Gem Diamonds - Set to Sparkle?

http://www.gemdiamonds.com/


Mining stocks have been under considerable pressure over the past couple of years, as can be seen in the heavily mining weighted Australian ASX 300 mining index, which continues to set new multi-year lows. That has largely been down to falling commodity prices including iron ore, gold, silver and copper. However, being a different type of commodity, diamond prices have been comparatively resilient (albeit down), and that has been reflected in the share prices of both Gem Diamonds and Petra Diamonds, who have performed relatively well from a share price perspective. With Gem Diamonds now having set key operating milestones, is this a company set to sparkle?

Technicals


The technical outlook for Gem Diamonds remains positive as long as the share price remains above the 170p level, and manages to break to the upside (through 180p). Following a re-test of the lower channel support in-line with the wider market, in October, the shares have rebounded higher by roughly 20p to around 172.25p currently. Resistance remains at 180p, but with the MACD and RSI on balance trending higher, the upside case looks more likely than the downside case, which would be a return to 140p (market conditions allowing).

Liquidity is good, as is expected given the market cap is comfortably over £200m, and that is assisted by a free float of over 75%. Just over 8% of the issued share capital is owned by directors, which is encouraging given the company size, and given that CEO Clifford Elphick's stake is valued at over £16m, providing a strong incentive and comforting degree of management alignment. Numerous institutions hold notifiable stakes, including Lansdowne Partners and Capital Group International. Although Blackrock have reduced their stake significantly (from 13% to sub-5%), Lansdowne have increased their stake to over 14%.

A significant number of brokers cover Gem Diamonds. All have "Buy" recommendations (or stronger), with the ratings as follows and target prices in ascending order: Westhouse Securities (210p TP), Liberum (210p TP), RBC Capital (240p TP), Panmure Gordon (256p), FinnCap (261p), Citigroup (262p TP), Bank of America (275p), JP Morgan (280p).

Operations

Unsurprisingly, Gem Diamonds is a company involved with diamonds; in this case the production of diamonds in the Sub-Saharan countries of Lesotho and Botswana. Before looking closer at the two operations, a brief overview of the serious pure-play operators within the diamond industry, that are listed on the LSE is shown below. In fact, investors looking for serious diamond production candidates (away from the conglomerates such as Rio Tinto and Anglo American) on the London Stock Exchange are essentially restricted to five options.


Gem ranks second out of five in terms of the market capitalisation, and that is also linked to both Petra Diamonds and Gem Diamonds having much higher quality production plays at present, with both increasing their production capacity heading through 2015. Gem's board is highly rated with CEO Clifford Elphick having held senior positions in both De Beers and Anglo American, with COO Alan Ashworth also having held senior roles in De Beers, including the Head of Operations for the Consolidated Mines division.

As per the table, Gem has fairly large-scale operations at two assets;  Letseng and Ghaghoo, with the latter being ramped up into 2015 having encountered delays recently regarding a water ingress (since it is Botswana's first diamond underground mine.

Letseng itself is a 70% owned asset, with the balance being owned by the government of Lesotho. Located in the Maluti mountains, Letseng is a truly world class mine with the highest average $/carat kimberlite diamond mine in the world, boasting a significant resource and in-situ value (100%) of over $10 billion. The mine has a history of uncovering large diamonds, with 'exceptional' qualities that attract high sales prices; five diamond sales have been:
     -  August 2011: 550ct diamond sold for $16.5m @ $30,000/ct
     -  October 2013: 12.5ct blue diamond sold for $7.5m @ $603,000/ct
     -  January 2014: 2 rough 160ct+ diamonds that sold for $68,687/ct and $14,636/ct respectively
     -  July 2014: 198ct white diamond sold for $10.6m @ $53,746/ct

The presence of such high value diamonds at Letseng presents investors with speculative upside, as numerous finds of scale can dramatically alter results forecasts and present the company with a welcome windfall to bolster their cash balances. Plans at Letseng are currently to drive operating efficiencies, which include the setup of new coarse crushing plants to reduce the damage inflicted upon larger multi-carat diamonds, and reduce diamond breakage levels in general.

Ghaghoo, which is entering production and already has 4,000 carats stockpiled, is a significantly lower $/carat project located in Central Kalahari Game Reserve, Botswana. In fact, whilst the average $/carat value for a Ghaghoo diamond is expected to be around $250/ct, the average value for Letseng diamonds is over 8x higher, so this enables Gem to tap the lower end of the value spectrum and provide welcome diversity in terms of pricing fluctuations that may affect one part of the pricing spectrum more significantly that another. The tonnage for Ghaghoo is much larger at over 20 million carats; phase 1 production will confirm the grades, prices and recovery rates that are achievable at Ghaghoo, and this will be used as a template to determine the medium-run development plans. Ghaghoo is comparable to Petra's Cullinan mine in terms of value of production and margin/tonne.

CEO Elphick commented, "We are very pleased to be bringing the Ghaghoo mine into production. This is a significant step forward for Gem Diamonds as a Company as we add another mine to our portfolio of producing assets."

One of the most intrinsic risks associated with any miner is of course the commodity price for what they are producing; therefore, it is paramount to identify the potential outlook for the diamond price. One of the most difficult aspects to overcome when deciding upon this is how impartial consultancy reports are regarding pricing forecasts, and also how the real market is trending. 

Taking a particularly long-term perspective, it's currently hard to argue against robust supply-demand dynamics that are underpinning the market, with demand anticipated to outstrip supply as a growing middle class in China, and a return to strength in the US drive demand for diamonds, which are largely incorporated into high-quality jewellery. Demand consequently largely tracks economic growth and with no material discoveries in the past 25 years, there could be a market shortfall over the next two decades.

Gem's market dynamics are currently different to most of the market at present, given the especially high $/carat and quality, and that means that Gem has been partially insulated to a recent drop in prices, but it also means that fashion trends amongst the wealthiest buyers can have a disproportionately large impact upon demand. After all, diamonds are just carbon, hence it's the rarity value and mindset of buyers that supports high prices. It remains the case that the right diamond, can still attract significant returns; elsewhere in the market a 9.75ct fancy vivid blue diamond recently smashed its £15m estimate and sold for $32.6m, setting a new record in terms of price/carat (@ $2.4m/ct).

Indeed, whilst demand and prices have slipped in recent months for both rough and polished diamonds, Gem's prices have held up comparatively well, albeit circa 5% below some analyst's expectations for Q3. That market weakness is despite Investec forecasting a high single-digit rough diamond price rise for 2015, and is potentially linked to seasonal demand weakness within key markets. Equally, consultancy company Bain is forecasting rough diamond demand increasing around 4%-5% per annum over the next decade, versus supply which is expected to average 3.5%-4% to 2019 before entering decline.

The reality is that the mining market rarely forecasts major price declines, as has been the case with iron ore; very few consultancies were forecasting a drop, let alone the sheer scale of iron price drop that has materialised. Looking at more recent sources, Gem Diamonds noted in its November Interim Management Statement that "Diamantaires are cautious in the period leading up to Christmas following the Hong Kong Diamond and Jewellery Show in September. Prices achieved for Letšeng's high value production have remained healthy, as illustrated by the strong average price of US$ 2 603 per carat achieved in Q3 2014. The market for both rough and polished diamonds has declined towards October, however, we remain optimistic that prices for Letšeng's high value production will be resilient for the remaining sales of 2014."

Furthermore, large-tier mining company Dominion Diamond Corp noted last week that:

"In the third fiscal quarter, the rough diamond market felt the impact of tighter credit and lower than expected demand from the retail markets in India and China and approached the annual Diwali holiday shutdown in a cautious mood. Demand for rough diamonds that produce the commercial ranges of polished diamonds remained resilient but demand for the better quality ranges failed to improve, causing prices to weaken further. The retail jewelry market in the United States continued its growth and was the focus of activity for the bulk of the Company's clients and expectations for the Christmas season are favourable. Demand in the Far East was disrupted by the political events in Hong Kong over the Golden week in China, but the Chinese mass market has remained resilient. Retail demand in India failed to meet expectations in the run-up to Diwali but demand for the wedding season, which starts in December, is more encouraging."

This again supports analysts expectations that diamond prices are facing a period of weakness, and that is a key point to bear in mind.


Financials

Aside from the discovery of the near 200 carat white diamond earlier in the year, which generated a significant profit, Gem released encouraging H1 results on August 20th that showed continued strong progress at Letseng.

Revenues rose sharply (54%) to $148.9m, with a 29% rise in carats recovered to circa 55,000. Unit costs were up during the period, driven by inflation, but with the oil price having plummeted by almost 50% in recent months, there will be some operating costs benefits that should trickle down and hit Gem's bottom line for H2. The movement in the exchange rate, which has depreciated by around 7% versus the dollar, has largely been eliminated by the inflation rate in Lesotho.

Impressively, full year guidance was increased in several categories including the quantity of ore treated, and the number of carats recovered. Even more impressively, Q3 results beat expectations in terms of the proportion of recovery from the satellite deposits (which are higher grade) being 33%, which leaves potential for a top-line beat for the full-year. Underlying EBITDA jumped 87% to $62.2m, assisting in Gem maintaining a strong $98.4m attributable cash, despite high levels of CAPEX being incurred at Ghaghoo.

That ensured that the balance sheet remained very healthy, with current assets 2.04x current liabilities or 0.92x total liabilities, and far superior to that of counterpart Petra Diamonds who have corresponding figures of 1.58x and 0.36x (albeit that is still good). These figures are before the receipt of major diamond sales, hence at September 30th, cash attributable to Gem stood at circa $106m, or £68m, amounting to a highly material 28.6% of the market cap. However, stripping out attributable debts and that figure drops to around £46m, or 19% of the market cap. There is plenty of room in funding facilities in addition.

Heading into 2015, forecasts for Gem are relatively mixed with EV/EBITDA and PE forecasts spanning from 1.9 to 2.6, variable on certain input metrics. Likewise, various PER ratio forecasts span a range as wide as 7 to 9.5 (albeit materially lower ex-cash). Choosing my preferred input figures, a 2015 PER of circa 8.7 appears fair, and that drops towards 7 when stripping out the most recent cash pile. Regardless, those figures compare favourable to a peer group of Petra Diamonds, Lucara Diamonds and Dominion Diamond Corp. In each of these cases, the average $/carat is a fraction of that achieved at Letseng, although Dominion operates in Canada, which is a superior operating environment, and that is partly reflected in the high double-digit forward PER. Across the board, Gem appears to be trading on both comparative and absolutely discounted valuations, which looks unreasonable.

In a similar vein, Gem is trading on comparatively low Price/Net Present Value multiple of between 0.63 and 0.67 in its current trading range, and its EV/In-situ multiple stands at roughly 1.3%; again a discount to peers. So why is Gem Diamonds trading at a discount? The answer may lie within general caution towards the mining sector, a cautious near-term outlook for diamond prices, plus delays with production at Ghaghoo (caused by the water ingress). In reality, the latter point is not a point to be concerned with (as 0.55MT could be produced ~28cpht in 2015), nor is the first point given Gem's operational progress. The diamond price outlook remains the core point of doubt, and although a modest decline would not significantly impact Gem at an operational level, it could have an impact upon investor sentiment, delaying upside.

That said, CAPEX on Ghaghoo now looks to be nearing completion, and the company has commented upon its intention to commit to a maiden dividend, likely during the next set of results. That should assist in increasing market credibility, and a ~1.5% dividend at current prices would appear reasonable. That would amount to a dividend of around 2.60p. That dividend potential should be backed up by a free cash flow yield in 2015 exceeding 15%.

Cautious diamond price outlook dampens attractive valuation

Taking a medium-term outlook (6 - 18 months), Gem Diamonds offers a highly attractive asset base to investors at a highly attractive price; the caveats being assumptions that diamond prices across the spectrum (predominantly high value for Letseng) are at least stable, and that wider market conditions are broadly favourable. The start of production at Ghaghoo provides investors with an opportunity to gain access to a world-class asset that is Letseng, with production upside as decisions are made regarding the long-term production profile of Ghaghoo. Although the valuation is compelling with broker targets generally north of 220p, it makes sense to monitor the rough diamond price heading into Q1 2015 and watch for the next trading update due in mid-January as a precaution. Ultimately, if diamond prices at least hold where they are, and market conditions are not detrimental, then Gem Diamonds could be set to sparkle. No Rating

3 comments:

  1. Have you seen the videos from 2010 when the Big Bang Theory made synthetic diamonds using a super hot flame and putting it on a high flame setting for 24 hours and focusing it on carbon. It created very small /and im talking millimetres if that/ synthetic diamonds. The cost of making synthetic diamonds must be giant but I know that diamond recycling is becoming more popular even if its about 10 per cent of new supply I think. GEMD seems like a really professional outfit but its a shame I see no value in diamonds. Im bonkers but its just carbon and I'd rather buy coloured gems like rubies. Great piece of research and I'll reluctantly add it to my WL just incase my second half needs another 'girls best friend'

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    1. I just watched it in youtube. Intriguing :0) but not efficient :0P. I am a diamond bull so have picked some up

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  2. Excellent precis on the investment case that gem diamonds offers

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