All that glistens might not be valuable
The company has grand plans for vertical integration which would result in a much higher operating margin. However, this step is seen as a prerequisite for a potentially profitable business because the chances are that the mining operations in their own right would be marginal.
Most junior diamond companies get re-rated on making a discovery or resurrecting an old project. Then it is struggle-street with very little return to shareholders.
The share price for North Australian Diamonds is reflecting the uncertainty surrounding the economics of an integrated diamond business.
SHARE PRICE CHARTS AND COMMENTS:
Fat Prophets initially recommended buying NAD at 5.1 cents in September 2006 (Fat Mining 44). Our last review of this stock was in November (Fat Mining 202).
Turning to the charts, North Australian Diamonds has been trading within a consolidation pattern for the past three months in between the 4.4 cents support level and 5.2 cents resistance. A breakout could occur in either direction. Given the strong performance of the broader index and the flat performance by North Australian Diamonds, there is more potential for a downside move.
Looking at the weekly chart, the theme of consolidation remains the major technical pattern forming. The relative strength index is flat which is common during ranges as it becomes a fight between the bulls and bears as to the direction of the breakout.
STATE OF PLAY
At the start of 2005 the PalSac pipe had indicated and inferred resources of 6.7Mt grading 20 cpht (carats per hundred tonnes). The total resources for the four pipes that made up the Southern Cluster stood at 9.2Mt grading 21.4 cpht.
Resource definition at PalSac resulted in an increase of total resources at Merlin to 26Mt at 23.5 cpht. More tonnes at PalSac lifted the overall grade from 18.2 cpht to 23.5 cpht.
The PalSac resource was increased by 39% to 13.46Mt and contained diamonds and indicated and inferred resources were increased by 36% to 4M carats. This equates to an average grade of around 30 cpht. This is a good grade by any standards, especially taking into consideration the high quality diamonds that were previously mined.
The high quality of Merlin diamonds is undisputed but the problem was that the pipes could not be economically mined because of the small surface size of the pipes that do not allow bulk mining methods.
It also has to be kept in mind that a diamond grade of 30 cpht is very low compared with say the equivalent gold grade which is 0.06 g/t.
The average diamond price used to model Merlin in 2005 was US$150 per carat. This simple analysis is going to be more generous and assume a mid point between US$150 and US$300 per carat. Diamond recoveries should be very high, approaching 100%.
Let’s make the assumption of 98% recovery and an average price of US$225 per carat. This means that one tonne of kimberlite from PalSac will carry revenue of US$66.15 or around $A73 per tonne.
The revenue is unlikely to provide a profitable margin to support an underground mine, and a high stripping ratio as PalSac deepens might result in a relatively short mine life. Mining studies are underway but at this point in time there is no indication how mining will proceed.
The company will have the same problem in as much that the pipes are too small in size to achieve an economic scale of mining. This dilemma is being tackled through investigating the merits of building an integrated business.
Building an integrated business makes sense because the “middle man” is cut out and the uplift in price is up to many times the price of rough stones. Going this route means setting up a cutting and polishing factory in Asia and marketing under the Merlin brand through dedicated retail outlets.
However, if this is the only route to making Merlin economic, we have to ask ourselves if the risks for the small investor justify the reward. At this point in time we see the risks as very high. With 2.28 billion shares on issue, the leverage is very low.
Diamond price indexes are few and far between. However, there is one index that includes a range in size and quality. In April 2009 the index stood at 196.7 and was flat through to December 2009. The index has increased slightly in 2010, and in mid-March stood at 206.2, an increase of around 5%. This is a paltry increase compared with the price increases for base metals, iron ore and coal.
NAD has a market capitalisation of $A111.6M and at the end of 4Q09 had $A13.67M in cash. Although the company is well funded for the medium term, we now think that the risk to reward ratio is not suitable for Members.
Accordingly, we recommend North Australian Diamonds as a SELL for all Members.
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