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Tanzanite is a trichroic blue (-violet) gemstone. Trichroism is a rare gemstone phenomenon, in tanzanite’s case it displays blue, violet and flashes of burgundy (or yellow or green) depending on crystal orientation. The biggest premiums are paid for stones that are a deep royal blue, similar to sapphires.

Tanzanite was first discovered (as a Zoisite) in the late ’60s, and it took off when Tiffany & Co (TIF:US) renamed it and began marketing it. To date, the US has been the biggest market, with tanzanite often chosen as a birthstone for new mothers. In 2002, it was also designated as a December birthstone, the first revision since 1912 in the AGTA‘s birthstone list.

Last year’s Royal Wedding also provided an unexpected boost for tanzanite. Kate Middleton’s ring (formerly Princess Diana’s) is an 18 ct sapphire and diamond ring, and jewelry manufacturers and consumers were quick to realize that tanzanite was a cheaper but v acceptable substitute for sapphire. There are also high hopes in the industry that an increased Asian preference/acceptance for coloured gemstones, coupled with increasing incomes/aspirations, means there is huge untapped potential to sell tanzanite in China, India and the rest of Asia.

Interestingly, the ascendancy of diamonds in the Western world has really only been a phenomenon since the Second World War. Before that, coloured gemstones were equally popular and as valued as diamonds – Royal jewelry collections world-wide attest to that. This diamond supremacy can almost certainly be ascribed to the control and influence of De Beers.

Taking a closer look, I learned that gemstone prices mostly appear to be correlated with their degree of hardness. I did not know this – unlike the fairer sex, who seem to intuitively divine what gem is the hardest…to pay for! There’s a scale for this – the Mohs Scale. This ranges from 1 for talc (yes, a stone!), to 10 for diamonds. Sapphires are at 9, while emeralds are at 7.5-8. By comparison, tanzanite is at 6.5-7, which of course is ‘hard’, but is actually relatively soft for a gemstone. While I can see some merit to this hardness premium, above a certain point I’d have expected pricing to be actually based on rarity?!

This is an interesting thought, as tanzanite is far rarer than diamonds – in fact, it’s often cited to be a thousand times rarer! Who knows for sure, but you get the point. This comes down to the fact that tanzanite can only be found in one place on earth – the Merelani foothills of Mount Kilimanjaro in northern Tanzania. And it’s generally estimated that the total resource will be exhausted in another 20-40 years. This presents an intriguing prospect for future tanzanite prices, relative to diamond prices, for example.

This tanzanite resource is divided locally into 5 blocks. Blocks B and D are mined largely by small artisanal miners. Medium scale mining is undertaken by Kilimanjaro Mining in Block A and Tanzanite Africa in Block D-extension. Finally, Richland Resources (RLD:LN)** undertakes larger scale mining in Block C, and is considered to be the largest and most advanced miner and supplier of tanzanite in the world. It is also Bermuda registered, and publicly listed on the London AIM market. This is the company we want to focus on. First, let’s take a look at their historic figures:

Richland Resources     (xlsx file)

Richland Resources     (xls file)

On the production front, things look good. Carats produced, despite hiccups, has been increasing by 9.4% per year. This has been accompanied by a rock steady cash cost of $3.67 per carat, on average, while the yield has stabilized in the 50-60 carats per tonne range for the past few years. We see a very different story on the revenue and earnings front, however, all of which can be traced back to the crunch year of 2008. The best way to see this is by calculating an estimated revenue per carat. (If you’re interested in the math, I’ve adjusted for changes in inventory. To keep it simple, I’ve assumed inventory carrying value is at 50% of sales prices). There has been a changing business mix (of rough, polished and jewelry) over the years, but v clearly the credit crunch/recession caused a price crash in tanzanite (to $5.69 per carat in 2009), with a slow recovery to $8.89 since then.

This was, of course, also seen in the diamond market, and in the wider coloured gemstone market. Gemfields (GEM:LN), a peer company which focuses on emeralds, has provided some interesting recent disclosure. For their recent lower quality auctions, price per carat has gone from $0.31 in Mar-10 to $1.12 in Nov-11, while higher quality has jumped from $4.40 in Jul-09 to $42.71 in Jul-11! It should be noted, however, that auction prices/results are notoriously volatile based on the specific characteristics of the inventory offered, so one should not conclude that prices have multiplied from their lows! Diamond miners also reported a dramatic surge in prices from 2008/09 to mid-2011, which has been tempered by some degree of price retracement since then.

All in all, considering the diamond/gemstone price increases, gold up 170% in the past 5 years, and a possible (very) inflationary (and/or alternative asset friendly) environment to come, the pecking order and price outlook for tanzanite appears neutral (at worst) to decidedly bullish. Wider appreciation of its increasing rarity would provide another powerful tail-wind, but this may take a lot longer to unfold.

Management appear professional and generally shareholder friendly. This is seen in the high level of dividends paid out pre-2009 (almost unique among the junior miners), while since 2009 I would consider that management have righted the ship as quickly and efficiently as possible. There has been no continual call on shareholders for more funding either, the other big problem in the sector. There is an unusual A class of shares, but these are being steadily reduced and are not dilutive in any way to ordinary shareholders. They have also appointed advisers to add a listing on the Dar Es Salaam exchange, which should encourage new interest and shareholders.

The CEO is Bernard Olivier is a geologist – his PhD dissertation actually covered all aspects of the Merelani tanzanite deposit. He’s been closely involved with tanzanite mining/geology since 1999 and, prior to becoming CEO, was a consultant and then director to the company. Ami Mpungwe is Non-Exec Deputy Chairman (having swapped the Chairmanship with Ed Nealon), but remains Chairman of the company’s Tanzanian sub. – he’s a director on a number of Tanzanian boards, and has served 25 years in the diplomatic service, including 6 years as the Tanzanian Ambassador to South Africa.

I’m also delighted to see some recent share purchases by the directors, including a receipt of shares in lieu of salaries/fees. They now own 14.5% of Richland. This collective stake is worth about $2.6 million, which far exceeds their $0.67 mio of emoluments in 2010, so we can rest assured that their incentives are appropriately aligned with shareholders. Now, let’s take a look at a couple of negatives:

a) Let’s tackle the biggie: Richland’s current Special Mining License expires in July! The license will be extended for a further 25 years providing Richland is in compliance with the Tanzanian Mining Act. Clearly, this presents (in theory) a critical risk for Richland. Oddly enough, when you consider that the share price was already down 93% three years ago, it appears that nobody’s actually pricing in this risk! On the other hand, I don’t think the reverse is true – in fact, news of an SML renewal would likely be seized on by the company and investors as a significant positive development. So how risky is this decision/event?

Well, Richland has consistently stated it’s been compliant. It appears to be a good corporate citizen: It funds local community needs and projects, it’s created a unique tourist attraction in The Tanzanite Experience, and it funds The Tanzanite Foundation which promotes the entire tanzanite industry in Tanzania. They have Ami Mpungwe, a well-respected local figure, on board. They’ve created a new JV structure that may prove to be a model for working with local artisanal miners. And they’ve suffered from unauthorized local undermining, so perhaps they’re more sinned against than sinning? Additionally, despite investor fears, refusal of a mining license renewal is pretty rare for an established producer and is generally preceded by plenty of warning signs/rhetoric.

Like all politics, this one’s unpredictable – but Tanzania is generally considered a low political risk country (at least in an African context!), and the risk of license non-renewal appears to be low.

b) Of course there’s also mining production risk, but this exists with all companies, so I won’t discuss it further. Perhaps the most obvious other risk is the renewed fears of recession/slow growth in Europe and the US. That’s the billion dollar, sorry trillion dollar, question..! Yes, that’s a real risk, but I think if the (global) economy starts tanking, we can rely on another Tepper rally to bail us out..! Not that central banks and governments losing their collective minds is really going to solve anything longer term.

I’ll write about this more another day, but suffice it to say I’m not tempted to sell stocks en masse (i.e. I’m not afraid of recession), but I certainly will continue to re-allocate a significant portion of my portfolio to natural resources and other real assets (i.e. I’m afraid of inflation). Fortunately, there are plenty of these type of assets still going cheap – just like Richland? And with the price of tanzanite still sufficiently beaten down since 2008/09, I’d venture that a recession wouldn’t necessarily impact it further at this point anyway…

c) Hard to say if this is a positive or a negative: In mid 2011, Richland announced it had entered into (for a small fee) an option to potentially acquire an established sapphire project in Australia. This has previously been partially mined and produced significant quantities of gemstone quality sapphires. They’ve recently extended their due diligence period on this project. If they exercise the purchase option, the consideration will be a relatively small $4.0 million.

I am concerned however that this purchase would be mostly funded with the issuance of shares. At the current low share price, this would appear to imply a dilution of shareholder value. Additionally, even though the project’s been previously mined, it’s not at all clear what level of project capex and working capital might be required to bring this project online? Finally, sapphires should certainly be within the company’s existing circle of competence, but I’m concerned about the additional costs and distraction of setting up/operating in another country.

OK, I’ll continue from here on Friday – we shall take a look at any key positives for the company, take a stab at a couple of different valuations, and then we’ll draw some conclusions about Richland as a potential investment opportunity.

** Richland Resources Ltd. was formerly known as Tanzanite One (TNZ:LN) (name changed in Aug 2011). It should not be confused with a small listed US oil & gas exploration company named Richland Resources Corp. (RRCH:US).

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