Five diamond plays to dazzle

London's larger diamond producers have done well over the past 12 months, and with geopolitical events increasing the need for an alternative currency and increasing diamond demand outstripping diminishing supply, there is further significant upside for the industry say insiders.

Conditions have certainly improved since the post-Lehman slump. But it's been a real “rollercoaster ride" since 2008, says Bain & Co, with prices plummeting a year later before rebounding in 2010-2011. So far this year, prices are up 18%, according to data from Allenby Capital.

The mining sector as a whole bottomed out in July last year, and although Allenby's James Rose does not expect it to re-rate just yet, he is upbeat on the vast potential of certain companies.

"There no longer appears to be a net downward trend in mining stocks, thus enabling companies with positive news flow to actually realise share price gains, rather than such events merely being used to clear overhanging positions," he says.

Diamonds - an alternative to gold

There are three types of diamond; industrial diamonds, exceptional diamonds and those sold to retailers through their colour, clarity and carat. Assessing the health of the diamond industry is far more difficult than for the oil and gas sector for which spot prices are widely available online. There are alternatives, like Rapaport (link), but it is this lack of price transparency that Philip Manduca, the new executive chairman at Paragon Diamonds, believes is the industry's biggest issue.

That aside, the investment case for diamonds is not new, so why should investors be bullish on the stones now? Manduca says it is down to the growing uncertainty around global geopolitics, "weak politics and weak leadership." Religious warfare and significant youth unemployment in Europe don't help. "There are problems just about everywhere on the planet," he laments.

"In that environment you have got to look at investments that can secure one's wealth and provide returns on one's investment. And it is hard to see why diamonds won't be one of the more optimal ways to do that, not least because we are in a period where I think history will look back at the current era of monetary policy and describe it as crazy, where money is being printed at will and central banks are buying government debt. Just because it is acceptable now, doesn't mean it is right."

When considering hard assets, many investors immediately think gold is the best way to get exposure. But Manduca disagrees, not least because of its connection to the banking system.

"Generally you will hold gold in a bank, if you want to transfer gold you can't draw up with a truck outside, you tend to have to move it from one bank to another, typically electronically. The reason for holding gold is that you probably don't trust the bank in the first place. So it really is a difficult, practical currency. Diamonds on the other hand are extremely mobile. They can remain and be stored outside of the banking system they have a proven currency track record going back 600 years."

How to time your investment

Investing in equities, especially commodity-focused stocks, is so often about timing. For mining firms, investors are advised to buy in before a project is fully-funded to production, as those that aren't typically trade at a 70% discount to project equity value, says Rose. Investors should also consider investing before a pre-feasibility study is published and after the project has been de-risked, but it should be close to maiden cash flows and you should be confident of the firm securing finance, he adds.

Rose reckons that of the circa 135 million carats produced in 2013, 70% were from just 15 mines around the world, owned by just four companies and two state-dominated joint ventures. He predicts production to rise at 4.8% per year to 2018 after which output will begin to fall.

Manduca is upbeat on the market, especially since De Beer's has loosened its grip on the market: "There isn't a manipulation of the market. There are too many producers, there is no monopoly."

And it is because of this scarcity of mines that prices are going north. Producers have to dig deeper, increasing capital expenditure costs. And Asian demand does looks unlikely to slow any time soon.

Between 2007 and 2012, middle income households in China and India grew at a compound annual growth rate (CAGR) of 23% and 9% respectively, and the trend is set to continue. That means demand is growing, too - Bain & Co predicts a CAGR for global rough diamond demand of just over 5% between 2012 and 2023 to $26 billion. It's a more modest $17 billion this year.

So with the supply and demand story supporting Manduca's long-term view on the diamond industry, Interactive Investor has taken a look at five ways investors can gain exposure to the theme.

Paragon Diamonds (PRG)

With the appointment of Manduca as chairman of Paragon, the Africa-focused firm is to undergo a transition to become a "vertically integrated miner," where its reach will extend from production to retail marketing in order to benefit from the expected increase in price. In another move to boost investor accessibility to the stone, Paragon plans to launch an investment fund, possibly within the next 2-3 years.

It is also going against the grain, being run by businessmen instead of miners, and Manduca reassures the market that paying management in shares rather than cash will work for in favour of market value rather than their own pockets in the short-term.

Paragon's main asset is the Lemphane kimberlite diamond project in Lesotho, southern Africa, which currently has an in-house estimated value of between $900 million and $1.4 billion. Stage one production is expected to start in the first half of 2015. By the end of next week (12 September 2014), Manduca will have confirmed the exact day the plant will be commissioned, currently expected to be 1 February. Stage one is expected to cost up to $10 million to develop, with operating costs of $10 per tonne. Revenues are expected to reach up to $20 million in two years. Talks are on-going to secure financing for the project.

Petra Diamonds (PDL)

Concerns over the health of Petra Diamonds' balance sheet and whether it can fund its capital programmes have been put to one side following a strong financial performance. The discovery of high-value stones, especially a 122 carat blue diamond worth up to $45 million, helped.

This improvement has seen its free cash flow yield shrink, with positive yield expected in 2015, supporting Petra's aim of returning cash to shareholders in 2016. Investec Securities pencils in a 2.4% dividend yield.

The miner has controlling interests in six producing mines - one in Tanzania and five in South Africa -with the vast majority of its asset value in Cullinan and Finsch.

Although improving, weaker grades and rising costs at the historic Cullinan mine forced Investec to lower cash profit forecasts to $232 million, with earnings per share (EPS) falling to 21 cents. But the broker still believes the bullish diamond market could make $495 million in 2017, giving EPS of 47.7 cents.

Investec has a 'buy' recommendation on the stock with a 245p target price, underpinned by the positive diamond market. After the downgrade, Petra trades on nearly 25 times forward earnings and on an enterprise value-to-cash profits (EV/EBITDA) multiple of 5.2 times.

Gem Diamonds (GEMD)

On Friday, Gem Diamonds announced that its Ghaghoo mine in Botswana, the first underground mine in the country, had been officially opened. Production should hit a rate of 60,000 tonnes a month by December 2014, with first sales expected by the end of the year.

Gem also joins Paragon in Lesotho, where it operates the 70% owned Letseng mine, which is pegged to produce up to 100,000 tonnes this year. Letseng is well known for its large, high value diamonds. But Westhouse Securities warns that the bulk of the company's revenue comes from these big finds, so income is lumpy.

After impressive first-half results, Gem looks on track to introduce its maiden dividend at the end of this year, especially with the strong cash flow generation it displayed in the period. While Westhouse maintains its 235p target price, it has lowered its guidance to 'add' from 'buy', due to recent share price strength, which saw it rally by 40% since mid-June.

With EPS expected to double to 31.8 cents, the stock is trading on a price/earnings (P/E) multiple of 11.2 times, with an EV/EBITDA ratio of 3.2.

Gemfields (GEM)

Claiming a more responsible approach, Gemfields sources emeralds and rubies from its operations in Zambia and Mozambique. After a tough 2013, things are looking up for the firm, with Investec expecting revenue to more-than double to $149.5 million, with EBIDTA reaching just under $50 million from $1.1 million last year. This will push its EPS into the black, at 0.2 cent, and a forward P/E of 397 is expected to normalise by 2015, at 13.1, dropping to less than 7 in 2016.

Gemfields produced 6.3 million carats of emeralds in its fourth quarter, which although was down nearly a third on the year, was up 75% quarter-on-quarter. And this "gave no major cause for concern since the nature of the asset base typically delivers considerable volatility," said Investec.

With cash of $36.7 million and debt of $16.7 million, Gemfields' balance sheet is healthy, and although the broker trimmed its price target to 55.6p, it reiterated its 'buy' recommendation.

Firestone Diamonds (FDI)

Another reveller at the Lesotho party is Firestone Diamonds, which has completed a $225 million debt and equity package to begin construction of its fully-funded Liqhobong mine, which should take two years and cost $185.4 million. The open-pit project is expected to produce 1.2 million carats per year and process 3.6 million tonnes per annum or ore at a 32cpht grade for 15 years. But it gets a bit more exciting than that.

Allenby's James Rose reckons that in its first year of production, Firestone will find more than one exceptional 100 carat-plus stone. The project has a net present value of $728 million.

It is not all rosy for the miner though, with cash outflows increasing during construction due to its mining licence revision.

But with first production expected in 2016 and 1 million carats targeted in the next year, many are bullish on the stock. Charles Stanley expects Firestone's share price will nearly double to 62.5p.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.