When a share keeps on falling you have to decide whether the decline is terminal or how good the chances are of a recovery at some point. In some cases you will just be throwing good money after bad, and just because the shares have traded at a higher level in the past doesn’t mean that they will necessarily do so again if the fundamental changes to the business are terminal. But we also see cases where there is a temporary decline followed by quite a strong recovery, especially where the business is reliant on factors that are cyclical - such as in the natural resources sector as commodity prices fluctuate - or where it has suffered from shorting or a persistent seller, or even a combination of all of these. I believe that Petra Diamonds (PDL) fits into that category, and since covering the company as a buy a while back I have actually ended up taking some shares myself, with a longer term view.
There is no doubt that the diamond market has been weak and there are no immediate signs of a significant recovery, but the forecasts longer term do look more encouraging, and I would expect the closure of the largest diamond mine in the world - Argyle in Australia - to have some positive impact on the market and prices. The company recently issued its results for the year ended June 30 2019, and initially they didn’t seem to go down well with the market – despite being inline with expectations from the last trading update in July. At first glance the accounts look fairly healthy, with revenue of $463 million, down around 6% which pretty much reflected the drop in diamond prices, and operational free cash flow of over $70 million showing a vast improvement on the $61 million outflow the previously year, and reflecting the efforts of the company to reduce costs, and especially capex. The net loss looks bad on paper, but includes an impairment charge of $246 million to reflect the poorer diamond market, and adjusted EBITDA actually came in at $153 million. Petra produced 3.87 million carats during the year, and the current period got off to a good start as well with 705kcts for July and August, plus a weaker Rand is also helping to some degree. It also has one of the largest diamond resources across its operations - including at the famous Cullinan mine which produces some huge stones each year - with reserves of 42.5 million carats, and resources of 250 million carats.
Based on all of that it seems surprising that the market cap is only around £74 million, but the big concern here is the level of debt. Although the recent plummet in share price has also been down to a persistent seller, who should be close to being out if not already so, plus several funds shorting the shares, and accompanied by fairly thin volumes. The shares were trading at around 16p post the full year trading update in July. In terms of the debt, it has $603 million in outstanding 2022 7.25% notes, as well as $120 million in loans from the BEE, and it does look likely to breach the covenants during December and next June as well, but so far the lenders have been very supportive, and I would expect that to continue. Even taking into account the free cash flow that the company is expecting to generate as part of its new Project 2022 overhaul of the business, and assuming that it finds several exceptional stones at Cullinan each year, as has been the norm, there is no way that it will be able to repay all of the outstanding notes as they become due in 2022. But given the mining life of its assets, plus hopefully a stronger diamond market by then, I would expect it to be able to refinance the outstanding amount – as is fairly common with many oil and mining companies that have invested large amounts of money into their assets and in bringing operations into production. It is similar to what we saw with some oil companies during the slump a few years ago, but many of those are now thriving, despite looking in trouble with huge amounts of debt at that time.
It definitely isn’t without risk though and I view it as speculative and one that could take several years to really recovery – assuming that it ever does. But in spite of all that debt and write-downs, the NAV still stands at in excess of £325 million, or roughly five times the market cap. To me that suggests that there could be value here and I’m happy to see how it plays out, although I wouldn’t be throwing the kitchen sink at it until it can show signs of a real turnaround and the market improves. So, in summary, the latest results haven’t done anything to change my view of it being a speculative buy.
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