Petra Diamonds: Now Materially Undervalued And Offers Exceptional Asymmetric Reward

Summary

• Petra Diamonds' recent trading update was exceptional, showing the company has turned a corner on the cash generation front.
• The company is paying down debt at a fast pace, paving the way for the company to be net cash positive by late 2022.
• The current share price is not a fair reflection of Petra's future prospects.
• High likelihood of valuable 'bonanza' diamond finds at Cullinan to aid debt pay down further.

THEGIFT777/iStock via Getty Images

I have written about Petra Diamonds (PDMDF) previously, investors should see this as an update to my earlier articles on the company

Back in October, I took a very bearish view on Petra Diamonds leading up to and following the company's restructuring. Though in my most recent article I did admit the restructuring was very well thought out and beneficial on Petra's part, I still believed the end result for shareholders would be zero and certainly did not foresee the sort of turnaround in financials that Petra has delivered.

The recent trading update was extremely impressive, showing a Petra Diamonds that is benefitting heavily from a recovery in the diamond market and improved operational efficiencies at its diamond mines. Following the fresh restructuring and new trading update, Petra has now become materially undervalued, and I will admittedly hold my hands up and say I was wrong in previous articles. The disconnect between market valuation and Petra's underlying cash generation and fresh balance sheet position is large.

Trading update

Petra diamonds' Full Year trading update was pretty impressive and reflects a company with new operating prowess and a clear-cut focus on improving balance sheet health - fast.

Gross revenue for the quarter was $406.9 million, up 38% YoY, reflecting a strong recovery of diamond prices seen over the last quarter - total diamonds sold was up 37%, total ROM diamonds recovered down 11%. Sales of exceptional stones contributed $60.2 million over the course of the year - a record for the company. This included the sale of the exceptional Type IIb blue diamond sold In April ($40.2 million).

The recovery in the diamond market can be shown by the breakdown of results of Q4 compared to FY. The average price per carat in Q4 was 112 compared to 98 for the year. It is important to note that this also included the exceptional blue diamond sale (over $1 million per carat). Realized diamond prices were up 5.7% YoY. Petra cited strong retail demand and other factors for this improvement:

Positive demand for rough diamonds continued in Q4 FY 2021 driven by strong consumer demand in the key retail markets, notably the US and China, coupled with low inventories and the return of capacity in the midstream in India. Demand was also supported by upstream supply discipline and shortages in some areas.

This strong sales performance was primarily driven by very strong YoY performance from the Cullinan in respect of both sales and diamonds produced. This was slightly offset by lower production at Finsch and Koffetonin mines while Williamson remains on care and maintenance. Both Finsch and Koffetonin's improvement in production rates could also provide a catalyst for improving cash flow generation moving forward.

Debt position markedly improved

Now looking to the most important consideration when weighing up the risk/reward on Petra - its debt pile. Over Q4 (March - June) Petra managed to reduce its net consolidated debt position by just under $50 million to $241.2 million from $290.7 million. This is also a significant improvement on the $700 million debt pile pre-restructuring and shows how beneficial that restructuring actually was. It's important to note that lenders are now far more aligned with shareholders after taking 91% of the equity in the restructuring (conversion price of 3.5p).

Breaking down Petra's net debt (end of June) - This includes bank loans and borrowings and loan notes minus cash, diamond debtors, and Black Economic empowerment guarantees (BEEG).

• BEEG now account for zero
• $173 million cash at the bank, up $19.2 million.
• $38.3 million Diamond debtors, up $35.7 million.
• $347.8 million Loan notes, up $9.1 million.
• $104.7 million Bank loans, down $3.7 million.

This consolidated net debt reduction DIDNT include 39.35-carat blue diamond sold for $50 million post period end and won't include the other exceptional find of a white diamond that was just announced last week, most likely worth around $15 million. Both of these will also be vital and significant in further reducing consolidated net debt.

Considering the above and how fast Petra is paying down debt and generating cash with the potential for even better cash flows moving forward with the anticipated restart of the Williamson mine and better operating efficiencies. A current enterprise value of just over $400 million substantially undervalues Petra Diamonds prospects. This is materially lower than pre-restructuring where Petra had an EV of over $700 million.

So Petra's current valuation makes little sense:

• Petra's balance sheet has now become deleveraged, with a clear path to net cash by the end of 2022 amid sizeable cash generation
• The restructuring was a very promising outcome for shareholders when studying the debt pile Petra faced at the start of the year - to reduce it by two-thirds and align bondholders with shareholders is admirable at this point - yet the share price remains level comparative to that period.
• Debtors converted into shares at 3.5p conversion price - that's their breakeven, they trusted Petra's modeling and ability to deliver high cash generation - Petra has started to deliver on that word.
• Petra is now facing far improved diamond market conditions and is on a run of exceptional diamond finds over the last few months - I expect this to continue.

Considering all of the above, and the fact Petra now sits just 5% up from when the trading update was delivered, I see a significant misprice in shares at the moment, where the market hasn't fully priced in the trading update and the transformation Petra has experienced since its trading update.

Potential for big finds

As mentioned above, the potential for large finds is a significant component of paying down debt. Luckily for Petra, its Cullinan mine is known for this and the last few months have proven that. The Cullinan has provided some of the finest diamonds the world has seen and I believe it will continue to do that over the coming years. The fact that Petra can come along with individual diamonds that can supply $50 million of free cash flow is pretty astounding and doesn't seem to be taken into account by the market. Just five truly exceptional $50 million+ finds would take Petra to net cash - of course, this is very unlikely, however, it does show the significance of each exceptional find.

Strange price action

Petra's price action since the trading update has been bizarre, to say the least. Immediately after dropping the update, shares ran to as high as 2p a share from 1.6p. I felt this was more than justified considering the results delivered, but as soon as volume started to abate shares started to trail down once again, all the way back to below 1.6p. Then Petra announced another exceptional diamond find, shares jumped and have once again started to trail down.

Studying the level 2 order book through these price movements, it appears much of it is in relation to the MMs walking the shares down. They will reduce the bid price on even the most minor volume and even when buys are significantly outweighing sells. Though I don't usually discuss price action much because I believe that price is what you pay and value is what you get therefore eventually, if Petra delivers, shares will have to see a re-price. It is something for prospective investors to note, patience is required in the London Stock Exchange at the best of times and this is no more applicable to Petra. The low volume creates large swings and can lead to short-term frustration even after some pretty impressive results.

Conclusion

I understand the importance of taking caution regarding Petra, due to its previous position of huge underperformance and diminishing shareholder value. However, it really does look like the company has now turned a corner and is relishing the fresh start the restructuring has given.

These prices seem ludicrously cheap and I am seriously surprised there hasn't been a significant reprice in shares since the trading update. It begs the question, what is the market really expecting? The restructuring was shrewd and the best possible outcome for shareholders with lenders taken a significant haircut - they are now aligned with smaller private investors, and the trading update regarding consolidated debt improvement couldn't have been much better than it was. Whilst debt paydown will rely on exceptional finds at Cullinan, I have no doubt it will continue to deliver. Things are looking a lot brighter for Petra now and there appears to be light at the end of the tunnel. My stance has materially changed, it's a strong buy and luckily (somehow) you can pick up shares for just 5% higher than the pre-trading update.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of PDMDF either through stock ownership, options, or other derivatives. 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.

Comments

[Arkadiy Burdin]

it seems that now it has become even more attractive. What do you think, Noah?
Maybe it is time to reiterate your forecast.

[SG10x]

Hi Noah, thanks for the continued great play by play on Petra. What is the difference between ticker PDMDF, PDLMF, and LON: PDL ?

[Noah Riley]

@robertg2 i believe that PDMDF and PDLMF are the ticker symbols for US OTC (pretty sure there is little to no liquidity). The former one was Petra's previous ticker and the latter s its new OTC symbol. PDL is its standard London stock exchange ticker.

[NPC #24601]

Is a squeeze out on the table given the 91% ownership. What happens to the 9% in this scenario?

[Noah Riley]

@NPC #24601 Sorry don't quite understand the question? Although the 91% is technically in 'sticky hands', I do not believe they have a lock-up period - though I may be wrong. low float does provide an opportunity for big moves but LSE shares struggle with this due to lower volume.