Lucara wrestles with weak diamond prices at Karowe

Though ramp-up appears to be on schedule at emerging producer Lucara Diamond’s (LUC-T, LUCRF-O) fully owned Karowe open-pit diamond mine in Botswana, markets have taken notice that the company is realizing a lower price per carat than it had projected in an independent valuation this past December. The discrepancy emerged during the company’s inaugural diamond tender in early June, and the price gap seems to have widened based on a second sales report in mid-July.

Lucara released an updated valuation on Karowe’s diamonds — then called “AK6” — on Dec. 6, which marked a 24% increase in the overall modelled value to US$301 per carat at a 1.5 mm cut-off size. The study was commissioned in light of Lucara’s near-term production target in first-quarter 2012, with the company expecting full ramp-up by the end of the second quarter.

Karowe is a hard-rock, open-pit operation with a planned depth of 324 metres. Based on probable reserves of 36 million tonnes containing 6.3 million carats, the mine’s life is expected to be 15 years. The US$120-million capital development was projected to produce 325,000 carats of diamonds during its first year with an annual throughput rate of 2.5 million tonnes. Lucara originally modelled annual earnings before interest, taxes, depreciation and amortization (EBITDA) at US$64 million, though this was based on the US$301-per-carat realized price.

Indications that Lucara had possibly overshot its diamond values appeared in mid-June when the company released the results from its first diamond sale at Karowe. Lucara tendered 35 individual lots containing 29,400 carats of diamonds, though only 30 lots were sold. The company realized total revenues of US$5.64 million at an average diamond value of US$215 per carat.

“It is a direct reflection of the current status of global markets that not all diamonds were sold during this first auction — however, we are extremely bullish about the market outlook overall,” president and CEO William Lamb comments. “The Karowe mine produces high-quality diamonds, and we can expect to see steady demand regardless of the cycle the market is in.”

Markets took notice of the price discrepancy following the first tender, as Lucara’s shares dropped 19%, or 19¢ during the June 11 and June 12 trading sessions, en route to an 82¢ close. Shares declined through July as the company failed to restore market faith in its previous valuations, and things got even more uncertain after Lucara reported its second diamond tender on July 16.

Lucara did not report a realized price per carat on its second diamond sale, though the company indicated it tendered 35 individual lots containing 36,800 carats of diamonds, of which 32 lots were sold for gross proceeds of US$6.5 million. Lucara suggested that the bidding for high-colour, high-quality diamonds was “particularly soft” during its second tender, which forced the company to withdraw three diamond lots.

It is possible to estimate an average realized price from the sale statistics, however, which could indicate that Lucara only achieved between US$170 and US$200 per carat during its second tender.

The widening of the price discrepancy did not go unnoticed by investors, and the July 17 sales report triggered another sell-off, with 2.3 million shares trading hands as the company’s stocked dropped 18%, or 11¢, on its way to a 52-week low of 50¢ per share.
The larger picture looks even grimmer. When the two sales reports are taken in tandem, Lucara shares have tumbled 52%, or 53¢ since early June, without the company addressing the gap between its modelled market estimates and actual realized prices at Karowe.

“In these challenging market conditions, Lucara is fortunate to be in a strong financial position,” Lamb states. “This gives us the option to retain goods which we feel have not achieved an acceptable market price. Like many other diamond companies, we anticipate an improvement in the diamond market in the latter part of the year. The viewing of the diamonds in Antwerp will allow us to take advantage of this expected strengthening of rough diamond pricing.”

BMO Capital Markets analyst Edward Sterck dropped his target price from $1.40 to $1 following news of the second diamond tender, noting that the 30% reduction in prices compared to the original models seems excessive, when considering the decline in the broader diamond market has been estimated at 6% on the high end.

BMO analysts forwarded four possible scenarios to explain the large price gap in Lucara’s numbers, suggesting that: the independent valuation was incorrect; the diamonds are not being marketed correctly or sold in the right country; diamond markets are undervaluing Lucara’s tender in a bid to be cautious about a new product; and finally, that an oversaturation in diamond supply has made markets stick with established producers and familiar products.

“Lucara remains relatively well financed, and on BMO Research estimates, are cash-flow positive at current diamond prices — albeit only just,” Sterck notes in a July 17 research update. “As such, BMO Research maintains an ‘outperform’ rating. Any uplift in diamond prices going forward should be reflected strongly in the share price. Despite maintaining the rating, BMO Research feels a little more cautious on Lucara’s outlook.”

The company reported it has yet to drawdown on a US$25 million revolving credit facility finalized in late April, and that Karowe’s first phase came in below the original US$120-million capital expenditure estimate. An excess of 310,000 tonnes have been processed at Karowe to date, yielding 87,000 carats. Lucara expects to hit full-capacity by the end of the third quarter and is working on optimizing its dewatering system, which should improve plant throughput.

The company has 373 million shares outstanding for a $186-million presstime market capitalization, and reported a net cash position of US$26 million at the end  of March.