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Summary

  • Lucara Diamonds has outperformed all expectations and has raised its revenue guidance by 66% to $250M.
  • The EBITDA margin is fantastic, at approximately 60% in H1 2014, and the exceptional stone tender will probably increase this EBITDA ratio.
  • The company has a net cash position and is looking for growth opportunities.

Introduction

In this article I'd like to discuss Lucara Diamond (OTCPK:LUCRF) which is operating a diamond mine in Botswana, Africa. The company is in production and seems to be surpassing all expectations as some of its stone tenders have resulted in better than expected revenues.

Source: company presentation

Trading liquidity on the US exchanges is relatively low so I think it's a better idea to trade in shares of Lucara Diamond through the facilities of the Toronto Stock Exchange where the company is listed on the main board with LUC as its ticker symbol. As it's a Canadian company I recalculated Canadian Dollars into US Dollars using an USD/CAD exchange rate of 1.09.

The calculations in this article are my own and should only be seen as a starting point for your own due diligence. All images in this article were taken from the company's website, presentation, technical reports and other public sources.

The Karowe Diamond Mine in Botswana is a cash cow

Lucara Diamond owns 100% (so there's no free carried government interest like in other African countries, but there is a 10% royalty) of the Karowe diamond mine in Botswana. The project was brought into production in 2012 and has since then outperformed the expectations. So what caused this outperformance? Before mining the property, the technical report was unable to include very large diamonds which were thought to be there but could not be confirmed. As the project has now been in production for approximately two years and as during that period several large diamonds have been found, the independent consultant which writes the NI43-101 compliant report now feels more secure to include an estimate of very large diamonds. So the original feasibility study of the project and the analyst expectations were based on a very conservative resource estimate which excluded the occurrence of very large diamonds as there wasn't sufficient scientific evidence of a sufficient amount of those stones.

This has lead the company to outperform on all metrics, and for this year, Lucara expects to generate a total revenue of $240-250M after reporting a revenue of $129M in the first half of this year. The most impressive thing here (besides a 65% higher revenue margin compared to the first guidance) is Lucara's operating margin. As it's (for now) an open pit mine with exceptional diamonds, the operating margin was a stunning 79% in H1 2014 as the company received $586 per carat it produced for $124/ct. And Q3 will shape up to be even better, as in July the company was able to sell another exceptional tender of 1,445 carats at an astonishing price of $40.1M ($27,000+ per carat). So I don't have any doubt Lucara will be able to meet its revenue guidance, as in the first seven months of this year it generated $168M in revenues. Let it be clear you cannot extrapolate this number as such extraordinary tenders don't happen every month.

(click to enlarge)

Source: company presentation

So how much cash is the Karowe mine spitting out right now? The company has reiterated its expected cost per carat sold, and the EBITDA margin in H1 2014 was approximately 60% (this includes the royalty payments to the government and General and administrative expenses). As I expect this ratio to remain quite stable, Lucara's Karowe mine should generate a net pre-tax cash flow of $150M this year which is absolutely sufficient to cover the $55M in capital expenditures.

So what will the $55M be spent on? The company plans to modify the currently existing processing plant so that it can treat the 'harder' ore from the South Lobe of the property. Additionally, the throughput should be increases a bit from 2.2Mt to 2.5Mt in 2015. This should result in additional economies of scale, albeit on a small scale. At this point, the remaining mine life for the open pit (until a depth of 324 meters) is approximately 12-13 years at the 2.5Mtpa treatment rate. Should the company be able to extend the depth of the open pit at a decent cost (keep in mind the strip ratio will be quite high for a 76 meter depth extension, but it should be doable), the mine life could be extended to 18-19 years. So basically there will be a trade-off study to determine if an extensive (pre-) strip program is warranted for a 6 year mine life extension. Personally I think this will definitely be warranted, given the high operating margin at the Karowe mine. Additionally, the pre-stripping activities could be spread out over several years to minimize the impact on the annual cash flow.

Source: company presentation

Let the numbers surprise you

Enough talking. Let's see what the numbers can tell you. In the first (very conservative) scenario I will use a 13 year mine life based on the current mine plan. This should result in an annual production of 375,000 carats per year. If I'll use a price of $450/carat (which is very conservative, given the fact the company received an average price of $586/ct in H1 2014 and even more in July 2014) and an all-in sustaining production cost of $190/ct, resulting in an operating margin of $260/ct or an annual pre-tax cash flow of $97.5M. The corporate tax rate in Botswana is 22%, and I will use a discount rate of 6%, as it's an operating mine in a very reliable and stable country (see later).

Cash Flow

Corporate Tax Rate (22%)

After-tax cash flow

Discount rate (6%)

NPV 6%

 

-

-

 

-

97,500,000.00

22.0%

76,050,000.00

1.00

76,050,000.00

97,500,000.00

22.0%

76,050,000.00

1.06

71,745,283.02

97,500,000.00

22.0%

76,050,000.00

1.12

67,684,229.26

97,500,000.00

22.0%

76,050,000.00

1.19

63,853,046.47

97,500,000.00

22.0%

76,050,000.00

1.26

60,238,723.09

97,500,000.00

22.0%

76,050,000.00

1.34

56,828,984.05

97,500,000.00

22.0%

76,050,000.00

1.42

53,612,249.10

97,500,000.00

22.0%

76,050,000.00

1.50

50,577,593.49

97,500,000.00

22.0%

76,050,000.00

1.59

47,714,710.84

97,500,000.00

22.0%

76,050,000.00

1.69

45,013,878.15

97,500,000.00

22.0%

76,050,000.00

1.79

42,465,922.78

97,500,000.00

22.0%

76,050,000.00

1.90

40,062,191.31

97,500,000.00

22.0%

76,050,000.00

2.01

37,794,520.10

    

713,641,331.67

In the second scenario I will use the same diamond price but use a 18 year mine life. In years 10-13 I will deduct an annual pre-stripping cost of $15M.

Cash Flow

Corporate Tax Rate (22%)

After-tax cash flow

Discount rate (6%)

NPV 6%

 

-

-

 

-

97,500,000.00

22.0%

76,050,000.00

1.00

76,050,000.00

97,500,000.00

22.0%

76,050,000.00

1.06

71,745,283.02

97,500,000.00

22.0%

76,050,000.00

1.12

67,684,229.26

97,500,000.00

22.0%

76,050,000.00

1.19

63,853,046.47

97,500,000.00

22.0%

76,050,000.00

1.26

60,238,723.09

97,500,000.00

22.0%

76,050,000.00

1.34

56,828,984.05

97,500,000.00

22.0%

76,050,000.00

1.42

53,612,249.10

97,500,000.00

22.0%

76,050,000.00

1.50

50,577,593.49

97,500,000.00

22.0%

76,050,000.00

1.59

47,714,710.84

82,500,000.00

22.0%

64,350,000.00

1.69

38,088,666.13

82,500,000.00

22.0%

64,350,000.00

1.79

35,932,703.89

82,500,000.00

22.0%

64,350,000.00

1.90

33,898,777.26

82,500,000.00

22.0%

64,350,000.00

2.01

31,979,978.55

97,500,000.00

22.0%

76,050,000.00

2.13

35,655,207.64

97,500,000.00

22.0%

76,050,000.00

2.26

33,636,988.34

97,500,000.00

22.0%

76,050,000.00

2.40

31,733,007.87

97,500,000.00

22.0%

76,050,000.00

2.54

29,936,799.88

97,500,000.00

22.0%

76,050,000.00

2.69

28,242,264.03

    

847,409,212.91

In the third scenario, I will use the 18 year mine life (as I'm pretty sure any trade off study to deepen the pit to 400 meters will be positive), but at an average price of $575/ct (which is closer to the price it received in H1 2014).

Cash Flow

Corporate Tax Rate (22%)

After-tax cash flow

Discount rate (6%)

NPV 6%

 

-

-

 

-

144,000,000.00

22.0%

112,320,000.00

1.00

112,320,000.00

144,000,000.00

22.0%

112,320,000.00

1.06

105,962,264.15

144,000,000.00

22.0%

112,320,000.00

1.12

99,964,400.14

144,000,000.00

22.0%

112,320,000.00

1.19

94,306,037.87

144,000,000.00

22.0%

112,320,000.00

1.26

88,967,960.25

144,000,000.00

22.0%

112,320,000.00

1.34

83,932,037.98

144,000,000.00

22.0%

112,320,000.00

1.42

79,181,167.90

144,000,000.00

22.0%

112,320,000.00

1.50

74,699,215.00

144,000,000.00

22.0%

112,320,000.00

1.59

70,470,957.55

130,000,000.00

22.0%

101,400,000.00

1.69

60,018,504.20

130,000,000.00

22.0%

101,400,000.00

1.79

56,621,230.38

130,000,000.00

22.0%

101,400,000.00

1.90

53,416,255.07

130,000,000.00

22.0%

101,400,000.00

2.01

50,392,693.47

144,000,000.00

22.0%

112,320,000.00

2.13

52,659,998.98

144,000,000.00

22.0%

112,320,000.00

2.26

49,679,244.32

144,000,000.00

22.0%

112,320,000.00

2.40

46,867,211.62

144,000,000.00

22.0%

112,320,000.00

2.54

44,214,350.59

144,000,000.00

22.0%

112,320,000.00

2.69

41,711,651.50

    

1,265,385,180.97

If I would now use a 30%-30%-40% weight for all three scenarios, the average weighted value of the Karowe open pit mine is approximately $974M.

How does Lucara's future look like?

Now that the Karowe mine is spitting out cash flow like never before and now the company has converted a net debt position into a net cash position, it's time to look at the possibilities to increase the output. The company has said it is 'continuing to look for growth opportunities', but it looks like the 75% owned Mothae project in Lesotho will be developed with the cash flow coming from Karowe. The Mothae project is low grade and the economics will never be as great as the Karowe mine (as the average grade at Mothae is just 1/5th of the Karowe grade).

As such, I would not be very happy if Lucara would spend its money on a so-called marginal asset, and I think the company will be eyeing to make an acquisition sooner rather than later instead of relying on Mothae for its future plans. Additionally, the total resource base at Mothae is just 1 million carats, which is peanuts compared to the 5-7M carats from the high-grade Karowe open pit mine.

That being said, I can't be blind for the exceptional 'type IIa' diamonds which were recovered and sold for $25-57,000 per carat. These diamonds were recovered from a bulk sample program and I would be very interested to see some official guidance about how many Type IIa's are expected to be found at Mothae.

What about Botswana? Should the geopolitical risk scare you?

Not a lot of people will have heard about Botswana before, and it might surprise you that Botswana is generally considered to be the safest country in Africa to do business in. On the world's corruption perception index, the company is scoring very high (the highest of all African countries) and even better than first world countries like Spain and Portugal. So I'm not worried about the situation in Botswana - from an economical point of view- and that's why I actually feel comfortable using a discount rate of 6% in my calculations.

Source: transparency.org

Investment thesis

Lucara Diamonds has been outperforming the market's expectations in the past few years and the most recent revenue guidance increase from $150M to $250M underpins this. At this point in time I would estimate the value of Karowe at $975M and if I'd throw in the estimated net cash position (current assets - total liabilities) of approximately $90M (it was $61M at the end of June but the exceptional stone tender should have brought in a substantial amount of cash), the company's fair value would be $1.065B.

As there are 377 million outstanding shares, I would estimate the fair value (excluding giving any value to the exploration properties or the Mothae property in Lesotho) to be $2.82/share, which is approximately 12.5% higher than today's share price. This means that there isn't sufficient upside value to initiate a position now, but it also means I should be disappointed in myself for not moving in and taking a position when I learned about the company in February of this year, when the share price was trading at just $1.50.

Should the share price go down to $2-2.25/share, I would be very interested in initiating a position as at this moment I don't have any exposure to diamonds in my portfolio.

Editor's Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks.

Source: Diamonds Are A Girl's Best Friend, But Can Lucara Diamond Be My Best Friend?
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