Editor’s Note: The following article is an abridged version of the March 2012 In Focus feature for CE’s sister letter Australian Edge.

“Urbanization” is the physical growth of urban areas as a result of widespread change. It’s closely linked to modernization, industrialization and rationalization. It can describe a specific condition in a place in time, for example the proportion of total population or area in cities or towns, or it can describe the increase of this proportion over time. It can represent the level of urban relative to overall population, or it can represent the rate at which the urban proportion is increasing.

In China rapid urbanization over the past couple decades has coincided with an equally rapid rise in the rate of homeownership. In fact homeownership in urban China is extremely high, about 89 percent. A large percentage of Chinese households have a direct stake in the housing market. And the percentage of household wealth wrapped up in housing is quite large, almost 60 percent greater than in the US and equivalent to around 120 percent of gross domestic product (GDP).

Much has been written on the relationship between housing prices and consumption in developed economies, focused primarily on the theory that increases in home prices make homeowners feel wealthier and therefore consume more. This is described as a “wealth effect,” a trend readily apparent in the US during the last decade.

The two factors mentioned above–a high rate of urban homeownership and the amount of wealth tied up in housing–support the idea that a housing wealth effect in China could be quite significant and lasting.

At the same time there hasn’t yet developed in China significant secondary market for housing, and homeowners are restricted from taking out home equity lines of credit. Many Americans took out home equity loans to finance higher consumption, effectively converting their domiciles into ATMs, so this latter is probably a good thing.

A secondary market is likely just a matter of time, given the rate of urbanization and the consumptive desires already unleashed as the Middle Kingdom has climbed up the global value chain.

Floor Space

Iluka Resources Ltd (ASX: ILU, OTC: ILKAF, ADR: ILKAY) makes a key ingredient, zircon, in coatings for ceramic tiles. For CEO David Robb China’s urbanization is all about increases in gross floor space. Everyone has their favorite China stats. Mr. Robb’s favorite factoid, cited during the company’s conference call to discuss 2011 results, is that China will build the equivalent of the entire floor space of Europe in the next 10 to 15 years.

What’s compelling is what comes next, beyond this explosive phase for the Middle Kingdom so many seem to lament lately: “And we’ll then have to do it again in 30 years’ time, on a rolling basis, obviously, given that they typically build buildings to last some 30 years versus Europe at 100 years-plus.”

Skylines in China–across Asia, for that matter–are unrecognizable from what they were 15 to 20 years ago. Some have sprung from the ground, others have been entirely recast, Shanghai, Singapore, Kuala Lumpur. And the first generation of housing has actually been torn down and replaced. At both the commercial and industrial level as well as the housing level there remains significant potential for new floor space. Rising incomes–helped by housing, but also by China’s progression up the global value chain to higher-wage work–and associated desires for more living space should make the per capita figure grow, too.

This begs a fundamental question about the forces unleashed during the course of China’s–and Asia’s–development: Will the aspirational Chinese consumer settle for an outcome that gives them less square meters per capita than Taiwan, for example, only reaching this benchmark by 2025? And will this Chinese consumer settle for less, generally, than what post-Industrial Revolution middle classes in the West enjoyed?

Iluka Resources is a bet that China and the rest of emerging Asia will follow a trajectory similar to those traveled by developed economies, and that aspiration and a “wealth effect” will continue to exert a powerful influence on global supplies of and demand for all manner of resources, many of them found in Australia or worked globally by Australia-based firms.

As Mr. Robb pointed out during his recent earnings presentation the countries that happen to be leading global growth in the 21st century also happen to be tile-and-ceramics-centric than developed economies, which has its roots in culture.

On a global basis, therefore, Iluka is well positioned for a shift in the heretofore common relationship between GDP growth and tile demand.

China, Asia-Pacific, Central and South America, Africa and the Middle East are broadly taken to be the next growth engines for the world economy, and rates of tile use are higher in these regions than in North America and Western Europe.

The New Iluka

Management described their company as “New Iluka” when introducing headline 2011 numbers. The second item on the list of “2011 Key Features” that kicks off Iluka’s presentation to investors of full-year results is “Balance sheet = net cash.”

This snapshot item does capture the essence of what was a transformational year for a company with a durable position in its market and a reasonable opportunity for significant upside for the dividend and the share price over time.

On the ground the biggest development was Iluka’s ability to realize significantly higher prices for its two key products, and those price increases were absorbed by its customers and appear to making their way through the value chain. At the same time revenue surged on price increases and relatively stable volumes costs were contained. Revenues were significantly higher, which, combined with Iluka’s modest capital appetite “produced an order of magnitude difference in free cash flow” that fueled the aforementioned No. 2 “Key Feature,” the transformation of its balance sheet.

Iluka is a mineral sands producer and a play on the long-term transformation of China’s economy. But it’s the major producer of zircon globally and the largest producer of high-grade titanium dioxide-based products, rutile and synthetic rutile. Based in Perth, Western Australia, it has major operations at home and right here in Virginia.

Although the Middle Kingdom is and will drive and support the long-term health of the business use of tiles for flooring is a deeply ingrained aspect of some Eastern cultures. Management is secure in its ability to keep up with and fend off any technical challenges to its products’ dominance–it makes the primary ingredient in coatings for floor tiles and a key ingredient for pigments used in paint-making–though history has demonstrated that such events are slow-moving. This means, now with a strong balance sheet, Iluka can focus on growing market share and building wealth for investors.

The company also has a royalty associated with a tier one iron ore operation, AE Portfolio Aggressive Holding BHP Billiton Ltd’s (ASX: BHP, NYSE: BHP) Mining Area C province in Western Australia. But its key outputs are rather rudimentary. Iluka obviously benefits when new construction drives demand for tiles and paint.

Less obvious, apparently, and in light of recent reactions to an announcement about a downward adjustment to China’s gross domestic product (GDP) growth target, is that a middle class, rapidly flowering in the Middle Kingdom, is a resource-hungry group.

China’s urbanization is far from over. And what’s been built over the past decade and a half will soon require upgrade, refurbishment, even rebuilding.

It’s important to understand, too, where Iluka is in the building process. Housing starts in China have tapered, causing some to warn of a US-style housing bust. Iluka’s key metric, however, is housing completions, the time when consumption of a tile occurs. Completions in China were up modestly in 2011 and are expected to double in 2012.

Iluka’s concerns in China go well beyond housing, as demand for titianium oxide as well as zircon from chemicals and other manufacturing industries has been strong. There’s no question a potential lull in China’s growth will harm Iluka in the short term.

The good thing is that Iluka has taken advantage of the enormous opportunity fiscal 2011 created, that is management zeroed out debt, positioning the company to benefit should its informed-on-the-ground forecast about China’s trajectory prove true.

Net profit after tax (NPAT) grew an astounding 1,400.8 percent to AUD541.8 million, and free cash flow was AUD589.6 million, or AUD1.41 per share. Mineral sands revnue was AUD1.54 billion, a 75.7 percent increase over 2010, while group EBITDA rose 221 percent to AUD305.1 million. Interest costs declined by 35.9 percent, and the company reduced its “gearing,” or net debt, from 21.8 percent to nil.

Mineral sands sales volumes–including zircon, rutile and synthetic rutile–were down 4 percent. By product, zircon sales volume up 7.5 percent, rutile sales rose 10.8 percent and synthetic rutile declined 28.9 percent. Mineral sands revenue grew on higher prices and higher volumes for zircon and rutile are partially offset by a stronger AUD (USD1.03 versus USD0.92). Unit cash production costs were flat at AUD538 per metric ton.

Management described the production performance as “excellent,” as output was in line with expectations, was also well within cash cost guidance for its integrated, flexible production base. Iluka also recorded a net increase in ore reserves and mineral resources. 6.84 million metric tons of heavy mineral ore reserves were added during the year, a 25 percent increase. Following depletions and adjustments Iluka’s net reserves rose 13 percent. Mineral resources of 10.14 million metric tons were added in 2011, a 9 percent year-over-year increase; after depletions and adjustments the net increase was 6 percent. Importantly, roughly a quarter of revenues come from each of the major economic and geographic regions of the world.

Management has made a “higher commitment of funds and resources to global exploration effort.” Return on equity better than 40 percent during 2011 suggests the company is doing good things with invested capital.

As for the balance sheet, Iluka reported a net cash position as of Dec. 31, 2011, after transformational year. The question is what it will do with the flexibility it’s gained. This is an aggressive situation because we are essentially banking on management’s conclusion that the price increases realized in recent years do in fact represent a “step change” and that they are durable. These changes in prices for zircon and high-grade titanium dioxide have passed through to the next layer in the value chain.

As of early 2012 zircon prices are approximately 30 percent higher than the average for 2011. High-grade titanium dioxide prices are roughly double the average for 2011. On this basis Iluka “feels confident looking forward to 2012.”

Mr. Robb continued: “We’re confident advances we have made in terms of our technical capabilities, our ability to run a variety of ilmenites into our kilns, our ability to produce new products from those kilns and our ability to monetize low-value tailing strings, for example, augurs well for shareholders for the future.” Iluka has also used its bountiful 2011 cash flow to invest more in research and exploration. The company is attempting to “refresh” its resource bases but continues to exploit existing areas such as the Eucla Basin, the Murray Basin and the Perth Basin with the bulk of its capital expenditure.

Titanium dioxide, according to management, is the underrated element of the portfolio. The last couple years have been driven by uptake of zircon and new pricing; now management is noting a similar type of trend for titanium dioxide.

Iluka is a large company with a market capitalization of more than AUD7 billion. It’s a member of the ASX 50. The company will report fiscal 2012 (end Jun. 30, 2012) results on Aug. 23, 2012. Iluka’s production and exploration report for the quarter ending Mar. 31 is due Apr. 12. The company will hold its annual general meeting May 23 in Perth.

The next dividend dates will be announced Aug. 23 along with results for the six months to Jun. 30, 2012.

It trades with significant volume on its home board, the Australian Securities Exchange (ASX); you can buy the equivalent of these ASX-listed shares in the US over-the-counter (OTC) market under the symbol ILKAF.

Management’s dividend policy is to “provide a floor rather than a specific number.” The floor is currently 40 percent of free cash flow. For 2011 it was actually 53 percent, a sign that management appreciates the cash-generative qualities of its business and that, while it can and will look for ways to prudently invest, it sees it as entirely reasonable that a good percentage of what operations generate be returned to shareholders.

Iluka Resources is a buy on the ASX or on the US OTC market using the symbol ILKAF up to USD18.

The Bank of New York Mellon Corp/Deutsche Bank Americas Holding Corp jointly sponsor an American Depositary Receipt (ADR) representing five ordinary shares of Iluka Resources. The symbol for the ADR, which trades on the US OTC market, is ILKAY. Your broker should have no problem executing a “buy” order for the ADR and shouldn’t charge you any extra fee or commission to do so.

The ADR conveys the same currency impacts, up and down, as if you owned the ASX-listed share or the OTC-traded facsimile. The custodian of the ADR will extract a fee for handling currency conversion and other transaction fees.

Since the ADR was introduced Feb. 4, 2011, it has generated a total return of 96.8 percent. Volume is about 5,000 shares a month. Five-year average monthly volume for OTC-traded ILKAF is about 15,000 shares.

If you buy Iluka Resources through the ADR, don’t pay more than USD90.