Dermot Desmond’s dream of a Canadian diamond mine started in the mid-1990s. His first investment was in a company called Glenmore Highlands, which in 2000 merged into Mountain Province. Desmond kept the faith. He continued to back Mountain Province, investing tens of millions in further fundraisings through the years. Today, he owns close to 30 per cent of the company and is owed CAD$60 million by it. 

Desmond’s dream was a giant diamond mine near the Arctic circle in Canada. One of the world’s biggest. 

Diamonds are created deep inside the Earth, and carried to the surface by volcanoes. After a volcano erupts, its “pipe” of molten rock cools and hardens. Eventually, the pipe fossilises into a bluish rock called kimberlite (so named after the South African hamlet of Kimberley, where Cecil Rhodes and the De Beers company got their start).

Kimberlite pipes are themselves rare, and only one in six kimberlite pipes has diamonds. One in a hundred has enough diamonds to justify a mine.

Mountain Province discovered a giant Kimberlite pipe in the Northern Territories of Canada in 1995. Testing showed it had extraordinary promise, with the potential to be one of the richest mines on the planet. 

Getting the mine built was a heroic engineering and financial challenge. The pipe is located in a flat, watery, empty tundra dotted with tiny lakes. There are no roads. The nearest town is Yellowknife, 280km away. 

The mine is connected to the outside world by a 120km ice road which is passable only in winter. It is what it sounds like. It’s constructed by compacting snow, letting it freeze, drilling through to the water underneath it to flood it, letting the water freeze, and repeating the process continually until the ice is strong enough to carry heavy mining equipment. 

Construction of the mine took twenty-one years and cost more than $1 billion. Getting the regional government on board was not easy. The environmental survey alone ran to more than 15,000 pages. 

Investors like Desmond poured money into the project because the promise of the Gahcho Kue mine, as it’s called, was so great. Mountain Diamond partnered up with De Beers to develop and operate it (Mountain Diamond owns 49 per cent of the mine). The prize was a mine capable of producing 12,000 carats per day (at a projected average carat price of $167) for 14 years. When it opened in September 2016, it was the biggest new mine in more than a decade. 

Opening day turned out to be the high point in the 24-year history of Mountain Province as a listed company. At that point, it was worth €950 million. 

Today Mountain Province is worth €52 million and its bonds are trading at a discount to face value. Just what has happened? And what happens next?

A good time to buy a diamond

Diamond mining is a slow business. Investors need deep pockets and they need patience.

Dermot Desmond has been a stalwart backer of Mountain Province. He is the most prominent of a group of Irish shareholders which also includes Des Sharkey, the low-key owner of Romania’s biggest shopping centre. “Without the support of the Irish we would be up the creek,” said Mountain Province’s former CEO Patrick Evans. 

When Gahcho Kue was being planned and built, the market for diamonds was strong. Diamond prices hit a peak around 2011. That spurred extra exploration and supply.

Mountain Province snapped up the rights to explore the areas surrounding Gahcho Kue from De Beers for a song – $10,000 – and proceeded to spin out a separate company to do the work. Kennady Diamonds, of which Sharkey and Desmond were also shareholders, was later re-acquired by Mountain Province in an all-share deal worth $176 million in 2018.

Shortly after Gahcho Kue started operating, three major diamond mines opened: Botuobinskaya and Grib in Russia, and Renard in Canada. These three mines, along with Gahcho Kue, boosted global diamond production by 24 per cent. According to Bain & Co, the production increase in 2017 was the biggest single-year increase since 1986. 

What’s more, Gahcho Kue produces a lot of small and off-colour diamonds. It’s precisely this variety of diamonds which were getting produced by the new mines. So just as Gahcho Kue’s diamonds were hitting the market in Antwerp, the world capital of the diamond trade, there was a supply glut. 

The year before the mine opened Mountain Province forecast its diamonds would be worth $163 per carat. In 2017, the mine’s first full year of operation, it got $70 per carat. The following year it got $74 per carat. And last year, in 2019, it got $63 per carat (all are Canadian dollars).

At the same time, costs were rising. All-in cash costs rose from $33 per carat in 2017 to $47 in 2018 and $54 in 2019. 

The supply glut after Gahcho Kue opened in 2016 did its bit to depress diamond spot prices. Last year the problem was compounded by a drop in demand, as jewellers cut their inventories. That led to a 25 per cent drop in sales across the industry in 2019, according to Bain & Co.

As with any miner, diamond mines are a leveraged bet on the price of the underlying commodity. In other words, the company’s share price is incredibly sensitive to the commodity price. A small change in the spot price can have a big impact on the value of the company.

That’s because the company’s value comes from its profit margin. A 5 per cent drop in the spot price of the commodity could translate into a 50 per cent decrease in a company’s margin and profits. For example, in a note in the 2019 accounts, Mountain Province says a 10 per cent increase in the price per carat of would increase the value of its assets by $131 million. 

Mountain Province’s troubles are shared by the industry. Operating margins shrunk at the four biggest mining companies last year. ALROSA’s fell from 45 to 35 per cent, De Beer’s from 13 to 12 per cent, Rio Tinto’s from 26 to negative 3 per cent, and Petra’s from 10 to 8 per cent. (That 2 per cent drop in Petra’s operating margin was accompanied by a 78 per cent drop in its share price.)

It’s been a rough few years for the diamond industry and Mountain Province. Covid-19 has made everything much worse.

Mountain Province makes rough diamonds. The rough diamonds are then taken to dealers in Antwerp, Belgium, where they’re sold at auction. Later they’re taken to India for polishing. 

Covid-19 has shut down the diamond market in Antwerp, which means Mountain Province is cut off from its customers. The company was forced to cancel an Antwerp diamond auction in the middle of March. An auction by De Beers in early March, shortly before the shutdown came into effect, saw sales down 28 per cent from the previous year. 

It’s a good time to buy a diamond. Paul Zimnisky, founder of Diamond Analytics, says a one-carat diamond now retails for US$5,300, compared to US$6,200 in 2015. “The economics of the Gaucho Kue mine were quite good when they decided to move forward with the project,” said Zimnisky. “Even with rough diamond prices down a double-digit percentage in recent years, the mine was still profitable. But now, prices are down another 10 per cent plus,” he added.

With the shutdown in place, Mountain Province is going to struggle to generate cash. Gahcho Kue is still operating, but it can’t reach customers. It’s exploring direct sales with trusted customers, but these aren’t in place yet. 

Debt and torment

As we’ve seen, Mountain Province’s share price has been hammered since Gahcho Kue opened in 2016. First by the disappointing prices per carat attained by the mine, second by the global decline in rough diamond prices, and third by the Covid-19 lockdown. 

Another big factor is Mountain Province’s debt. Covid-19 torments indebted companies in particular. The company owes $338 million in senior secured notes, paying an 8 per cent coupon. The notes mature in 2022. 

How big is $338 million? Remember, the market cap of the business is down to $73 million. 

Normally you’d compare the debt minus cash to the company’s earnings before interest payments. But Mountain Province is losing money, even before interest payments. 

Finance costs came to $47 million in 2019. That’s compared to $79 million in operating cash flows. The other big number, apart from finance costs, that comes out after operating cash flows is capital expenditure — ie the money invested in, for example, machinery in order to keep the business running. Capex can be cut in the short run but without it, a business will ultimately collapse. Capex for 2019 was $27 million, down from $79 million the previous year. 

Subtracting Capex of $27 million and financing costs of $47 million gets to levered free cash flow — ie the amount of cash the business generates after everyone has been paid and investments have been made — of just $4 million. This is what was left over after $276 million in sales in 2019. 

You can see why getting shut out of Antwerp for a few months could be so harmful to Mountain Province. It was already struggling with low diamond prices and high interest payments. 

Asked whether Mountain Province’s problems are more about the diamond market or Gahcho Kue, Paul Zimnisky said “this is a levered company problem. This company borrowed a lot of money to build a diamond mine.”

The 8 per cent 2022 notes, which had been trading at par on 25 February, are now trading at 73 cents. This means the market is suddenly forecasting a higher probability of default. Which goes to show how badly the Covid-19 crisis has rocked Mountain Province. 

I had to compare Mountain Province’s interest payments to cash flows because its earnings were negative last year. It made a net loss of $128 million last year, compared to $17 million the previous year. What happened? The company was forced to take a $115 million write-down. It said that basically, the market’s valuation of the mine was significantly lower than the book value of the mine for a long time. So it had to concede that the mine was worth less than it had thought. 

Even now, Mountain Province trades at 22 per cent of its book value. The market is telling the company that it doesn’t believe it’s going to see returns from those assets. Either the assets are worth less than the company says, or return on equity is going to be small, or both. 

Covid-19 torments indebted companies.

As with all stressed-out companies in the time of Covid-19, the question now is how long Mountain Province can wait it out. Does it have the cashflow; or failing that, the cash; or failing that, access to credit?

Cashflow, as we’ve seen, is drying up. As for cash at hand, the company had $34 million at the end of 2019. That’s about three months of operating costs, to say nothing of its interest payments. 

On March 31, the company announced it had reached a deal whereby its bank would loosen up the covenant terms under which it would offer a $50 million credit line. The credit line hasn’t yet been used. 

Between the interest payments and the operating costs, the disappearing cash flows, and the relatively tight cash and credit reserves, it looks like it’ll be a tight squeeze for Mountain Province this year. “It doesn’t have the same balance sheet flexibility as, say, a larger miner such as Rio Tinto or BHP Billiton, which have more liquidity to absorb a shock like this,” says Ziminsky. 

That said, there are some reasons to be hopeful. The diamond mining industry is highly concentrated and highly cyclical. The closure of one mine can impact global prices, and as we’ve seen the value of these mining companies is highly sensitive to market prices. Gahcho Kue is a mine with good economics. After a shakeout, Gahcho Kue is likely to be among the survivors. “There are probably a lot of other diamond mines in the world that won’t work before Gahcho Kue,” says Zimnisky.

The mine should survive this. But there will be plenty of restructuring ahead.