Rocky Road Ahead For Iluka Resources

This story features ILUKA RESOURCES LIMITED, and other companies. For more info SHARE ANALYSIS: ILU

-Downgrades to earnings estimates
-China's property market soft
-Question over dividend levels

By Eva Brocklehurst

Towards the end of last year, reports on the mineral sands industry signalled a weakening trend for prices. For 2016 so far this is being confirmed, with brokers observing a period of price stability could be nearing an end. This spells the start of a rocky road for Iluka Resources ((ILU)).

The company has matched its peers, conceding to a US$100/tonne reduction in zircon pricing for the June quarter. Tronox was the first to announce a price cut, followed by Rio Tinto ((RIO)). The three major players represent 65% of the market. Rio Tinto's action puzzled Deutsche Bank, considering zircon is but a small share of the company's diverse portfolio. The broker suspects Rio has decided to either sell down zircon inventory or wants to lift market share.

Whatever the reason, Iluka has been forced to follow suit and reduce its premium zircon price to US$950/t. Deutsche Bank lowers its average zircon price forecasts by 6.0% for 2016 and by 10% for 2017, suspecting there may be further risks to the downside.

The company has guided to 2016 production of 660,000 tonnes and suggested aggregate sales volumes – zircon/rutile/synthetic rutile – might exceed production. Yet, Iluka also expects a greater share of standard zircon sales in 2016 which, all up, suggests to brokers a lower realised price.

UBS draws this conclusion from lower transaction prices towards the end of the March quarter and its assessment of the weak demand-supply situation, pointing to the curtailing of Jacinth-Ambrosia for 18-24 months. Furthermore, UBS has lifted Australian dollar forecasts between 1-5% over 2016-20. Hence, the company's cash flow outlook is reduced and the stock is downgraded to Sell from Neutral.

How the cuts to zircon prices translate to average realised prices depends on a number of factors, Morgan Stanley maintains. Nevertheless, the price cut should equate to a 15% reduction in medium-term earnings, and reduce the broker's base case valuation by 6.0% if it carries over the longer term.

Credit Suisse also deduces from the company's comments that while combined production will be sustained, the composition may change in terms of lower zircon volumes. Incorporating changes to zircon prices and sales volumes means the broker downgrades revenue by 6.0% for FY16 and 7.0% for FY17. Profit estimates are downgraded 24% for FY16 and 23% for FY17.

Credit Suisse suspects it has a more downbeat view of China's property construction industry than consensus after the most recent TZMI report. The survey suggests demand could be down in single digit percentages in 2016 because of sluggish property clearance rates, weak margins and environmental pressures leading to the closure of smaller operators.

This signals lower demand for zircon, potentially. Industry feedback suggest new construction starts could be down 10% year on year, more than the broker previously expected, and it appears the mineral sands industry is starting to look like many other commodities, for prices need to push deep into the cost curve to bring about the necessary curtailment of supply. Hence, Credit Suisse suspects zircon prices may move sharply lower.

One aspect to the supply/demand balance Deutsche Bank observes is that while demand for zircon is improving slowly, new supply has entered the market from smaller producers. For these producers zircon is a by-product and a small revenue stream. Now the majors have cut prices, the broker suspects there might be further downside to pricing over 2016.

Macquarie expects the outlook for Iluka will be challenging, with a number of key decisions to be made, none the least of which is managing the current business in a weak market. Having failed to acquire Kenmare, the need to address a shortfall in sulphate ilmenite also presents a hurdle, along with the suspension of Jacinth-Aambrosia and falling future revenue from BHP Billiton ((BHP)) Mining area C.

Iluka may not be able to sustain its current dividend levels, Credit Suisse asserts. The company's policy is to pay out a minimum of 40% of free cash flow but given the current balance sheet and the fact it does not need the cash at this point, the broker has assumed a 100% pay-out of free cash flow through to FY19.

After adjusting for lower zircon prices this generates a dividend of 39c a share in FY16 but in FY17 this is considered likely to contract to 25c. Hence, Credit Suisse does not find valuation multiples nor the dividend yield compelling in 2017, even assuming a zircon price of US$975/t.

FNArena's database shows one Buy rating (Citi), one Hold (Morgan Stanley) and five Sell for Iluka Resources. The consensus target is $6.11, suggesting 9.2% upside to the last share price.
 

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