Clifford Elphick, chief executive and largest single shareholder in mining group Gem Diamonds, is not letting concerns about a US recession or global credit crunch interfere with his expansion plans. The company, which raised £550 million last year when it floated on the London Stock Exchange and followed that with a series of acquisitions around the world, has completed the building of a second plant at Letseng, its key mine in the southern African kingdom of Lesotho, to double its annual production of high-quality stones to 101,000 carats, worth an estimated $200 million (£100 million) at an average price of $2,000 a carat.

That is many times the world average of $91 a carat for uncut diamonds.

In the diamond business, values rise disproportionately for larger stones and those with particular brilliance, colours and other special features.

Gem has cut costs and boosted production at the Ellendale mine in Western Australia after buying its previous owner, Kimberley Diamonds, for £131 million last year and hopes to produce 600,000 carats from the mine this year, with 730,000 carats on the cards for 2009. The company intends to embark on a new project at Gope in Botswana, costing some £225 million over three to four years, and is eyeing expansion and acquisition opportunities around the world.

A former managing director of E. Oppenheimer & Son, a company at the heart of the international diamond business as owner of 40 per cent of world leader De Beers, and himself South African, Elphick echoes the views on the diamond market recently expressed by Gareth Penny, De Beers’ chief executive officer. Penny said demand for high-end diamonds was ‘very, very strong’, though he expects sales of smaller, lower-quality gems in the key US market to be ‘pretty flat’ in the second half of this year.

Referring to the high-quality Letseng output, with stones typically ranging from 20 to 70 carats, Elphick says: ‘The US economic problems and credit crunch have not impacted on us yet. If anything, we are seeing upward pressure, from rich individuals in China, Russia and the oil-producing countries.’

Letseng, which Elphick describes as head and shoulders above Gem Diamonds’ other present operations, should be able to continue producing at its increased rate for 46 years, with average margins of 50 per cent. He says group output will fall short of this year’s target of one million carats only because of environmental problems at the company’s Cempaka mine in Indonesia and difficulties at its non-core operation in the Democratic Republic of Congo.

Elphick has his eye on more, and has lately been sounding out potential new acquisitions without as yet agreeing on price. He thinks there could conceivably still be pickings from De Beers’ portfolio in Botswana, though that has now mostly been cleaned up. He also says he wants to be ‘head of the queue’ for any discussions about the future of base metal giant Rio Tinto’s diamond interests – including Argyle in Western Australia, which produces a third of the world’s natural diamond output – if world mining leader BHP Billiton’s £75 billion bid for Rio Tinto succeeds and the diamond side is held to be a ‘non-core’ activity.

Argyle produces 35 million carats a year, though they are mostly small, low-value stones averaging only $7 a carat, and, as such, might be vulnerable to easing demand. But the scale would be such as to transform the company for the long term.

Gem Diamonds, which increased pre-tax profits last year more than sevenfold to £29 million, on sales trebled to £72 million, has no debt and says it will deploy its existing cash flow to help fund developments such as Gope, though it does suggest it could go to the banks for some project finance to ‘leverage’ the operation, if and when debt markets return to normal.

Strategy
Since flotation, Gem Diamonds has pursued a strategy of securing high-quality potential or producing diamond properties, where its own skills and access to finance can enhance performance and profitability. Elphick says he has three growth plans: one purely organic, a second envisaging the acquisition of two more ore bodies and a third taking major chunks of a combined BHP-Rio Tinto.

It was Rio Tinto that had worked Letseng in the 1950s. De Beers opened it in the 1970s, only to become embroiled in a dispute with the Lesotho government in 1982.

De Beers pulled out and sterilised the plant, but another South African group, Johannesburg Consolidated Investments, headed by maverick entrepreneur Brett Keble, reopened it a few years ago. Gem Diamonds took it over in 2006 when Keble was vulnerable, entangled in a bitter and labyrinthine corporate dispute elsewhere, which culminated in his own mysterious death.

Elphick says the mine is now exhibiting exactly the same ‘size and frequency curve’ in its distribution of diamonds as the company predicted and is producing in the same way as under De Beers. Letseng is low grade, with an average of only a little more than two carats per tonne of earth, but that is more than compensated for by the size and quality of its stones.

In 2006, the 603-carat Lesotho Promise, the 15th-largest diamond in the world, sold for £6.2 million, and last year Gem Diamonds sold the 493-carat ‘Letseng Legacy’, the world’s 18th-largest, for £5.2 million. Last month, ten diamonds from Letseng totalling 261.4 carats fetched an average of $42,000 a carat.

According to Elphick, the best prices per carat are realised not by the very largest stones but by those in the 20- to 70-carat range, where the risk to the buyer is lower. Now Letseng is set to double production from two kimberlite, hard rock sources, the company has decided to improve margins further by starting its own polishing operation for the highest-value stones.

Using high technology and lasers, the polishing activities, scheduled to start by January, will be based in Mauritius and Dubai. Gem Diamonds’ aim is to win some of the hefty margins made between sales of rough, mined diamonds and the retail market for cut and polished gems.

In Western Australia, the company gained control of Ellendale through what some felt was a keenly priced £131 million bid for Aussie-quoted Kimberley Diamonds. Ellendale was losing money at the time, but Gem Diamonds was able to cut unit costs by doubling throughput of ore to 8.5 million tonnes a year, with 10.5 million in prospect for 2009.

The company says it has sorted out plant bottlenecks at Ellendale and increased selling prices to 20 per cent by convincing merchants it was no longer a cash-strapped forced seller. Elphick argues that Gem Diamonds has improved geology and mine planning at Ellendale and is evaluating new ore bodies there to extend the life of the mine.

The company says a strong Australian dollar is the principal cloud on Ellendale’s financial horizon but prefers not to take the risk of currency hedging. It has looked at another Australian company, Blina, with adjacent alluvial (river bed) operations, where Gem Diamonds already has a stake. Elphick sounds unimpressed by the way it runs things, but says ‘it is very much in our minds’.

Cempaka in Indonesia came into the company through another takeover last year, the £42 million purchase of AIM-quoted BDI Mining, then chaired by entrepreneurial Australian David Lenigas (now boss of Lonrho). Seen as a ‘special case’ because of the variously coloured stones it produces, Cempaka recently had production suspended for two months over an environmental dispute, but Elphick insists this is now resolved and production will resume ‘imminently’.

Less central to Gem Diamonds’ plans are its ventures in the Congo, Angola and the Central African Republic. The Congo is rich in gems but presents formidable and costly infrastructure problems, though the company is trying to find the hard rock source of the alluvial diamonds there.

Management
Elphick, whose Gem Diamonds Holdings owns nearly 15 per cent of the company, knows his way round the diamond business better than most. After joining the Anglo American diversified mining colossus in 1986, he became personal assistant to the legendary Harry Oppenheimer, head of the whole group. Anglo encompassed gold, coal, platinum and a range of minerals, as well as other South African activities, from breweries to food.

But diamonds, through De Beers, were seen as the Oppenheimers’ first love. After serving on the boards of Anglo and De Beers, Elphick founded Gem Diamonds in 2005.

The same stable has provided the company’s key people. Terry Stewart, chief operating officer of Gem Diamonds, spent 20 years working for Anglo and De Beers. The chief mineral resource manager, Graham Wheelock, has 23 years’ experience with Anglo and De Beers and chief financial officer Keith Burford worked for the same two groups for two decades.

Roger Davis, the company’s non-executive chairman who joined the board last year, is from a different mould. He is the former chief executive of Barclays’ UK banking division.

Prospects
Gem Diamonds’ efforts to increase production and profitability at its key mines and its continuing quest for new ones, backed by strong finances and cash flow, augur well for its prospects – provided a world recession, engulfing China, Russia and the emerging economies as well as the West, does not knock the stuffing even out of gems at the top of the market. Analysts’ estimates of pre-tax profits for the current year range from £35.5 million to £54.5 million, with £70 million on the cards for 2009.

The planned move into polishing should add something to margins, and more success on the exploration front would provide another fillip to future profits. Gem Diamonds’ own organic growth and acquisition strategy could put it in an interesting position if another wave of consolidation sweeps the sector.

Resuming output at Cempaka will help the bottom line. Meanwhile, the company hopes to start building another mine at Gope in Botswana next year, which should enhance longer-term supply prospects.

The chief imponderables remain how long the expensive end of the retail diamond market will stay firm and how successful Gem Diamonds’ future exploration efforts will be.

Valuation
Quoted diamond producers of any size have become something of a rarity these days and could become even rarer. Of the giants, De Beers is no longer public, Alrosa is Russian, tightly held and not publicly traded, and BHP Billiton and Rio Tinto are not pure plays and could possibly exit the business.

That gives Gem Diamonds a certain rarity value, to say nothing of longer-term possibilities of corporate deals amid further industry consolidation. At a price of £10.30, against a 52-week high of £11.91 and an 830.5p low, the shares trade at a modest discount to brokers’ most cautious estimates of net present value, while most precious metals producers command a premium.

The shares are not without risk. But on a medium- to long-term view, they should outperform the sector.