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Pilbara Minerals' Rally Considered Excessive

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Pilbara Minerals ((PLS)) plans to supply direct shipping ore (DSO) from its Pilgangoora lithium-tantalum project to Atlas Iron ((AGO)) over a period of 15 months. Brokers expect this sale will provide some early cash flow as commissioning of stage I gets underway.

Capital for stage I of the Pilgangoora project has been increased by around $50m to $274m. The additional capital is to be spent on the process plant with costs being incurred in order to accelerate construction and maintain the original schedule. Additional investment in the plant is in line with the company's strategy to target long-term supply of high-quality material.

The agreement encompasses 1.0-1.5 mtpa of run-of-mine ore, and pricing is underpinned by a US-dollar fixed base price, with adjustments according to material specifications and the cost of final shipping. Atlas Iron will use the existing Mt Dove infrastructure to crush and ship the product to final customers in China. As part of the deal Atlas will make a pre-payment of US$3m to fund the establishment costs and claw this back with US$500,000 in offsets over the first six invoices.

Canaccord Genuity expected Atlas Iron would be engaged for mining services but welcomes the extension to a purchase of ore. The broker also suspected an additional $40m in cash flow could be generated over 2018/19 if the company undertook 1mt of DSO sales.

The broker calculates that assuming Atlas Iron can achieve a price of US$110/t, Pilbara Minerals can receive a mine gate price of around $50/t for its product. This should cover the additional capital of $40m associated with increasing work activities at Pilgangoora, and retain the goal of first production by June 2018. Canaccord Genuity has a Hold rating and $1.19 target.

Pilgangoora will come into focus as the market for battery materials evolves, in Macquarie's opinion. Despite the up-front payment from Atlas, the broker believes the project schedule is still looking stretched. The lithium market remain short and demand for DSO high, so a supply shortage is expected to persist in 2018, and there is potential for sales to continue beyond the scheduled 15 months.

The stock has rallied strongly amid positive news on the lithium sector and Macquarie downgrades to Neutral from Outperform on valuation grounds, raising the target to $1.15 from $1.10.

Citi also downgrades, to Sell/High Risk on the back of the share price performance. The broker believes most of the positive catalysts, such as offtake and expansion, are factored into the current share price. There is now the potential for downside risk associated with delays that are prevalent for construction and commissioning in the mining industry.

To allow for the agreement Citi increases the costs of DSO sales and assumes revenue of US$120/t and effective costs of US$78/t for Pilbara Minerals. Increasing the probability of the 5mtpa expansion to 100%, given the outlook for the lithium market, and the signing of offtake contracts, increases the broker's target to $1.05 from $0.95.

Citi agrees a 200% increase in the share price since September is excessive and this does not allow for any execution risk associated with the Pilgangoora project, which is yet to generate any cash flow.

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