What Every Investor Needs to Know About the Diamond Market: Dundee’s Matt O’Keefe
Investing in diamond equities is quite different from investing in gold equities, explains Matthew O’Keefe, vice president and senior analyst with Dundee Capital Markets, one of a handful of Canadian analysts covering the diamond space. O’Keefe says diamond deposits require “an order of magnitude” greater study than gold deposits in order to properly determine grade, and says diamond prices are almost exclusively driven by consumer demand. In this interview with The Gold Report, O’Keefe sheds some light on two undervalued diamond producers, as well as three promising developers.
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.
“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.”
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.
“Diamonds are a luxury good that people buy in a consumer-driven economy.”
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.
“China still has the highest growth rate for diamond demand, though that has weakened recently with the pullback in the Chinese economy.”
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.
“There are far fewer diamond mines and projects than for gold, so it’s a much narrower space.”
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.
Matthew O’Keefe is vice president and senior analyst at Dundee Capital Markets. O’Keefe has worked 12 years as a research analyst in mining, including 10 years covering diamonds. As an exploration geologist, he worked on gold, base metals and diamond projects, including the development of the Diavik and Snap Lake diamond mines. O’Keefe was awarded “Best on the Street” for Mining in 2010 by the Wall Street Journal. He holds a Bachelor of Science in geology from the University of Toronto, a Master of Science in geology from Queens University and an MBA from the Ivey Business School at the University of Western Ontario.