Lucara Diamond Is A Diamond In The Rough

Aug.15.13 | About: Lucara Diamond (LUCRF)

Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.

Lucara Diamond (OTCPK:LUCRF) is still being valued as a riskier exploration stage miner rather than a profitable and growing producer. The current "backward looking" valuation fails to reflect the recent and significant operational transition.

Company overview

LUCRF.PK (incorporated in 1981 as Le/O Oil & Gas) is a diamond miner focused in Africa. LUCRF.PK acquired Tellis Gold Mining in 1986, Motapa Diamonds in 2009 and African Diamonds in 2010. Below are the two key mining assets:

Karowe mine (Botswana)

This mine is a single open pit mine located in the Orapa/Letlhakane district, one of the highest diamond producing areas. Operations started in April 2012 with the ramp-up to full production in August 2012. LUCRF.PK owns 100% of Karowe.

Mothae Project (Lesotho)

A trial mining program has been completed. In Q412, work on the preliminary economic assessment (PEA) was suspended pending a review of the overall mine economics. LUCRF.PK owns 75% of Mothae while the Government of Lesotho owns 25%.

Investment thesis

Traditional "backward looking" value investors as well as those that rely on screens in the idea generation process miss out on many misunderstood and undervalued investments.

LUCRF.PK is one of the few publicly traded, pure-play and profitable diamond miners. A majority of the world's diamonds are produced either by larger publicly traded miners such as BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO), state owned companies (ALROSA in Russia) or private companies. Similar to the gold and silver mining industry, there are many exploration stage diamond miners with little to no production and consistent operating losses. Until late last year, LUCRF.PK was one of these miners. Even though the stock is up ~50% YTD, the current valuation fails to reflect the significant transition from no production and losing money to growing production and earning money.

Furthermore, overall industry valuations are still depressed as diamond prices fell last year due to lower global economic growth as well as the sharp decline in the Indian Rupee, which negatively affected Indian manufacturers. However LUCRF.PK noted in the 2012 annual report (PDF) that rough stone prices stabilized at the end of 2012 and that the medium to long-term diamond outlook is positive due to expected production shortfalls as mature mines approach non-economic depths and a lack of new projects to replace the diminished reserves. As a result, the short term oriented market is providing an opportunity for longer term oriented investors.

Source: Company presentation

The Karowe mine is exceeding expectations and has significant upside potential

Karowe came in within its budget of $120 million (a significant accomplishment considering the inherent risk of cost overruns) and achieved full production in ~four months (despite initial water supply and demand issues) and exceeded design capacity in 3Q12.

Source: Company presentation

LUCRF.PK recovered 303,000 carats in FY12 (~12% higher than forecast of 271,000 carats) at an average grade of 22 carats per hundred tonnes (compared to budget of 20.2). LUCRF.PK expects to sell 420,000 carats in 2013.

In addition to its regular tenders, special tenders of high value stones represent a significant opportunity for increased revenues. LUCRF.PK is planning its second exceptional stone tender in September 2013 to feature 16 single diamond lots, including five diamonds larger than 100 carats and one small pink diamond. Furthermore, LUCRF.PK made modifications to the top size of material that the process plant treats, which should result in additional recovery of larger than expected diamonds.

In December, an updated independent valuation by Shlomo Tidhar of Mercury Diamond indicated a 24% increase in overall value to $301 USD per carat.

Valuation should eventually catch up to growth profile

As LUCRF.PK completes the previously mentioned transition, its multiple should rise to reflect the significantly reduced uncertainty typically associated with exploration stage miners. As the charts below show, revenue continues to grow while high operating leverage generates significant bottom line growth (e.g. cash operating earnings in the mrq were $33.3 million or 71% of gross revenue).

Moreover, unlike other commodity producers, LUCRF.PK can withhold its product from the market in order to realize better prices (e.g. you can't do this with corn). LUCRF.PK postponed two sales last year after receiving inadequate bids and later sold the diamonds months later for a significantly higher price.


Financial strength reduces chance of dilution or high interest costs

LUCRF.PK has low net debt despite its growth through acquisitions strategy. In the mrq, cash/equivalents more than doubled to $28.5 million (from $7.7 million in the year ago period) due to strong operating cash flow, which provided the funds to reduce debt to $32 million (from $51 million in 4Q12). LUCRF.PK has access to an undrawn $25 million credit facility.

Risks

Exploration risk. There is inherent risk in the mining industry, including exploration projects failing to produce economical deposits as well as operational challenges (e.g. access to water, power and equipment as well as accidents and labor disruptions). Furthermore, there is a high degree of uncertainty related to estimating reserves and the economic feasibility of a project.

Country risk. LUCRF.PK would be negatively affected by a deterioration in relations with the Botswana or Lesotho governments including permits, royalty rates, etc. This risk is reduced given that operating conditions in Botswana and Lesotho are considered favorable compared to other developing countries.

Competition. LUCRF.PK competes against many other diamond miners, many of which have greater resources (see above).

Diamond price risk. LUCRF.PK would be negatively affected by a decline in the price of diamonds.

Relative lack of transparency. Sale prices are often kept confidential and there is no quoted market for diamonds. Moreover, diamonds (unlike gold or heating oil) are not a homogenous product (e.g. no two diamonds are alike).

Foreign exchange risk. LUCRF.PK is exposed to foreign exchange risk through its African operations (Botswana Pula is the currency) although this risk is significantly reduced through hedging.

Conclusion

The target price of 1.15 is based on a 5x EBITDA multiple (annualizing 1H13 EBITDA). This valuation assumes no value for the Mothae Project.

A stop loss should be placed 5% below entry. The time frame is 12-18 months given the medium term investment thesis, dependent on a recovering diamond market and increasing investor acceptance of the LUCRF.PK growth story.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.