A LONG ROAD TO RECOVERY
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!!
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....