Company Background- Harry Winston Diamond Corporation (HWD), engages in mining and retailing of diamonds in the U.S., Canada, and internationally. The Company, through its subsidiaries, holds a 40% ownership interest (60% owned by Rio Tinto) in the Diavik Diamond Mine which supplies rough diamonds; and engages in the retailing of fine jewelry and watches under the Harry Winston brand. The Company currently operates 19 retail locations with 8 in the US, 5 in Japan, 2 in Europe, and 4 in Asia ex-Japan. HWD was founded in 1980 and is based in Toronto, Canada.
Investment Thesis- Buy Harry Winston (HWD) as the vertically integrated diamond miner/retailer will benefit from strong diamond prices, improving mining recoveries, rebounding luxury spending, and reinvigorated retail unit growth in Asia. The Company is uniquely positioned to leverage mine ownership and proprietary diamond pricing information flow and HWD has already witnessed surging revenues over the last two quarters with mining revenues rising 121% y/y (70.1% price, 51.1% volume). Nevertheless, short term production issues such as a thick top soil have led to lower recoveries and higher costs in the near term. As HWD finishes its transition to underground mining the Company is positioned to surprise the investment community with lower than expected costs and more sustainable pricing.
HWD will continue to experience robust diamond prices, which have risen past pre-recession highs, which will in turn flow through to the bottom-line as mining efficiencies reduce operating costs and HWD has minimal additional variable costs. All of which have set the stage for earnings to surge past lagging sell-side estimates.
Target Price- Harry Winston’s base case intrinsic value is $16.29 implying a >40% return over the next twelve months. Valuation is based on a sum-of-parts valuation using a 7x EV/EBITDA multiple for the mining assets and 10x EV/EBITDA multiple for retail assets. Commodity companies typically trade at 6-8x normalized EBITDA. However, Diavik represents a compelling asset as it was the last substantial high grade diamond discovery in nearly a decade and long term diamond supply is dwindling. For retail, we use 10x EV/EBITDA as Harry Winston’s closest comparable, Tiffany’s (NYSE:TIF) is trading at 10x Jan. 2012 EBITDA.
Operating assumptions for FY Jan. 2012 mining include: 3.1 mm carats (guidance), $105/carat ($99.34/carat in FY ’11E), and 3.5 grade (3.4 in ’11E).
Operating assumptions for FY Jan 2012 retail include: revenue growth +15% (10% unit growth, 5% comps), 2 new stores (guidance), 51% gross margin (51.4% in FY ‘11E) due higher gold/silver, and 6.1% EBIT margin (5.5% FY ‘11E). Based on these assumptions and my multiples each $10/carat = $1.00 of implied share value.
HWD’s valuation is also compelling by looking at the Diavik diamond mine as a standalone asset. In August 2010, HWD repurchased a 9% stake in Diavik for $220 million, implying HWD’s 40% Diavik stake was valued at $980 million - even before the continued rise in polished diamond prices over the past four months. Additionally, it has been rumored that Anglo American will offer to buy the Oppenheimer’s 40% stake in DeBeers for at least $3.1 billion. Using available data this would imply that Diavik is worth ~$1.1 billion. Harry Winston’s current enterprise value is ~$1.1 billion, allowing for tremendous downside protection as investors are essentially getting 19 high end jewelry stores for FREE.
Harry Winston Thesis
Strong Branded Business- Harry Winston is possibly the strongest jewelry brand in the higher end diamond market allowing the Company to earn robust EBITDA margins in good times (~44% EBITDA margins) vs. an LTM EBITDA margin of 22.2%. This very discretionary and cyclical business has passed its inflection point and explosive earnings potential lie ahead. Downside protected by HARD ASSET ownership of diamond mine asset.
Back From the Brink- In March 19, 2009, HWD suspended its dividend and raised $150 million by selling a 9% stake in Diavik to Kinross Gold Corp (NYSE:KGC). Additionally, the Company enacted two six-week shutdown periods in mid-summer and at year end. HWD’s share of carat production in FYE Jan. 2010 dropped ~40% to 2.23 million carats from 3.69 million carats the previous year. On the retail side, HWD took over $12 million out of discretionary SG&A between 2009 and 2010 to right size its cost structure. As a rebound has commenced HWD has reacquired this 9% stake and has initiated new hiring and compensation increases on the retail side.
Mining Segment, formerly Aber Diamond Corporation, (LTM: 48% of revenues, 89% of EBIT)
Diavik Mine is located in Canada’s Northwest Territories. The Diavik deposit comprises three diamond bearing pipes that are being mined using open pit and underground mining methods, with a fourth pipe being reviewed to determine the viability of mining. Production commenced in 2003 making it the most recent large scale diamond discovery in the world. At 7.8 million carats per annum, Diavik controls ~5% of global diamond production and Diavik remains the highest grade diamond mine in the world. Diavik now maintains nearly 60 million carats of reserves and resources which will take production beyond 2022. The mine’s life, from the start of production in 2003, and including the underground mining operation is estimated to be 16 to 22 years.
Over the last two years production has been changing from open pit to underground and HWD is assessing cheaper mining methods, which would lead to higher velocity and lower mining costs. Underground production should accelerate as the year progresses and by 2012, Diavik is expected to be a 100% underground mine. In the short term costs have been higher than expected forcing short term speculators out of the name and clearing the way for an attractive investment opportunity for the more patient investor once operating margins rise again.
Retail (LTM: 52% of revenues, 11% EBIT)- Harry Winston salons, which are located in 19 prime markets around the world represent the most luxurious diamond retail franchise in the world. The brand has proven its resilence with sales rising 48.3% y/y in the last quarter.
In Spring 2010, HWD hired Frederic de Narp to build the Harry Winston Brand watches and accessories after he successfully built the Cartier brand. HWD also announced a long term retail growth strategy including 26 salons by 2013 and 35 salons by 2016. Plans also include the introduction of partnered stores (±20 stores) in riskier markets in which Harry Winston would retain control of the brand image but share the operating costs with a business partner. Also, HWD will be expanding its wholesale watch network from 188 locations at the end of FY10 to ±300 by 2016. Lastly, Harry Winston will develop its bridal business in every salon, which HWD doesn’t currently have.
With a balanced geographical sales footprint HWD isn’t overly exposed to the indebted consumers of the developed market and Asia has now passed Europe and North America as HWD’s biggest sales generator. No other luxury diamond retailer is better positioned to meet the need for high end diamond clientele quiet like Harry Winston, which is the go to diamond retailer for the world’s rich and famous.
Risks Diamond demand collapse, lower recoveries at Diavik, synthetic diamonds have been manufactured since the 1950s and have yet to make a major impact on the market. Russia flooding the market with stockpiles (Russia showed discipline with palladium). Inventory turns only ~1.0x per year.
Other Potential Catalysts-
* Rumors surfaced in Sept. 2010 that Rio and BHP Billiton Ltd., may combine Canadian diamond operations. The two parties have had long talks about this potential multi-billion merger of their Canadian diamond operations.
* On HWD’s last call Mgmt claimed they would love to buy some more rough diamond production because they have a very good marketing platform for it.
Diamond Industry Primer- Rough diamond prices have rebounded after falling as much as 65% from September 2008 through March 2009. Diamond prices are now well above pre-recession highs and represent the top performing commodity worldwide after palladium and copper. Large volumes of production from Zimbabwe have probably depressed prices somewhat in smaller, cheaper, off-color goods. Nevertheless, quality diamond prices continue to strengthen as long term supply declines and demand builds.
Diamond Supply Diamonds weren’t discovered until 140 years ago. Since then over 5,000 mines have been explored with only 50 found to be economical. Despite a boom in exploration in the last decade, there have been no new discoveries of any significance since the early 1990s. The industry is consolidated with 90% of all rough diamond production coming from De Beers, Rio Tinto, Alrosa and BHP Billiton. In 1902, De Beers controlled 90% of the world's diamond production. Nevertheless, De Beers, now with 40% market share is more profitable today as the Company has created tremendous brand value associated with top notch diamond retailers.
In total, due to a consolidated and disciplined production base global diamond supply was cut by as much as 90% in Q1 2009. Producers realize that scarcity drive price and value. Inventories are now very low at retailer levels and any uptick in demand would lead to a rise in retail diamond prices. Furthermore, existing mines are beyond peak production levels and no new major mines are in the pipeline. Even new discoveries would take 7-10 years from discovery to production.
Diamond Demand- The diamond jewelry market is valued at over $58 billion. With 35% of global sales, the United State is the biggest consumer of diamonds. China, at around 10%, is now the world’s second largest diamond market, surpassing Japan in 2009. China consumption is still growing strongly and is expected to roughly double its share by 2015. The Indian and Chinese markets view diamonds with more of an eye to investment, much as they do gold.
A large part of the diamond market still grows no matter what the economic environment — bridal jewelry - which is as much as 50% of the diamond market. In 2011, as consumers recover from the “Great Recession” global luxury spending is forecasted to increase 5-10% with the following composition: China +15%, Rest of Asia +10%. North America +5%, Europe +5%, Japan 5%. Demand for luxury brands continue to strengthen globally, especially by consumers in China supported by the rapidly expanding wealth of its consumers and in the Middle East as a result of higher energy prices. The supply chain is now de-stocked and retailers are seeing pull-through in demand for diamonds.
Disclosure: I am long HWD.