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Tracker 2009-04
June 1, 2009
A breakthrough for Mountain Province's Gahcho Kue appears imminent
Synopsis: I am confirming the existing Spec Cycle Hold 100% recommendation related to my original bottom-fish buy recommendation in 2001, but, more importantly, I am now declaring Mountain Province Diamonds Inc (MPV-T: $1.52, MDM-A: $1.41) a Good Absolute Spec Value Buy at $1.52 with a target price range of $4-$6 within the next 12 months. The company has just achieved an important milestone by publishing a 43-101 resource estimate for the Gahcho Kue diamond project, but an equally important milestone will be an announcement that the junior has renegotiated the underlying agreement with De Beers on terms which ideally eliminate the diamond marketing rights currently held 100% by De Beers. Under ordinary circumstances it would be inconceivable that De Beers would give up the marketing rights and the associated 10% marketing fee, but the poor current shape of the diamond market and the weak financial condition of De Beers represent the sort of unusual circumstances where this type of concession would be a win-win for both parties. De Beers would have to fund only half the development costs of a project into which it has already sunk $180 million, potential headaches involving European anti-trust complaints would be avoided, and valuation issues involving both the Canadian tax authorities and the minority partner would become moot in the context of the sort of price discovery mechanism commonly used to divide diamond production among partners. It would make Mountain Province attractive as a takeover target and it would make it easier for the junior to fund its 49% share of mine construction at Gahcho Kue rather than drop down to 44% and let De Beers fund everything. If such a decision is made during the next couple months it would likely be immediately followed by a definitive feasibility study which is estimated to cost $8 million and take about 12 months to complete. The terms of reference for the permitting process were set in late 2007 and the feasibility study would define the cost of complying with the outlined mine approval requirements. Mine approval and a production decision could be in hand by late 2010, with production starting in late 2012 or early 2013. The market is currently implying a value of $190 million for the Gahcho Kue project based on 62.1 million fully diluted shares, a 49% net interest, and a $1.52 stock price. This is very low for an open pit mining scenario where the rock value ranges US $150-$200 per tonne and the in situ resource has a gross value of US $5.4 billion. The market is thus betting against the timeline and modified agreement terms I have outlined and which form the basis for my Spec Value Hunter recommendation. Mountain Province stock, which trades on TSX and AMEX, is thinly traded and should not be chased beyond $2 unless we receive news that the agreement has been modified favorably and a feasibility study has been initiated.
Mountain Province has had an open bottom-fish cycle since December 20, 2001 when it was recommended as a top priority bottom-fish buy in the $0.50-$0.75 range based on its Gahcho Kue diamond project in the NWT. The recommendation was switched to a Spec Cycle 100% Hold at $2.03 on March 20, 2003 and has been repeatedly confirmed as a hold since then, with the last confirmation occurring at $1.08 on December 24, 2008. During this bottom-fish cycle the stock has traded as low as $0.60 on May 23, 2003 following a decision by De Beers to postpone development of Gahcho Kue in light of "geopolitical uncertainties" to a high of $5.95 on May 23, 2007 amid speculation that a takeover bid from De Beers would be imminent once the merger with Camphor Ventures had been completed. A plausible rumor exists that an informal discussion about a De Beers takeover bid in the $5-$6 range took place during 2007 but was turned down by Mountain Province's Irish shareholders. Since he joined Mountain Province as the new CEO in late 2005 Patrick Evans has worked to persuade De Beers to expand its mining plan to include the Tuzo pipe, explore lower capital cost alternatives, and renegotiate the terms of the underlying agreement so that Mountain Province can fully participate in funding construction costs in the event that a production decision is made and mine approval is secured. At the half way price of $5.50 within the 2007 rumored "offer" range the Gahcho Kue project had an implied value of nearly $700 million based on 62.1 million shares fully diluted. In my view this represented a reasonable valuation for Gahcho Kue, but apparently the junior's major shareholders thought otherwise. Unfortunately, diamonds did not hold up well during the Crash of 2008. The stock price collapsed from the $4 level in September 2008 and did not bottom until it hit $0.73 in late February 2009. Mountain Province languished during the first quarter of 2009 because the destiny of its primary asset, a 49% interest in the Gahcho Kue diamond project, was completely under the control of De Beers, which itself was suffering from the collapse of the diamond market and its $1.1 billion investment in the Snap Lake Mine which was already losing money before the economic downturn. While De Beers may have been in a position to make a $342 million cash buyout offer in 2007, it is hard to imagine that De Beers has the means or will to do so today. It is thus understandable that the market lost interest in Mountain Province.
Mountain Province stock started to recover in April after Kinross made a strategic investment in Harry Winston Diamond Corp (HW-T: $7.71) and the Diavik project that prompted me to recommend Harry Winston as a Good Absolute Spec Value Buy at $3.08 on March 20, 2009. My rationale was two-fold. I expect demand for diamonds to recover quickly once the economic downturn has bottomed some time in 2010. And with the arrival of Kinross as a major shareholder I saw the financial muscle fall into place that is needed to allow Harry Winston to grow its business through a mergers and acquisition strategy that was simply not possible while management was beholden to creditors and institutional shareholders. Harry Winston's stock price has increased 150% since my recommendation and remains a hold in anticipation of significantly higher prices during the next 12 months. It is worth noting that the implied value for Diavik is now $1.9 billion.
Although I speculated that the new Harry Winston had the will and logic to eventually make a paper takeover bid for Mountain Province, at the time there remained two important obstacles which stand in the way of a bid by Harry Winston. One was the status of the Gahcho Kue diamond resource, and the other was the status of the Gahcho Kue diamond marketing rights. On May 26, 2009 Mountain Province achieved a critical milestone by publishing the first 43-101 compliant resource estimate for Gahcho Kue. The combined indicated resource for the 5034, Hearne and Tuzo pipes now stands at 30.2 million tonnes at an average modeled grade of 167 cpht and the inferred resource is 6.0 million tonnes at 173 cpht. The in situ value of the 60.8 million carat resource is US $5.4 billion based on the average of a De Beers modeled value using June 2008 prices and a WWW modeled values using October 2008 prices, with a 20% premium added to account for price increases based on long term supply and demand projections. The AMEC resource estimate is a major development because it replaces the internally generated De Beers estimate of 2005, incorporates subsequent bulk sampling on the Tuzo pipe, and puts most of the 60.8 million carat resource in the indicated category. The 2005 resource estimate consisted of 31,409,000 tonnes grading 148 cpht. Of this 14,392,000 tonnes at 164 cpht were indicated and 17,017,000 tonnes at 135 cpht were inferred. On an overall basis the total carats have increased 31% and the grade has increased 14%. Some of that increase will be due to AMEC's use of a 1.0 mm mesh rather than the 1.5 mm mesh used as a cutoff in the 2005 internal estimates.
| Project Resource Estimate - Gahcho Kue - 5034 |
| May 26, 2009 | NI 43-101 | AMEC Americas Ltd | Cutoff: 1.0 mm mesh, mid-08 price + 20% |
| Resource Category | Tonnage | Total
Rock Value | Metal | Grade | Recovery | Contained Metal | % of GMV |
| Indicated Resources | 12,700,000 | $212/t | Diamond | 188 cpht | 100.0% | 23,876,000 ct | 100% |
| Inferred Mineral Resources | 800,000 | $170/t | Diamond | 150 cpht | 100.0% | 1,200,000 ct | 100% |
| All Categories Spot | 13,500,000 | $210/t | Diamond | 185.7 cpht |
| 25,076,000 ct | 100% |
|---|
| Spot Gross Metal Value | Market Cap as % of Net GMV | Spot Prices Used |
| $2,833,588,000 | 6.7% | Diamond $113.00/ct |
| Project Resource Estimate - Gahcho Kue - Hearne |
| May 26, 2009 | NI 43-101 | AMEC Americas Ltd | Cutoff: 1.0 mm mesh, mid-08 price + 20% |
| Resource Category | Tonnage | Total
Rock Value | Metal | Grade | Recovery | Contained Metal | % of GMV |
| Indicated Resources | 5,300,000 | $169/t | Diamond | 223 cpht | 100.0% | 11,819,000 ct | 100% |
| Inferred Mineral Resources | 1,600,000 | $137/t | Diamond | 180 cpht | 100.0% | 2,880,000 ct | 100% |
| All Categories Spot | 6,900,000 | $162/t | Diamond | 213.0 cpht |
| 14,699,000 ct | 100% |
|---|
| Spot Gross Metal Value | Market Cap as % of Net GMV | Spot Prices Used |
| $1,117,124,000 | 17.0% | Diamond $76.00/ct |
| Project Resource Estimate - Gahcho Kue - Tuzo |
| May 26, 2009 | NI 43-101 | AMEC Americas Ltd | Cutoff: 1.0 mm mes, mid-08 price+20% |
| Resource Category | Tonnage | Total
Rock Value | Metal | Grade | Recovery | Contained Metal | % of GMV |
| Indicated Resources | 12,200,000 | $85/t | Diamond | 121 cpht | 100.0% | 14,762,000 ct | 100% |
| Inferred Mineral Resources | 3,500,000 | $126/t | Diamond | 180 cpht | 100.0% | 6,300,000 ct | 100% |
| All Categories Spot | 15,700,000 | $94/t | Diamond | 134.2 cpht |
| 21,062,000 ct | 100% |
|---|
| Spot Gross Metal Value | Market Cap as % of Net GMV | Spot Prices Used |
| $1,474,340,000 | 12.9% | Diamond $70.00/ct |
This resource estimate by AMEC, an independent engineering firm, gives Mountain Province the fundamental data needed to raise its share of costs related to a feasibility study and mine construction. The market, however, did not respond to the removal of this obstacle, which is why I have seized this as an opportunity to make a Spec Value Hunter recommendation before the second obstacle also disappears. Mountain Province is currently negotiating an amendment to the Gahcho Kue agreement which would facilitate rapid development of a diamond mine. The target of the negotiations is the diamond marketing rights for Gahcho Kue which De Beers understandably would prefer to retain. However, there are potential complications associated with a hard line stance by De Beers, including a decision by Mountain Province that forces De Beers to fund all the capital costs of mine development. Given De Beers' weakened financial condition I think an agreement which is a win-win for all parties will emerge during the next couple months. The next milestone for Mountain Province would be the announcement of an amended agreement and a decision to proceed with a definitive feasibility study
Mountain Province and De Beers have received a proposal for a definitive feasibility study whose cost is estimated at about $8 million. If De Beers makes a decision to proceed with a feasibility study Mountain Province will have the choice of contributing 49% of the cost or dropping to 45%. Given that De Beers has already spent about $180 million on Gahcho Kue since optioning the project in 1997, Mountain Province will very likely fund this extra $4 million. The MacKenzie Valley Environmental Impact Review Board published the final terms of reference for an Environmental Impact Statement on October 5, 2007 towards whose fulfillment De Beers has since been working. No physical work remains to be done at Gahcho Kue; the feasibility study, expected to take 12 months from initiation, will result in the filing of a Project Description that complies with all permitting requirements. Mountain Province and De Beers have been engaged in a "review of strategic alternatives" since June 2008. The Gahcho Kue agreement allows Mountain Province to fund its share of construction costs to maintain 49% or require De Beers to fund the entire project, dropping Mountain Province to a 44% net interest. The agreement also includes a clause which gives De Beers the marketing rights to Gahcho Kue diamond production and a 10% "marketing fee". These are archaic provisions which Mountain Province would like to replace with the right to receive its share of production in kind. De Beers is apparently in poor financial shape after investing $1.1 billion in the non-profitable Snap Lake mine and dealing with the collapse of the rough diamond market in the second half of 2008. The "strategic review" is geared toward an outcome which sees Mountain Province recover diamond marketing rights and become a working interest partner with De Beers in the development of Gahcho Kue.
The diamond marketing rights are a critical obstacle. De Beers has the right to market all the diamonds and for this service collect a 10% "marketing fee", in effect a 10% gross royalty on the rough diamond value of Gahcho Kue production. This onerous fee was a holdover from the days of the Central Selling Organization through which De Beers controlled the supply of rough diamonds to the market. De Beers acted as the sole buyer of mine production and the sole supplier of diamonds to the cutting and polishing sector, which in turn supplied the retail market through a series of intermediaries. The justification for this fee was the role De Beers played in maintaining price stability and uniformity within a complex classification system. During the late nineties De Beers abandoned the cartel model when it became apparent that it could not prevent independent suppliers from finding wholesalers not trapped in a dependency relationship with the CSO. All competently written contemporary joint venture agreements now allow the junior to receive its share of production in kind, though generally not until after payback has been achieved if the partner funded mine construction. The reason producers are eager to receive their share of production in kind is in part related to the Kimberley Process which requires source certification for diamonds. Whereas historically the diamond supply chain consisted of distinct and independent segments, the need to certify the source of natural diamonds has created an argument for vertical integration of the supply chain. For example, Harry Winston has the ability to market polished diamonds through its luxury retail outlets that come from its own Diavik Mine. Not only does this allow the producer to capture a source premium, but it also gives it a chance to capture part of the substantial markup between the rough and retail value of a diamond. Unfortunately for Harry Winston, the Diavik pipes only rarely produce the large high value stones required by the high end jewelry in which the Harry Winston retail outlets specialize. Furthermore, who gets the "specials" is decided by a sealed bid process where the partner bidding the highest amount "gets" the diamond while the loser gets the cash. The word is that Rio Tinto has been more aggressive than Harry Winston in this regard, with the result that Rio Tinto has been scooping the specials for its own distribution system.
The Gahcho Kue pipes appear to have the potential to produce very valuable diamonds, as was demonstrated in 2008 when a bulk sample from Tuzo yielded a 25.13 carat gem valued at US $17,500 per carat. Several years ago a bulk sample from the 5034 pipe yielded a 9.9 carat gem valued at $15,000 per carat. These and other large high quality stones have led WWW to state that once commercial production is achieved the value will likely be at the high end of the modeled range, which is 18-24% higher than the official modeled values assigned to the above resource estimate. Although De Beers has resolved all its anti-trust problems in the United States and has opened two De Beers luxury retail outlets, there is no evidence yet that De Beers is ready to accompany its production downstream through the supply chain in the manner that Rio Tinto, Harry Winston and BHP Billiton are able to do with their production. Because De Beers is still committed to its role as a "Supplier of Choice" which sells rough diamonds to wholesalers, it has no incentive to "overpay" for specials. Thus if Harry Winston were to acquire Mountain Province and be in a position to receive its share of Gahcho Kue production in kind, it would probably prevail over De Beers with its sealed bids for the specials. In this scenario Harry Winston would have a strategic reason to acquire Mountain Province, namely a supply of high end stones for its Harry Winston outlets.
Conclusion: The risk in buying Mountain Province at current prices lies largely in the possibility that De Beers' financial problems are so severe that it is in no hurry to accelerate development of Gahcho Kue. If De Beers does not relent on the diamond marketing rights Mountain Province would have a tough time raising capital for its share of construction costs. But De Beers may have a strategic incentive to move forward with Gahcho Kue which in retrospect should have received the company's attention rather than Snap Lake, a boondoggle created in London when De Beers was stymied in its bid to acquire Ashton Mining Ltd. Snap Lake is currently in a temporary shutdown awaiting better diamond prices, which need to do more than just rebound to justify resumption of production. This situation does not sit particularly well with the inhabitants of the NWT who are starting to sense that the best diamond mining days of the Slave Craton are over. The Snap Lake infrastructure, however, is conveniently located to assist the development of Gahcho Kue. It has a large airstrip which would allow De Beers to fly in pre-assembled modular chunks of the Gahcho Kue facility and truck them over an ice road between Snap Lake and Gahcho Kue. This would avoid the uncertainty associated with relying on the ice road from Yellowknife. In addition, Deze Energy Corp Ltd, which is owned by native groups and operates the Taltson hydro-power facility at the southeastern end of Great Slave Lake, is pushing a proposal to expand power capacity and construct a 700 km transmission line to the Snap Lake, Diavik and Ekati mines. Not only would this bring cheap power to these expensive diesel based mines, but it would significantly reduce the carbon footprint created by the diamond mines. This transmission line would pass by the Gahcho Kue project, which, if it became a mine, would benefit from lower electricity costs and ultimately help justify the Taltson expansion proposal. It is my assessment that a host of factors justifying the fast-track development of the Gahcho Kue diamond project are rapidly converging. The timing for a quick double or triple in the price of Mountain Province which brings the implied project value back into the $600-$700 million range is imminent.
*JK owns shares of Mountain Province
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