Description

Dominion Diamond Corporation (DDC) – an investor’s best friend – is an opportunity to buy $1 for 70c. With an NAV of ~$21 versus a current share price of $14.70, DDC trades at a P/NAV of 70%. As a Canadian-domiciled, Canadian-asset-based company with minimal project risk as it stands today, selling a commodity which is largely controlled by a few large players, and with a finite mine life, DDC should trade at least to its NAV, and as the only pure-play listed mature diamond producer, there is an argument that it should trade at a premium to NAV. Beyond the currently derived NAV there are upside levers, including the acquisition of the 60% portion of Diavik it does not own and exploitation of related synergies as well as the build-out of the Jay kimberlite pipe, potentially the largest diamond deposit in North America.

Background of the Opportunity

DDC, formerly known as Harry Winston Diamond Corp., has recently undergone a dramatic transformation. Today, its main assets are its 40% stake in the Diavik Diamond Project in the Northwest Territories and its 80% interest in the Core Zone at Ekati (in addition to a 58.8% stake in the prospective Buffer  Zone). To become a pure play diamond miner, DDC sold its Harry Winston watch and jewelry brand to Swatch Group AG for $750mm and the assumption of approximately $250mm of debt; this deal was announced on January 14 and closed on March 26. Out of the cash proceeds, DDC paid $500mm for the previously-announced Ekati mine assets from BHP, closing that transaction on April 10 (announced November 13, 2012). The deal to sell Harry Winston to Swatch represented a tidy return on that asset: the formerly-named Aber Diamond paid $85mm for 51% of that asset in 2004 and then another $157mm for the remainder in 2006. In keeping with the transformation, the company’s name was changed from Harry Winston to Dominion Diamond upon closing the sale.

Post these transactions, the company looks like this (balance sheet data as of April 30):

Share price: $14.70

Shares out (FD): 87.0mm

Market cap: $1,279mm

Cash: 231mm

Restricted cash: 126mm (letters of credit to the Government of Canada in support of Ekati reclamation)

Inventory (only including rough diamonds): 202mm

Debt: 83mm

Enterprise value: $800mm (including restricted cash and diamond inventories to be sold)

The company is investing in one of the kimberlite pipes (diamond-containing rock) at Ekati named Misery, such that free cash flow will be minimal this year and next, with the harvest period after that at Ekati and remaining mining at Diavik generating substantial FCF for the life of the two mines. The company is likely to re-invest a portion of that FCF in Jay, described further below, or will give the cash back to shareholders. Diavik should produce 5-8mm carats per year until 2023 (not counting A-21 pipe) while Ekati should produce 3-5.5mm carats until 2018 (not counting Jay). By our estimates, DDC generates its current share price in FCF through the end of calendar 2017.

Valuation

There are a number of ways to look at a miner, but in a finite-lived asset such as DDC, arguably the only pure valuation approach is NAV (i.e. a DCF, which is the basis of all valuation exercises, after all). Due to Canadian mining and reporting regulations, the company has provided much of the data required for an NAV build-up in the form of so-called NI 43-101 reports. This reporting standard was created after the Bre-X scandal, in order to protect investors from misleading, erroneous or fraudulent information related to mineral properties. To get from the NI 43-101 to an NAV, there are certain adjustments which need to be made (for example, if a resource does not have a core sample drilled, e.g. in the case that a miner knows the rock contains mineralization and chooses not to test drill ahead of actually mining it, it cannot be considered a reserve and thus cannot be included in the 43-101). I encourage you to speak to management to validate estimates, but using the 43-101 as a base, this is a representative NAV build-up, underpinning our estimate of a $21 NAV.

Note, I have chosen not to include the guts of the DCF in this write-up, but please refer to the company’s mine plans / disclosures for Diavik (8/20/12) and Ekati (4/24/13) for most of the details on capex, ore mined, grade, carat value, operating costs, etc. I am happy to discuss other assumptions in the discussion thread as necessary.

Diamond Industry

Long controlled by one company, De Beers, the diamond industry is likely the most opaque general commodity in terms of pricing and supply/demand. Up until 2000, De Beers maintained a monopoly on pricing of natural diamonds, having sold 85-90% of the diamonds mined worldwide throughout most of the 20th century. A number of events undermined the monopoly, as discussed in this Fortune article, with the last milestone in the 1990s being the discovery and development of the Canadian industry. Even without the control exerted by De Beers, prices have trended up, though with more volatility than historically over the last decade (weakening in 2008 during the Great Recession and mid-2011 due to slowing Asian demand, a weakening Indian rupee, and temporary over-supply in inventories).

http://money.cnn.com/magazines/fortune/fortune_archive/2001/02/19/296863/index.htm

Rough diamond prices have staged a strong rally since last year, up 9% since August. The outlook near-term is for stable prices, and that is a driving assumption in the NAV above.

Without digressing too deeply into a discussion on a commodity, the basic thesis on the industry from here is that with no major new supply in sight, and continued growth in China and India consumer diamond purchasing (with no discernible drop in the habits of US consumers, the lynchpin of global diamond demand along with the Japanese), rough diamond pricing should be supported. A recent positive Bain study on diamonds ended with this conclusion:

"As long as major global financial turmoil over an extended period does not force consumers to significantly change their purchasing habits, global demand is set to outstrip supply in the long run, and the future of the diamond business looks bright." I would refer you to the report for more background on the industry.

http://www.bain.com/Images/PR_BAIN_REPORT_The_global_diamond_industry.pdf

Diavik

As mentioned, DDC owns 40% of Diavik; Rio Tinto owns the remaining 60% and operates the mine. As widely publicized, Rio Tinto is shedding assets, and has included its diamond assets – of which Diavik is the largest and their only diamond mine in Canada – on the sale list. As part of the joint venture agreement, DDC has a right of first refusal in the case of a sale by Rio Tinto, a right DDC claims is also enforceable in the case of an IPO (an arbitrator would come to a valuation of Diavik within Rio’s diamond division, if they in fact proceed with an IPO as reported in the press). DDC has stated that it would only acquire Diavik at a discount to NAV, while Rio is publicly stating that it will not sell at a fire-sale price:

http://www.telegraph.co.uk/finance/newsbysector/industry/10122715/Sam-Walsh-no-bazaar-sale-at-Rio-Tinto.html

It remains to be seen what will occur. There are undeniably synergies – with two offices, two runways, two processing plants, one could estimate a very preliminary figure of $80mm/year (10% of combined costs of $800mm, $400mm each). The present value of that synergy stream, in addition to the discount to NPV which DDC has committed to get in a purchase scenario, would clearly create value. For a very imprecise guess of per share upside value from a deal, one could take a low estimate of synergy NPV (~$200mm) and the discount to NAV which DDC would negotiate to even enter the transaction (another ~$200mm) and project a $4-5 upside depending on how the deal would be financed (if equity was issued at a discount to NAV, the upside would be reduced). We should know something this year.

Jay

The Jay kimberlite pipe contains 90-100mm ct of diamonds, making it one of the largest mines in North America. DDC has said that the Ekati transaction pays for itself without Jay, but Jay “is really the prize here”. BHP had drilled the resource but did not develop the kimberlite as their initial estimate suggested that at $1bn capex, the resource was uneconomic at current diamond prices. DDC is investigating different methods and has discussed with investors the idea of not building a causeway and dyke as BHP had designed – Jay is submerged under a lake – but using other creative mining methods (e.g. lowering the level of the lake, as the hydropower plants in the Canadian north sometimes do) to be able to build Jay for an expenditure well below $1bn. While still very early days – they are currently working on environmental impact studies and if they proceed, DDC has said it could take 3 years to get all the required permits – we can model out scenarios where Jay adds $2-4/share on a present value basis. In addition, building Jay would push out Ekati reclamation costs by 10+ years, further materially boosting NAV.

Other?

If Diavik does not occur, and depending on the decision on Jay, DDC will be over-capitalized. Management has committed in that case to returning cash to shareholders.

DDC is also a call option on higher diamond pricing, if the supply/demand thesis does in fact result in sustainably higher prices going forward.

Finally, DDC has other exploration assets (such as North Arrow) which may yield resources.

Risks

• Diamond pricing can weaken especially in a scenario of a Chinese / US consumer-led recession
• While costs and capex at Ekati/Diavik have generally been controlled and predictable, the nature of surprises are that they are unpredictable, and mining is more prone to surprises than other industries
• Although this is a very low probability, perhaps the recent public statements from DDC are bluster, and they overpay for Diavik

Catalyst