Rough year creates opportunity in diamonds: Q&A

Diamond equities have had a rough ride in 2015, but what about next year? In an interview in early November, Matthew O’Keefe, vice-president and senior analyst at Dundee Capital Markets, explains why diamond prices have been hard hit over the past year, and why he expects 2016 to be a more exciting year for the diamond sector.

Diamonds in Canada: For quite a while diamond stocks were the only segment of the mining sector that was doing well. That’s changed over the past year with diamond producers down on average 32% for the year and developers down 18%. Why have diamond equities started to follow the other commodity equities down?

Matthew O’Keefe: The main driver has been diamond prices — they have been weaker and weakening since last year and that’s put pressure on equities. Year-to-date, rough diamond prices are down about 16% and polished prices are down about 7%. The catalyst that started the decline was the closure last year of the Antwerp Diamond bank and that really put a lot of pressure on the middle pipeline — the cutters and polishers — where a lot of the inventory, both polished and rough, has been stored traditionally.

The result has been a bit of a liquidity crisis for the middle pipeline, so they have had to sell more inventory and reduce the amount of inventory they’re carrying. So it’s not so much that demand for diamonds has dried up — it’s that there’s been a shock to the system putting more diamonds up for sale than the system can handle in the short term.

The pipeline has to be rebalanced, which means moving out a lot of what’s now become oversupply.

The other thing that’s added pressure more recently has been the slowdown in the Chinese economy. The Chinese market for diamond jewelry has slowed and basically the stores are overstocked — they were expecting much stronger growth for longer than they’re seeing. That’s put pressure on diamond prices as well and it’s affected the equities.

It’s not all bad. In the United States, which accounts for about half of the diamond market overall, demand for diamond jewelry is back to historic levels.

DiC: You mentioned that rough prices are down about 16% year-to-date (based on the WWW rough diamond index). Are prices likely to fall further?

MO: Maybe not a lot further, but we think there’s probably still some weakness there. We aren’t expecting to see diamond prices recover before the new year. Producers have acted pretty responsibly: De Beers still controls about 40% of the market, and they did a lot of things that you would want to see a big producer do — they reduced output, so they’re leaving diamonds in the ground. They also allowed their sightholders to defer purchases, so they’re carrying more inventory themselves. And they’ve recently lowered prices, so that should also help the middle market to buy more diamonds once they’ve increased their liquidity.

They’ve also increased their advertising budget for this holiday season, which should help to spur demand, so they’re doing what they can to manage the situation and help rebalance the pipeline.

We’re coming up on the holiday season here and in the U.S., which is still about half the market for diamond jewelry, this is the biggest season for diamond jewelry. About 40% of purchasing happens between Christmas and Valentine’s Day.

That should help to clear off this oversupply, but we do need to have a strong holiday season. If it’s a weaker season, we might see the muted prices for another year. But right now we’re thinking this will be a good opportunity to clear off a lot of inventory and then lead to restocking next year: so we’re expecting prices to improve early next year.

DiC: And you’re still positive in the long-term on diamonds.

MO: Long-term we’re positive: The supply dynamic is such that after 2017, there aren’t really any big diamond mines coming onstream. And mines do get old, so supply starts to drop fairly consistently after 2018. So the long-term fundamentals are quite strong in that there’ll be a lack of supply by the end of the decade that should lead to higher prices.

DiC: Let’s talk about some of the equities you cover. Which companies are you most bullish on right now — if not in the short term, then in the medium to long-term?

MO: There’s going to be a headwind right through to the end of the year, plus because a lot of diamond stocks have had a rough year, you might get some additional pressure toward the end of the year due to tax-loss selling. So in the short-term it’s not looking too rosy, but in the new year, we’re pretty positive.

One company that stands out for us is Dominion Diamond (TSX: DDC; NYSE: DDC). We’re buy-rated, we have a $25 target on Dominion, which is trading at around $12.40 now. It had a rough year — it sold off quite a bit, mostly due to diamond headwinds. But we like it for 2016, which should be a real turning point for them as the Misery Main pipe is coming into production at Ekati. They’re getting into the core of that pipe and it’s very high grade, over 4 carats per tonne, with very good margins. They’ll also get the full effect of Pigeon, which is another pipe they’ve been developing with very high-value stones (US$200 per carat). So the net effect will be a significant increase in their margins and in our model, the cash flow jumps to almost US$300 million, which is more than double this year’s estimate. So 2016 should be a very, very good year for Dominion.

Longer-term, we should also see permitting progress on their Jay pipe, which is really important for Ekati’s long-term future.

DiC: Dominion Diamond took over Ekati in 2013 and before that they hadn’t been an operator, just a 40% owner of the Diavik mine. How would you rate their performance as an operator?

MO: Mostly good. Since they received the operation they’ve effectively updated the plant, which was due for some upgrades, and they were able to increase throughput. They’ve also kept the Pigeon and Misery projects on track. They had a couple of hiccups earlier this year — they had a belt failure at Ekati — but this is mining, those things happen. They managed to get it back on track without too much disruption. A lot of the credit I think goes to their CEO, Chantal Lavoie, who was brought in right after the acquisition. So they brought in the right people to lead the operations and they kept much of the operating team from the former owner BHP Billion (NYSE: BHP; LSE: BLT) (not rated).

In addition to maintaining and improving operations at the existing and planned projects, they’ve pushed ahead with the Jay and Sable projects, which BHP Billiton hadn’t shown much interest in. Dominion made the acquisition based on adding mine life and formally adding new projects into the mine plan and they’re on track to do that with both Jay and Sable.

I think the market has been particularly tough on Dominion as a reflection of diamond prices as opposed to their performance.

Another positive with Dominion is that their balance sheet has been very well managed in light of the weaker market and this transition that they’ve been going through. It’s exceptionally strong, with about US$340 million in cash and only about US$40 million in debt. So they should be able to fund their development out of cash flow.

DiC: What other diamond stocks are you especially positive on going forward?

MO: We’ve got a buy rating and a $1.30 target on Stornoway Diamond (TSX: SWY), which will have first production from its 100%-owned Renard project in Quebec by the end of 2016. That’s a medium-sized mine, about 1.9 million carats with some very good diamond values, about US$200 a carat. The other company in a similar situation is Mountain Province Diamonds (TSX: MPV; NASDAQ: MDM): we have a buy rating and a $6.50 target on them. They are the 49% owner of the Gahcho Kué project in the Northwest Territories that De Beers is operating. They’re on track to start production in mid-2016. It’s a much bigger mine, expected to produce over 5 million carats a year.

These are both developers that will become producers next year, and that’s generally a catalyst for a stock price rerating.

DiC: How is the strength of the U.S. dollar and the corresponding weakness in the Canadian dollar affecting diamond producers and developers with projects in Canada?

MO: For Canadian producers, it should be a wash. We adjusted our models for the F/X rate and there was virtually no change to our NAVs or our targets. The bulk of their costs are in Canadian dollars, and their revenues are in U.S. dollars, so for Canadian producers, the diamond price pullback has been offset largely by the exchange rate. Diamond equities have come off, but that’s more of a concern over diamond demand given the oversupply in the pipeline.

As far as the developers go, they’ve actually benefited more from the F/X because they raised some proportion of their financings in U.S. dollars when the Canadian dollar was stronger. Mountain Province and Stornoway have benefited from the exchange rate to varying degrees, and regardless of what happens to the Canadian dollar from here, they’ve already locked in some F/X gains.

The other thing that’s been benefiting these developers is there’s not a lot of competition to build mines right now, so they’re getting access to good people, and almost no wait for equipment. It’s a very good time to be building a mine in Canada: We’re not expecting these guys to fall behind schedule or go over budget on their projects.

DiC: Lucara Diamond (TSX: LUC) recovers some really large and special diamonds from their Karowe mine in Botswana. Is the market for those high-value stones holding up better?

MO: Lucara has seen similar reductions in prices on their run of mine production, their small and regular stones. But with their large stones, they’ve seen continued strength in prices. Mining has moved into the South Lobe of the AK6 kimberlite, where they’ve been getting more of these large stones, so as a result, their overall average diamond value hasn’t been impacted. The bulk of their revenue comes from their higher value and large stones and they’ve proven that the Karowe mine is a consistent and reliable source for those stones. We have a buy rating and a $2.25 target on Lucara.

DiC: Just to touch on some of the diamond explorers that you cover, we’ve had diamond valuations recently from both Kennady Diamonds’ (TSXV: KDI) Kennady North project in the Northwest Territories and North Arrow Minerals’ (TSXV: NAR) Qilalugaq project in Nunavut. What did you make of those results?

MO: We have a buy rating on Kennady Diamonds and their initial diamond results were positive, but lower than we expected. We were expecting US$100-140 a carat and they were at the low end of that, which was a reflection of two things. One, we’re in a weak diamond price environment and they did their valuation at one of the lowest points. Second was an insufficient sample size. It was clear from the discussion in their press release that WWW needed more sample to give a fully confident diamond valuation — they just didn’t have enough stones. So Kennady is doing another 500-tonne bulk sample this winter from the North lobe of the Kelvin kimberlite and that should give them over 2,000 carats in total to come out with a more reliable result. The results were positive, but they weren’t conclusive so they need to do more work and we’re going to see that coming up.

With North Arrow, their valuation results from Qilalugaq were disappointing. It was a small sample as well and they got a pretty low value, US$43-92 a carat. Our research suggested they would need at least US$155 a carat to support an economic project, so that fell well short of the mark. There might be some limited follow-up work — the yellow stones they were hoping to find were there and some of the diamond people we talked to were pretty excited about the colours, but it appears that the shapes and some of the underlying stones didn’t quite carry the value. It’s a fairly large pipe and more work should probably be done on it, but for a company of North Arrow’s size and the expense of doing that, they’ll probably save it for another day and focus on their earlier-stage Pikoo project in Saskatchewan instead.

At Pikoo, they’ve discovered several new diamond-bearing kimberlites and are planning a drill program for 2016. We do like that project for its proximity to infrastructure, which means it will have a much lower economic threshold than anything at Qilalugaq or any of the other northern projects and it has great team on it, but it’s still early days. We have a buy rating on North Arrow.

DiC: Both Kennady and North Arrow have had more luck accessing financing in what’s been a terrible market for exploration.

MO: Yes, that’s one of the reasons we like all three of our explorer picks, Peregrine Diamonds (TSX: PGD) being the third. Not only do they have good projects and very good technical teams, they have the boards and the supportive shareholders that will allow them to continue to fund these projects. Diamond exploration is high risk, expensive, and it takes a long time, so you need supportive shareholders that are in it for the long haul and all these three companies have demonstrated they have that.

DiC: What milestones does Peregrine have coming up?

MO: We have a buy rating on Peregrine Diamonds. Peregrine was a fairly quiet story in 2015, but they’ve actually got a lot of catalysts coming up in early 2016. They collected a bulk sample from the CH-7 pipe, so we’re expecting to see a valuation on those stones in the new year.

They’ll also provide a resource update on CH-6 and CH-7, which will inform a preliminary economic assessment they are targeting for delivery in mid-2016.

CH-6 is very high-grade and high-value — usually you get one or the other, but you have both with CH-6. However, it is a fairly small pipe. With two pipes, you might get the tonnage up to support a mine — but you also have to have the value in the second pipe, and that’s what the current program is designed to answer.

Disclosures: Matthew O’Keefe beneficially owns, has a financial interest in, or exercises investment discretion or control over, securities issued by SWY.
Dundee Capital Markets (DCM) has provided investment banking services to NAR in the past 12 months. DCM and its affiliates, in the aggregate, beneficially
own 5% or more of a class of equity securities issued by PGD. Matthew O’Keefe has visited material operations of PGD, DDC, LUC, SWY, MPV and KDI. Matthew O’Keefe and/or DCM has been partially reimbursed for expenses or partial expenses were paid for by SWY, MPV, and KDI for travel to material operations.

— This interview originally appeared in the November 2015 issue of Diamonds in Canada.