Grange Resources Ltd (ASX: GRR, OTC: GRRLF), an aggressive play on China’s long-term urbanization story, is replacing Iluka Resources Ltd (ASX: ILU, OTC: ILKAF, ADR: ILKAY), also an aggressive play on China’s long-term urbanization story, in the AE Portfolio.

Grange produces magnetite iron ore from its Savage River mine in Tasmania and is in the late-stage development phase of the relatively prodigious Southdown project in Western Australia. It’s the largest producer of magnetite, an oxide of iron and a key input for steelmaking, in the world. Grange’s processed magnetite pellet output commands premium prices because of its higher iron content and lower rate of impurities versus other forms of hematite iron ore such as fines and lumps.

Iluka also occupies a rather unique niche vis-à-vis the Middle Kingdom and the rapid transformation taking shape there, as its mineral sands are in high demand for use in pigments and dyes and particularly as the main input for ceramic tiles. Tile is pervasive in China and throughout Asia, the flooring of choice for literally centuries. Iluka had what it called a transformational year in fiscal 2011, realizing higher prices on larger volumes than it had yet experienced during Emerging Asia’s rapid expansion during the last decade.

We were seduced by an enormous dividend increase as well as management forecasts for similar if not quite as robust results for fiscal 2012 and beyond. Management, however, has now revised downward its guidance for full-year sales for fiscal 2012 twice in a matter of three months and made what appears to us to be a significant error in judgment by opting for short-term pricing schemes rather than long-term contracts for its output.

The former is cause enough to question management’s credibility; the latter, though it may help the company realize outsized returns during boom periods, is no way to establish revenue visibility so crucial to sustaining a consistent dividend.

Following on an announcement made in mid-May adjusting guidance it issued with its 2012 Key Physical and Financial Parameters document on Feb. 23, Iluka management on Jul. 9 provided a still lower forecast for sales volumes because calendar second-quarter sales came in below expectations.

A statement released by the company also noted “deteriorating economic outlooks, discussions (which in many cases are ongoing) with customers in relation to second half volume requirements, and completion of the initial stages of the company’s usual mid-year reforecast process” as factors driving the downgrade.

Zircon, rutile and synthetic rutile sales in calendar 2012 are all expected to be materially lower than previous guidance provided only eight weeks ago. On the titanium dioxide side, Managing Director David Robb said during a conference call to discuss this latest revision that the outlook has changed from “full steam ahead, to full stop,” with chloride pigment production down 25 percent and sulphate production down slightly less.

Similarly, on zircon, Mr. Robb suggested that although recent indicators suggest that China property may have bottomed out, this comes after nine months of declines, and overall demand conditions are worse than in 2009.

Iluka’s revised guidance highlights a significant lack of visibility, with the largest producer of zircon completely changing its view within a matter of weeks. There’s likely upside potential from here for the stock, given that the price has come down about 23 percent over the past week.

But there’s substantial value elsewhere, and with a particularly uncertain outlook and a lack of visibility for revenue in support of a significantly increased dividend from 2011 to 2012 it’s difficult to justify sticking with Iluka.

AE is about building wealth over the long term by collecting solid, sustainable dividends. On the heels of Iluka’s second forecast change since May, we’re removing the stock from the Aggressive Holdings in favor of Grange Resources.

Grange is currently yielding more than 9 percent and has actually been more volatile than Iluka based on its beta of 1.69 to the latter’s 1.47 versus the S&P/ASX 200 Index. The stock is down 13.63 percent in price-only terms on the Australian Securities Exchange (ASX) in calendar 2012 but has ranged as high as AUD0.67 per share on Mar. 1 and as low as AUD0.45 on May 16. As of this writing it’s at AUD0.49.

And there is very little dividend history as well. The company paid its first dividend in October 2011, AUD0.02 per share, an interim payment for the first half of fiscal 2012. It followed up with a final payment for the fiscal year ended Jun. 30 of AUD0.03 in April. We give Grange no credit for a dividend increase over the trailing 12 months under the AE Safety Rating System, nor do we credit it for not cutting its payout in the last five years. We do, however, give it a point for its low payout ratio, 26.6 percent based on earnings per share.

And we give it two more points because of its debt position. The company has no net debt, with short- and long-term borrowings totaling AUD44.9 million as of Dec. 31, 2011, against a cash balance of more than AUD170 million. Of these liabilities approximately AUD25 million relates to amounts outstanding under heavy equipment leases. Approximately AUD20 million is owed on fixed-rate borrowings with an average interest rate of 4.76 percent.

The 9 percent-plus yield at first consideration implies the market is pricing in a dividend cut. But the market isn’t pricing Grange on its dividend, yet. It’s pricing it on its iron ore exposure and the potential for downside in the commodity’s price based on slowing global demand. And here the selling is overdone.

Magnetite and Grange’s pellet output represent a specialized segment of the market; these pellets are more efficient than the other forms of iron ore, lumps and fines, the use of which will actually decline over coming decades as global resources decline, even as China’s urbanization continues.

It has a very important property: It’s a magnetic mineral. This property is fundamental in aiding discovery through magnetic surveys and in ore processing. Ore can be crushed, passed over a magnet and the magnetite is extracted, leaving a clean high-grade product.

In situ magnetite ore grades are lower than commercially exploited hematite ores, which is the dominant type at present. But after processing a product with much higher iron grades and much lower costly impurities is available for sale to steelmakers. All iron fines are recombined to form a suitable product for steelmaking; as part of Grange’s process at Savage River magnetite is combined with bentonite, a type of clay, and heated to produce pellets.

These high-quality pellets are used in blast furnaces or direct reduction (DR) furnaces to make steel and is a preferred product by steelmakers, as they greatly increase the efficiency of the furnace, reducing costs and pollution. Magnetite and pellets attract a higher price over hematite ores for this reason, offsetting the added costs involved in processing.

Two of the major hematite exporters, Australia and India, continue to report that the iron grade is dropping. In Australia research by Macquarie Bank has concluded that the implied grade derived for Australian exports is well below 60 percent. This grade decrease could be due to blending lower-grade ores to cash in on good prices, but nevertheless the evidence suggests hematite grades are dropping overall.

The additional costs in producing a magnetite concentrate are offset by the premium received due to the higher grade. For example, on Jul. 11, 2012, the spot price for 62 percent iron fines was USD130.70 per metric ton. For 58 percent iron fines it was USD120.80. For 63.5 percent the price was USD137.20 per metric ton. Grange’s Savage River magnetite ore boasts iron content of 65.5 percent.

The major long-term boost for Grange will come once the Southdown project–which is four times bigger than Savage River–reaches production stage, which is expected to happen in mid-2015.

Grange released the definitive feasibility study (DFS) for Southdown on May 1, 2012. The total mineral resource is now estimated at more than 1.2 billion metric tons at 34.1 percent iron ore according to Davis Tube Recovery (DTR) tests. Ore reserves, meanwhile, are estimated at 397 million metric tons at 35.69 percent DTR.

The DFS concluded that Southdown has a potential mine life of 14 years within the current permitted area, while the total resource figure indicates a potential mine life more than 30 years. And following recent additional test work, the expected concentrate quality has improved to 69.4 percent, with lower contaminants. The project should produce 10 million metric tons per year of magnetite concentrate.

Southdown will cost an estimated AUD2.885 billion, which is 12 percent than the AUD2.57 billion forecast provided in Grange’s pre-feasibility study. Operating costs are expected to be AUD59 per metric ton. The key issue is financing the project.

Grange hopes to firm up financing this year in order to commence a two-year construction period. Grange announced in October 2011 that it and co-owner (30 percent) Sojitz Corp, which is based in Japan, have appointed Standard Chartered Bank to act as debt advisor.

In mid-June Deutsche Bank was hired to advise on the sale of at least 30 percent stake to a “suitable strategic investor requiring long-term off-take of a premium quality pellet feed.” The basic plan is to finance Southdown partly from cash generated by Savage River, with additional financing from debt and equity as required.

During the March 2012 quarter Grange produced 573,625 metric ton of magnetite concentrate, up 64 percent from the prior corresponding period. The company posted record pellet sales in January, and there were no “lost time injuries” for the sixth consecutive quarter.

The average price received during the quarter was USD172.57 per metric ton of pellets, while total sales revenue was AUD126.2 million.

Cash costs at Savage River were less than budgeted for the quarter, at AUD56.8 million, exclusive of royalties. Unit costs were USD111.09 per metric ton of pellets produced, compared to USD160.81 per metric ton in the prior corresponding period. Improved unit costs resulted from a shorter annual maintenance shutdown in February and improved ore grades and consequent concentrate production.

Management reiterated full-year guidance, stating, “Cash generation at Savage River is forecast to remain strong throughout the next quarter. Whilst contract iron ore prices reduced in the March quarter, in line with the spot price reduction experienced in late 2011, the spot price for iron ore has improved.”

Unit costs remain with forecast, though fluctuations with the Australian dollar versus the US dollar will have an impact on margins. Management still anticipates “healthy” margins, however.

Australia has benefitted from the vast tonnages of hematite particularly in the Pilbara Region. Magnetite, however, is becoming more important as a source of high-grade iron as hematite grades fall over time.

Unlike Iluka with its rutile, synthetic rutile and zircon output, Grange contracts with customers under longer-term arrangements. It will, therefore, experience general ups and downs with the broader iron ore market. But its niche guarantees that volumes will remain consistent and that pricing will be relatively strong.

Key to this story, like Iluka, is the Middle Kingdom. Chinese data has been largely flat in recent months. Steel production ran at an annualized rate of approximately 727 metric tons per annum in April, up from below 700 metric tons in the first two months of the year. Iron ore port stocks have been largely flat since the start of the year, and Chinese steel prices of RMB4,216 per ton are at similar levels to the November 2011-to-February 2012 period. The implication is that iron ore prices could stabilize rather than reaching new low levels.

Grange is in good position now to meet existing demand for higher-quality ore, and the Southdown project sets it up to serve customers for the long term as well. Grange Resources, a new addition to the AE Portfolio Aggressive Holdings, is a buy under USD0.65 on the Australian Securities Exchange (ASX) using the symbol GRR or on the US over-the-counter (OTC) market using the symbol GRRLF.

Note that the yield quoted in the How They Rate and the Aggressive Holdings tables reflects only the AUD0.03 final dividend paid in April, not the AUD0.05 total dividend paid over the past 12 months.

Grange Resources’ fiscal year runs from Jul. 1 to Jun. 30. 30. The company reports full financial and operating results twice a year; it typically posts first-half results in late February, with full fiscal year numbers out in late August.

The board approved and management declared the company’s first interim dividend, AUD0.02 per share, on Aug. 31, 2011. It was paid Oct. 13, 2011, to shareholders of record as of Sept. 27, 2011. Shares traded “ex-dividend” on this declaration as of Sept. 21, 2011. A final dividend in respect of fiscal 2012 of AUD0.03 per share was declared Feb. 29, 2012, and was paid Apr. 27, 2012, to shareholders of record as of Apr. 11, 2012. Apr. 3, 2012, was the ex-dividend date for this payment.

Dividends paid by Grange Resources are “qualified” for US tax purposes. The Australian government withholds 15 percent, based on the US-Australia tax treaty on double taxation. The two countries have not taken the step of eliminating withholding from dividends paid in respect of shares held in a US IRA, as have the US and Canada.

Among the analysts who cover the stock, all seven rate it a “buy” according to Bloomberg’s standardization of brokerage house recommendation terminology. There are no “hold” and no “sell” ratings on the stock at present. The “best consensus” 12-month target price among the four analysts that provide such a number is AUD0.79, with a high of AUD1.01 and a low of AUD0.75.