A midcap miner outperforming the majors

As a longtime observer and investor in mining companies, there are a number of key attributes I like them to exhibit. Iluka (ASX:ILU) fortunately displays these attributes in spades, which helps explain why it has outperformed the ASX200 accumulation index by +45% over the past year compared to BHP and RIO, which have outperformed by a pedestrian 19-22%.

Substantial increase in final dividend

Iluka reported a net loss of $172m for the year after $182m of asset impairments and a $127m increase in rehabilitation provisions. However, the underlying profit told a completely different story.

Market conditions were very strong across their suite of mineral sand products and will continue to improve. Mineral sands revenue was up 40% for the year due to a combination of increased sales volumes (+27%) and three price rises during the year for zircon, and higher prices achieved for high-grade titanium dioxide sales.

Pricing for zircon has increased by 15% to US$1410/t, and will start to impact earnings from April, which will result in substantial upgrades through the market. Free cashflow was up strongly from 2016 resulting in net debt falling from $324m to $183m, and a substantial increase in final dividend to 25cps.

The balance sheet is in pristine condition with the net debt gearing ratio falling 14ppts to 17%, and thus placing the company in a good position to fund the high returning growth projects it has in the pipeline.

Reaping the benefits of discipline through the cycle

Mining companies have continually been guilty of many sins over the years and I think it is worthwhile outlining the ones that are repeated, and pointing out that Iluka has avoided committing them. 

Sin 1: A complete disregard to capital discipline, particularly at the top of the commodity cycle.

Sin 2: Perhaps a corollary of Sin 1, but making acquisitions at the top of the cycle.

Sin 3: No volume control, thus causing prices to eventually collapse as supply overwhelms demand.

Sin 4: Perhaps the worst sin of all, to repeat these sins every cycle.

Iluka has shown remarkable restraint and has essentially been disciplined with capital by ensuring all investments make an appropriate return through the cycle. The recent acquisition of Sierra Rutile Ltd was done during a period of depressed mineral sand prices, and the acquisition price allowed attractive returns on a mid-cycle pricing regime. Iluka put the Eucla Basin zircon operations on to care and maintenance and thus reduced the impact of a zircon market that had become oversupplied.

Iluka’s balance sheet is in great shape due to strong cashflows and capital discipline; not asset sales of poorly performing assets often acquired via abysmal acquisitions.

Iluka hasn’t just talked the talk, like many peers, it has actually walked the walk.

Source: Iluka

What is the market missing about the company?

Iluka is the largest producer of zircon, with 29% market share, and market tightness has come on quite quickly with little inventory globally.

Further, producer response to pricing is limited, which is exacerbating the fact that demand currently can’t be met and modest underlying growth is evident.

It appears that thrifting and substitution have reached logical limits and many of the substitutes are of lesser value-in-use and have technology issues. China is now the largest consumer of zircon with the majority of the demand in ceramics — e.g. tiles, toilets.

Higher prices are required to incentivise new production to be developed. The list of potential projects are dismal and will take at least until 2019 to develop. It is poorly understood by the market that high-grade rutile and zircon are typically by-products of much lower grade ilmenite projects.

Demand for high-grade materials in all forms is accelerating as governments worldwide look to reduce pollution. For example, the political aspiration of the Chinese Government is to reduce annual emissions by 50–70%. This target will result in profound changes to the industrial China we know and understand today.

Mineral sands tend to be late-cycle commodities and are directly correlated with global GDP growth. We expect long-term pricing for both titanium dioxide and zircon to move higher as demand creeps up in an environment of synchronous global growth and little prospect of short- to medium-term volume response.

Further insights

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