was driven into a spectacular price bubble, mineral sands products were swept along in the tide. The zircon and titanium derived from mineral sands are not rare earth elements, but there are similarities in that production development of both had been neglected over decades, and large deposits are relatively rare. Australia's Iluka Resources ((ILU)) boasts the largest reserves and production globally – a clear leader amongst a mere handful of commercial producers.

A clear difference is that China controls the global rare earth market but has no mineral sands to speak of. Hence while the rare earth price bubble was directly related to Chinese export restrictions, and a herd mentality, the simultaneous bubble in zircon/titanium was more a case of rocketing Chinese demand meeting limited supply. The herd, again, did the rest. Zircon is used primarily to make pigments used in the production of tiles (think bathroom, kitchen, floor) while titanium oxide produces the pigment that puts the “white” in “whitegood”. Exponential Chinese demand was not hard to justify given the substantial shift of the Chinese populace towards middle class home ownership.

The rare earth price bubble all but destroyed the rare earth industry, such that when China finally eased export restrictions prices went into a free-fall from which they are yet to recover. As rare earth prices fell, so too did zircon/titanium prices. To a large extent this was by association, but the price peak also represented the point at which China was just going to buy more product. Along the way, China had been stockpiling, as it is wont to do, so when prices became too ridiculous, consumers started drawing down inventory.

They've been doing so ever since.

Hence began the age old game among analysts oft called “catching the falling knife” in which a price floor is estimated. To date, analysts have been proven overly ambitious. In what has seemed like a heartbeat, Iluka has gone from desperately ramping up mineral sands expansion projects to limiting production in the hope of arresting price falls. To top things off, Iluka is one resource producer very sensitive to the currency, and the strong Aussie is certainly not helping.

Last week UBS decided destocking was still underway right across the zircon and titanium production chains, notwithstanding weak end-consumer demand, such that prices are expected to remain under pressure at least in the near term. UBS doesn't which to commit, but suggests prices will likely recover sometime between the second quarter of 2013 and 2014 in general.

As far as Deutsche Bank is concerned, price weakness will continue for at least six months. The earlier price spike affected some long-term demand destruction, the analysts suggest, and despite destocking, inventories remain elevated.

Iluka is showing flexibility, Deutsche notes, in cutting operating costs and capex, but the analysts believe the company will suffer negative free cash flow over the next twelve months. Shareholders can rest a little easy that Iluka can always draw on its debt facility to enure consistent dividend payments as the company waits for the tide to turn back again, but in the meantime Deutsche has cut its FY13 earnings forecast by 80%.

This leads to a target price cut to $7.55 from $10.00, and prompts a downgrade to Sell from Hold.

Deutsche now joins Macquarie on a Sell or equivalent rating, following the latter's downgrade last month. CIMB has been sitting on a Hold rating since July, but all other FNArena database brokers, who have each updated their views over October and up to the end of November, retain Buy ratings.

What we're left with is a pretty wild spread of target prices. Consensus is $11.02, which is 35% above the current trading price, but consensus means little when targets range from Macquarie at $6.50 to Citi at $16.80.

Deutsche is expecting the market to de-rate Iluka over the coming months, and it way well follow that other brokers will start downgrading their ratings and targets as well. Zircon and titanium prices have already dropped through what maost had previously considered to be floor price levels, and as both Deutsche and UBS note, there is no immediate end in sight to p[rice weakness.

Interestingly, UBS maintains a Buy rating on Iluka, with a target of $11.00 reassessed in October. Are the commodities analysts and stock analysts not on speaking terms, or is UBS just holding out for the longer term bounce? Target prices are, after all, supposed to reflect a 12-month view.
 

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