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Diamonds Are Forever
Spotlight on the Diamond Mining Industry & Where to Invest
Another week, another rollercoaster ride in the Casino Royale that is the stock market! My portfolio did amazingly thanks to the huge commodities rally on Friday. My recent portfolio refresh has already begun to pay off. If you haven’t caught up yet, you can find all the details of that in my last post “Putting My Neck on the Line”.
A summer of engagement parties and weddings has meant many more conversations about something I didn’t pay much attention to before, engagement rings. Not to say that my girlfriend is pressuring me to get on one knee, but I've already been given her ring size.
I haven’t (yet…) gone to look at engagement rings, however, naturally, being curious about economics and markets, I have found myself trying to understand how the jewellery market works and if there are investment opportunities available. This is where I began researching the diamond mining industry.
For your eyes only, this week’s Porchester Papers is about diamonds.
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As a reminder, this article should not be considered investment advice.
Diamonds Are Forever
Spotlight on the Diamond Mining Industry & Where to Invest
Throughout history, multiple cultures have believed that diamonds had supernatural powers from fighting pestilence to attracting metals and wealth. Nowadays, diamonds are generally used either in jewellery because of their shine, rarity and refractive properties or in industry to create cutting and polishing tools thanks to diamond being the hardest of all natural materials.
Modern diamonds come from two sources: they are either mined or they are synthetically made in a laboratory. Laboratory-made diamonds are predominantly used in industrial applications whereas mined diamonds are generally used for jewellery.
Synthetic diamonds are increasingly being used for jewellery thanks to being much cheaper, however, they only make up approximately 8% of diamond sales to the jewellery market.1 Although synthetic diamonds will slowly increasingly be used for jewellery, they aren't expected to take significant market share from natural diamonds in the near term. In the longer term, as laboratory diamonds become more acceptable, the demand for natural diamonds will eventually fall.
Natural diamonds are mined in very few countries with Russia having far and away the largest diamond reserves followed by a few African countries.
Russia ranks first when it comes to natural diamond production and Russian state-owned company Alrosa accounts for 93% of Russian production.2 Alrosa is also the leader when it comes to natural diamond production globally, just ahead of De Beers (owned by British mining company Anglo American).
As with other commodity markets where Russia is (or at least has been) an important player, the conflict with Ukraine has changed the outlook in the industry significantly. Alrosa and the Russian diamond market have been heavily sanctioned by Western governments, including the United States and the European Union. Joe Biden has banned all diamond imports from Russia to the US for example. There is no more love from Russia.
It is reported that Alrosa has seen sales drop -30% from 2021 levels, and could have been worse had it not been for a resumption of sales to India.3 Since the start of the war, companies such as Tiffany and Signet have refused to buy diamonds of Russian origin. What makes things additionally difficult is that Alrosa particularly focuses on smaller diamonds, and as such, there is now a huge supply deficit when it comes to these smaller-sized diamonds.
The next largest producer, De Beers, is being asked by many luxury retailers to increase production to match the hole in supply. The diamonds in this world are not enough. This supply fall has led to a +20% increase in the price of diamonds since the start of the war in Ukraine, and De Beers currently can’t make the extra supply even at full tilt.4
As such, in the longer term, natural diamond prices are expected to fall as synthetic diamonds play a more important part in the jewellery industry. However, in the shorter term, with supply levels falling as a result of sanctions on Alrosa, other diamond miners will benefit from increased demand and higher overall prices.
De Beers Necessities
The second largest producer of diamonds is De Beers. Founded in 1888, it was for a very long time the outright largest diamond company in the world. It is now 85% owned by mining giant Anglo-American and 15% owned by the Government of Botswana.
De Beers mine diamonds in four different countries: Botswana, Canada, Namibia and South Africa. These are principally done via joint ventures with the governments of the countries of these mines.
I will go into some of the details about De Beers, however, if we are looking from an investment perspective, owning Anglo-American stock is not a good way to gain pure exposure to the diamond mining industry. Diamonds only contribute to 5% of Anglo-American’s overall EBITDA (2021 full-year figures), with the bulk of EBITDA being allocated to other commodities notably 34% in platinum group metals, 33% in iron ore and 19% in Copper.5
If you read my article last week about my new investment strategies for my personal portfolio, you will have noticed I have an allocation to Anglo-American under my copper and energy transition metals theme because of their significant operations in copper and platinum group metals. Nice to also have a little bit of exposure to diamonds there too.
In the 2021 Anglo-American annual report, we get further colour on the supply dynamics of mined diamonds before the Ukraine conflict. Limited new significant kimberlite findings (the most common ore to find diamond in) and the closure of mines not operated by De Beers is seeing supply tighten in the medium term. We already have a short-term supply shrinking with Alrosa being taken out of the market, additionally shrinking diamond supply globally will extend the supply deficit into the future.
Demand depends significantly on the United States, which is the overwhelming demand driver contributing around 51% of global demand according to De Beers. As such, from a demand side, the health of the US economy will play a huge part in keeping prices elevated.
As we know, the spectre of a global economic slowdown is looming. However, US consumer confidence is remaining high and the job market tight. These are what are allowing the Federal Reserve to raise interest rates as aggressively as they are. If we begin seeing consumer spending in the US fall significantly, then there is a risk for the diamond market in the medium term. In the latest quarterly reporting from De Beers, demand for diamonds remains robust with 9.1 million carats sold as compared to 7.8 million carats for the same quarter last year.
De Beers has very high margins, with EBITDA margins close to 50% based on the latest results. As such there is plenty of cushion should prices begin to fall slightly if demand were to begin slowing. From a production side, production is stable, with a slight +4% increase in production this last quarter as compared to last year and a +20% increase as compared to the second quarter this year. Production guidance for the rest of the year is unchanged.
Even though we can’t directly invest in De Beers since it is not publicly listed, it plays such an important part in the diamond industry, it’s important to keep a golden-eye on it and the changes in the broader diamond market.
Is Petra Diamonds the Wonder of the Diamond Mining World?
Since we cannot directly buy De Beers stock if we want to gain exposure to the diamond market, we need to start looking at some of the players in the industry. This is why we need to begin looking at Petra Diamonds.
Petra Diamonds is a diamond miner founded in 1997, and they own one of the world’s most productive diamond mines: the Cullinan Diamond Mine near Pretoria in South Africa. It has produced over 750 stones that are greater than 100 carats, more than a quarter of the world’s diamonds over 400 carats and is the only significant source of blue diamonds. Additionally, the largest ever diamond of gem-quality found was mined there, the Cullinan Diamond.
The company is listed on the London Stock Exchange with a market cap of GBP 223m, and as such, we can very straightforwardly add this to a portfolio to gain exposure to the diamond mining industry.
Petra Diamonds owns four mines (using figures for financial year end June 2022):
Cullinan Mine, South Africa - 54% of Petra’s total production, produces large, high-quality white diamonds and very rare blue diamonds;
Finsch, South Africa - 38% of Petra’s total production, regularly produces highly commercial diamonds of over 5 carats, occasionally diamonds of over 50 carats and smaller gem-quality diamonds;
Williamson, Tanzania - 7% of Petra’s total production, beautiful round white diamonds and pink diamonds;
Koffiefontein, South Africa - 1% of Petra’s total production, producing high-quality white diamonds of between 5 and 30 carats.
The company has the third largest diamond resource base in the world, with a diversified portfolio of different colours and quality diamonds. A strong balance sheet with significant debt reduction. Steady cash flow generation that can both support mine expansion and shareholder value via dividends.
For financial year 2022, the company saw an increase in revenue by +44% to USD 585m and a doubling of EBITDA to USD 265m. This has seen operating free cash flow rise by 91% to USD 230m and a net debt position of only USD 40.6m or 0.15x of leverage. These are very encouraging numbers and show a company is in great health as the global economy begins to see a slowdown. Low debt will also minimise the impact of interest rises on the company.
Further growth is being entirely self-funded via cash flow generation. There are projects in place to extend two of the South African mines, Cullinan and Finsch. The USD 173m investment to extend Cullinan should deliver a project with an internal rate of return (IRR) of more than 30%, with production from that project expected to begin in 2024 and be steady by 2026. The USD 216m investment to extend Finsch should deliver a project with an internal rate of return (IRR) of more than 30%, with production from that project expected to begin in 2023 and be steady by 2025.
The company has a committed dividend policy of between 15% and 35% of free cash flow after tax, guaranteeing a solid return on investment to stockholders. The company has not issued dividends before, so we will forecast financials using the company’s guidance to see where we might expect a dividend to be.
Below are the current income statement, balance sheet and cash flow statement with the company forecasts then applied, including the increased capital expenditure for the new mine expansions.
Using some fairly straightforward and conservative assumptions, I predict a dividend yield of around 2% for the next financial year, around 2.6% for the year after and then 4.8% for 2025. This jump is thanks to the costs of the two mine expansions being already accounted for and the increased production as a result. Additionally, the company’s equity value could be in line to increase by over +75% under these assumptions. A great potential return for a stockholder. In view to make a killing.
Petra Diamonds is also currently trading at a price of 4.4x price to earnings. If we are to compare this to mining companies globally, the MSCI World Metals and Mining Index trades at around a forward price-earnings of 8.6x, nearly double the ratio for Petra Diamonds. The company is trading much more cheaply than other mining stocks.
Live & Let’s Buy
The reasons above are why I have chosen to add Petra Diamonds to my portfolio. Not only does it look cheap relative to other mining companies, but a strong balance sheet and steady cash flow generation will help it grow organically and deliver shareholder value. Potentially a significant dividend and value growth too.
Despite slowing global economic growth, diamond prices seem to be supported by much tightening from the supply side as a result of sanctions on Russia and falling production numbers from smaller mines. Diamonds are indeed forever.
The Name’s Papers, Porchester Papers