Timing of Tender Sets Up Trade For Small-Cap Diamond Miner
Weak diamond prices have hindered all miners as of late, but Toronto-listed Lucara Diamond Corp’s (TSX: LUC) Q2 results looked especially dismal at first glance with the company’s average price-per-carat for the period falling a staggering 53.3% year-over-year and income concurrently dropping 44.9% (see Figure 1).
However, after digging a little deeper, its apparent that the timing of Lucara’s first “exceptional" diamond tender of 2015 made the company’s Q2 financial results appear worse then they actually were. The tender did not conclude until July 16th, so it’s contribution was not included in the company’s Q2 figures, which only included activity up until June 30th.
The company’s "exceptional" diamonds, those it estimates to sell for at least $1 million, make the Lucara’s Karowe mine in central-Botswana the source of world’s 2nd most expensive diamonds on an average per-carat basis; a figure which tends to be skewed by the few, but extremely valuable, "exceptional" stones the mine produces. Lucara's "exceptional" diamonds represent <2% of of the company's production by carat volume, but on average sell for over 100 times the company's regular production.
On top of the timing impact the "exceptional" tender had on headline sales figures, the company also guided that milled ore would be approximately 6% lower then previously estimated for full-2015 due to temporary plant optimization disruptions. Ore will still be mined at planned rates, but processing of the ore and recovery of diamonds will be effected. This will lower the recovery of diamonds available for sale by about 35,000 carats, or approximately $18.5 million in revenue, in the back-half of the year. While actual production decreased by about 35,000 carats in the first half of the year over 1H 2014, diamond sales in 1H 2015 dropped less than proportionately as sales tend to lag production; however this lag will catch up and the impact should be apparent in the second half of the year and early 2016.
In the first day of trading following the Q2 report, which was released after the close of trading on August 11th, Lucara’s stock sold off 8.8%, down to C$1.76 per share. The stock has since traded down further to C$1.53 per share, or -20.7%, since the release, equivalent to a C$152 million decrease in market cap. C$1.53 marked a new 52-week-low for the shares, which traded as high as C$2.45 in November of last year (see Figure 4).
While the market responded negatively to the report, Q2-over-Q1 numbers actually look quite promising. The company’s average price-per-carat increased 42.5% over the previous quarter, and income increased 43.3% (see Figure 1). The company attributed the increase to the recovery of higher-valued diamonds, those not qualifying as "exceptionals," during the period. The ongoing plant optimization aimed at improving recovery played a role as a greater percentage of larger stones were recovered without damage.
Even more promising, the July 16th “exceptional" tender produced $68.7 million in sales, which if included in the Q2 numbers would have further improved the average price-per-carat for the period 168.6% to $1,064 per carat, and net income by approximately 107.0% to $17.8 million, equivalent to an increase of 2.4 U.S. cents per share of earnings (see Figure 2). Further, the July tender resulted in the second highest prices ever achieved for the company at an "exceptional" tender; an average price-per-carat of $41,045, second only to the $42,376 achieved in April 2014 (see Figure 3).
It is worth noting that the company increased the threshold for what qualifies as an "exceptional" diamond in 2015, a change in categorization that should impact the average price-per-carat figure for "exceptional" diamond sales as well as regular sales, as some stones that in previous years would have been sold as "exceptional" are now sold at regular tenders. That said, cumulative diamond sales for 2015, "exceptional" sales included, have yielded an average price-per-carat of $662, which is an increase of 2.8% over the $644 achieved in 2014.
The prices Lucara recently recieved for it's production mix show how relatively well positioned the company is in an overall weak diamond market. Global rough diamond prices on average are down 12.1% over the last 12 months, according to the Zimnisky Global Rough Diamond Price Index.
Dampened demand for diamonds in Asia, continued credit challenges in the industry, and a stronger dollar have led to a global glut of polished diamonds. In some cases jewelry manufacturers can currently buy polished for less than they can buy and produce rough. This negative spread has effectively wiped out some diamond cutter’s margins, especially those primarily dealing with average-quality product.
However, higher-end rough, such as Lucara's "exceptional" diamonds, are much more limited in supply, and prices have held up significantly better than average-quality diamonds. Manufacturers have shown that they are still willing to pay top dollar for premium product needed fulfill special high-end customer needs.
For example, in July, the highlights of Lucara's "exceptional" tender were the sale were a 342 carat Type IIa white, and a 270 carat white (both pictured) which sold for $20.6 million and 16.5 million, respectively, which on a per-carat basis is in line with what the company has received for similar quality stones going back as far as 2013.
Since the July sale, Lucara has recovered 5 more “exceptional” stones, which will most likely be sold at a recently announced November tender in Gaborone. A 336-carat Type IIa white, 184, 94, and 86 carat whites, and a 12-carat faint-pink, were all recovered in a two day period, August 15 and 16th.
The pink is the first fancy colored stone recovered from the mine's South Lobe, a higher grade section of Karowe's kimberlite body that has recently become the company's target area of production.
While I typically avoid stocks making new lows, I like the prospect of a long Lucara trade going into Q3 results, especially at current levels. The headline quarterly figures will benefit from the July “exceptional” tender, and there is potential for more notable high-quality diamonds coming out of Karowe's South Lobe in the meantime. With "exceptional" diamonds historically representing on average 57% of the company's total revenue, the company has remained profitable despite global diamond price weakness. The C$580 million market-cap company is currently trading at 9.6 times trailing earnings, and maintains a dividend program, with a trailing yield of 5.2%.
In addition, the backdrop of a highly anticipated De Beers second-half 2015 marketing campaign should the benefit the diamond industry as a whole and in turn support prices. Lastly, mining equities in general appear to be bottoming out as they make multi-year lows on record volume, which could result in some general rotation back into the space after multi-year long investor apathy.
This was published in print in the London Mining Journal in September 2015.
At the time of writing the author held a long position in Lucara Diamond Corp. Please read full disclosure below.