Spec Value Hunter Comment - March 16, 2012: Recommendation Strategy for Mountain Province Diamonds Inc
Mountain Province Diamonds Inc was recommended a Good Absolute Spec Value Buy at $3.90 on December 30, 2011 based on the expectation that the Gahcho Kue diamond project in the NWT will have a permit in place to allow construction to begin by mid 2013 with mine commissioning in 2015. The 49:51 joint venture with De Beers is the subject of a definitive feasibility study (DFS) completed in December 2010 which recommends mining in sequence over a 11 year period three pipes - 5034, Hearne and Tuzo which collectively host 31.3 million probable tonnes at 157 cpht representing 49 million carats. The DFS projected a capital cost of $550 million and utilized a life of mine average carat value of $74.52 based on an average of DTC and WWW International Diamond Consultants Ltd (WWW) 2010 price books. The result was an after tax net present value of $792 million using a 5% discount rate, which translated into a $4.77 per share target for Mountain Province based on 81,309,866 shares fully diluted and a 49% net interest. This was a disappointing outcome because not only was a 5% discount rate rather low, but the price target did not include whatever dilution Mountain Province will need to incur to raise its share of the equity portion of the capital cost, estimated by CEO Patrick Evans to be about $100 million. The 33.9% internal rate of return, however, did clear the 15% hurdle rate De Beers had set, and the permitting process was initiated in 2011. Although the multi-staged approval process will not complete until Q3 of 2013, De Beers and Mountain Province intend to place long lead time plant and construction equipment orders worth about $50 million during H2 2012. Mountain Province management hopes to raise $100 million plus during 2012 after Kennady Diamonds Inc has been spun out on a basis of 1 Kennady share for every 5 Mountain Province shares. The obvious question is that if Mountain Province has a price target of only $4.77 based on the DFS assumptions prior to raising the equity portion of project financing, wherein lies the upside that justifies a Good Absolute Spec Value Buy recommendation with a $10-$12 target over the next 12 months?
The upside lies in the peculiar nature of diamond valuation for kimberlite bodies and the general outlook for diamond prices which are expected to rise at a rate above inflation due to a projected imbalance as Asia driven demand growth exceeds supply growth from an industry characterized by aging diamond mines and a paucity of world class deposits at the development stage. Unlike metals which are extracted from ore to produce a uniform material for which fabricators pay a global market price, diamonds are liberated from ore as individual crystals called rough diamonds whose market price depends on the four C's: clarity, color, cut (shape) and carat (size). Grade can be readily measured through a series of steps starting from micro diamond analysis and ending with bulk sampling which results in a carat/tonne grade. Carat value is more complicated because of the lognormal size distribution of a diamond population (in simple terms bigger diamonds are less abundant than smaller diamonds), within which may be sub-populations that have different quality characteristics. This situation is further complicated by the fact that a kimberlite pipe typically consists of multiple eruptive phases carrying different diamond population payloads. So not only do the resource estimators need to assess grade variation within a pipe, but they must also deal with spatial distribution of different quality diamond populations. Because there is an exponential value per carat increase in the larger stone sizes, compounded when there are corresponding boosts in clarity, color and shape, the value of the output at a commercial production scale can be much higher than measured during the sampling stage. This quirk arises because the odds of recovering those high quality diamonds are very poor with the sample sizes used to evaluate a kimberlite.
Unfortunately, because exploration samples only a slice of a kimberlite containing a randomly distributed diamond population, it is also possible to "get lucky" and recover a very high value stone during sampling which the statisticians discount as an "outlier". During the Gahcho Kue bulk sampling stage from 1997-2005 De Beers recovered 8,317.29 carats from the 5034, Hearne and Tuzo pipes whose "actual" value using the WWW price book as of April 11, 2011 was $1,535,024 or $185 per carat. This high carat value is due to a pair of zinger stones, a 9.9 carat stone from 5034 valued at $24,000 per carat and worth $237,600, and a 25.13 carat stone from Tuzo valued at $20,000 per carat worth $502,600. Imagine these stones were located a few centimetres outside the bulk sample bore holes, or got crushed to smithereens during processing. The actual value of the Gahcho Kue parcel would be only $96 per carat. Don't have those 2 diamonds and all you can do is dream that the carat value is better than measured; have those 2 diamonds in hand and you can hope that they are indicative of better yet to come. Glass half empty versus glass half full.
An exercise in contrast would be the Renard project of Stornoway Diamonds Corp, which recovered 7,006.81 carats worth $770,730 using the WWW May 9, 2011 price book, or $110 per carat average ("actual", "observed", "measured") for the Renard 2, 3 and 4 pipes that are the subject of a feasibility study published December 29, 2011 which envisions an 11 year mine at 6,000 tpd that open pit mines for the first 2 years but then shifts to underground mining of what have turned out to be a group of "fat-bottomed pipes" similar to what De Beers and Mountain Province hope to demonstrate with regard to their Tuzo pipe. Stornoway did not recover any high value "outlier" diamonds, but nevertheless WWW has modeled value ranges of $153-$263 per carat for Renard 2 (actual value was $173 per carat), $153-205 for Renard 3 (actual value $171 per carat), and $105-$185 for Renard 4 (actual value $100 per carat) with base case prices of $182, $182 and $164 per carat respectively (the unusually high base case price for Renard 4 is based on the belief that the low observed results arose through the destruction of diamonds during processing which created a false impression of a "fine" size frequency distribution). When comparing the WWW modeled values for Renard and Gahcho Kue is is hard to avoid the conclusion that Renard is a superior diamond project in terms of the diamond value it could generate, though in terms of capital cost and projected cash flow Renard is inferior with a projected after-tax net present value of $375.6 million using a 7% discount rate, which works out to a price target of $2.17 based on on 173,431,665 shares fully diluted which includes the recent $15 million bought deal and the conversion of the Quebec government's stake. (When the Renard DCF is normalized to the one I use for Gahcho Kue the outcome is considerably lower, whose analysis I will save for another time.) If you are inclined to worry about the quality of the Gahcho Kue diamonds, you may find some support in the fact that photographs of Gahcho Kue bulk sample parcels are not readilly available while those of the zinger stones are. It is generally understood that the majority of Gahcho Kue diamonds have a shabby quality, but within the overall package is a sub-group of absolutely stellar diamonds whose value eclipses the rest of the lot. In comparing the low-high modeled range WWW is willing to assign to the Gahcho Kue and Renard parcels, it is clear that WWW is much more optimistic that commercial production from Renard will exceed the average "observed" value of the parcel recovered through bulk sampling,which is so-so, than it is that commercial production of Gahcho Kue will match the observed value of the recovered parcel, which has been boosted by a few spectacular stones.
The statisticians at WWW have used the bulk sample parcel to model the Gahcho Kue diamond population in terms of color, clarity, size and shape to come up with a modeled base value of $122 per carat, with a pessimistic "low" value of $109 and an optimistic high value of $161 per carat which is below the actual average value of $185 per carat. These are based on their price book as of April 11, 2011, which in turn is based on prices the diamond market is paying for rough diamonds in the different 4C categories. What tantalizes diamond deposit developers is that statistically quantifying the abundance of such high value diamonds within the overall deposit may be more art than science, and since feasibility studies need to be based on science rather than intuition, the more conservative "base" modeled value of $122 per carat will be used. This April 2011 base value is 63% higher than the $75 per carat base modeled value used in the DFS which reflects the rise in diamond prices since the 2008 financial crash which decimated rough diamond prices. The upside for Mountain Province thus lies in the speculations that 1) the recovery of rough diamond prices since the crash is at a minimum sustainable, 2) Asia will continue to drive demand growth at a rate which grows diamond prices at a higher than inflation rate, and, 3) commercial production will reveal that the value of Gahcho Kue output skews toward the upper end of the modeled range and possibly reaches or exceeds the actual value measured during the evaluation stage. A fourth speculation relevant if the third speculation is fulfilled would be that Asian demand for large high quality diamonds will push their prices up at higher rates than manifested for diamonds in general.
In an effort to understand this speculative upside I have created a discounted cash flow model based on the DFS mine parameters that estimates the after-tax net present value per share using the different valuation scenarios. The sensitivity charts above and below use the same model, except that the above chart uses 81,309,866 shares fully diluted while the one below assumes that Mountain Province will raise $100 million at prices above $5 to boost fully diluted to 100 million shares. I present both scenarios because there is a possibility that De Beers, which is sitting on about $1.8 billion in tax loss carryfowards related to Snap Lake, a good portion of which could be used to offset Gahcho Kue profits, could make a pre-emptive takeover bid for Mountain Province during the next month or so. De Beers would do so during the next month in order to prevent the spinout of Kennady Diamonds, for which special meeting has been called on April 25, 2012. Spec Value Hunters eager to own Kennady Diamonds may want to own Mountain Province before April 25. If De Beers made a bid before the meeting Mountain Province management would be obliged to postpone the meeting and thus jettison the spinout if the takeover bid is successful. Given that the last time De Beers moved swiftly it was very painful for the company, it is unlikely that De Beers would act during the next month, so my recommendation is to use the DCF with the 100 million fully diluted shares to assess potential price targets. I also don't expect a pre-emptive bid from De Beers because the stock is sufficiently well held that De Beers would have to offer a hefty price to succeed, something hard to imagine given the current price was once considered too rich when there was a lot less Mountain Province stock issued.
My DCF model incorporates several changes to the parameters presented in the December 2010 DFS whose technical report is missing some of the details needed to reconstruct the underlying cash flow model. For example, although the technical report includes graphics showing how the pipe mining sequence overlaps, the associated tonnages and grades as well as carat values are not presented. This is problematic because 5034 has multiple lobes with different grades and carat values. As a result I have simply "mined" each pipe at the average grade and value, and overlapped them in a single transition year rather than multiple years as suggested by the bar charts. Another change is that I have excluded the 4% "selling fee" which De Beers insisted be in the DFS because that is what its wholly owned DTC subsidiary charges the De Beers mining divisions for their rough diamond output. According to Patrick Evans this 4% fee would not apply to Mountain Province's 49% share of diamond output which it is entitled to receive "in kind". The DFS also escalates costs with an inflation rate and diamond prices with a slightly higher rate reflecting expectations of above inflation rate price increases for rough diamonds. My model has no revenue or cost escalation which may be why the after-tax NPV at the $75 per carat 2010 base value using a 5% discount rate works out to only $665 million or $4.01 per share instead of $4.77 per share. The DFS indicates that 3 taxes totaling 39% apply, but the NWT mining profits royalty of 13% is a maximum with a complex sliding scale formula; I have applied Patrick Evans' suggestion to use a 37% effective rate. I have also assumed zero taxes until payback of the $550 million capital cost but not the $142 million sunk cost related to the 15 years De Beers spent evaluating Gahcho Kue (boy, what a long trip this one has been!).
So how do we interpret the result? Assuming 100 million fully diluted, the 2010 base value of $75 per carat scenario generates price targets of $3.26 at a 5% discount and $2.31 at a 10% discount. This is the pessimistic macro scenario where "China is a Mirage" and a worldwide depression awaits the global economy; Spec Value Hunters inclined to favor this macro outlook need to avoid all diamond plays. The targets jump to $4.93 and $6.75 for the 2011 low modeled value of $109 per carat which reflects concern that the better quality diamonds in the bulk sample parcel are flukes. This conservative scenario offers only modest upside for Mountain Province from the current price. The stock should thus be avoided by Spec Value Hunters who are negatively skeptical about the diamond evaluation process. The 2011 base of $122 per carat is only modestly less conservative than the low value, offering price targets of $6.07 and $8.17 at the 10% and 5% discount rates. Much more interesting is the high modeled value of $161 per carat which offers price targets of $9.25 and $12.28 per carat. The NPV based on the actual value of $185 per carat jumps sharply because only the 5034 and Tuzo pipes benefit from the "outlier" stones, and, because 5034 is first in line for production at a $280 per carat actual average, it creates an upfront blast of cash flow. The resulting $16.48 and $21.91 after-tax NPV per share targets for Mountain Province at 10% and 5% represent the "holy cow" upside for Mountain Province. However, one should keep in mind that confirmation of this "actual value" scenario can only come in 2016 and beyond after Gahcho Kue is in production.
Although it is conceivable that non-operating diamond companies such as Harry Winston Diamond Corp could make a takeover bid for Mountain Province in order to secure a supply of the sort of rough diamonds its upscale retail division cannot get from the company's share of Diavik production, the most probable bidder is De Beers itself for two reasons. De Beers has a very intimate understanding of the Gahcho Kue system, and, probably better than anybody else, including WWW, has a strong internal intuition as to whether commercial production will produce diamonds whose value skew towards the lower or upper end and beyond of the modeled range. On the other hand, one does have to wonder why De Beers, despite prior hands on involvement with Gahcho Kue, chose to sink $1.8 billion into the Snap Lake sink-hole rather than aggressively develop Gahcho Kue. The bailouts Randy Turner and Bob Gannicott scored from De Beers, however, may yet benefit Mountain Province. It is unlikely that De Beers will ever recover its $1.8 billion investment in Snap Lake from Snap Lake diamond production thanks to the complex local displacements of the kimberlite dyke. While it cannot use tax loss carryfowards to offset the 13% NWT mining profits royalty, it can likely utilize them to offset the 15% federal and 11.5% NWT corporate income taxes. De Beers can thus look at the value of Mountain Province's 49% Gahcho Kue stake in close to pre-tax NPV terms, which would allow us to entertain a target in the $9-$12 range that corresponds to the optimistic end of the modeled value range. But the Mountain Province shareholder base may be ready to wait several more years for actual production, especially if Mountain Province raises the $100 million or so it believes it needs for the equity share of project financing.
Mountain Province shareholders are in no immediate hurry to tender to a takeover bid. At 11 years the Gahcho Kue mine life is very short, and during the final four Tuzo years diamond production drops from 5 million carats plus to 3.4 million carats due to the lower grade of Tuzo, as is evident in the production graph above. De Beers is close to completing a 5 hole deep drilling program on Tuzo which is testing a theory that Tuzo flares between 350-750 metres. The graphic below depicts the tonnage implications for a pipelike continuation at the diameter present at a 350 m depth. If this volume of material is present and has a similar grade to the upper portion, it would add 30-50 million carats in future production extracted by underground mining. An update which allows the market to calculate the volume intersected is expected in April, with micro diamond analysis by De Beers arriving late in Q3 of 2012. The grade of the upper portion is diluted by large blocks of granite; if this is absent at depth it is conceivable that underground mining is done simultaneously with open-pit mining to provide a higher grade ore feed for the processing facility. Success on this front would not only lengthen the mine life but also boost the cash flow during years 8-11, both of which would improve the after-tax NPV.
The main hope for a snap takeover bid from De Beers in the short run depends on the probability that there remains much more diamondiferous kimberlite to be found in the Gahcho Kue backyard, not just on the Gahcho Kue joint venture, but also on the 12,360 hectare property adjoining to the north owned 100% by Mountain Province and which is being spun out as the main asset of Kennady Diamonds. Last year Mountain Province persuaded De Beers to undertake a 50 metre spaced airborne gravity gradiometry survey on the joint venture ground as a last ditch ever to see if there are any other pipes that could be developed. As part of the program Mountain Province flew its 100% ground which hosts the high grade Kelvin and Faraday "dykes" or "blows" which De Beers chose to abandon a few years back rather than take to lease, which Mountain Province decided to acquire for its own benefit. This survey has added a major "brownfields" dimension to Gahcho Kue. On December 22, 2011 Mountain Province reported that it had identified 70 new targets on Kennady North of which 20 are deemed high priority. On March 1, 2012 Mountain Province reported that the survey generated 57 new targets on the joint venture ground. In the context of existing data sets the new data has illuminated a brand new exploration candy store for the De Beers and Mountain Province exploration teams. Apparently there are many untested targets on both properties with pipe-like signatures resembling the bodies slated for development. Mountain Province is conducting a ground magnetic survey to prioritize targets on the Kennady North property. If it gets a land use permit without requiring an environmental review, which the NWT normally insists on only when the exploration target is uranium, Mountain Province expects to be drilling in April (the joint venture ground is already permitted for drilling, so work on these targets will depend on De Beers). Mountain Province plans to drill 150 m angle holes to test 20 targets at a cost of $1 million.
If the spinout occurs as planned within a month of the April 25 special meeting, Kennady North will have 16,261,973 shares outstanding. At a minimum Kennady North will be able to outline a small resource at Kelvin and Faraday, but the big upside resides with the possibility that a threesome like 5034, Hearne and Tuzo are discovered. Given that Kennady Diamonds will start out with $3 million working capital and hopefully no intention of financing until after the stock is listed for trading and the results of the initial drilling are known, success could turn Kennady Diamonds into a high flyer in the $5-$10 range, which admittedly is only $1-$2 extra for existing Mountain Province shareholders of record when the spinout happens. Since Kennady North will have the same shareholder structure as Mountain Province, it will become the ersatz diamond play for TIGS ("The Irish Guys") if De Beers or another party should subsequently take over Mountain Province. That is one headache De Beers can do without, which is why there is an outside chance that De Beers might make a pre-emptive bid during the next 4 weeks. But as mentioned, for such a bid to be successful with unresolved issues such as Tuzo Deep and the brownfields exploration potential it would have to be uncharacteristically aggressive.
Conclusion: Mountain Province Diamond Inc is a Good Absolute Spec Value Buy at the current $5.10 price with a $10-$12 equivalent target (including the Kennday Diamonds spinout) during the next 12 months premised on the assumptions that a major near term financing of $100 million will happen that eliminates the risk that Mountain Province might due to market conditions be unable to raise its equity share of project financing during the next 12 months, that mine approval will be received by mid 2013, that the Tuzo Deeps will succeed in extending the mine life, that exploratory drilling on the joint venture ground will discover new diamondiferous kimberlties that inject brownfields exploration excitement into the play, and that the market will lean towards the 2011 high model carat value as the likelier future for Gahcho Kue whose DCF based valuation supports a $9-$12 after-tax NPV per share range (assuming 100 million fully diluted - post $100 million equity financing).
*JK owns shares in Mountain Province Diamonds Inc