rbs report - $9.90 target

A night on the tiles
ILU recently hosted a mineral sands information session to provide an update on market dynamics. As a result of information presented, we have revised our mineral sands price deck substantially. We believe the mineral sand space will remain tight for the foreseeable future. We move to a Buy recommendation

Market tightness to remain in zircon and build in TiO2
ILU re-emphasised observed zircon market tightness and flagged the TiO2 market as following a similar path. Management repeatedly flagged a step-change in TiO2 pricing over CY11. We were left with the impression that a step-change implies a +30% price increase for premium TiO2 products. This is broadly in line with our previous price deck, but we have increased our long-term rutile and syn-rutile prices by about 50% as a result of our revised
inducement analysis.

Prolonged prosperity to follow prolonged neglect
A lack of new project development over a number of years has left the zircon and TiO2 markets structurally short of production. This is a situation that cannot be resolved in the near term, in our view. Admittedly, we had been sceptical of ILU’s ability to realise the full extent of a looming structural shortage. We have changed our view and believe ILU’s approach to management of the zircon and TiO2 markets will result in a steady increase in prices over a prolonged period of time.

One deposit could change the industry, but not for a while
Global zircon demand is about 1.2-1.5Mtpa, with JA accounting for about 30% of that. While JA is unique in terms of its mineral assemblage, in our view it’s not unreasonable to assume there are similar deposits that could materially impact global production. As these deposits haven’t been found yet, it will be at least five years before such a deposit could be factored into global supply.

Investment view – move from Hold to Buy
We have reviewed our mineral sand price deck to reflect near-term market tightness and longer-term inducement requirements for new capacity. The result is a material increase in our NPV from A$6.31ps to A$9.90ps. We move to a Buy recommendation.

Incentive pricing
Due to the variability of mineral sand assemblage between deposits, modelling of incentive prices requires a larger number of assumptions to be made relative to other sectors such as copper or iron ore. In its recent presentation, ILU provided its internal incentive price modelling, which suggests a zircon price of US$1,500/t is required to meet global demand by 2015. This assumes there is a 30% increase in TiO2 pricing over the same period.

We have run a number of scenarios based on a 10Mtpa ROM project with HM grade of 5%, Zr/TiO2 ratio of 0.5 and capex of US$400m or US$40/t of throughput capacity. Due to the substantial impact of HM grade and HM composition (zircon / rutile / ilmenite) care must be taken in extrapolating the results to individual projects that may vary substantially from the assumptions on which our figures are based. That said, we believe that our HM grade (rutile 10%, ilmenite 50%, zircon 30%, trash 10%) and operational inputs are conservative on most measures, and that the outputs are valid for a generic project assessment.

Currency needs to be factored in
The above graphs suggest that a weighted average product price of between US$600 and US$800/t is required to achieve an adequate return on investment (IRR +20%). The table below shows that our LT price deck (LHS) results in a weighted after product price of US$467/t base on our conceptual project. As Australia is the world’s largest supplier of zircon and TiO2, we believe the AUD/USD exchange rate must be incorporated into incentive prices. We have factored in the RBS LT AUD/USD rate of 0.73 in setting our LT mineral sand price assumptions. Our AUD weighted average product price is A$639/t, which we feel is conservative based on the incentive analysis above. It follows that should the LT currency assumptions used in project financing be above 0.73, higher mineral sand prices may be required to incentivise new capacity in Australia and possibly overseas.

Valuation, target price and risks
Our DCF-based valuation has increased from A$6.31 to A$9.90ps due to the factors outlined above. Our target price of A$9.90 is set at our NPV. Key risks to our target price are an ongoing rally in the AUD, increases in operating costs, lower-than-forecast zircon and rutile prices, and a resumption in the build-up of product stockpiles. Upside risks lie in the strengthening of Asian demand leading to sustainably higher zircon and TiO2 prices.