Globally, it has become evident over the last few months that not only are most governments extremely comfortable in borrowing an enormous amount of capital to inject directly into the economy, but there is very little resistance (from the public or opposition) to this fiscal stimulus. On top of this you have central banks wanting to keep monetary policy extremely loose for long periods of time with little appetite to tighten too soon. With such supportive fiscal and monetary policy, combined with a vaccine roll-out in 2021 normalising human behaviour the foundations are in place for a strong economic recovery. We see the resources sector being a clear beneficiary in 2021 and beyond.
We are keeping a close eye on the Northern Hemisphere where a severe second COVID wave over the winter is likely to force governments to embark on further massive fiscal stimulus packages and central banks to go harder on their QE programs. In the US, it is looking increasingly likely the Democrats will control the Senate which clears the path for further stimulus injections. Where this could get interesting is that the impact of these stimulatory measures will probably occur at the same time as the vaccine roll-out, which could super charge the economic recovery. Therefore, the year-on-year economic growth likely to be experienced around the globe could be enormous.
This trend is likely to drive up domestic cyclicals and boost the resources sector while the sell off in long dated bonds and long duration shares could continue. If we start to see global synchronized growth being the new narrative, then clearly resources will be the big winner. With this in mind, we would like to highlight a company we continue to believe is good value. Iluka Resources (ASX: ILU) is a mineral sands producer with its main products being zircon and rutile/synthetic rutile. 2020 was particularly tough for Iluka with the downturn in demand for zircon due to COVID resulting in production settings at the mines being adjusted to prevent a build-up of inventory.
This pre-emptive move limited the downside pressure on prices and positions Iluka well to leverage the expected recovery in demand in 2021 and beyond. Additionally, Iluka has had to contend with the logistical challenges posed by the pandemic in getting staff into and out of its operation in Sierra Leone and a contract default by one of its largest customers. However, in October Iluka spun off its iron ore royalty business – Deterra Resources (ASX: DRR) – in which it still holds a 20% stake (worth about $500m). ILU’s share price has done well since then with ILU trading at a two-year high.
We expect that Iluka will have net cash of just under $300m by the end of 2021 and we think that the business will generate about $500m EBITDA in 2021 (it did more than $500m in both 2018 and 2019). Put this all together and you have a company with a $2.8bn market cap where, if you strip out the cash and Deterra stake, the adjusted market cap/enterprise value is $2.0bn which will generate pre-tax free cashflow of $400m, which is an eye-watering 20% pre-tax free cashflow yield.
Spike in demand
What makes the investment case even more interesting is there are many levels of potential upside. Firstly, the supply side dynamics of the core business are quite concentrated with Iluka accounting for 26% of global zircon supply ahead of Tronox (24%) and Rio Tinto (13%). In the high-grade chloride feedstock market, Iluka is the third largest producer behind Rio Tinto and Tronox with a 12% market share. We like commodities with concentrated supply side dynamics as it generally results in more sensible pricing and when there is a spike in demand the underlying commodity price tends to skyrocket (as we have seen with iron ore recently).
The last time there was such a demand for mineral sands was in 2010 and 2011, which saw zircon and rutile prices double to over $US2000/t. Over this period the Iluka share price increased almost fivefold and it was one of the top three performing stocks in the ASX200 in both 2010 and 2011. Our 20% pre-tax free cashflow yield does not forecast this scenario but in a macro environment of synchronized global growth it is not out of the realms of possibility. This is not our base case, but a not unreasonable upside risk, which we think is not being priced in.
Another optional upside comes from the rare earths (REE) opportunity. REEs are set to experience a significant increase in demand as one of the major uses is in magnets for electric motors used in electric vehicles, wind turbines and other applications that benefit from the push towards renewable energy and decarbonization. The first stage of the move into REEs began earlier this year with the sales of a monazite concentrate from a tailings deposit at Eneabba, Western Australia that is the highest grade REE “deposit” in the world. This project achieved payback on the initial investment in less than six months. Stage two of this project will involve producing a 90% grade monazite concentrate (the mineral that contains the REE) that will increase price realization. Iluka has the potential to significantly increase its exposure to REEs through the development of the Wimmera project in Victoria that would also be a significant zircon producer and could be in production in 2024.
Published by Anthony Aboud, Portfolio Manager – Perpetual