Gemfields Group — Coloured gemstones outperforming diamonds

It may be tempting to read across from the downturn in the diamond sector, which some are calling a crisis, to coloured gemstones. But Gemfields’ most recent ruby and emerald auction results paint a positive picture of the state of the coloured gemstone market, which is echoed by management.

The biggest cutting and trading markets for rubies are Thailand, Sri Lanka and India, whereas the largest consumer markets are China, the US, Europe and India. In general China is a more important player for larger stones while European brands play an important role in the smaller but high-quality stones. Gemfields’ management is positive on the state of the ruby market and told us that some of its customers have indicated sales at the Hong Kong show were better than expected (albeit pre-show expectations were low). Last week, Chiswick Auctions sold a 10.5ct ruby ring for £462,500 – more than 18 times its pre-sale low estimate, indicating the strength in this market.

India is a key emerald cutting and polishing centre and in 2017 and 2018 Gemfields suffered the aftereffects of the impact of Indian demonetisation on both liquidity in the cutting centres and Indian demand for emeralds. However, in May 2019 Gemfields started to see ‘green shoots’ of recovery and this has continued strongly into the second half of the year.

An important shift is that where China was not previously a key market for emeralds (preferring jade), the market has begun to see more Chinese interest in Zambian emeralds in particular.

The four key challenges facing diamonds have very limited read across to coloured gemstones:

Gemfields reported a solid set of half-year 2019 results despite the (previously announced) lower auction revenue from MRM and lower sales at Fabergé. EBITDA was up 3% to US$33.1m (from US$32.1m in H118) despite revenue 13% lower at US$89.0m (from US$102.1m). Gemfields generated reported net profit after tax of US$12.4m (H118: US$16.0m). In H119, Gemfields generated US$7.5m in cash flow from operations before movements in working capital (H118: $23.9m) and received US$15.5m from the partial sale of its stake in Jupiter Mines, with a further US$15.1m to come in H2. Gemfields ended H219 with net cash of US$35.5m (from US$9.8m in December 2018).

There were a number of positives on costs in the H1 results relative to our forecasts, most notably:

As we noted in our last Gemfields update note H1 auction sales at MRM were below our expectation, seemingly a result of mix with a higher volume of stones sold than previous auctions. The H1 production results reflected the reason for the lower average pricing with just 35kcts of premium rubies recovered (H118 51kcts). We understand this lower level of premium rubies reflects:

In addition to the reduction in the proportion of premium rubies, we are also adjusting our forecasts as the planned construction of the second washplant is not as advanced as we had previously thought, with the focus this year remaining on optimising the existing washplant through upgrading of the thickener. As a result, we now expect MRM to process a total of 0.9Mt of ore in 2019 (previously 1.3Mt) and 1.2Mt in 2020 (previously 1.5Mt). This change is offset by grade, which is running higher than our previous forecast: H1 grade is running at 3.0cpt against our forecast of 2.2cpt as a result of the processing of additional ores from the higher-grade (but lower average value) Maninge Nice deposit, which is likely to continue into H2 and also 2020.

For the full year we now expect premium ruby production to total 92kcts, down from a previous forecast of 124kcts (implies 58kcts of premium ruby production in H2). For 2020e we now expect premium ruby production of 119kcts down from a previous forecast of 136kcts. We now forecast total 2019 gemstone production of 2.8Mcts (previously 2.9Mcts) and 2020 production of 3.2Mcts (previously 2.9Mcts). The impact on revenue and EBITDA numbers of this change in mix and the lower overheads discussed previously sees our forecast MRM EBITDA (before inventory movements) rise in 2019e to US$57.6m (from US$52.5m previously) and forecast FY20e EBITDA rises to US$61.9m from US$59.1m. Our longer-term forecasts also increase by US$2–3m a year with the lower overheads driving the delta.

After H1 Kagem auction sales totalling US$33.2m, we previously forecast US$71.4m in total Kagem auction sales in 2019, including US$25.5m in commercial quality auction sales. However, August’s auction surprised to the upside with the total of US$18.6m being the highest commercial quality auction achieved by Kagem since November 2015. As a result, we have increased Kagem’s forecast auction revenue for 2019 to US$74.8m. Taking into account the US$3.2m in reduced costs discussed earlier, this sees our forecast cash EBITDA for Kagem (before inventory movements) rise to US$17.8m from US$11.2m previously (Kagem’s H119 EBITDA was US$13.1m). For 2020e our revenue forecast is unchanged at US$83.2m but the lower forecast costs see forecast Kagem EBITDA before inventory movements rise to US$24.3m from $21.3m previously.

Fabergé’s H119 revenue of US$3.8m was down 46% on H118, largely as a result of lower sales of significant pieces of high jewellery, the timing of which can be unpredictable, but a number of such sales are expected to be completed in the second half. However, at the EBITDA level, Fabergé saw an EBITDA loss of US$2.9m, just slightly higher than H118’s US$2.5m loss, illustrating the impact of growing gross margins (45% in H119 vs 40% in H118) and lower overheads (US$4.6m in H119 vs $5.6m in H118). We expect the second half to see an improvement in sales relative to the first half, driven by:

We have adjusted our 2019 revenue forecast down to US$12.0m (from US$14.9m previously) to reflect the lower than expected H1 sales. Our updated forecast implies H2 sales of US$8.3m (US$1.4m a month), which we believe should be achievable given the expectation of the completion of a number of larger sales in H2 as well as the continued increase in the number of wholesale points of sale operational during the full period and increased seasonal trade in Q4. Beyond 2019 we have revised down our Fabergé revenue forecasts by US$2.7–3.6m per year to take into account the lower 2019 starting point; however, this impact is largely offset by slightly higher gross margins and lower overheads, resulting in a reduction of just US$0.5m–0.9m in forecast EBITDA each year. We continue to expect Faberge to reach EBITDA breakeven in 2022e.

Taking into account the factors described above, we have updated our full year 2019 and longer-term forecasts. At group EBITDA level the downward revision to our cost assumptions more than offsets lower forecast revenues at MRM and Fabergé, resulting in our 2019e forecast consolidated EBITDA increasing to US$50.1m from US$39.0m previously and 2020e EBITDA rising to US$57.6m (from US$53.1m previously).

The key risks facing Gemfields are country and fiscal in Mozambique and Zambia, market risks relating to the coloured gemstone market and variability in the recovery of premium rubies and emeralds at MRM and Kagem respectively.

As previously, for Gemfields we use a sum-of-the-parts valuation based on discounted cash flow analysis of each asset (at a 10% discount rate). Our previous valuation has been adjusted for the:

This gives us an sum-of-the-parts valuation of Gemfields of US$463m (previously US$458m) or ZAR5.27 per share (previously ZAR4.91/share) before the impact of the share buyback and payment of any special dividend. Our valuation continues to reflect our view of the long-term potential value of Gemfields’ assets based on strong future production and sales growth at MRM and Kagem and the expected turnaround of the Fabergé business.

If the planned share buyback were fully implemented (with the maximum of 143m shares bought back) at the current share price of ZAR1.60/share, it would move our SOTP valuation of the remaining shares outstanding to ZAR5.72/share. The significant gap between the current share price and our valuation strongly supports the case for returning cash to shareholders in the form of a buyback.