Diamond stocks stronger than ever: analyst Des Kilalea

Fresh off RBC Capital Markets’ 8th annual diamond conference, held in March in Toronto, Diamonds in Canada interviewed RBC mining analyst Des Kilalea in late March.

Kilalea discussed the state of the diamond market and spoke about the current disconnect between optimistic miners with cash flow to spare on one hand and the pain being felt elsewhere in the diamond sector. He also discussed some of his preferred diamond stocks.

Diamonds in Canada: What were your main takeaways from attending RBC’s diamond conference? Were there any surprises?

Des Kilalea: The main takeaways from the RBC conference included the strong financial position of the diamond miners and developers — perhaps the most financially robust the sector has ever been. This sees the likes of Petra Diamonds (LSE: PDL), Dominion Diamond (TSX: DDC; NYSE: DDC), Lucara Diamond (TSX: LUC) and Gem Diamonds (LSE: GEMD) all either paying dividends or about to pay dividends as free cash flow is generated.

Another theme was improved investor interest in the sector, given diamond miners’ outperformance of most mining indices in the past two years.

DiC: You’ve written that you expect diamond prices to be flat to slightly lower (up to 5%) this year. When do you see a robust market returning?

Des Kilalea: We think rough prices will start recovering towards year end and into 2016 as the global economy improves. Diamond jewelry demand growth at present is relatively muted as evidenced in the recent De Beers Diamond Insight Report. China’s 2014 jewelry demand growth was 6% in local currency and India 3% in local currency. A strong U.S. dollar is not helping retail demand in soft currency countries.

Longer-term, it still looks as if supply will be flat to lower. So, if demand continues in the U.S., China and other jewelry markets, the prospect for a firm underpin to rough prices exists from 2017 onwards. Naturally, issues such as synthetics and competition from the likes of other “luxuries,” such as the new Apple Watch, need to be addressed — perhaps by renewed generic advertising.

DiC: Diamantaires are having a tough time with liquidity. Why is liquidity so tight? Why are banks withdrawing from the diamond sector or cutting their exposure?

Des Kilalea: The middle of the diamond pipeline started relying on bank debt when De Beers ceased to be pipeline manager. The global financial crisis probably precipitated the current tightness in funding as it led, eventually, to Antwerp Diamond Bank withdrawing from the sector (it announced in September 2014 it would not be making any new loans). In addition, other leading banks started reassessing the risk/reward proposition in lending to the sector and decided to reduce exposure.

New funding sources will emerge, such as direct retailer deals with miners and Middle Eastern banks coming in, as well as a new player in India (Industind Bank), but it is likely to take some time. In addition, it is likely the size of the pipeline will shrink with less rough and polished tied up between the mines and the retailers.

DiC: It doesn’t seem sustainable for diamantaires to be struggling while diamond producers are doing quite well. How do you expect that to get resolved?

Des Kilalea: Diamond miners have been able to dictate prices to some extent because of the availability of funding in the pipeline. But with banks refusing to lend on low margin or loss-making business, the miners, in particular the big ones, are having to address their supply and prices. This resulted in De Beers and Alrosa (RTS: ALRS) reducing prices 3-5% in the first quarter of 2015, and both allowing customers to defer goods. The optimistic forecasts of leading producers, such as De Beers and Alrosa, are probably somewhat at odds with the mood in cutting centres right now.

DiC: What are your thoughts on the idea of an industry association for diamond miners, as reported by Bloomberg in February? Is collaboration on synthetics, marketing and potentially other issues necessary now that De Beers is not in control of the industry?

Des Kilalea: An industry association makes sense to tackle synthetics. The association might also look at the benefits of some generic advertising to boost diamond jewelry’s share of luxury spending. De Beers’ Diamond Insight Report last year showed that growth in demand for luxury jewelry was well below that of electronic gadgets, fine wines, accessories, etc., in the period 2004-2013.

DiC: Undisclosed synthetics have been a concern for the industry for a while now: How is the industry dealing with synthetics?

Des Kilalea: The efforts to counteract undisclosed synthetics need to be boosted. De Beers is introducing new equipment and a producers’ association (see previous question) could help push this. It is a potentially serious issue unless the producers, cutters/polishers and the retailers get to grips with it. Highlighting the importance of decent grading labs for better stones is also key to getting undisclosed stones off the market.

DiC: What about recycled diamonds?

Des Kilalea: Recycled diamonds have always been around, but like anything, the larger the market, the more this grows. De Beers is trying to highlight the fact that diamonds sold secondhand may not be fetching real value. Overall, this is a natural result of a growth market and for cutters/polishers, it remains an attractive source of stones.

DiC: You are not expecting an exciting year for the diamond sector in terms of diamond prices — you’re modelling flat to 3% lower. However, you expect diamond stocks to maintain their preferred status compared to other mining stocks. What are your preferred names and why?

Des Kilalea: The major producing companies (Petra, Dominion, Lucara and Gem) are now finally very robust financially and able to pay dividends. This should underpin their investment case. We like the leading producers, such as Petra and Dominion, and also think developers such as Stornoway Diamond (TSX: SWY) and Mountain Province Diamonds (TSX: MPV; NASDAQ: MDM) are attractive because they have good projects and the funds to build them.

DiC: You have an “outperform” rating on all of the diamond stocks that you cover except for Alrosa, indicating that the companies are in good shape and that the fundamentals for diamonds are good. But the highest implied returns (based on current share prices and your target prices) are for developers Stornoway Diamond and Mountain Province Diamond. What makes the potential upside so high for these companies and what are the potential risks to that upside for each?

Des Kilalea: The market tends to place a discount on developers with that discount narrowing as projects move closer to production. The risks to developers are slippage in project time lines and capex overruns. If companies are fully funded and are able to bring projects in more or less on time and within budget, re-ratings should follow.

DiC: You note that here’s a trend among diamond producers, who are doing very well, to start paying dividends. Lukas Lundin last year mentioned that Lucara (which instituted a dividend last year) started paying dividends to attract a new class of investors. Do you see that happening yet?

Des Kilalea: For investors to buy for dividends, the dividends need to offer decent yields of 4% or higher. Over the next year or two, the diamond sector will attract investors for the dividends, I think.