The Gold Report: You're different from most analysts on Bay Street in that you
cover both diamond producers and developers. What are some key differences
between gold producers and diamond producers that investors should know
about?
Matthew O'Keefe: The big
difference is really the drivers for the respective commodity prices. Gold
prices are largely driven by currency exchange rates and the safe
haven/investment demand, whereas diamond prices are about supply and demand
and global economic growth. Diamonds are a luxury good that people buy in a
consumer-driven economy.
China has been a big part of that story for diamonds as
it moves from its investment-driven economy driven by infrastructure, which
took a lot of base metals, to a consumer-driven economy, which is more about
buying finished goods and includes diamonds and jewelry. China still has the
highest growth rate for diamond demand, though that has weakened recently
with the pullback in the Chinese economy. But that's the biggest
difference—diamonds are much more of a consumer product.
TGR: How do diamond
deposits differ from gold deposits?
MO: A diamond deposit is
like the ultimate "nuggety" gold deposit. These deposits require a
certain level of additional bulk-sampling work and geostatistics on the
capping of the gold grade. This is similar to diamonds but with diamonds,
because they're lower grade and each deposit has a different diamond
population, it's another order of magnitude of work to determine value. That
means there tends to be higher risk on the exploration side, yet by the time
a company has gone through the pains of properly defining the resource, it is
generally pretty sound. There are also far fewer diamond mines and projects
than for gold, so it's a much narrower space. There are not many names of any
size, probably a dozen.
TGR: The diamond space is largely controlled by a few players. How
does that affect the market?
MO: Diamond supply is largely controlled on the supply side by two
major players: Russia's ALROSA-Nyurba OAO (ALNU:RU) and De Beers, which
controls about 40% of global production. De Beers is part of Anglo American
Plc (AAUK:NASDAQ) now and is still a big player, but in the 1980s, it
controlled closer to 90% of production. That changed in the late 1990s when
new mines outside of De Beers came in, including Rio Tinto Plc (RIO:NYSE;
RIO:ASX; RIO:LSE; RTPPF:OTCPK) with the Diavik diamond mine and BHP Billiton
Ltd. (BHP:NYSE; BHPLF:OTCPK) with Ekati, both of which are in Canada's Northwest
Territories.
Recently diamond prices have been under pressure due to tightened lending
and resultant deleveraging to the middle diamond pipeline, the cutters and
polishers. As a result, they've had to push out a lot of inventory, which is
what has put pressure on diamond prices. But the producers, led by De Beers,
have acted quickly to reduce supply in order to help offset the glut. De
Beers is also helping by allowing deferrals of purchases from some cutters
and polishers and increasing its advertising budget to help bolster demand
for diamond jewelry. So there's a rebalancing happening in the diamond
pipeline. The next big catalyst is the upcoming holiday season. About 40% of
diamond jewelry sales occur during the holiday season, and that big movement of
inventory should help reduce the oversupply situation.
TGR: How are the economic woes in China affecting parcel prices?
MO: Chinese demand has softened recently and exacerbated the liquidity
issues in the middle pipeline. As a result, diamond prices have come down
about 15% over the course of the year. Different suppliers have approached
the issue in different ways. Companies like Dominion
Diamond Corp. (DDC:TSX; DDC:NYSE) have steadily reduced their prices as
price-takers, whereas De Beers and ALROSA reduced their prices in bigger
steps later in the year after first reducing supply.
Diamond prices are stabilizing, but demand is still soft. We're not
expecting them to go down much further, but we aren't expecting them to
bounce back before January–February 2016 either. Part of the issue is China,
but China accounts for only about 20% of diamond demand for jewelry. The U.S.
remains the dominant purchaser of diamonds. Over half of diamond jewelry
sales occur in the U.S., and we are expecting some good retail results in the
U.S. over the holiday season given its stronger economy. That should lead to
restocking by the cutters and polishers and more stable prices.
TGR: What are some diamond companies you'd like to introduce to our
readers?
MO: We cover Dominion Diamond Corp. with a Buy rating and
CA$25.00/share target and Lucara Diamond Corp. (LUC:TSX.V) with a Buy rating and $2.25/share
target. Dominion is the established producer, with two mines, two mills and
multiple pipes feeding those mills. Dominion shares have sold off quite a bit
in the last six months, based largely on these diamond price headwinds, but
we see this as an opportunity because Dominion is bringing on a high-grade
pipe called Misery in 2016. That should help double cash flow by H2/16, so
you have a strong catalyst in the next 12 months. Over the longer term, it's
permitting its Jay project, which will add 10 years to the mine life at
Ekati—Dominion bought Ekati from BHP Billiton in 2013—and should solidify the
longer-term sustainability of the company. The stock is trading in the
developer range as opposed to the producer range, so we think there's some
excellent value in it.
Mine-wise, Lucara is at the other end of the spectrum. It's a single asset
producer in Botswana that doesn't produce a lot of diamonds, but it produces
some of the highest-quality diamonds in the world— and 100+ carat stones on a
regular basis. It produces about 30 or more a year of those super high end
stones, the best of which can fetch upwards of $10 million ($10M). The
benefit of being at the high end of diamond production is that its high
margins insulate the company from price fluctuations in the greater diamond
market. It also has specific customers who consistently go after its goods
and are less sensitive to the recent weakness in pricing and demand for more
average diamonds. Both Dominion and Lucara pay a regular dividend but Lucara
currently delivers a special dividend at the end of each year based on
additional value taken in from exceptional stone tenders.
TGR: What are some diamond developers you are following?
MO: On the developer side, there are two names we cover that I think
are going to be quite topical in 2016—Mountain
Province Diamonds Inc. (MPV:TSX) and Stornoway
Diamond Corp. (SWY:TSX). We rate Mountain Province a Buy with a $6.50
target and we rate Stornoway Diamond Corp. a Buy with a $1.30 target. They're
both building diamond mines and are well into construction.
Stornoway's 100%-owned Renard project is in Québec and we really like Stornoway,
particularly for the upside when it gets into production. It's going to be a
large-stone producer with modeled values in the $200/carat range but we
expect it should go higher than that once in production based on its coarse
diamond distribution. It is fully funded and trading relatively cheaply
versus its peers.
Then there's Mountain Province Diamonds, which owns a 49% interest in the
Gahcho Kué mine in the Northwest Territories. It's a fairly large mine that's
a joint venture with De Beers, the operator and 51% owner. So investors who
want the comfort of De Beers as a partner may tend to go for Mountain
Province. Gahcho Kué is about six months ahead of Renard, so it should be
producing diamonds by mid-2016. It will probably be the best mine that the
Territories has seen since Diavik but arguably lower risk because the lakes
are shallower and it's a technically easier build.
TGR: Stornoway President and CEO Matt Manson deserves the credit
for putting together the financing for Renard, a combination of debt, equity
and diamond streaming. Is there enough margin left to generate cash flow?
MO: We've modeled Renard in detail and we see margins in the 55% range
after the stream—that's in line with other quality diamond producers—and
annual free cash flow averaging in the $120M range, so plenty of margin. The
unique aspect of that deal was probably the diamond stream, but that was
necessary. Stornoway had to raise almost $1 billion to build the mine and at
the time, that was really the only way to do it. We think Renard is going to
be one of the better producers, but also we see the most upside because it
has the best chance of an increase in diamond value once in production.
In diamond pipes, you get coarser and finer diamond
populations. A coarse population means that there are more large stones.
Diamond size is the biggest driver of diamond price. We like to refer to
diamond prices in the Diamond Price Index, but that's just an index of
average sales of all diamonds, mostly small, over a period of time. Each mine
is different. Each diamond is different. So when you look at a diamond
population within a specific pipe, the coarser the population, the more large
stones and generally the higher the value. Statistically Stornoway should get
a 100-carat stone every few weeks, but whether it's going to be of good
quality or not you can't tell until you start mining and have the data.
TGR: Where is the growth
going to come from for Lucara?
MO: That's one thing that's troubling with Lucara. It has a top-end
asset, and the diamond space is not deep. It's doing a bulk sample on a
neighboring project in the same cluster of pipes. We'll see if it gets
another mine out of that. But other than that, it would have to look to
M&A for growth. It doesn't seem keen on South Africa, which would
mean either something else in Botswana or in Canada. There are only a few
names in Canada that would fit. Besides Stornoway one potential name would be
Peregrine
Diamonds Ltd. (PGD:TSX), which is a small developer in Nunavut with
high-value stones. We have a Buy, Speculative Risk rating on Peregrine.
TGR: Any others?
MO: Kennady
Diamonds Inc. (KDI:TSX.V) has an interesting discovery with its Kennady
North project in the Northwest Territories. It has done a great job. A lot of
people would have written off that area, yet Kennady outlined a whole new
style of kimberlite in that region. In our view, the most logical path for
the Kelvin pipe is to find its way into the Gahcho Kué mine plan. So far, it
doesn't stand out as being any better than the existing pipes in the plan,
but it would certainly complement that mine vis-à-vis longer life.
Kennady is still working on its bulk sample and the company is fully
financed to get this thing through a feasibility study at the end of 2017. Of
course, if Kennady can demonstrate that Kelvin would be economic as a
standalone mine, that could open up the door to other potential bidders or
builders. Technically, you could have developed Diavik and Ekati as a single
operation, but they were robust enough to support two mines and two owners.
We'll see how things work out at Kennady, but it could be a similar
situation. We have a Buy, Speculative Risk rating on Kennady.
TGR: Thank you for your insights, Matt.
