GML – A gemstone at bargain prices

Gemfields (GML) is a unique business globally and we are fortunate to have the opportunity to have it listed on the JSE. The company developed out of the Pallinghurst stable of companies. Pallinghurst is a mining investment vehicle set up by former Billiton chief and mining deal legend Brian Gilbertson. His son, Sean, is CEO of Gemfields. What makes the business unique is its exclusive focus on coloured gemstones. Primary mining assets and cash generators are the Kagem Emerald Mine in Zambia and the Montepuez Ruby Mine in Mozambique.

The real value creation is that they have invented and implemented an auction system (probably borrowed from the De Beers business of the 80’s), which has ensured that they are not simply price takers at the mercy of the gemstone traders and dealers. Rather by controlling a large portion of supply and by creating additional demand through the Faberge brand, they have ensured that they can somewhat control the price received for their stones. In the group’s own words: “[The Faberge brand] promotes the positioning and perception of precious coloured gemstones by producing jewellery, timepieces and objects.”

The company has developed this system through trial and error and they appear to have settled on three separate auctions, each taking place twice per year. The Singapore Ruby Auction averages revenue $60m on sales of around 600,000-900,000 carats. The Lusaka Emerald Auction focuses on lower quality stones and averages sales of $13m on around 3m carats. The Singapore Emerald Auction focuses on higher quality Emeralds and nets an average revenue of $25m on sales of 300,000 carats. In total the auction system yields annual revenues of around $200m.

Free cash flows for the 2018 FY were $27m (profits were impacted by the revaluation and impairment of certain mining assets). In H1 2019, free cash flows were reduced to $10m, however, the group reported paying export duties of $5m on Zambian emeralds. In December 2019 it was announced that the Zambian government had suspended this tax. This increases Zambian profits by $10m/year and would put the group back on annual free cash flows of around $30m.

The company is trading at around R1.80/share or a market cap of R2.5bn ($170m). This puts the business on a 6 times free cash flow multiple.

In April, the company sold a non-core stake in manganese producer Jupiter mines for $31m. Further assets by the group are a 6.5% stake in Sedibelo Platinum platinum mine, which produces around 150koz/year, and gemstone and gold exploration activities in Mozambique, Madagascar and Ethiopia. The exploration activities provide upside and a pipeline for the gemstone core business, while the minor stake in the platinum mine is clearly non-core and is likely to be sold at the right price, similar to the Jupiter mines stake.

Major shareholders are Christo Wiese with 12.6% and several fund managers (Fidelity, Oasis, Investec Asset Management, Old Mutual). Management holds a few percent and in May, former chairman Brian Gilbertson purchased another R2m of shares at current depressed prices.

The group holds 7.6% of its own shares and voted in a December 2019 EGM to cancel these treasury shares. In fact, given the large amounts of cash on hand and the significant discount to NAV, the group is continuing with an aggressive buyback program, which was first announced in June 2019. In September they announced a successful repurchase of 10% of the issued share capital of the company at R1.50/share. Further repurchases were approved in the recent EGM and the company will continue to reduce the number of shares in issue at these depressed prices.

I believe that the group represents a compelling investment at the current price and have added the stock to my portfolio. The following factors present significant value upside in the medium term:

  • Gemstones, like diamonds, represent discretionary expenditure, incured mostly by the very rich. This is the layer of the population that is most protected from economic downturns. The people forking out $100,000 on a jewel encrusted iPhone cover or a Faberge egg will continue to do so, no matter what the economic climate.
  • Gemstones are gaining popularity when compared to diamonds. Increasingly, people in my circle of friends are choosing coloured stone engagement rings and the Faberge brand is helping in strengthening this trend.
  • Gemstones are also less at risk of substitution from lab grown varients, as they are less expensive in $/carat then gem quality diamonds, thus providing less incentive for creating alternatives.
  • I like the capital allocation approach developed by the group. Over the last year they have have disposed of most of their non-core assets. This has resulted in very low debt levels and a large cash pile which is being put to specific use in a Distribution fund. At current low share prices, I agree with management that repurchase of shares is the best way to deploy this cash horde.
  • The disposal of the non-core assets has ensured that management focus on the core business, which is creating a market for and then selling coloured gemstones. The two existing mines are long life, large, high quality assets and other assets may complement this in the future. This may be through exploration (in Ethiopia and Madagascar) or through acquisition.
  • Suspension of the Zambian export duty, is likely to significantly increase cash flows. In fact, the group is trading at less than 6 times free cash flow.
  • The group has stated its intention to sell its stake in Sedibelo Platinum. The asset has a carrying value of $50m (around 30% of the GML market cap). However, with palladium prices notching up record highs, the asset may well be worth significantly more. As a comparison, Northam Platinum produces 520koz/annum of 4PGE and carries a market cap of $4.4bn. This implies a valuation of $80m for the Sedibelo stake. The value of this holding does not appear to be considered at all in the market cap of the group and has the potential to release significant cash. It is not surprising that the group is trading at only 30% of NAV.
  • If we exclude the Sedibelo stake, the company is trading at a free cash flow multiple of only 4 times.
  • As all sales are in US$, the group functions as an effective Rand hedge. Any devaluation in the ZAR should increase the share price.
  • Management is eating their own cooking with recent purchases at the current share price.

 

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