Gem Diamonds, which raised £550 million last year when it floated on the London Stock Exchange and followed that with a series of acquisitions around the world, has completed the building of a second plant at Letseng, its key mine in the southern African kingdom of Lesotho, to double its annual production of high-quality stones to 101,000 carats, worth an estimated US$200 million (£107 million) at an average price of $2,000 a carat.

That is many times the world average of $91 a carat for uncut diamonds. In the
diamond business, values rise disproportionately for larger stones and those with particular brilliance, colours and other special features.

Gem has cut costs and boosted production at the Ellendale mine in Western Australia after buying its previous owner, Kimberley Diamonds, for £131 million last year and hopes to produce 600,000 carats from the mine this year, with 730,000 carats on the cards for 2009. The company intends to embark on a new project at Gope in Botswana, costing some £225 million over three to four years, and is eyeing expansion and acquisition opportunities around the world.

CEO Clifford Elphick echoes the views on the market recently expressed by Gareth Penny, De Beers’ chief executive officer. Penny said demand for high-end diamonds was ‘very, very strong’.

Referring to the high-quality Letseng output, with stones typically ranging from 20 to 70 carats, Elphick says: ‘The US economic problems and credit crunch have not impacted on us yet. If anything, we are seeing upward pressure, from rich individuals in China, Russia and the oil-producing countries.’

Elphick says group output will fall short of this year’s target of one million carats only because of environmental problems at the company’s Cempaka mine in Indonesia and difficulties at its non-core operation in the Democratic Republic of Congo.

He has lately been sounding out potential new acquisitions. He thinks there could conceivably still be pickings from De Beers’ portfolio in Botswana. He also says he wants to be ‘head of the queue’ for any discussions about the future of base metal giant Rio Tinto’s diamond interests – including Argyle in Western Australia, which produces a third of the world’s natural diamond output – if world mining leader BHP Billiton’s £75 billion bid for Rio Tinto succeeds and the diamond side is held to be a ‘non-core’ activity.

Gem Diamonds, which increased pre-tax profits last year more than sevenfold to £29 million, on sales trebled to £72 million, has no debt and says it will deploy its existing cash flow to help fund developments such as Gope.

Strategy
Since flotation, Gem Diamonds has pursued a strategy of securing high-quality potential or producing diamond properties, where its own skills and access to finance can enhance performance and profitability. Elphick says he has three growth plans: one purely organic, a second envisaging the acquisition of two more ore bodies and a third taking major chunks of a combined BHP-Rio Tinto.

Elphick says the Letseng mine is now exhibiting exactly the same ‘size and frequency curve’ in its distribution of diamonds as the company predicted. It is low grade, with an average of only a little more than two carats per tonne of earth, but that is more than compensated for by the size and quality of its stones.

According to Elphick, the best prices per carat are realised not by the very largest stones but by those in the 20- to 70-carat range, where the risk to the buyer is lower. Now that Letseng is set to double production from two kimberlite, hard rock sources, the company has decided to improve margins further by starting its own polishing operation, based in Mauritius and Dubai, for the highest-value stones.

Gem Diamonds’ aim is to win some of the hefty margins made between sales of rough diamonds and the retail market for cut and polished gems.

At Ellendale, Gem Diamonds was able to cut unit costs by doubling throughput of ore to 8.5 million tonnes a year. It has sorted out plant bottlenecks and increased selling prices to 20 per cent by convincing merchants it was no longer a cash-strapped forced seller.

Cempaka in Indonesia came into the company through last year’s £42 million purchase of AIM-quoted BDI Mining. It is seen as a ‘special case’ because of the variously coloured stones it produces.

Less central to Gem Diamonds’ plans are its ventures in the Congo, Angola and the Central African Republic. The Congo is rich in gems but presents formidable and costly infrastructure problems, though the company is trying to find the hard rock source of the alluvial (river bed) diamonds there.

Management
After joining the Anglo American mining colossus in 1986, Elphick, whose Gem Diamonds Holdings owns nearly 15 per cent of the company, became personal assistant to Harry Oppenheimer, head of the whole group. After serving on the boards of Anglo and De Beers, Elphick founded Gem Diamonds in 2005.

The same stable has provided the company’s key people – chief operating officer Terry Stewart, chief mineral resource manager Graham Wheelock and chief financial officer Keith Burford – while non-executive chairman Roger Davis is the former CEO of Barclays’ UK banking division.

Prospects
Gem Diamonds’ efforts to increase production and profitability at its key mines and its continuing quest for new ones, backed by strong finances and cash flow, augur well for its prospects – provided a world recession does not knock the stuffing even out of gems at the top of the market. Analysts’ estimates of pre-tax profits for the current year range from £35.5 million to £54.5 million, with £70 million for 2009.

The move into polishing should add something to margins, and more success on the exploration front would provide another fillip to future profits. Gem Diamonds’ own organic growth and acquisition strategy could put it in an interesting position if another wave of consolidation sweeps the sector.

Cempaka’s output will help the bottom line. Meanwhile, the company hopes to start building another mine at Gope in Botswana next year, which should enhance longer-term supply prospects.

The chief uncertainties remain how long the expensive end of the retail diamond market will stay firm and how successful the company’s future exploration efforts will be.

Valuation
Quoted diamond producers are rare these days. Of the giants, De Beers is no longer public, Alrosa is Russian, tightly held and not publicly traded, and BHP Billiton and Rio Tinto are not pure plays and could possibly exit the business.

That gives Gem Diamonds a certain rarity value, with longer-term possibilities of corporate deals amid further industry consolidation. At a price of 955.5p, against a 52-week high of 1191p and an 830.5p low, the shares trade at a modest discount to brokers’ most cautious estimates of net present value, while most precious metals producers command a premium.

The shares are not without risk but should outperform the sector in the medium to long term.