Base metals prices surged earlier in the June quarter of 2024 before partially reversing due to concerns over China’s economy. Iron ore prices are broadly stable despite China's struggling property market and weak infrastructure spending, leading to questions over China's steel demand. After updating our commodity price assumptions, no-moat Iluka (ASX: ILU) is the cheapest miner we cover, trading 31% below its unchanged fair value estimate of $9.50.

Business strategy and outlook

Iluka is a global mineral sands miner. Major mines are Jacinth-Ambrosia in South Australia and Cataby in Western Australia. Relatively low operating costs for zircon are supported by Jacinth-Ambrosia, but its reserve life is less than a decade. Like the industry, Iluka is facing a declining grade profile at its mines, but a constrained outlook for supply should support prices.

Mineral sands prices and volumes are the primary drivers of our fair value estimate. Iluka's focus is on managing volumes and the resulting impact on prices. Efforts to maintain margins and prices mean sales volumes can fall in periods of weak demand as Iluka shoulders part of the responsibility for balancing industry supply, but Iluka can also flex production to increase market share or liquidate excess inventory as prices rise.

Primary products are split between zircon (used in tiles and ceramics, refractories, chemicals, and so on) and titanium dioxide feedstocks rutile and synthetic rutile (used for pigments in paints, coatings, plastics, and paper).

Iluka is building a rare-earth refinery at Eneabba which will utilize its existing monazite stockpile as initial feedstock. The refinery will also be able to process feedstock from third parties as well as from Iluka's West Balranald development and its potential Wimmera project.

Maintenance capital expenditure is relatively modest, but expansions and reinvestment to prolong life are generally pursued when Iluka sees a need for new demand and the potential for reasonable returns on investment.

The balance sheet is relatively strong with net cash of around $230 million as at the end of December 2023, but debt will increase materially to help build the rare-earth refinery. Iluka maintains a conservative balance sheet with no net debt on average through the cycle. This should provide the capacity to finance inventory build when necessary and invest through the cycle. Management values returns to shareholders, primarily through dividends, but will flex depending on investment needs.

Moat rating

We assign Iluka Resources a no moat rating. As a commodity producer, Iluka is generally a price taker and needs low-cost mines with long lives and a low installed capital base to support the longer-term excess returns needed to justify an economic moat.

In calculating return on invested capital, we have added back to invested capital $1.2 billion in write-downs and provisions taken over the past decade on the basis that these amounts relate to assets developed or acquired in the ordinary course of business and so should be included when calculating ROIC.

The company averaged return on invested capital (“ROIC”) in the 10 years ended 2023 of around 13%. ROIC averaged around 18% in the five years ended 2023 and we estimate that Iluka will generate a ROIC of roughly 10% midcycle in 2027.

As its midcycle ROIC is similar to Iluka’s weighted average cost of capital of around 10.5%, we assign a no moat rating to the stock.

While two thirds of production from the high-grade, low-cost Jacinth-Ambrosia mine is high-quality zircon, a remaining reserve life of less than a decade and declining grades as mining moves to the Ambrosia deposit means we don’t assign a moat to Jacinth-Ambrosia.

Commissioned in 2019, the Cataby mine in Western Australia is a chloride ilmenite-rich mine with a remaining life of about five years with potential for a four-year extension, with grades falling off beginning calendar 2023. Given its short reserve life and lack of a cost advantage, we don’t assign a moat to Cataby either.

The ilmenite mined at Cataby and Jacinth-Ambrosia is processed into synthetic rutile using Iluka’s synthetic rutile kilns at Capel. As approximately 80% of the ilmenite feeding these kilns is from Cataby, these are also not moaty assets, in our view.

Iluka's 20% shareholding in Deterra Royalties brings exposure to high-quality cash flows from the high-returning, long-life Mining Area C royalty. We consider the Mining Area C royalty moatworthy but given it only accounts for roughly 10% of our fair value estimate, it is not a large enough contributor to confer a moat to Iluka.

Finally, Iluka’s rare-earth refinery at Eneabba requires significant capital expenditure and will utilize the company's existing monazite stockpile as initial feedstock. However, being the byproduct of past mining activities, it is a stockpile rather than an actual mine and to move into the rare-earth market longer-term, Iluka needs new resources and new mines whose economics are likely to be very different to mining the stockpile at Eneabba. While the financial assistance obtained from the Australian government helps minimize the downside to Iluka while retaining exposure to the upside, we lack the confidence to forecast return on invested capital will be greater than weighted average cost of capital for at least 10 years and so it also isn't a moaty asset in our view.

In terms of growth options, the company is developing its West Balranald project while continuing to progress the potential development at Wimmera. West Balranald is a high-grade, rutile-rich deposit with a potential mine life of eight to 14 years. Given its relative depth, mining West Balranald economically required the successful development of a new, underground mining technique. Wimmera is rich in zircon and rare-earth elements, but the fine-grained mineral sands in this deposit contain impurities, which make the zircon ineligible to be sold into end markets without processing. The company is working on a feasibility study and also on validating a new zircon processing solution to resolve this issue, with early results also pleasing.

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