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Saturday, December 11, 2010

Harry Winston (HWD): Whoops, We Can't Forget Key Mining Variables and Risk Factors; Revisiting Earnings Power and Reducing Stake

We will soon follow-up on our 12/1 post:
At long last, a reader provided the correct answer to our question in the comments section -- please see the post for details.

In the meantime, we -- unfortunately -- need to revisit our Harry Winston Diamond Corporation (HWD) post from earlier in the week with a change. Following Harry Winston's results on Thursday evening, we realized that we made two mistakes in our post the other day: (1) improperly calibrating our normalized earnings expectations and (2) not adequately discussing key risk factors that may impact earnings results.

In our September post, we indicated that normalized earnings power contains many moving parts that create range of possible outcomes. In our post this week, we included a wide range of $1.00-$2.00. While our normalized earnings range was intended as a mid-range estimate assuming global economic conditions continue to improve, we received a wake-up call to revisit key assumptions after Harry Winston's earnings report on Thursday. Namely, in addition to rough diamond prices and retail segment performance as key variables, we can't forget about diamond grade and production volumes as significant components of the equation.

Based on results and the forward outlook, we can safely say that the near-term earnings outlook is less robust than we expected, which is why shares traded down 13% on Friday. Also, our normalized range is too high, which we should have known even prior to the report since the company provides excellent disclosure around forward expectations for mining production as well as operating and capital expenditures.

The more realistic range might include the low-end of our prior range, yet even arriving here requires a number a variable assumptions: successful ramping of underground mining at the Diavik mine, production of high grade ore, reduced and contained expenses, as well as sustained increases in rough diamond prices. In addition, although a recent transaction with Kinross Gold Corporation (KGC) brought Harry Winston's Diavik ownership stake back to 40% (higher earnings potential), related share dilution and potential incremental dilution from the transaction ($70 million promissory note maturing August 2011 that may be repaid with shares) are a headwind to per share earnings estimates.

To better understand risks around mining segment earnings results, here's a brief explanation directly from Harry Winston's F3Q11 report:
  • "The comparability of quarter-over-quarter results is impacted by seasonality for both the mining and retail segments. Harry Winston Diamond Corporation expects that the quarterly results for its mining segment will continue to fluctuate depending on the seasonality of production at the Diavik Diamond Mine, the number of sales events conducted during the quarter, and the volume, size and quality distribution of rough diamonds delivered from the Diavik Diamond Mine in each quarter. The quarterly results for the retail segment are also seasonal, with generally higher sales during the fourth quarter due to the holiday season."
In the most recent quarter, the ore mix was notably less favorable:

(reported on a one-month lag)
Three Three Nine Nine
months months months months
ended ended ended ended
September September September September
30, 30, 30, 30,
2010 2009 2010 2009
Diamonds recovered (000s carats) 713 331 1,983 1,614
Grade (carats/tonne) 2.98 4.43 3.28 4.05
The result: "Although rough diamond prices showed continued strength, increasing approximately 20% over the comparable quarter of the prior year, our achieved price increased 4% due to a change in the ore mix."

Further, citing a reduction in processed ore and "mud-rich material," the company lowered it's production forecast for calendar 2010 and offered a similar forecast for calendar 2011:
  • In calendar 2010, the original mine plan contemplated open pit mining from the A-418 kimberlite pipe supplemented by the A-154 South kimberlite pipe to be the primary source of ore. Underground ore was expected to be sourced from the A-154 South and A-154 North kimberlite pipes. Production was expected to be approximately 7.8 million carats from approximately 2.3 million tonnes of ore mined and processed.
  • The production forecast for calendar 2010 has now been revised to approximately 6.9 million carats from 7.8 million carats. The revision is primarily the result of two factors. First, a reduction in ore processed to approximately 2.1 million tonnes from the 2.3 million tonnes mined. Certain ore in the A-418 pipe contains mud-rich material, which has reduced processing capacity. Rio Tinto plc, the operator of the Diavik Diamond Mine, expects to make modifications to the processing flow to remediate this issue by the end of the year. Second, a lower grade has resulted from a shift in underground ore mined from the A-154 South pipe to the lower grade A-154 North underground and A-418 open pit while a revised, more efficient underground mining method is reviewed.
  • A new mine plan and budget for calendar 2011 is under final review by Rio Tinto plc and the Company. The plan for calendar 2011 foresees Diavik Diamond Mine production of approximately 6.9 million carats from the mining of 2.0 million tonnes of ore and processing of 2.2 million tonnes of ore, with the increment delivered from stockpile.
On a related note, the ongoing shift from open-pit mining to underground mining involves higher risk and expense - an image from a recent Harry Winston management deck (click to enlarge):

HENCE, a number of factors are impacting the near- to mid-term earnings forecast. As a result, Wall Street analyst estimates and target prices have been and/or will likely be reduced from prior levels, negatively pressuring shares. No doubt, results and management commentary reminded all investors of the realities and inherent risks related to the mining segment of Harry Winston's business model.

For us, Harry Winston was an asset play (CS$ investment caveat number two), trading well below net tangible book value in late 2008 to early 2009. Like gold, diamonds viewed as a store of value may constitute a reasonable investment consideration. Unlike many investors, we have no gold exposure, instead focusing mostly on growing, cash generating businesses.

Today, the fact remains that Harry Winston has a 40% interest in one of the world's most valuable diamond mines, which are extremely scarce. According to Harry Winston's management deck, economic value derived from diamond exploration is far more scarce than that derived from gold:

AND, the company is successfully expanding its retail presence around the globe with a targeted plan and vision:

We rarely flip-flop immediately following results, but sometimes things change and new analysis alters an investment thesis. This was the case with our PetMed Express (PETS) -- if interested, please see Why We Moved to the Sidelines from last August.

With Harry Winston, our re-calibrated earnings expectations suggest lower implied equity upside for shares of the company. Put another way, we now own shares with a diminished margin of safety. As a result, we plan to reallocate an incremental portion of our Harry Winston position into other ideas where we see higher margins of safety and correspondingly higher potential upside. For now, we will likely retain some exposure to Harry Winston.

One such idea includes our container shipping company Seaspan (SSW), where we recently added more shares and may continue to add. We've also been adding to our 1-800-Flowers.com (FLWS) position in recent weeks/months.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long HWD, SSW, FLWS.

© 2010 Jeffrey Walkenhorst
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