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Press Release: Caerus Global Investors, the beneficial owners of approximately 450,000 shares of Dominion Diamond Corporation (NYSE:DDC), issued the following letter to the mining company's CEO and its board of directors.
Board of Directors
Dominion Diamond Corporation
Attention of Robert A. Gannicott
Chairman & Chief Executive Officer
Dominion Diamond Corporation
P. O. Box 4569, Station A
Toronto, ON M5W 4T9
Dear members of the board:
As long-term institutional shareholders of the Dominion Diamond Corporation, (Dominion), Caerus Global Investors LLC is deeply concerned about management’s capital allocation priorities which, we believe, are the primary reason for the depressed state of the company’s equity valuation. We strongly suggest that the board reconsider its intent to reserve cash for stepped up future investment in the Ekati mine and immediately return a material amount of excess cash on hand to shareholders in the form of a significant share repurchase program. We believe the stock is trading at least 50 percent below fair value, not including consideration for the Jay pipe, and thus presents a unique opportunity for repurchase. We also believe such a share repurchase program would generate the greatest return on capital for current shareholders. We strongly disagree with management that cash must be reserved for the Jay pipe investment, which is nearly seven years away from any potential revenue realization.
During multiple conversations with the company over the past few months, we urged Gannicott to request that the board consider returning cash to shareholders through a significant share repurchase initiative or a special dividend. In response, Gannicott indicated that he believed such actions would not be appropriate for Dominion at the time because of the company’s potential future capital investment needs and because he believed such actions would not create significant incremental shareholder value. The purpose of this letter is to urge the board to reconsider the capital allocation priorities in light of the factors we discuss below.
Caerus initially invested in Harry Winston Diamond Corporation during 2011. We were attracted to the company’s strong position in diamond and high-end jewelry retailing and the brand equity that the Harry Winston division presented. The value of the Diavik mine interest was a secondary factor in our decision to invest, albeit an important one. When the company announced the sale of Harry Winston in January 2013, we reconsidered our investment thesis. Based on Dominion’s opportunity to redeploy the net sale proceeds into two potentially integrated Canadian diamond-mining enterprises, we became convinced that significant value could be created for shareholders by acquiring the two controlling interests in the Ekati mine zones, to be potentially followed by acquiring the 60 percent interest in the Diavik mine held by Rio Tinto.
Last February, Gannicott met with many institutional investors. In these presentations, he cited substantial synergies that were possible if Dominion were to control both Diavik and Ekati. Recently, however, Rio Tinto indicated that it would not sell its Diavik interest. This leaves Dominion with a substantial excess cash reserve, previously earmarked to support possible additional investment in Diavik. In our most recent conversation, Gannicott indicated that he was not disappointed in Rio’s decision because he viewed Diavik as a stream of cash flows with a finite mine life of less than 10 years. Thus, at best, the possible Diavik 60 percent interest acquisition terms would have been evaluated on a rigorous cash flow analysis, with due consideration to the ongoing uncertainty of diamond prices in the markets as the primary risk factor.
In various presentations during investor calls since February, Dominion management has indicated that it would be rigorously objective in its capital allocation process, not investing in mine development just for the sake of producing more carats. We interpreted this to mean that if the optimal course of action, considering the risks and uncertain timing of returns, was to use capital for share repurchase and/or dividends, as opposed to further mine investment, the company would act accordingly. While we appreciate the complexity of the capital use considerations, we sense that the board has become too focused on risks and possible capital needs far out into the future and has put too little focus on the trade off of these factors against the unique opportunity to repurchase shares at a very deep discount to their underlying value. If this impression is correct, it calls into question adherence to the primary duty of Dominion’s management and board: Enhancing shareholder value.
Recently, Gannicott indicated that the magnitude of the eventual Ekati mine investment (principally the Jay kimberlite) is quite uncertain and that Dominion’s 58.8 percent share of future capital calls to support this investment could be $353 million or even more. This point was reiterated on the second quarter earnings conference call this past week. The precise amount of this investment would depend on the mining method determined upon and permitted to deal with the lake resting above the submerged Jay kimberlite. It also would depend on the willingness of Dominion’s minority partners to commit their combined 41.2 percent share of the capital needed, presumably about $247 million.
Gannicott has also stated that the company must preserve cash so that Canadian officials reviewing the permit applications would be confident in Dominion’s ability to make the investment and guarantee eventual mine area reclamation once the diamond reserves were fully depleted, perhaps 20 or more years into the future. While we appreciate these concerns, we also note that the Ekati Jay development would be a source of future employment in the region, so that there are great incentives for regulators to permit the Jay pipe development, albeit subject to certain financial conditions being met and environmental considerations. It is our understanding the permitting would take at least three years, so that actual production would not commence at Jay for at least five to seven years, as reconfirmed in last week’s earnings call.
Surely Dominion would not make the Jay pipe investment commitment unless the projected return was extraordinary and superior to other potential uses of capital. If the minority buffer zone partners fail to meet their respective capital calls, the extraordinary return could become super-extraordinary, we assume. Aside from the long lead time, the major construction cost and carat yield uncertainties involved with opening new pipes, the Dominion board would need to be most certain that diamond prices would be sufficiently high to support extraordinary returns for many years into the future before it would commit to such a large capital investment. If the investment projections were to prove so compelling, Dominion would surely have no trouble securing the capital required. Otherwise, the prospective investment should simply be postponed, or the Ekati position should be sold or partnered, in part or in full, to other investors who appreciate the magnitude of the return. And, presumably, if this value becomes manifest years from now, Dominion’s shares would appreciate greatly from today’s depressed levels, and the company could re-issue previously re-acquired shares at a large premium to facilitate the investment. This would be a very optimal scenario for Dominion’s existing shareholders.
The most recent mine plan for Diavik states a net present value for Dominion’s 40 percent interest of $750 million. The Ekati core and buffer zone mine interests were acquired for cash consideration of $500 million, a substantial discount to the Ekati mine plan net asset value (NAV) available prior to the transaction with BHP Billiton. Adding in the company’s diamond inventory valuation using current pricing, the unrestricted cash balance at July 31 of $224 million and the restricted cash of $123 million collateralizing long-term reclamation for Ekati, less debt of $5 million, Dominion has an NAV of about $1.8 billion.
(Dollar figures in millions except where noted with *.)
Net Asset Value (1)
40% Stake in Diavik Mine (using DDC and Rio Tinto Mine Plan) $750
Purchase of Ekati (valued at acquisition cost) $500 (2)
Inventory valuation (second quarter) $200
Un-restricted cash balance (second quarter) $224.2
Restricted cash (second quarter) $123.4
Debt (second quarter) ($5.1)
Net Asset Value: $1,792.5
Fully diluted shares outstanding: 87
Net Asset Value per Share: $20.60*
Current Enterprise Value:
Current share price (9/6/13) $12.67*
Fully diluted shares outstanding: 87
Equity Capitalization: $1,102.3
Debt: $5.1
Un-restricted cash ($224.2)
Restricted cash ($123.4)
Current Enterprise Value: $759.8
Discount to Total NAV: 58%
(1) Using publicly available information and current mine plans.
(2) Analysis excludes any potential value for Ekati Jay pipe.
Yet at the closing price on September 6, 2013, Dominion’s common equity is being valued at only $1.1 billion by the stock market and the current enterprise value is only $760 million, excluding any potential value for diamond inventory on the balance sheet. Our calculations suggest that Dominion is trading at approximately a 58 percent discount to our estimate of its NAV.
Why the large discount of market price to NAV? Partly it reflects overall market trends and investor disillusionment with mining shares in general. However, this is not the most relevant consideration in our view. We are interested in absolute valuation and are not permitted the luxury of making excuses to our investors concerning relative valuation.
The major cause of the deep discount from NAV is that after making much fanfare about creating value for shareholders when the retail chain was sold and the Ekati interests acquired, Dominion’s management is now passing up a unique opportunity to acquire a large amount of the company’s shares at a deep discount to their fair value (or NAV). Dominion is passing up this compelling opportunity in favor of facilitating a prospective major capital expenditure, which is both speculative and very long-term in nature. These are precisely the types of investment priority-setting considerations that have caused the sharp sell-off in mining shares recently, and led to management changes at several large mining concerns. From our perspective as investors in Dominion, it seems questionable for Dominion to pass up a more certain benefit to shareholders by returning capital today so that a prospective speculative investment could be made in Ekati far into the future, with the returns probably not to be proven or reflected in the share valuation for many years down the road.
We believe Dominion could generate at least $200 million in excess free cash flow annually by the end of 2015 and for several years thereafter, over and above expected capital expenditures anticipated on the two mines. This should increase the company’s net cash to more than $400 million by that time (not including the low yielding restricted cash). There seems little question that Dominion could commit to acquiring a material amount of the shares outstanding with excess cash on hand without compromising the Jay pipe investment opportunity in any meaningful way. The value of the diamond resource owned by Dominion would not be diminished. The Jay kimberlite would still be there for investors to prize, and to be developed when diamond prices hopefully are much higher in the future.
Meanwhile, despite the “round-trip” success of building up the retail business and selling it at an attractive price, improving the overall corporate balance sheet, and opportunistically acquiring the Ekati Core and Buffer zone interests, Dominion’s shares are trading 70 percent below their 2007 peak. With all due respect we vehemently disagree with management’s intention to reserve cash for the Jay investment. We are deeply concerned that the board and management seem to be too focused on long-term mining investment considerations and far too little focused on the company’s long suffering shareholders. Accordingly, we urge the board to rethink this aversion to returning cash to shareholders and to approve a substantial share re-purchase commitment in the very near future. Such an action should not be viewed as being mutually exclusive with Dominion’s exploitation of Dominion’s tremendously valuable diamond mine resources. The undersigned principals of Caerus Global Investors LLC would be pleased to discuss this recommendation with Gannicott and/or the board at any time.
Very truly yours,
Ward Davis
Brian Agnew
Managing Principals,
Caerus Global Investors LLC
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