Gemfields Group — A Valentine’s Day gift for the AIM market

Gemfields is a world-leading supplier of responsibly sourced coloured gemstones. It owns 75% of Montepuez Ruby Mining (MRM) in Mozambique, 75% of the Kagem emerald mine in Zambia, the Fabergé jewellery business and a 6.5% stake in Sedibelo Platinum. Gemfields is listed on the Johannesburg and Bermuda stock exchanges and (since 14 February) on London’s AIM market.

We value Gemfields based on DCF valuations of MRM, Kagem and Fabergé, reflecting the long-term potential of these assets given their expected growth. Adjusting for the group’s investment in Sedibelo, overheads and net cash gives a sum-of-the-parts (SOTP) value of US$522m (ZAR6.63 or 34p/share).

Gemfields’ core assets, MRM and Kagem, are already profitable and cash flow generative, and we forecast that continued production and sales growth will drive further EBITDA increases.

Gemfields’ focus is firmly on the coloured gemstone business. Its assets and investments comprise:

The coloured gemstone market is significantly smaller than the world diamond market, but demand is rising. Some US$2–3bn of rubies, emeralds and sapphires are produced each year compared to US$16bn of rough diamonds (De Beers, Diamond Insight Report 2018). Production in the coloured gemstone market is fragmented and dominated by artisanal miners (70–80% of global production).

Colombia, Brazil and Zambia are the primary producers of emeralds globally, while Mozambique is the largest producer of rubies. The US is the largest market for emeralds globally (around 40% of world demand) followed by China and Europe. China is the largest market for rubies (around 50% of global demand) followed by the US and Europe.

Key to Gemfields achieving value (ie stable and rising prices) from emerald and ruby sales has been providing the market with a consistent supply of high-quality emeralds and rubies through regular auctions. Increasing production coupled with the success of the auction process has seen Gemfields’ auction sales rise from US$62m in 2012 to US$200.5m in 2019, as shown in Exhibit 1 below. Gemfields’ 2019 auction revenue gives it just under 10% world market share in coloured gemstones.

As production from Kagem and MRM continues to grow, we forecast continued steady growth in Gemfields’ auction sales, to reach US$280m by 2024 (a 7% five-year CAGR) and US$340m by 2029 (a 5% 10-year CAGR).

Montepuez Ruby Mine (MRM) is one of the largest producers of rubies globally. Gemfields owns 75% of MRM, with the remaining 25% owned by local partner Mwiriti. MRM is located in Cabo Delgado province in north-eastern Mozambique, approximately 170km west of Pemba.

Rubies are mined at MRM from a series of shallow open pits: at Mugloto (five open pits mining secondary gravels), Glass (three open pits mining secondary gravels) and Maninge Nice (two open pits mining both primary and secondary mineralisation). Mining is a conventional open-pit gravel operation and all material is free dig. At the wash plant, ore is processed through a scrubber and dense medium separation plant, with the resulting concentrate sorted in the recovery plant using automatic optical sorters in a secure hands-free environment. The updated (January 2020) SRK Consulting Competent Person’s Report (CPR) forecasts that construction of a second wash plant would increase capacity to 1.5Mtpa by 2021.

The updated CPR sees total SAMREC compliant reserves of 20,768kt (similar to the previous report’s 21,630kt after adjusting for depletion), but with the premium ruby grade now 0.13ct/t against 0.18ct/t previously. The downward adjustment reflects the overall premium grade actually recovered from each of the pits in the Mugloto domain from which secondary mineralisation has been extracted/processed since the previous SRK CPR, particularly in Pit 3 where the premium ruby grade was 0.20ct/t vs a previously modelled grade of 0.27ct/t for this area. MRM’s mine life based on reserves runs to 2033 at the expanded production rate of 1.5Mtpa.

We have updated out forecasts for future MRM production and costs to reflect the January 2020 SRK CPR. Compared to the previous CPR, the 2020 report sees total gemstone production similar over the life of mine (185.9kcts in the 2020 report vs 186kcts in the 2018 report adjusted for depletion) but with a lower proportion of premium rubies (1.5% in the 2020 report vs 1.8% in the 2018 report).

However, offsetting this, the latest CPR assumes a price of US$976/ct for premium rubies (vs US$800/ct previously), with this price assumption set 10% below the actual average price achieved for premium rubies between 2014 and June 2019. However, we note that historically the reported production of premium rubies exceeded the volumes of stones sold in the premium ruby category, suggesting that some production categorised as premium ruby was sold in the lower-premium ruby category (at a lower price). Taking this into account, we assume a slightly more conservative US$950/ct for premium rubies (vs US$800/ct previously) and US$3.50/ct for all other gemstones (vs US$3.08/ct previously). This gives us a new average price overall of US$18.19/ct (versus US$17.57/ct previously).

A key risk for MRM will be the market’s ability to absorb its planned increase in premium ruby production over the next 10 years. As previously, we assume that during key periods of rapid production increases, some production will be kept in inventory to prevent any adverse market impact of a sudden rise in supply. We forecast an increase in total MRM revenue to US$253m by 2029 from US$122m in 2019 (a CAGR of 7.5%, which we believe is a level that the ruby market can absorb without adverse price impact, noting that between 2014 and 2019 MRM auction sales grew at a 10% CAGR). As shown in Exhibit 4 below, this sees our forecast premium ruby sales nevertheless fall short of production in 2021/22 and again in 2029/30, with the inventory build unwound at the end of the mine life.

Overall, our revenue forecasts for MRM are within 5% of our previous forecasts, except for 2019 (updated to reflect actual auction revenues announced) and 2020 (where we adjust sales growth forecasts to reflect the higher 2019 starting base).

Another change in the most recent CPR relative to the previous CPR is an increase in forecast cash mining and production costs to US$22.33 per tonne processed vs US$17.02 per tonne previously. The cost increases are driven by a 6% increase in the strip ratio in the updated CPR (to 3.69 from 3.48 previously), as well as labour and fuel cost inflation. Our cash cost forecasts are driven by the CPR, except that we assume 1.0% real annual cost inflation on mining and processing costs. Despite the increase in forecast costs relative to the previous CPR (and our previous forecasts), MRM’s EBITDA margins remain above 50% throughout the life of mine.

Kagem is the world’s largest emerald mine, accounting for just over 25% of world production. Gemfields owns 75% and the Industrial Development Corporation of Zambia the other 25%. Kagem is situated in the Ndola area in the Copperbelt Province of Zambia, approximately 260km north of Lusaka and 31km south-west of Kitwe. Gemfields’ Mbuva-Chibolele licence adjoins Kagem and Gemfields plans to integrate it into Kagem following agreement with Kagem’s minority shareholder this year.

Kagem is an opencast mine producing from two main open pits: Chama and Fibolele, with the bulk of production currently coming from the Chama pit. Visually identified high-grade ore zones are first chipped out manually in the pit and delivered directly to the sort house, and other selected reaction zone mineralised material is trucked to the wash plant. At the wash plant, stones are hand-picked from belts and then sent to the sort house, where rough stones are tumbled, and then chipped and cleaned manually, and sorted into 181 size and quality categories. Currently, Mbuva-Chibolele is not included in the life of mine plan.

The January 2020 Kagem CPR reported a small increase in reserve tonnes to 3,621kt from 3,498kt previously, but offset by a decrease in total gemstone grade to 209cpt from 250cpt previously, to give 755kcts of contained gemstones (vs 873kcts previously). Total resource tonnes of 6,015kt are little changed from the previous CPR’s 6,160kt adjusted for depletion. However, average emerald and beryl grade has decreased to 229cpt from 250cpt previously, with the grade adjustment reflecting actual production results achieved at Chama between 2012 and July 2019.

Our production forecasts for Kagem are based on SRK’s January 2020 CPR on Kagem. Over the remaining life of mine, we thus forecast production of 739kcts (previously 837kcts), with 3,512t of ore processed at an average gemstone grade of 210cpt.

However, we differ from the CPR in terms of the proportion of stones forecast to be sold at high-quality (HQ) auction: where the CPR assumes that 5.6% of emeralds and beryl produced will be sold at HQ auction, we note that between 2012 and 2019, a total of 5.9Mcts were sold at HQ auction from total gemstone production of 205.7Mcts – an average of 2.9% before adjusting for unsold inventory. Our forecasts assume that 3.5% of total gemstone production is sold at HQ auction initially, rising to 4.3% in the longer term (previously we modelled an average of 3.5% over the life of mine).

The CPR also forecasts rising real emerald prices starting at US$68.67/ct in 2020 and increasing by 3.7% pa until 2025, whereas we more conservatively model US$68.67/ct with no real price inflation (the 2019 actual was US$78.7/ct and our previous forecast was US$64.6/ct, in line with the previous CPR). We follow the CPR in assuming US$4.39/ct for commercial-quality auction pricing (previously US$4.19/ct). As a result, our average forecast price for Kagem auction emerald sales over the life of mine is US$15.34/ct vs US$20.86/ct in the CPR (and US$11.27/ct achieved in 2019). Kagem also generates US$2–3m a year from the sale of beryl.

Over the life of mine, our updated forecasts reflect an 11% increase relative to our previous forecasts, driven by a slight increase in the assumed proportion of premium emeralds relative to our previous forecasts, a 6% increase in our premium emerald price forecasts and a 5% increase in other emerald prices.

Our mining and production cost forecasts are closely aligned to those in the CPR. However, we assume 1% real annual cost inflation to take account of local wage and other inflation (wages are 40% of costs). Relative to the previous CPR, cash mining and production costs have decreased to US$191.47/tonne from US$225.10/tonne previously, with the benefit partly offset by an increase in forecast administrative overheads to US$26.61/tonne in the latest CPR vs US$24.35/tonne previously.

A key change in our updated Kagem forecasts is the suspension of the 15% export tax on coloured gemstones (imposed at the beginning of 2019) from 1 January 2020. We had previously forecast US$13–14m a year in export taxes over the next three years, so the removal of this tax has a materially positive impact on Kagem cash flow and valuation.

Fabergé is an iconic name with an exceptional heritage, promoting the use of coloured gemstones in jewellery. Fabergé currently sells jewellery and timepieces via mono-brand boutiques, a concession within Harrods in London, wholesale partners, via the website and through direct relationships with clients. Fabergé’s products are manufactured for the company by external workshops under multi-year agreements. Gemstones are not sourced directly from Kagem or MRM.

Our forecasts for Faberge are unchanged. Although at current sales volumes, Fabergé is EBITDA negative, we continue to expect it to reach EBITDA break-even in 2022, with strong sales growth driven by the growing number of wholesale locations (ie new customers stocking Fabergé jewellery in their stores). Fabergé reached 72 wholesale locations at the end of H119, up from 45 such locations in 2017 and we forecast continued growth to 150 locations in 2022.

Gemfields owns a 6.54% interest in Sedibelo Platinum (previously Platmin), which owns the Pilanesberg Platinum Mine and contiguous Magazynskraal and Sedibelo deposits. In South Africa, Pilanesberg Platinum Mine comprises an operating open pit, a second open pit under development and a concentration plant, and concentrate is sent to Northam Platinum for smelting and refining. SAMREC-compliant measured and indicated resources total 32.2Moz of 4E platinum group metals (PGMs) with a further 62.8Moz in inferred resources. In the three months to September 2019, Sedibelo produced 34.86koz of 4E PGMs and generated US$9.5m in EBITDA from revenue of US$54.6m, Following the sharp rise in palladium and rhodium prices over the past year, there is increased interest in the PGM sector, potentially increasing opportunities for Gemfields to realise value from this non-core asset.

Gemfields’ board and management team bring a combination of mining and finance experience. In November 2019, independent director Martin Tolcher became chairman of the board.

Key risks for Gemfields are coloured gemstone and coloured gemstone jewellery market risk, political and fiscal risk in Mozambique and Zambia, and theft-related risks.

The gemstone supply chain is fragmented and characterised by the presence of many small businesses and agents. Gemfields generates almost all its revenue from Kagem and MRM through auctions held up to four times a year for Kagem (two high-quality and two commercial-quality auctions) and just twice a year for MRM (mixed quality).

Gemfields’ two key assets are located in Mozambique (MRM) and Zambia (Kagem), and it is thus exposed to the political, security and fiscal risks associated with these jurisdictions.

In diamond and gemstone mining, theft is a key issue given the extent to which a significant proportion of a mine’s production by value can be represented by just a handful of top-quality stones. The nature of the operations at Kagem and MRM are such that staff come into direct contact with the emeralds and rubies, particularly at Kagem where a large proportion of production is recovered by hand in the pit. Gemfields is well aware of the importance of security to the extent that almost 20% of the workforce at Kagem are security personnel.

There is also a risk of theft by artisanal miners, particularly at MRM where the size of the licence area means it cannot practicably be completely fenced off. Artisanal miners also present additional risks including significant and unmitigated environmental impact, social issues, criminality associated with gangs or syndicates, and the threat of violence against Gemfields’ staff. The recent incursion by 800 illegal miners at MRM’s Maninge Nice 3 Pit (in which, tragically, 11 illegal miners died in ground collapse incidents) is an example of the risk that illegal mining poses to Gemfields (albeit in this instance production at MRM was not affected).

Since Gemfields acquired the brand in 2007, Fabergé has been loss making and has required additional funding from the group. In 2018, Fabergé made an operating loss of US$6m. The trend in sales has been positive, and we believe this business is well positioned to continue growing sales across multiple channels, but there nevertheless remains a risk that in adverse luxury goods market conditions Fabergé may struggle to achieve its growth targets.

We value Gemfields using a sum-of-the-parts based on discounted cash flow valuations of Kagem, MRM and Fabergé, adjusting for corporate overheads, and adding US$40m for the company’s stake in Sedibelo (valuing it at a multiple of US$6.50/PGM resource ounce) and US$25.4m for end-December 2019 net cash.

We value Gemfields at US$522m (ZAR6.63/share or 34p/share) up from US$449m previously, with the increase driven mainly by the removal of export taxes on Zambian emeralds, which added US$72m. Other changes to our Kagem model discussed earlier added a further US$21m being primarily the slight increase in the proportion of premium emeralds and 5–6% increase in forecast emerald pricing. MRM’s valuation has decreased by US$13m, mainly because of an increase in cash mining and production costs reflected in the latest CPR (with the lower premium ruby grade offset by higher pricing). The end-2019 net cash balance of US$25.4m (according to the company’s announcement on 12 February 2020) was lower than previously forecast as the result of a change in receivables, which reflects the last MRM auction taking place close to the year end.

The table below summarises the key changes to our Gemfields forecasts resulting from the changes to our forecasts to Kagem and MRM discussed above, and particularly:

We now expect 2019 revenue of US$213m, EBITDA of US$70.0m and EPS of 1.6c rising to revenue of US$263m, EBITDA of US$102.4m and EPS of 2.8c in 2021e.

Gemfields is already in a net cash position, with both Kagem and MRM strongly cash flow generative. Gemfields ended 2019 with net cash of US$25.4m, which we forecast will rise to US$99.5m by the end of 2021 before any further share buybacks or dividends.