Diamonds are not necessarily an investor's best friends, but Petra Diamonds (OTC:PDMDF) shares have treated investors pretty well in just the past three months, shooting up more than 50% on increased optimism about the company's expansion plans and cost structure. The shares have probably overshot the mark in the short term, but Petra's collection of mines (and its plans to improve their productivity and value) certain bear watching.
A Sizable Player
Petra Diamonds is not likely a household name for most readers, even though it is the fourth-largest diamond miner in the world and the largest publicly-traded pure-play. "Fourth-largest" requires some context, though, as Russian state-owned (but recently IPO'ed) ALROSA produces almost one-quarter of the world's production, while DeBeers produces another quarter and diversified miner Rio Tinto (RIO) around 10%.
Even so, Petra is a sizable player with over 300 million carats of resources and five primary mines. Four of these mines are located in South Africa, while the fifth is in Tanzania. Petra also owns exploration assets in Botswana, thus far a relatively under-explored potential source of gem-quality diamonds.
The Finsch and Cullinan mines are the core of Petra's operations. Together, I expect these two mines to account for about 85% of 2014 production and they likewise account for more than 80% of the company's identified diamond resources.
Finsch was acquired from DeBeers for under $200 million in 2011, despite boasting relatively modern infrastructure. Petra is looking to make significant investments into Finsch in the coming years aimed at moving into fresh, undiluted kimberlite ore. With that, management believes that it can increase production by over one-third (from about 1.5 million to 2.0 million carats), improve the yield of high-quality stones (Finsch has averaged more than 27 stones of 45 carats or larger per year), and perhaps reduce operating costs due to less wear and tear on machinery and the use of new automated systems.
Cullinan was likewise acquired from DeBeers (in 2008) and while the mine's current plan would see a useful mining life of less than 20 years, it seems plausible that expansion plans could boost that to 50 years or more. Critical to the Cullinan story is its unusual concentration of high-quality stones. Cullinan has historically been an important global source of Type II (Type IIa and IIb) diamonds, and one-quarter of the world's 400 carat-plus diamonds have reportedly come from this mine. Uncommonly large diamonds, particularly colored diamonds, can carry almost unbelievable price tags of over $1 million per carat, and they are an important source of value.
Other Plays Need Some Work
Finsch and Cullinan drive the Petra story, but they are not all there is. The company's Williamson mine in Tanzania is the world's largest economic kimberlite resource (around 146 ha), but the grades are very low (five carats per 100 tonnes of ore on an indicated basis, versus almost 50 at Finsch and over 40 at Cullinan on a proven/probable basis). The size of the Williamson asset means that the mining has thus far been pretty shallow (I believe the deepest pit is only 90 meters), but the tenuous situation regarding electricity and water supply in Tanzania means it may well be difficult to ramp up automation to a level that could offset the low ore grades.
Koffiefontein (or Koffie) is another interesting case. Koffie accounts for less than 5% of Petra's production, largely because the grades are low (less than 10cpht on a proven & probable basis). The interesting thing is, Koffie produces uncommonly good diamonds and is one of the best mines in the world on a value per carats basis. Petra does have plans to triple production over the next three years, but going all-out at Koffie really only makes sense if diamond prices swing back up.
Will Rising Middle Classes Demand More Diamonds?
Gem-quality diamonds are a consummate luxury idea that nobody needs, despite the best efforts of DeBeers, Tiffany (TIF), and Signet (SIG) to convince us all otherwise. That said, there is a definite link between rising standards of living and rising demand for diamonds, and the growing middle classes in emerging markets like China and India could spell significantly increasing demand for diamonds. On the other side of the ledger, there are only about 30 quality diamond mines in operation today and many producers have scaled down or gotten out of the business - BHP Billiton (BHP) sold its diamond assets to Dominion Diamond (DDC), and Rio Tinto has reportedly looked into selling its diamond mining assets.
Ultimately the Petra story comes down to what every mining story comes down to - demand, supply, and mining costs. Petra is on the higher end of the cost curve relative to DeBeers and ALROSA, but the company has a knack for turning up incredible finds. I actually wonder if that is part of the reason for Petra's elevated costs - mining engineers tell me that the equipment/approach used by large miners like DeBeers is great for reducing costs, but they tend to crush/break large diamonds. That said, I'm still looking for Petra's cash costs to drop below $70/ct over time (and on-mine cash costs were down 8% as of the mid-year fiscal 2014 report), while I do believe that increasing global demand should be supportive to prices long-term.
Estimating The Value
Management pleasantly surprised investors with solid operating cash flow in the first half of this year, and I believe the company will be able to fund its additional expansion/optimization plans without needing large infusions of outside cash. Said differently, I think Petra's existing debt facilities should be enough to cover its capex plans and even there is an overage, it will be slight.
I calculate an NAV of almost $3 per share for Petra, with more than 85% of that value from Finsch and Cullinan. If diamond prices rise, I see a nearly 3-to-1 improvement in the company's NAV and Williamson comes into play as a more exciting prospect. Of course, that leverage works both ways and Petra shares would see significant pressure if diamond prices go into a prolonged slump. Pricing has been a little iffy for Petra in the last few quarters, but lower operating costs tied to a weak Rand have helped offset this.
The Bottom Line
Given how strong Petra has been lately, I'm tempted to let the shares cool and hope to buy in on a pullback. With a NAV of $3 based on an average weighted discount rate above 10%, though, there is still value here and Petra looks like an interesting way to play increasing global demand for an increasingly hard to find asset.