A LONG ROAD TO RE­COV­ERY

Solitaire - - FRONT PAGE - By Pranay Narvekar

A year ago, I had said that the in­dus­try had worked its way into a “chakravyuh”, from which the exit would not be easy. While the gen­eral con­di­tions within the in­dus­try have im­proved, es­pe­cially over the last six months, we are not out of the woods yet.

The mood in the in­dus­try has vis­i­bly bright­ened over the last 12 months. 2014 has been healthy for most com­pa­nies, with one hear­ing few com­plaints. The vol­ume of sales in the in­dus­try has picked up and com­pa­nies have seen prof­its over the last 6-7 months. The con­fi­dence for the rest of the year is high. While con­cerns are still ex­pressed over the man­u­fac­tur­ing vi­a­bil­ity, the sce­nario seems much bet­ter than in 2013.

The in­dus­try ben­e­fit­ted from the tail winds of the 2013 sea­son which was pos­i­tive, and it fu­elled sales in Q1 2014. This de­mand helped grease the wheels of the in­dus­try, which was grind­ing on in the sec­ond half of 2013.

For 2014, the de­mand sce­nario for the in­dus­try looks to be sta­ble, with re­tail pol­ished whole­sale price (PWP) growth ex­pected to be about 3-3.5% glob­ally for the in­dus­try. This seems to be driven by the seem­ingly un­end­ing sup­ply of global money be­ing pro­vided by the cen­tral banks. It can be ques­tioned whether the cen­tral banks are en­ter­ing their own “chakravyuh”, by keep­ing the money taps open. That said, our in­dus­try con­tin­ues to en­joy its ben­e­fits. De Beers es­ti­mates be­ing even more op­ti­mistic. This de­mand growth is ex­pected to con­tinue at these lev­els over the next few years.

De­mand growth helped re­ju­ve­nate the trans­ac­tion cy­cle. This, cou­pled with im­proved mar­gins, es­pe­cially as prices of both rough and pol­ished moved up helped im­prove the in­dus­try bot­tom line. On an av­er­age, pol­ished prices are up about 5% and rough is higher by about 7-10% in 2014.

The in­dus­try strug­gles in the lat­ter half of 2013 had meant that rough prices had soft­ened, which brought back mar­gins into man­u­fac­tur­ing. How­ever, the price in­creases in rough in 2014 have re­moved that ad­van­tage. Scratch­ing the sur­face of this sta­bil­ity you see a dif­fer­ent pic­ture.

Rough Prices: “Spec­u­la­tive” or “An­tic­i­pa­tory”

Old habits seem to die hard in the in­dus­try, which has again started over­pay­ing for the rough. The line be­tween pay­ing “spec­u­la­tive” or “an­tic­i­pa­tory” prices for rough is very fine. While man­u­fac­tur­ing might not look vi­able at to­day’s pol­ished prices, it looks vi­able at the pol­ished prices ex­pected by the time the pol­ished is pro­duced. Pay­ing “an­tic­i­pa­tory” prices is like pro­ject­ing the run rate for the next five overs in a cricket match based on run­rate in the pre­vi­ous five overs, un­mind­ful of the fact that a wicket has fallen on the pre­vi­ous ball. Pay­ing “spec­u­la­tive” prices

Pay­ing “spec­u­la­tive” prices is like pro­ject­ing the run rate in the power play overs to be much higher than the run rate in the pre­vi­ous five overs, ir­re­spec­tive of the num­ber of wick­ets in hand.”

is like pro­ject­ing the run rate in the power play overs to be much higher than the run rate in the pre­vi­ous five overs, ir­re­spec­tive of the num­ber of wick­ets in hand. It means un­vi­able rough is pur­chased in the hope that the prices would have gone up sig­nif­i­cantly by the time the pol­ished is pro­duced, en­abling the com­pany to make ex­tra­or­di­nary prof­its , or even hop­ing to sell the rough it­self, for a profit in a few months.

To my mind, both sce­nar­ios are sim­i­lar, and both amount to bet­ting on price move­ments. In any busi­ness, what is re­quired is a con­sis­tency of ap­proach. If we in­tend to price rough on the ba­sis of cur­rent prices, we should do so in both cases when prices are ris­ing as well as when prices are fall­ing. This would mean that in pe­ri­ods when prices rise, you make a greater profit, as you are pay­ing lower than sug­gested by “an­tic­i­pa­tory” pol­ished prices and when prices are fall­ing, you make the equiv­a­lent loss as you are pay­ing more than “an­tic­i­pa­tory” pol­ished prices. This ap­proach would en­sure less volatile rough pric­ing.

It was prob­a­bly one of the thoughts be­hind the sight sys­tem, where De Beers would in­crease rough prices when the in­crease was “sus­tain­able”. This meant that while dia­man­taires op­er­ated on slim mar­gins, they were al­most as­sured of reg­u­lar stock ap­pre­ci­a­tion, which com­ple­mented mar­gins and com­pen­sated the in­dus­try for the fi­nan­cial risks which they were tak­ing. This think­ing has now been dis­carded, as rough pro­duc­ers are un­able to re­sist the urge to raise prices fast in a ris­ing mar­ket. In a fall­ing mar­ket, they are slow in re­duc­ing prices.

The erst­while di­a­mond pro­ducer BHP was the torch bearer for mar­ket­de­ter­mined pric­ing of rough. They staunchly sup­ported their ten­der­ing sys­tem and held ten­ders even dur­ing the 20082009 cri­sis. Their ten­der prices served well as an in­di­ca­tor of mar­ket con­di­tions. In the fol­low­ing years, as rough prices tested new highs, it was con­sid­ered as the sys­tem which would be­come the pre-em­i­nent rough di­a­mond sale mech­a­nism. The au­thor felt oth­er­wise, de­spite oth­ers like even De Beers and Botswana launch­ing their own rough di­a­mond auc­tion sys­tems. De Beers is even ex­per­i­ment­ing with auc­tion­ing con­tracts!!

With the sale of BHP’s di­a­mond divi­sion to Do­min­ion com­plete, it was a sur­prise when Do­min­ion an­nounced that they would be mov­ing to a sight sys­tem. Clearly the two years since mid-2012, has made them change their mind. The pri­mary is­sue with a mar­ket-based pric­ing sys­tem is that it’s fast to re­act to price changes in both di­rec­tions, up and down. While it might be con­ve­nient dur­ing times of ris­ing prices, it does not work well when prices fall. Such a sys­tem will be in­her­ently more volatile as it is based on ex­pec­ta­tion of fu­ture prices.

Mov­ing to a sight sys­tem re­duces this vari­abil­ity, some­thing which would be looked at pos­i­tively on the stock mar­kets as well. With BHP, the vari­abil­ity did not mat­ter as part of BHP’s over­all re­sults. For Do­min­ion, whose main busi­ness is di­a­mond min­ing, the price vari­abil­ity di­rectly af­fects their profit vari­abil­ity. For them, lesser volatil­ity in prices, and hence prof­itabil­ity, will be looked upon

The Amer­i­can mar­ket had al­ways been driven by price points, but the Chi­nese mar­ket was more driven by the de­mand for bet­ter qual­ity di­a­monds. That changed in 2011, when prices for di­a­monds went up over 30-40%.”

more kindly by their in­vestors. The added ad­van­tage of this sys­tem en­abling higher pric­ing power is prob­a­bly just a bonus. I guess every­one likes to eat their cake and have it too!!

De­mand Har­mon­i­sa­tion

The big un­cer­tainty in this equa­tion are the re­tail­ers and the con­sumers. A ma­jor­ity of con­sumers do not buy di­a­mond jew­ellery for their in­vest­ment po­ten­tial, as you would ex­pect with say gold. While di­a­monds may have their emo­tional ap­peal – with the jew­eller’s fa­mous rule of three months’ salary for an en­gage­ment ring – it will still have a bud­get. And con­sumers’ in­comes are not re­ally grow­ing that fast any more.

This means that con­sumers would al­ways ap­proach di­a­monds with a “bud­get” in mind, driv­ing re­tail­ers to be­come “price point” driven. That in turn puts im­mense pres­sure on di­a­mond buy­ing, as qual­ity might be com­pro­mised with, in order to meet price and mar­gin tar­gets.

The Amer­i­can mar­ket had al­ways been driven by price points, but the Chi­nese mar­ket was more driven by the de­mand for bet­ter qual­ity di­a­monds. That changed in 2011, when prices for di­a­monds went up over 30-40%. Con­sumers in China, started down trad­ing, and moved into lower qual­i­ties. China is now very much an SI-VS qual­ity mar­ket, as com­pared to the pre­vi­ous de­mand for VS-VVS qual­ity. On the other hand, as re­tail­ers started fo­cus­ing on price points, the size of the stones was also re­duced from the ¾ and 1 carat stones to the 30-40-50 point­ers.

This de­mand har­mon­i­sa­tion be­tween the two largest mar­kets meant that the trends and de­mands across mar­kets started be­com­ing more spe­cific and over­lap­ping.

Hence, cer­tain sizes and qual­i­ties could be in de­mand and could rise in prices, how­ever the broader range of goods re­mains un­der price pres­sure. Cus­tomers are also will­ing to buy what is re­quired, but are hes­i­tant to pur­chase larger parcels, caus­ing the de­mand to frag­ment.

This poses a unique prob­lem to pro­duc­ers as well as dia­man­taires, as the tra­di­tional meth­ods of as­sort­ing parcels and cre­at­ing mixed parcels is un­der pres­sure. This means that while the goods in de­mand will be sold quickly, the re­main­der of the un­sold goods takes much longer to sell. This skews the stock in favour of the non-mov­ing goods, af­fect­ing the fi­nance re­quire­ments as well as prof­itabil­ity.

Shoring Up Liq­uid­ity

Liq­uid­ity con­tin­ues to re­main the pri­mary con­cern for com­pa­nies in the busi­ness. The ex­po­sure re­duc­tion by the global banks con­tin­ues to be slower than ex­pected. While lim­its have been re­duced, it has not af­fected the util­i­sa­tion, as unutilised lim­its were sur­ren­dered. While the easy part for banks was car­ried out, what re­mains would be much tougher to ex­e­cute.

At a global level, the con­trac­tion in liq­uid­ity is af­fect­ing busi­ness. Bank Leumi has de­cided to exit the busi­ness, while the An­twerp Di­a­mond Bank has to re­duce its ex­po­sure, as part of the terms of its buy­out by pro­posed Chi­nese buyer. If the deal falls through, it could be even worse, as there could be a pos­si­bil­ity that the en­tire bank needs to be dis­solved. Stan­dard Char­tered, pos­si­bly the largest lender to the sec­tor, con­tin­ues to re­duce ex­po­sures, as man­age­ment per­cep­tions about the in­dus­try seem to have changed at the bank.

The only game still in town are the In­dian banks. Their con­fi­dence in the in­dus­try is clearly shaken, but they have thank­fully not turned their backs on the in­dus­try.

Bank­ing Sem­i­nar – Un­der­stand­ing the Trust Deficit

This trust deficit be­tween the banks and the in­dus­try was clearly ex­pressed dur­ing the bank­ing sum­mit which was held in the last week of June. The sum­mit was well at­tended by peo­ple who mat­ter (see the re­port else­where in this is­sue). The sem­i­nar high­lighted the con­cerns which the banks have about the in­dus­try and it prob­a­bly gives point­ers to what steps the in­dus­try should take.

In Q1 2014, In­dian banks in­creased sanc­tioned lim­its, and some in­crease in util­i­sa­tion was vis­i­ble. How­ever, the bulk of the lim­its could not be utilised, as Ex­port Credit Guar­an­tee Cor­po­ra­tion (ECGC) had stopped pro­vid­ing cov­er­age on the ad­di­tional lim­its. ECGC had hit two con­straints – based on their cap­i­tal, they could cover only a cer­tain amount of ex­po­sure; and the sec­toral ex­po­sure to the gems and jew­ellery in­dus­try was fairly close to their in­ter­nal cap of 20% ex­po­sure to any one sec­tor.

Banks typ­i­cally cover a large part of their ex­po­sure through these credit poli­cies. Typ­i­cally these cover about 50% of their ex­po­sure, as it helps them bring down their risk weigh­tages and hence re­duce their cap­i­tal al­lo­ca­tion. Hence, banks asked for a 50% col­lat­eral to al­low com­pa­nies to utilise their sanc­tioned lim­its.

The only quick so­lu­tion to this sit­u­a­tion is if the banks agree to re­duce the amount of cover they would like against their ex­po­sures. While re­duc­ing that cov­er­age to 40% might do the trick, it would still mean

Liq­uid­ity con­tin­ues to re­main the pri­mary con­cern for com­pa­nies in the busi­ness. The ex­po­sure re­duc­tion by the global banks con­tin­ues to be slower than ex­pected. While lim­its have been re­duced, it has not af­fected the util­i­sa­tion, as unutilised lim­its were sur­ren­dered.”

While 2014 has been a step in the right di­rec­tion, it de­pends too much on a con­tin­ued rise in prices. That is too much to ex­pect in this mar­ket, which is still find­ing its feet. The cur­rent ex­u­ber­ance in rough prices will soften as more sup­plies en­ter the mar­ket.”

that banks need to al­lo­cate more of scarce cap­i­tal to this sec­tor. It is a moot ques­tion as to whether they would do that and if so, what would be the im­pact on the cost of fund­ing to the sec­tor.

The other con­cern ex­pressed by banks was on the trans­parency in the sec­tor. As an in­creas­ing num­ber of com­pa­nies are into mul­ti­ple busi­nesses, from di­a­mond pol­ish­ing to jew­ellery to re­tail, the bankers are con­cerned that the funds lent to one busi­ness are used for pur­poses other than what they were bor­rowed for. The funds could also be put to other uses in­clud­ing real es­tate or stock mar­ket in­vest­ments. This makes banks wary of lend­ing to the sec­tor, as they could be hit by un­re­lated losses in other sec­tors.

Trans­parency will be­come a ma­jor is­sue with banks, go­ing for­ward. Apart from the us­age-of-funds is­sue men­tioned above, the in­dus­try needs to take a more ac­tive ap­proach to how funds are trans­ferred and that pay­ments are against the cor­rect in­voices. The in­dus­try is used to keep­ing a run­ning ac­count ap­proach, where the to­tal out­stand­ing is viewed and not nec­es­sar­ily the in­di­vid­ual trans­ac­tions. Go­ing for­ward, that will need to change, where ev­ery trans­ac­tion needs to be closed.

What was re­as­sur­ing to take away from the Sum­mit was that banks are not pulling away. The growth in con­sumer de­mand will en­sure that the busi­ness sen­ti­ment will re­main pos­i­tive. While the growth is not spec­tac­u­lar, it con­tin­ues to be steady. The growth will also en­able sta­ble pric­ing over the next year as well as good stock ro­ta­tions. The mar­ket ro­ta­tion cy­cle has clearly restarted, and the in­dus­try needs to use this pos­i­tiv­ity to re­build the eq­uity in the in­dus­try. That is the best buf­fer it has against the var­i­ous head­winds.

In the ar­ti­cle last year, I had etched out two ex­treme sce­nar­ios, one utopian, where every­one be­haves ra­tio­nally and for the greater good, while the other sce­nario was more a doomsday one. In real life, it was ex­pected to pan out some­where in be­tween as it did.

While 2014 has been a step in the right di­rec­tion, it de­pends too much on a con­tin­ued rise in prices. That is too much to ex­pect in this mar­ket, which is still find­ing its feet. The cur­rent ex­u­ber­ance in rough prices will soften as more sup­plies en­ter the mar­ket.

The ex­pec­ta­tions of banks from the in­dus­try have changed. The in­dus­try needs to adapt those changes and bring in more trans­parency. It can­not con­tinue to op­er­ate as it has in the past. The fu­ture of fi­nanc­ing the in­dus­try will de­pend on whether com­pa­nies bring in more trans­par­ent work­ing pro­ce­dures and the abil­ity of those who get fi­nance to use it re­spon­si­bly.

Pranay is an in­de­pen­dent con­sul­tant who fo­cuses on de­mand and sup­ply, strate­gic, fi­nan­cial and struc­tural prob­lems of the di­a­mond in­dus­try. He has over 13 years of con­sult­ing ex­pe­ri­ence, and had worked with Rosy Blue for nearly six years. pranay@pharos­beam.com

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