Best of 2019: Why Iluka is bucking the mining company trend

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Glenn Freeman: In this edition of "Ask the Expert" I'm speaking to our mining and materials analyst Matt Hodge.

Matt, thanks for your time today.

Mathew Hodge: Thanks, Glenn.

Freeman: So, Matt, what does Iluka do?

Hodge: So, they produce zircon, rutile, synthetic rutile, and they also have a Mining Area C iron ore royalty, which is operated by BHP. Zircon is used in tiles and porcelain, so bathrooms. So, it's largely a consumer-driven product. Titanium dioxide is used in paints and plastics, things like that. It's used for fixing color. That's the predominant of titanium dioxide, largely tied to the consumer end of the market and both tend to be late cycle commodities.

Freeman: And Matt, one of the things you speak about in this recent special report you've put together speaks about the different demand patterns for these materials versus iron ore. Can you just explain a bit about that?

Hodge: Yeah. So, I guess, as I said, they are late cycle. So, what I mean by that is, if you think about an early uptick in economic cycle, you tend to be building roads or buildings, or structures and that tends to be steel heavy, concrete heavy. As the cycle gets longer, more of that activity moves towards like actually completing things. So, in the case of zircon, it's tiles and basins and toilets and things like that, which come at the end of a building. But on top of that, they are also used in alterations and additions. So, there is a real consumer angle to it. And there's been a real innovation in tiles in the last 10 years, I'd say. You're seeing much bigger tiles, digitally printed tiles. They look very much like stone, very convincing but at a fraction of the price and I think there's a very good value proposition for those as well.

Freeman: Why is Iluka considered to be undervalued when most of the other companies within this mining space are actually overvalued?

Hodge: Yeah. So, I think a couple of things. We're pretty positive on the supply-demand outlook. Key suppliers face declining grades. So, we expect zircon from current producers to decline at a meaningful rate. That means new supply is going to have to be added. That requires a price that is sufficiently attractive for new investment to be made. And the new deposits are generally not as good as the ones that are already in production. So, that's a positive story. We don't think the industry or Iluka is overearning at the moment. So, we think the earnings are sustainable.

The other thing that we like is this Mining Area C iron ore royalty. So, Iluka basically sold this asset to BHP a long time ago before it was even a mine and part of that sale was, they get a royalty. Lo and behold produce 55 million tons of iron ore of that lease at the moment and that's going up to 140, 150. So, there's a big growth path there. And it's like a bond. They get a percentage of the revenue, but that's a much lower risk asset than being a miner. There's no operating cost leverage, there's no capital cost required to expand, and that thing is going to grow. So, we think that asset is undervalued as well in the company.

Freeman: And so, how is Indonesia important within this story?

Hodge: Yeah. So, that's one of the things that we like on the supply side is, with zircon, Indonesia produces about 50,000 tons from very high cost mines. It's basically artisanal mining, very labor intensive. When the price declines, that supply goes away. And that's 50,000 tons out of a 1.2 million ton market. It's about 4% of supply. So, that's a nice little buffer if there's a downturn in demand, something that can switch off without the price moving too far. It's another reason why we think current prices are sustainable.

This report appeared on 2022 Morningstar Australasia Pty Limited

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