Petra Diamonds, a rough diamond producer, reported weak results in H1 20 (June 19-December 19). Low diamond prices, weaker product mix and seasonal accumulation of inventory put free cash flow in the red, despite prudent cost management and seriously reduced capex. In H2, the company traditionally sells more gemstones and reduces inventory, however, further weaknesses in diamond prices in February could mean lower cash collections. The absence of significant debt repayments until 2022, an adequate cash position to keep the business running, substantial rough diamond inventory and committed credit lines should support the company’s liquidity. However, in order to deleverage and smoothly refinance the US$650mn notes, the company needs to demonstrate its ability generate positive free cash flow. Meanwhile, the targets of Project 2022 aimed at deleveraging were revised down and the timeline pushed back, making diamond prices the key variable of successful refinancing.
Bonds on the crossroads – no positive triggers in sight. US$650mn 7.25% notes due May 2022 are indicated at a mid-price of c60, corresponding to a yield-to-maturity of 35%. We contend that the only positive driver that could emerge in the next 3-6 months is stabilisation and recovery in rough diamond prices. If, on the contrary, 1) rough diamond prices remain weak or deteriorate further, 2) unexpected adverse changes in the product mix (quality of gemstones) occur, or 3) mine operations are destroyed as a result of an accident, electricity load shedding takes place in South Africa or the upcoming negotiation of wage agreements with trade unions, Petra Diamonds could see further negative pressure on liquidity and leverage and, ultimately, on bond prices.
Revenues down 6% yoy on weak prices and product mix. In H1 20, revenues declined to US$194mn (Table 1 on page 2) due to a combination of weaker rough diamond prices and lower quality product mix at Finsch in South Africa and Williamson in Tanzania. Sales volumes, however, were maintained. We estimate that Petra’s averaged realised price per carat fell 7% yoy and 13% hoh in H1 20 (Figure 1 on page 3). Petra Diamonds seasonally accumulates inventories in July-December when it holds three tenders and increases sales in January-June when gemstones are offered in four tenders. In 2019, the world-leading diamond producers took measures to balance the market by holding back sales which, arguably, helped to stabilise prices towards the year-end. However, prices declined further in February, according to indices published by Polished Prices.
Liquidity under pressure from diamond prices. In H1 20, EBITDA declined 11% yoy to US$67mn and EBITDA margin tightened by 2ppts to 35%. The company managed to keep cash cost of production under control. However, after funding the build-up of diamond inventory (working capital), paying interest and financing significantly reduced capex, the company went into the red. Unrestricted cash decreased to US$40mn, which, according to management, is the minimum level required to support the smooth operation of the business. Diamond inventories of nearly 1mn cts, carried on the balance sheet at US$86/carat, amounted to US$85mn. According to management, the company maintained access to US$107mn (ZAR1.5bn) committed credit lines, which are subject to certain financial covenants.
Deleveraging is not a near-term prospect. In H1 20, the company’s debt reached US$780mn, including the US$650mn 7.25% notes due 2025. Because of lower cash and EBITDA, consolidated net leverage ratio calculated for the covenant purposes came to 4.4x, exceeding the maintenance threshold (4.25x) under committed but yet unutilised credit lines. For the first time, the company was granted a waiver for the 31 December 2019 testing period. In all likelihood, it will have to seek another waiver for 30 June 2020 (3.5x threshold). Management’s target for net leverage is well below 2x and it does not look achievable over the life of the bonds unless diamond prices or volumes increase significantly from current levels.
Potentially transformative Project 2022 is delayed. The company is focussed on increasing cash flow generation – Project 2022 is an action plan to achieve US$50mn-80mn annual cash flow generation. Previously, the company guided that by June 2022 it would cumulatively generate US$150mn-200mn. In the H1 20 results, this target was revised down to US$100mn-150mn with the delivery skewed towards the end of the period. In 2020, management expects neutral to marginally positive free cash flows.