Petra Diamonds (PDL) is a company that I covered back in March and so far I have been wrong about it having potential as a speculative investment, as the share price has just taken another big drop. Back then the share price was around 18p and over the next month or so it did manage to rise to over 26p, so nearly 50% profit was on offer for anyone who took it as a trade, but when I wrote about it I was looking at it as more of a longer term recovery play, so given the current share price of around 10p, it clearly looks as though I was premature with my speculative buy recommendation – although in the event of a proper recovery over the next few years, that could easily still yield a profit.
The diamond miner is still one of the larger outfits in this sector, but its shares took a tumble when it released a trading update for FY2019, along with guidance for 2020, and there were some third party comments about levels of debt and Capex, and this caused the share price to drop by nearly 50% from the level it had been stable at prior to this announcement. The company has since issued a statement in response to the drop, clarifying certain facts – including that the 3.87Mcts of diamonds produced during 2019 was inline with previous guidance, and the $81.7 million spent on Capex was below the $100 million that had been expected. Revenue for the year was down by 6% though to $436 million, and was largely inline with lower diamond prices, which fell by around 5% compared to the previous year. It also pointed out that it generated $17 million of free cash flow in H2 2019 after repaying $43.6 million in loans and bond interest payments.
The big concern here is still the level of debt that the company has, but that has been the case for some time and is nothing new, and that now stands at $560 million and is a fair bit higher than the $520 million it stood at a year previously, and the situation is even worse if you take into account diamond debtors. But the company has already recognised the issue and has taken measures to reduce costs, and as compared to six months ago the debt level is stable. In terms of the sustainability of that debt, if we look at the banking covenants currently in place I suspect that it does have a fair bit of headroom to play with for now – theses covenants relate to net debt to EBITDA ratios, and until the final results are known, we won’t have an exact EBITDA figure, but I would estimate that it will be comfortably in excess of $150 million (based on the interims). Currently the covenants require a ratio in excess of 4.5x, so by my reckoning the company will be well below that, and will continue to be when that ratio drops to 4.25x at the end of 2019. Where things could start to get tighter is at the end of 2020 onwards if there hasn’t been any improvement in the financial performance of the company. Looking slightly further ahead, $650 million of 7.25% loan notes mature in May 2022 which many are seeing as a problem, but I would expect that these notes will be refinanced and the coupon on them is being paid. Both Moody’s and S&P credit rating agencies have a stable outlook on this debt, and have ratings of B3 and B- respectively for both the company itself, and the notes. These ratings in themselves mean that these credit rating agencies view the company and the debt as being speculative and with a high credit risk, but the fact that both have a stable outlook means that they don’t see a high risk of default just yet. The company has enough working capital to meet its needs, with nearly $90 million in the bank as at the end of June 2019, along with inventories of $62 million and diamond debtors of $23 million, plus undrawn bank facilities of $106 million – although any significant drawdown on that facility would start to put pressure on its banking covenants.
The trading update also saw it announce the launch of Project 2022 which is designed to make the company more efficient and aims to generate free cash flow of $150-200 million over the next three years. The company has often seen its results heavily influenced by the recovery of large stones from the Cullinan mine and the number of these produced annually can have a significant impact on revenue, so Project 2022 is excluding any stone worth in excess of $5 million, so as to iron out these fluctuations. Of course, that won’t be enough to settle the outstanding notes when they become due in 2022, but it should put the company in a decent position to refinance that debt – this isn’t exactly an unusual situation when it comes to mining companies, and debt is regularly refinanced to extent the date that the remainder comes due. Current life of its projects extends to 2030 and beyond, so should still prove attractive to debt investors as long as it can show that it is repaying existing debt quickly enough. The risk when it comes to the debt is that it won’t have reduced sufficiently by then and that covenants have been breached – although if free cash flow targets are met then the covenants shouldn’t come into play, but the market will still need to see that the debt is being reduced at a significant rate. Especially given the fact that production is expected to be fairly flat in the near term.
The main factors here that determine how successful the company is over the next three years will be diamond prices; the number of exceptional stones found, which will add revenue in addition to the underlying business excluding these; and the strength of the Rand against the US Dollar. In terms of diamond prices, these have been weak for a number of years now, but could be just about to get a much needed boost. The world’s largest diamond mine, Argyle, in Australia, is set to close by the end of 2020, having finally exhausted its resources over the past 40 years. It is famed for its large pink diamonds, but also produced large quantities of cheap brown diamonds that sold for an average price of $15-25 per carat, compared to an industry average of $171 per carat in 2018. The removal of this glut of cheap diamonds is forecast to have a positive effect on prices over the coming years, and by 2023 some are predicting a supply deficit of up to 35 million carats per annum. In terms of large diamonds from Cullinan, this has fluctuated from year to year and is unpredictable, so there should be no reliance on that. The strength of the Rand has already come into play and has weakened even since the company put out its trading update – it forecasts are based on an exchange rate of ZAR14/$, rising to ZAR14.99/$ as the currency devalues, and the current spot rate stands at just under ZAR14.8/$. As things stand, it looks like the US Dollar will continue to show strength and there is no appetite for weakening it. I also suspect that a fair bit of shorting has been going on with this company, in addition to the notifiable positions declared by GSA Capital (0.59%) and Marshall Wace (0.62%), as the company has shown weakness. It may well take some good news to cause a reduction in short positions, but I wouldn’t expect to see them added to significantly down at this level. Overall, for me, shares in this company remain a speculative buy, and from a market cap of £86 million I see good upside potential if it does manage to turn things around – even just a return to the levels it was at prior to the trading update offers significant upside. There are certainly risks here, but then that is the case with most companies of this type, and if the diamond market does improve, as I suspect that it will, then this still has potential to do well over the next 5-10 years.
Filed under: Petra Diamonds, Verseon, Bluejay, Spud U Like, Independent Oil & Gas, Peel Hotels
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