Stock Pick: Petra Diamonds growing in a rough market

A rare diamond company, indeed

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If diamonds are forever, then buying a diamond company must be a good long-term play, right? That can be true, says Rick de los Reyes, a portfolio manager with T. Rowe Price, but only if you buy the right business.

There aren’t many diamond companies to choose from—De Beers, probably the most recognized operation, isn’t publically listed—but all you need is one good pick for your portfolio. In this industry it’s Petra Diamonds (LON: PDL).

This Saint Helier, Jersey-based company has come a long way in a few years. In 2007, it was producing 180,000 carats. Last year it produced 3 million carats and it’s expected to increase production to 5 million by 2019.

“It’s one of the few companies growing production in a market where growth is hard,” says de los Reyes.

It’s success is, in part, due to some smart mine purchases by management. Over the last few years, the company has purchased five mines in South Africa and Tanzania from De Beers and turned them around.

“They bought old mines that De Beers gave up on,” says de los Reyes. “Petra stepped in, did a lot of engineering work to figure out how to run them profitably, took on some leverage and made it work.”

He adds that by the end of 2014, its debt will be paid off and the company will be in cash flow positive territory and may even introduce a dividend.

“They’re past the hump in building capacity,” he says.

Dmitry Kalachev, an analyst with Canaccord Genuity, is also bullish on the business. He thinks the company can expand its operating margins from about 40% to 50% over the next five years, while free cash flow should average $180 million a year between 2016 and 2019.

He too thinks the company could initiate a dividend with that money.

Petra also looks attractive on a valuation basis. Kalachev says the company is trading at nine times enterprise value-to-EBITDA, which is below the historical average of 10.3 times.

Longer-term, the company should continue to do well because people are buying diamonds in new and large markets, such as China, says de los Reyes. There was some concern around whether engagement rings would catch on in the country and it appears they have.

“That was the key question, because while engagement rings are big in some places they haven’t caught on in others,” he says. “Go to the airport in Beijing and there are Tiffany advertisements everywhere.”

The company is currently trading at 152 pence a share ($2.81), but Kalachev things it can hit 162p over the next 12 months. Other analysts have a price target of 200 pence.