Lucara Diamond - Strategic Shift Could Make Investors Money

Interview with Eira Thomas, President & CEO of Lucara Diamond (TSX:LUC). The diamond market is complicated, has many moving parts, lots of people clipping their share along the way, and it hasn't really changed in decades. Time for change.

Thomas is maybe just what the space needs to cut through traditional channels and behaviours in what is a closed shop industry. It's also time to smooth the revenue curves for Lucara and give control to the market by introducing new partnerships and new technology. A lot to like about the thinking.

Not one diamond relation superlative used in the headline or description. We cut those out, which adds clarity and weight to the piece.

We Discuss:

• 1:25 - Company Overview
  
• 2:12 - The World of Diamonds; A Macro Overview
• 9:28 - Nervousness to Invest: Volatility of the Space
• 12:07 - Under Pressure; Changing Fortunes Around
• 13:56 - Financials & Dividends: "Don't Let a Good Crisis Go to Waste"
• 20:13 - Selling Diamonds: Clara Diamonds Economics, Costs, & Plan
• 30:01 - Financing it All: Options Available
• 32:37 - Consolidation VS Exploration
• 33:53 - Exciting the Market: Goals, Opportunities, & Deliverables

Matthew Gordon: Can you kick off, give us a 1-minute overview of Lucara Diamond?

Eira Thomas: Lucara Diamond is a high-margin Diamond producer that's been in production on our flagship asset, the Karowe Diamond mine, which is situated in Botswana, since 2012. We've really become renowned for our production of very large, high-value Diamonds including some historic Diamond recoveries. Lesedi La Rona at 1,109 carats, and in fact Botswana's largest ever Diamond, the Sewelo, which we recovered last year, which weighed in at 1,758 carats.

Matthew Gordon: Can you help me with the macro component? Botswana's obviously very well known for Diamond manufacturing, finding Diamonds in Botswana, but what does the eco-system for Diamonds look like?

Eira Thomas: Yeah. Listen, I think the first thing you have to understand about Diamonds is that it is the only mined commodity that actually doesn't behave like a mined commodity. In other words, we are producing a product that is ultimately sold as a retail luxury good. So, what's interesting about Diamonds is that if you do have a positive view on overall world GDP growth and the emerging economies like China and India, continuing to grow, then you have to have a positive view of Diamonds. So, it is a luxury product. It's not cyclical like gold or copper and in fact if you look at the price of your grandmother's Diamond ring from 1950 and what you could fetch for it today, it would have shown a steady increase in value, year over year.

Matthew Gordon: What's happening out there?

Eira Thomas: Yeah, well fundamentally, Diamonds have underperformed. There's no question, over the last several years, and there are a number of reasons for that, but if we talk about the macro, you have De Beers and ALROSA, which account for close to 70% of global production, and then you have the smaller players, of which Lucara is the largest of those. So, we would be qualified as a mid-tier, but you're absolutely right, this is kind of a polarised community. Diamonds overall, when you look at the universe of producers, you know, there are less then 25 active mines around the world and it has been a commodity which has underperformed in recent years, but the overall outlook for Diamond prices is actually very healthy. When we talk about Lucara itself, you've got to understand that this is a company that's been in production now for 8-years, you know, we invested USD$200M in total capital, into Lucara between 2015 and 2018, and between 2014 and 2019, we returned well in excess of that amount. In fact, we've returned USD$271M to our investors in the form of dividends, okay? So this has been an extremely successful company. It is a high-margin producer and we continue to be a high-margin producer. The challenge has been really around the performance of our peer group and what's been happening with Diamond prices in the last few years, which definitely have been under pressure.

There are a number of reasons for that. There has been underperformance in the midstream, and where Diamonds are polished and manufactured, so this includes India, where we've seen the demonetisation of the rupee, challenges with financing midstream polishers and really quite frankly erosions in their margins. So that has created and introduced volatility into the supply chain, and that in turn has had an impact on production. Compounding that, we had new production coming out of Canada in 2017 and 2018, largely small Diamond production, which put some additional pressure. So, it was kind of a perfect storm that conspired to really put pressure on Diamond prices. That in turn put a number of the smaller players into default because a lot of the smaller companies had, you know, carrying lots of debt and it was challenging for them to service that debt. We've kind of seen a number of factors playing into the overall underperformance. Lucara's been swept into that mix because it is a small peer group and I think we've been tarred with the same brush, but the reality is, we've maintained a very strong balance sheet throughout this period, despite the pressure on Diamond prices, we continue to generate high margins. We have no debt on the balance sheet and in fact we've got some really exciting growth opportunities ahead of us now.

Matthew Gordon: How does that fit into industrial Diamonds versus the retail Diamond segment and what are the sizes of those markets?

Eira Thomas: Sure, first of all the industrial market is relevant to conversation today. When we talk about natural Diamond production, we're really referring to Diamonds that feed into the gem market. That's where all the value.

What we've seen is the pipeline, you know, prior to Covid, which of course has been the latest challenge that all of us are dealing with, but prior to Covid, we actually saw the Diamond pipeline start to really clean itself out. So in fact, in the fourth quarter of 2019, Lucara had one of its strongest Diamond sales from the preceding 3 to 5-years, and so we really felt that we had worked through some of the real challenges in the pipeline and that we were setting up for a very solid recovery. And of course, then in the first quarter of 2020, Covid hit and we see Covid as an interruption of that recovery, not having sent us back in the direction, you know, where we were, sort of between 2017 and 2019.

Matthew Gordon: How did you describe them, the mid-tiers, to be affected, and it affects your business. I mean, is that a fair view of your world?

Eira Thomas: No, I don't think that's a fair view and it depends what you mean by to negatively affect. As I said in the priors actually, continue to produce and make money and generate hard margins, you know, through this volatility because we have a very special asset with a very special product. Yes, we have seen prices under pressure in the space from time to time but if you go back and look at the history of this business, Diamonds have actually performed reasonably well. I mean, they've lagged other luxury products, which is something that we're working on, but they have in fact been a strong, stable business for many, many years. In recent years, yes, we've seen some wobbles, but I think what we need to come back to is kind of looking at overall loaner level supply, and global demand. What we have seen, and interestingly as we come through Covid, is that demand has rebounded nicely, particularly in Asia. In fact, we're seen a decent demand coming out of the United States as well. I mean, it's too early to call a trend, but the demand is there. By contrast, global Diamond supply is starting to turn down. That's because we have large maturing mines around the world. Mines like Argyle in Australia, we have the Diamond mines in Canada which are now maturing, nearing end of life, and so in the next 3 to 5-years, the global supply picture is expected to change quite dramatically. We know there's nothing coming along in that pipeline that is really going to change that, so we do expect that that natural supply demand of fundamental will shift in the favour of producers and prices.

Matthew Gordon: When you're talking about some wobbles, are you talking about in the market or are you talking about with your own company?

Eira Thomas: No. I'm talking about in the market. Again, our company has performed well through this period. We've never been more efficient in terms of our production output. We've got a very strong safety record and we're now building on that success and looking at expanding our mine underground, which would extend our mine life up to 2040.

Matthew Gordon: We're changing the metrics internally, but the market's not recognising that so on that basis, it has been a difficult 3-years, so what’s the plan to fix that?

Eira Thomas: Yeah, listen the plan to fix that is to continue to focus on the things that we can control. I can't control the market. You're right, it has been a challenging period for us as shareholders, and by the way, I'm a very large shareholder. My view is, there will be recognition that there's significant value in the Diamond space, particularly right now, but we do need to see our peer group of companies sort out their balance sheets and get their businesses back on track. That will be important in creating an environment where people feel confident investing in the Diamond space. But for Lucara and in terms of what we're doing, we are going to survive this and we will be, I believe, the go-to Diamond company in the next year to 2-years as people start to think about this space for an investment opportunity.

Matthew Gordon: You've got some cash on hand at the moment, which came through in June didn't it with, was it HB?

Eira Thomas: Yeah, so listen, let's talk about some of the things that we've been doing, you know, as our chairman likes to say, we should never let a good crisis go to waste. You know what, Lucara again has been focused on are the things that we can control, making sure that we're operating our mine as efficiently as we can. We've also been looking for ways to create more value. The way that we're doing that is three-fold. One, we've entered into this agreement with HB. This is a Diamond manufacturing group out of Antwerp, and we've entered into an off-take agreement for all of our large stones. This is all Diamonds greater than 10.8 carats, for the remainder of the year. This is a very innovative, ground-breaking agreement because for the first time, we are creating true alignment between the producer and the manufacturing. You know, quite frankly, I do think that's one of the problems that we face as an industry, is the fact that our supply chain is really disjointed and each player in the supply chain really makes its money on the backs of one of the other plays.

So, with this HB agreement, for the first time ever, we are not competing, we are not trying to get the biggest price on the rough and the manufacturers are not trying to get the cheapest price on the rough. For the first time ever, we've created alignment because now, HB is buying our Diamonds on the basis of their polished output and they are getting a predictable commission on that. It's a set commission, plus the cost of manufacturing. So, for the first time ever, we're all pulling on the same rope. They're motivated to get the maximum price for that Diamond. We're motivated to get the maximum price for that Diamond. So, that's pretty transformational. You know, the second thing we're doing is Clara. We haven't talked about that yet but Lucara has a second business. It's a very important business to Lucara. It's called Clara, and it is a digital web-based rough Diamond sales platform. It is the only one of its kind in the world and it too aims to transforms the supply chain and unlock value and create alignment amongst the producers and the manufacturers.

Matthew Gordon: Should you have given back so much money to shareholders? Did they need to see the money returned that quickly?

Eira Thomas: Listen, I think our philosophy was, the Diamond business is a very small business, the assets are few, we continuously look for other Diamond mining opportunities but we also recognise that we have a very special asset, it's a very high-margin asset and identifying an accretive opportunity has been challenging. So, our view was, until we identified a better use of capital, that we should be returning that capital, that money to our shareholders. Once we determined that there was a really compelling opportunity in front of us in the form of underground expansion, we quickly redeployed that capital into this underground option and opportunity, and that's something we're quite excited about. That's planned a way forward, it is going to add potentially in excess of USD$4B of revenue to our future balance sheet, and that's our plan now.

Matthew Gordon: If I'm looking at that, the current open pit mine goes out to what, 2026, something like that?

Eira Thomas: Yeah.

Matthew Gordon: The revenue from that is, would you call it erratic or have you got a good sense of how that revenue flows?

Eira Thomas: No. Not erratic. I mean, we've been in production now for close to 8-years and we have predictably, you know, recovered Diamonds in excess of 10.8 carats and we understand its asset extremely well. This isn’t lucky. This is, we have a clear understanding of what this mine can do and we have predictably produced those Diamonds over 8-years, to the point where we've been able to achieve our revenue outlook. So, you know, what is important to understand here is that our very large, high-value Diamonds, like the Le Sette, I have a model of which here, these exceptional Diamonds, this one sold for in excess of USD$53M, we pull out of our revenue models. We know that we're going to recover more of these, but we can't say exactly when. So, we pull those out of our revenue models and when we go out with our operating outlook in any given year, it does not include the potential of recovering one of those, okay? I think that's really important to understand. We are using 8-years of data to help us predict and, you know, our operating models for the mine, and we consistently achieve those targets. So, this is not random. This is a high-performing asset that continues to perform and actually what's really interesting is that as we mine deeper, the ore body gets richer. So, the geology that's been giving us these large high-value Diamonds actually becomes the primary geological unit as we mine deeper in the open pit, and that's a big economic value driver in our underground. In fact, we can now confidently say that there is more value ahead of us in Karowe than behind us.

Matthew Gordon: What do you know with regards to the numbers? What's it going to cost you? How are you going to raise that money?

Eira Thomas: So, we're looking at about a USD$514M capex. The vast majority of which will come out of cash flow, using conservative Diamond prices, assuming difficult years for 2020, for 2021 and even 2022. So, we are looking now to put some debt on our balance sheet and just as a reminder, we don't currently have any debt on our balance sheet. We do have a working capital facility that we dip into now and again to manage our business because our sales are lumpy throughout the year, but we do expect to be able to raise USD$150M towards that shortfall from cash flows and that is something that we're actively working on. We've got great engagement with a number of lending institutions and we're a long way down the path on that, so that's kind of the opportunity for Lucara going forward. We are starting to spend on the underground now. We had planned to spend most of USD$53M in 2020. We've necessarily scoped that back, focused on long lead items and critical path pieces, but that's all going extremely well, and we are very optimistic that we will be able to basically finalise a financing plan for the remainder, late in the year, hue 1 at the latest and just as a reminder, you know, 514 in capex but the payback on that investment is under 2.8-years. This is a very economic prospect that generates close to a billion-dollar NPV.

Matthew Gordon: Your sales happen at certain times of the year, does it?

Eira Thomas: No, we generally sell our Diamonds through tenders 4 times a year, however, one of the reasons that we've gone to the HB agreement is because it does smooth out our cash flows, so we are now shipping Diamonds to HB every 2-weeks and getting paid for those Diamonds every 60 days. So, we will see how this relationship evolves for the remainder of the year. We're very optimistic, and if it goes well then, we will continue to sell this way. That will definitely smooth out our cash flows and it has the potential for achieving superior pricing versus what we could sell these Diamonds for in rough as well. So, there are 2 big advantages, and then of course our minus 10.8 carat Diamonds are being sold on Clara and we are holding sales with Clara every 2-weeks, again, you know, the idea behind Clara is that we can migrate from bimonthly sales to weekly sales to even daily sales, but the ambition there is really to bring on other producers onto the Clara platform. It's really not about our own production because we produce so few minus 10.8 carat Diamonds, but the opportunity for Clara is to sell other Diamonds from other productions and that's what we're actively working on right now with the on-boarding of third-party supply.

Matthew Gordon: What percentage of your revenue are you forecasting that to be? Was it really inconsequential?

Eira Thomas: Right now, it is inconsequential in the sense that we've got a 5-year ramp up plan, but our ambition with Clara in the first 2-years, which is where we are now, is to basically prove up the technology and this is new technology that was developed by Clara. It's a matching algorithm that we've patented all around the world and so proof of concept phase is where we're at now. It's gone extremely well and in fact I would say that the big silver lining for us through Covid has been Clara, because Clara eliminates the need for our customers to get on a plane to go view Diamonds to buy them. Clara allows our customers to buy Diamonds sitting at their desk, from wherever they are in the world, and that has been a big advantage for the customer base. We've grown from 20 customers pre-Covid. We're sitting at 70 today. We've now got demand that can't be met by our supply from Lucara alone.

We have started selling third party supply through the platform, as of 2-weeks ago and we've got other trials set to begin here in the coming weeks. So, the real game changers for Clara will be that third-party supply as I mentioned. Our goal is to ramp up to 10% of world global market share, and by the way, personally I think that's very conservative. The global Diamond supply sits at between 15B and 17B, so our ambition is to get to 1.5B. If we can do that, what I can tell you is that the cash flow from Clara will be comparable to the cash flows we're anticipating from our mines. So, this is a very important business to us in the future. It costs us very little to run. We're not at the point where we're making money. It is a volume story, but we're well on track and in fact I would say we're slightly ahead now because of Covid.

Matthew Gordon: I imagine there are going to be some teething problems initially, I suspect, and you've got to work out what those are. Who knows?

Eira Thomas: It's going extremely well and maybe I just need to explain why it's going so well; you know? Right now, the way we sell Diamonds, whether you're De Beers or Lucara, is basically the same way. Diamonds, as you rightly pointed out at the beginning of this conversation, are difficult to understand. It's a heterogeneous product. No 2 Diamonds are alike. They all sell for different price points, so if you're a producer, how do you sell this product regularly for repeatable revenues? The way we've overcome that problem as producers is that we basically inventory our Diamonds over a certain period of time; in our case it's an entire quarter because we're a little user. In the case of De Beers, it would be 5 or 6 weeks and then we take that heterogeneous product and we categorise it based on size, colour and quality. We create buckets or assortments of Diamonds. We then force our customers to buy that entire bucket. So, they don't have a choice. They can't pick 1 or 2. They are told that they must take the entire assortment and the problem with that is that they then take those Diamonds back to their polishing factory and determine that only a portion of those Diamonds are actually applicable for their own businesses, and their own markets they distribute into.

So, you end up with a lot of goods that then go into secondary trading. What Lucara does, and Clara specifically, is it transforms this very antiquated, inflexible, inefficient supply chain, which is a push style sales system, into a pull style where, for the first time ever, our customers can buy individual Diamonds based on their own specific polished needs. That's what's so unique about Clara and that's why believe it's going to be a game-changer for the industry. Of course, that is the feedback that we're getting for the 70 customers that are currently buying on Clara. They're very happy with the results, they're generating higher margins, we're selling our Diamonds for more and it's all because we're creating a more efficient supply chain.

Matthew Gordon: How long are you giving HB before you make a decision as to whether that's working or not?

Eira Thomas: Well listen, I mean, we entered into this agreement during Covid. It was obviously a stressful time for everyone, you know, we've made a commitment until the end of the year and that gives us the option of assessing and making sure that it's working for us. It gives us a chance to understand what the overall market is doing and how that's going to fit in with our ambitions around the underground. So, I would say we're very optimistic about this agreement. We feel it is the right way to go. We think the trend, the philosophy, makes so much more sense, creating alignment within the supply chain will reduce volatility, and will create a more stable marketplace. I think that's to the benefit of everybody. So, our view and hope is that we are able to continue with that arrangement, but we have not yet made that commitment.

Matthew Gordon: But tell me about those discussions, because they can't be easy.

Eira Thomas: We've got a very strong business plan and our outlook is necessarily conservative. You know, this is not my first rodeo and I know what it takes to sit in front of a crusty credit committee and make them comfortable. So, we have necessarily gone into this process with a very conservative outlook on Diamond prices, and hoping that we're going to under-promise and over-deliver. That's how we've always run this business. Again, we've got 8-years of data to draw on, so it's really about getting comfortable with our models, which to date, our resources performed extremely well against our models. We can show that. We can demonstrate that. The geology's not changing. We've got things going forward. So, you know, our outlook on Diamond prices is necessarily conservative, especially for 2020 and 2021. 2022, we're hoping it looks a little better and thereafter, you know, we're aiming to get back to pricing that we saw some time around 2018, which by the way is not the peak. So, we've taken a very conservative view with respect to the commodity price, and we still have a very resilient business case.

My view is that as this market starts to recover, it's going to be very apparent just what a cash machine Karowe can be. It has been in the past and it will be again, and as we mine deeper, we get into a higher rock value, and that in turn helps us generate more cash and support of our underground plans. In the meantime, we have Clara, kind of moving alongside us, which we think will start to ramp up and be meaningful in its own right, and we continue to look at the universe of opportunities out there with respect to industry consolidation. We do think that that will be important as kind of bringing interest back into the space. We need to stay stronger, more resilient companies with strong strategies and plans.

Matthew Gordon: You're going to have to raise cash. Is that just an expensive way of doing it or should you be exploring more?

Eira Thomas: Yeah, listen, as I said we're focused first and foremost on our underground expansion and Clara. Those are our 2 kind of immediate opportunities that are, in our opinion, no brainers. But we do see that there is value in asset diversification and having more than one asset in your portfolio, and we do believe there will be a time when consolidation makes sense. Let's build a bigger company that has broader appeal to a broader investment universe and one that can be thinking about a longer trajectory in terms of our strategic outlook. So, we continue to look at that universe very closely, but we are also very disciplined. We are not going to take on another asset for the sense of growth or for the purpose of growth alone. It needs to be accretive and it needs to fit in with our longer-term outlook.

Matthew Gordon: What are the short-term things that are going to change people's minds about your ability to deliver the strategy that you've outlined to me today? What are the quick wins for you?

Eira Thomas: I think the quick wins are around the HB agreement. The quick wins, we haven't talked about today but another thing that Lucara has done, which in my view is quite ground-breaking, is that we have partnered with the world's largest leading luxury brand, Louis Vuitton, on our largest Diamond Sewelo, and we think that that partnership will be very important in building awareness around our company. It'll build awareness around Botswana and natural Diamonds, and of course, when we finally polish that collection of jewellery from the Sewelo, 5% of the retail proceeds will flow back into our communities of interest in Botswana. So, those types of partnerships we think are going to be important and I think that will start to raise the profile of the company as Louis Vuitton gets back to business. That Diamond is now touring in Asia and we think that will definitely increase awareness and interest of our company. The HB agreement itself, Clara, obviously getting the financing for the underground squared away I think will be a very important milestone for our organisation and people will be, you know, I think comforted by that, that we have a plan that we're able to execute on, that we'll deliver in the coming years.

I think all those pieces together will be very helpful and again the great thing is, and listen, as a shareholder I’m obviously very disappointed in the share price, but I'm very confident in our business and our ability to weather the storm. I think there's huge potential in our equity valuation on that basis. If you look at the potential cash generation that's in front of us, based on 8-years of strong performance, this isn't wishful thinking. We have the track record and history to stand up and be very confident in our operating outlook, and I think all of that is going to start to resonate. The final thing I would say is that we are getting a lot of interest now, as Gold has kind of catapulted, we are starting to get interest in our product from investors that actually want to own Diamonds as an asset, as a hard asset they can stick away in the safe. I think that's really just looking for value, as Gold has run, and of course Diamonds are a very concentrated form of value. Much higher concentration than Gold itself.

Matthew Gordon: Do you think that is something that you're consciously trying to do? We've seen it elsewhere in other commodities where they've tried to move themselves into other sectors by dint of, you know, what they provide into those other sectors and get a re-rate that way.

Eira Thomas: Listen, I think at this stage for us it's about alignment. It's about recognising that we need to work together within the supply chain to unlock value, to foster new demand for our product. We don't preclude the idea of looking at other businesses within the value chain. Clara is an example of that and so is HB, but I think we also recognise that what we do and what we know is mining and Diamond resources, and I would say at this stage it's about aligning ourselves with good partners to ensure that our Diamonds are being transacted for the maximum possible price, and that we're protecting the market and actually growing the market and increasing demand for that product. I think we all have a part to play in that, and so for us right now it's all about alignment and looking at opportunities through the value chain of course as well, but that alignment is really critical.

Matthew Gordon: Okay, brilliant. Thanks for helping us understand the world of Diamonds

Eira Thomas: Thank you, my pleasure and I appreciate all of your time today. Thank you so much.

Here is the link to Lucara Diamond's Company website.