Equity Communications 2015
Sharp Observations
and
Keen Insights
Chapter 1 of 8
How to tackle high rough
costs and low profit margins
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Equity Communications 2015
Key Views
The diamond pipeline has made excessive investment in value-addition. Diamond producers have been the
ultimate beneficiaries of such excesses.
Pipeline has now choked from high rough diamond prices, dubious profitability and tepid consumer demand
Many traders agree that higher rough diamond prices have not been helpful for business. So is it possible to
do something about that?
The issue of rough diamond prices has two main viewpoints. We can look at rough diamond prices from the
viewpoint of diamond producers and from the viewpoint of diamond traders and bankers.
There is justification for higher rough diamond prices if you dabble in faulty one-dimensional analysis of the
global diamond industry.
Lower rough diamond prices will not rescue profitability for the pipeline because polished diamond prices
would likely follow them down.
If we can no longer count on banks to inject the liquidity needed to keep prices at artificial levels, then an
overdue steep market correction is inevitable.
The other standout issue is lack of profitability in the pipeline. Profit margins are trending down. So is it
possible to do something about it?
Using 2014 values and all things being equal, 200 diamond processors down from 5,000 would greatly
increase profit per company to $910,000 from $36,400.
Pure diamond processors compete for rough diamonds against businesses that have a different and superior
business model.
While rough diamond processing losses may ruin pure diamond manufacturers, they are not enough to ruin
vertically integrated companies.
Many traders and some countries want to increase production of polished diamonds for reasons that have
little to do with consumer demand.
Many pure diamond processors are dead weight, most of them in India.
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How to tackle high rough costs and low profit margin
Exhibit: Excessive production of polished diamonds
Source: Equity Communications
For more than two decades, the diamond pipeline has made excessive investment in value-addition. Diamond
producers have been the ultimate beneficiaries of such excesses. They have sold massive volumes of rough
diamonds into the pipeline and at inflated prices.
But it is a pyrrhic victory in many ways.
Excessive investment in value-addition in the diamond pipeline has produced diminishing returns over time. The
pipeline has now choked from high rough diamond prices, dubious profitability and tepid consumer demand. It
has barely avoided total collapse because of the generous charity of financial institutions.
But financial institutions have now been overwhelmed by the relentless requests for charity. They have buckled
under pressure.
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Here's where we stand in 2015:
Diamond producers still want high rough diamond prices
Diamond businesses want higher profit margins
Diamond banks want less risk and profitable clients
So how do we balance the interests of all these stakeholders?
The obvious solution is much stronger consumer demand needed to wipe out excess diamond stocks. It's
the only solution that fixes many problems of the diamond industry in one fell swoop. But we are not going to
get it for various reasons.
So what other solutions are available?
I think many traders agree that higher rough diamond prices have not been helpful for business. So is it possible
to do something about that?
High rough diamond prices
Exhibit: Rough diamond prices have outpaced polished diamond prices
Source: Equity Communications, Rough Index is quarterly average; Polished Index is end of quarter
The issue of rough diamond prices has two main viewpoints. We can look at rough diamond prices from the
viewpoint of diamond producers and from the viewpoint of diamond traders and bankers.
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On one hand, diamond producers persistently quote high prices for their product. I think producers genuinely
believe their product is worth a lot more, based on their understanding of supply and demand fundamentals. I'm
sure you have come across a few nice looking charts on the emerging supply and demand imbalance. So there's
justification for higher rough diamond prices if you dabble in faulty one-dimensional analysis of the global
diamond industry.
On the other hand, many diamond traders and bankers believe such high prices are unreasonable because they
only increase costs for the pipeline. High rough diamond prices do not translate into higher prices for polished
diamonds so they reduce profit margins.
But if you have listened to the utterances of Mr Phillipe Mellier (CEO of DE Beers), then you know producers are
reluctant to reduce diamond prices in order to restore profitability for the pipeline.
Diamond producers helped to create the mess in diamond markets but I think they are right to resist calls for lower
prices.
In theory, much lower rough diamond prices increase the profit margin available to diamond manufacturers. Of
course, this assumes polished diamond prices hold steady at the least.
Unfortunately, the expected outcome is quite unrealistic.
Lower rough diamond prices will not rescue profitability for the pipeline because polished diamond prices
would likely follow them down. Rough diamond prices are artificially high but there is also structural excess in
the pipeline. Many diamond traders have product they can't move because there are no takers.
Thus, traders who have become accustomed to wafer thin margins would soon resort back to wafer thin margins
in order to undercut other sellers in the market. It's the only way to move more volume in a pipeline overflowing
with polished diamonds.
I think those who are in favour of lower rough diamond prices would soon regret it once polished diamond prices
start to make a sharper retreat.
Still, I do not believe the market can defend inflated diamond prices for much longer. There's strong downward
pressure on diamond prices because of liquidity problems. If we can no longer count on banks to inject the
liquidity needed to keep prices at artificial levels, then an overdue steep market correction is inevitable. It's
going to hurt real bad.
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In the final analysis, those who desire respite from high rough diamond prices are going to get it. But the respite
will also bring about even lower polished diamond prices.
Moving on, I think the other standout issue is lack of profitability in the pipeline. Profit margins are trending down.
So is it possible to do something about it?
Low profit margins
Exhibit: Fundamentals of polished diamond production in a democracy
Source: Equity Communications, based on 2014 metrics alone (full cycle)
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The diamond pipeline has invested too much in the production of polished diamonds. Unfortunately,
consumption growth has not been strong enough to absorb excess production. Consequently, the profit pool from
sales is no longer adequate and sustainable for everyone.
For this reason, starting at the entrance, there is currency in the idea that 200 to 250 mid-sized companies can
process all the rough diamonds produced in a single year. Using 2014 values and all things being equal, 200
diamond processors down from 5,000 would greatly increase profit per company to $910,000 from $36,400.
In 2014, diamond producers generated $17.5 billion from rough diamond sales to traders. After value addition,
these rough diamonds produce polished diamonds with a market value of up to $23.6 billion. In other words, the
approximately 5,000 diamond processors have to share $6.1 billion from value addition services. It comes out to
about $1.2 million per company. From this figure, we subtract labour costs and other business costs to get a profit.
Earnings from diamond manufacturing activities average 3 percent so we get about $36,400 profit per diamond
processor.
But the market is not democratic. There are diamond processors making much more than $36,400 profit. That
also means there are diamond processors making much less than $36,400 profit, most of them in India. I suppose
it works out after you factor in India's GDP per capita and standard of living.
Anyway, in reality the average profit from diamond processing is probably much lower than $36,400. We have to
factor in excess stocks in the pipeline, rough diamond prices that increase faster than polished diamond prices,
and polished diamond prices that sometimes fall while rough diamond prices are increasing.
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How to improve profitability in the diamond pipeline
Since profit available in is no longer adequate for everyone, it can be increased in three ways:
1. The consumer market for diamonds is expanded
2. The number of players in the diamond industry is reduced
3. A combination of number one and two
Number 1 increases the size of the market for everyone. More sales of diamond jewellery equals more profit to
share.
Number 2 means that fewer businesses can participate in the market. Same level of sales but more profit to
share.
Number 3 is the best. More sales and more profit for fewer participants.
The supply contract system of leading diamond producers helps to implement number two. According to
calculations by Equity Communications, contract clients bought at least 61 percent of rough diamonds sold by
producers in 2013. That's about 132 buying groups or less than 3 percent of diamond processors.
Diamond processors often redistribute into secondary markets some of the rough diamonds bought from
producers. Nonetheless, producers are working hard to eliminate the need for contract clients to resell unwanted
diamonds. They are trying to match allocations with manufacturing requirements of contract clients. It's easier
said than done but success would greatly alter the processing landscape.
In my view, I believe the diamond pipeline has to eliminate pure diamond processors because they are no longer
competitive. Pure diamond processors compete for rough diamonds against businesses that have a different
and superior business model. Thus, industry stakeholders have to decide whether pure diamond manufacturers
still have an important role to play in the diamond pipeline.
Part of the reason why producers have been so successful in pushing up rough diamonds is because of vertically
integrated buying groups. Vertically integrated diamond manufacturers have the ability to recover costs and
make profit from downstream operations. That is how they can withstand high rough diamond prices.
Furthermore, any losses from in-house processing activities offset the margin that would have to be paid to
polished diamond traders. Thus, while rough diamond processing losses may ruin pure diamond
manufacturers, they are not enough to ruin vertically integrated companies.
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If you believe the process of procuring rough diamonds to produce polished diamonds is an expense centre, then
profitability of the process is not your immediate concern. Costs can be recovered further down the diamond
industry value chain.
If you believe the process of procuring rough diamonds to produce polished diamonds is a revenue centre, then
profitability of the process is your immediate concern. The majority of pure diamond processors are of that view.
But the writing's on the wall for pure diamond processors. Their business model is no longer sustainable. That
aspect of the diamond business is commoditized, with many extra participants (dead weight). Skills are relatively
easy to master and the main competitive advantage is access to good quality rough diamonds, which they don't
control.
How pure diamond processors make money
Without other avenues of making money from diamonds, diamond traders only buy rough diamonds if there are
able to make money from the resulting polished. Each mined diamond determines how it will be cut and where it
will be cut. Therefore, to make the most money from a diamond, the aim is to optimise yield and quality of the
diamond. This is where use of cutting-edge technology adds the most value.
There's also need to account for labour. The aim is to make use of productive highly qualified cutters and
polishers. The ideal in diamond processing is optimal speed, precision and perfection.
But it all comes to nothing when the main ingredient is too costly. In the last fifteen years, diamond producers
have greatly increased prices for rough diamonds and threatened the long-term viability of pure diamond
processors.
Diamond processors have tried to play defence. The following are some of the counter measures that have been
tried:
1. Diamond processors have worked hard to improve yield so that they get more out of expensive rough.
Costly diamonds have inspired greater use of technology and innovation.
2. They have also tried to reduce labour costs. Technology transfer and accumulation of processing
acumen has reduced the skills divide and enabled global proliferation of rough diamond processing
centres, particularly in the last decade.
The goal is to optimize yield and quality at the cheapest labour centre and then increase volume of
production.
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Of course, the diamond processor can rearrange other business processes to squeeze out more profit. But if
rough diamond prices are persistently higher, there are diminishing returns over time.
At the basic level, if you cannot pass onwards high raw material costs, the diamond manufacturing business
becomes less profitable with each new increase in rough diamond prices. Tenuous profit margins are squeezed
further.
I believe pure diamond processors reached breaking point in 2012. It is no longer possible to make profit from all
rough diamonds bought for processing and onward selling. Consequently, the diamond processor has to make
as much profit as is possible from his best diamonds so that he offsets losses from his unprofitable
production.
Indeed, some diamond processors have remained in business only because of generous bankers. But diamond
banks have now tightened lending terms and are no longer so understanding. Thus, worsening liquidity problems
are likely to push many processors out of business, assuming lending terms remain tight.
Earlier I said industry stakeholders have to decide whether pure diamond processors still have an important role to
play in the diamond pipeline. Their profitability is no longer certain and it's doubtful that it can be restored. In
other words, they have lost competitiveness.
Lack of competitiveness is sufficient reason for elimination. Still, there's another and perhaps more important
reason for elimination.
Let's go deeper into the issue that's at the core of problems in the diamond industry.
For more than two decades, the diamond pipeline has made excessive investment in value-addition. Three
stakeholders created the problem of excess stocks now pulling down the global diamond industry.
Diamond producers oversupplied the pipeline, particularly from 2000 to 2008. Diamond processors
converted the oversupply of rough diamonds into oversupply of polished diamonds. Lastly, diamond banks
were enablers because of their loose credit policies.
Consumer demand is necessary for sustainability of the diamond industry. Nevertheless, rough diamond
producers and rough diamond processors make their money long before diamonds are sold in consumer
markets. Producers sell to rough diamond traders and processors while processors sell to polished diamond
traders, jewellery manufacturers and retailers.
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I'm sure rough diamond producers and processors care about consumer demand. But the reality is that the
consumer market is not that important for their business models. To be sure, it used to matter much more but
that changed in 2000.
Since 2000, the business model of diamond producers is to sell as many diamonds as possible to diamond traders
at the highest possible price. What happens to those diamonds once they enter the pipeline is not of major
concern.
The business model of diamond processors has always been to process as many diamonds as possible for
onward selling. Higher volume of sales equals more profit.
Since 2000, bankers have injected generous liquidity into diamond markets and enabled diamond producers and
processors to pursue their business models to the fullest.
Consequently, there has been massive production of polished diamonds for many years. Polished diamonds exit
the diamond pipeline in consumer markets but demand has lagged supply. Thus, the substantial volume of
polished diamonds in the pipeline has provided backbone for the rise of circular trade in international
markets.
But excess supply and circular trade threaten diamond equity. The foundation of consumer demand for
diamonds is based on steady prices of diamond jewellery. Thus, there's need to restore balance in diamond
market before price risks from oversupply ruin the image of diamonds.
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How to eliminate excess supply in the diamond pipeline
Three things are required
1. Much stronger consumer demand
2. Restraint in new supply of rough diamonds
3. Elimination of dead weight in the diamond pipeline
The need for restraint in new supply of rough diamonds is straightforward. Producers oversupplied diamonds for
many years. But now they have to do the opposite so that excess stocks can be drawn down.
The need for much stronger consumer demand is also straightforward. Consumer demand for diamonds has
grown in emerging markets like India and China. But it has also gone down in mature diamond markets like
Japan and USA. Thus, demand from emerging markets has not been strong enough to absorb excess stocks.
Here is a working definition of dead weight:
dead weight - A person who just takes up space and has nothing to really offer any of his or her peers. Someone
who is just not a team player and may even be a brick wall to some.
There is excess supply of polished diamonds in the pipeline. Still, many traders and some countries want to
increase production of polished diamonds for reasons that have little to do with consumer demand. For
instance, India might support its diamond industry to increase export revenue and employment for locals.
But it's counter-productive to increase supply of polished diamonds in a surplus market. The result is greater
circular trade and depressed polished diamond prices. And that's why there's need to eliminate dead weight.
Many pure diamond processors are dead weight, most of them in India.
Thing is, diamond processing ability is no longer adequate as a skill set. Everyone can produce polished
diamonds but not everyone can sell polished diamonds. Both skills are now required. In a surplus market, it's
counter-productive to produce diamonds that have no takers.
Polished diamonds exit the diamond pipeline in consumer markets. For this reason, it is now logical for producers
to sell rough diamonds only to buying groups who demonstrate ability to move product in consumer markets.
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Perhaps it didn't matter so much in the past because the De Beers cartel worked hard to stimulate consumer
demand for diamonds. Everyone benefited from De Beers' generic promotion of diamonds. But things are
different now. No single stakeholder can afford generic promotion of diamonds so it has to be a collective
effort.
Since there's no collective effort, the industry has to rely on the individual efforts of industry players. But that's an
endeavour best suited to integrated diamond trading networks or supply chains. To this end, it makes sense for
diamond producers to enter into distribution partnerships with those that are in a position to help with marketing.
The way I see it, no one who cannot survive the low-margins that exist today in the mid-stream qualifies. Their
business model is wrong and unsustainable in the current diamond market. They are dead weight.
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A short thousand words to start with,
I'm a director and major shareholder of Equity Communications through Sibling Investments. Equity Communications is the
holding company for our commodity trading businesses.
In addition, the company has a Finance and Economic Research Division. Chiefly, the division exists to scrutinize and endorse all
investments above $100,000 made by shareholders of Equity Communications and their associate companies. It is my job to
arrange and recruit intellectual talent for this division.
In 2010, I put together a Diamond Industry Research team made up of five persons, which I disbanded in December last year.
Our interest in diamonds was triggered by the prospect of a US$2 billion diamond industry in Zimbabwe. We have a bit of
money invested in various sectors of the Zimbabwe economy so we couldn't ignore it. $2 billion for an economy like
Zimbabwe's is a huge deal. It changes a lot of things. So we had no choice but to investigate.
Anyway, we have known for about three years that such projections were pure hogwash. To be sure, the potential for a
massive diamond industry is there in Zimbabwe. It's just that economic illiteracy is far more prevalent.
We then turned our attention to the global diamond industry. We look for projects that scale within five years. Unfortunately,
the best opportunity we identified is in lab-created diamonds (LCDs). LCDs are coming and it's going to be a deluge. Obviously,
growth of LCDs is potentially negative for Botswana's economy so it's not something we are too excited about. Ultimately, we
chose not to pursue any investments in the diamond industry.
Still, I made the decision to release our final research on the diamond industry because I believe many people will benefit from
it. I meant to get it done in February but we've had a lot of tobacco and food commodities to trade. So it's been coming slowly.
Nowadays I mainly follow the diamond industry from the writings of Rob Bates, Charles Wyndham, Avi Krawitz, Edahn Golan
and Ehud Laniado. For anyone who's short on time, reading articles from these gentlemen is a good way to stay current on
goings-on in the diamond industry.
Even so, over the years we collected and curated lots of data on the global diamond industry and precious jewellery markets.
We became experts by accident. Now I can confidently say I know a great deal about factors that drive the diamond and
jewellery business even though I no longer have much use for the knowledge.
But that's ok. Ten years ago, I learnt German for a year in preparation for a visit to Frankfurt only to end up in Mozambique. I
can't remember most of what I learned but I did gain a flourishing friendship with one of my former classmates.
So maybe all that knowledge will be useful for something I look at in my spare time. How will 3d printing of jewellery disrupt the
jewellery retailing model? So far it's a fascinating journey. I think it's going to be a game changer for e-commerce. Could be
very disruptive too.
Anyway, I agree with Chaim Even-Zohar (D.I.B, 27 April 2015) on the current state of diamond industry research. Indeed, the
more the diamond industry gets over researched, the more it seems to be under-performing. His words, not mine. But I agree.
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I'm all for optimism but the diamond industry urgently needs a good dose of reality. And I don't think we are getting it from the
likes of Bain and De Beers.
Maybe the target audience is different because there's just too much smoke and mirrors. Don't get me wrong, their research
provides good overview of the diamond industry. I've made generous use of it myself. But I think it glosses over the bad and
uncomfortable stuff.
Too bad. I don't see how the diamond industry can conquer its countless challenges while its head is buried in the sand.
Anyway, I suspect many diamond industry stakeholders just want assurance that everything is going to be ok. Still, many do see
that they are being driven towards the cliff.
From our experience, good diamond industry research is time-consuming and complex. It has to be a slow and methodical
process because there's too much written garbage to plough through.
Frankly, it takes too much time and effort and maybe that's why many people just choose to regurgitate information published
elsewhere. Sadly, most of what's put out there is appalling.
But I really hope someone will throw serious resources into it. Maybe that's a challenge for the recently formed Diamond
Producers Association.
With this in mind, I do hope we can point people in the right direction with our final publications on the diamond industry and
precious jewellery markets. I don't think we got everything right but these are serious complex issues that need sorting out.
Finally, it's not included in the reports, but some of our research points to harmful things going on in the so-called silk route.
Africa to Dubai to India (rough diamonds). From India to Dubai (polished diamonds). There are things going on there that are
potentially problematic for the image of diamonds. FIFA type of things, in my view. It has to be sorted out before someone like
Andrew Jennings gets to it. One only needs to scrutinize the statistics and you can see strange things going on. And it tallies
with some of the bad media reports that pop up every now and then.
State of Diamonds 2015
Part 1: Diamond Pipeline
Part 2: Diamond Consumption
There are two distinct markets for diamonds. Diamonds are a commodity in the pipeline and a luxury good in consumer market.
I think the separation is important for analysis. Most analysts don't know how to reconcile the two and that's why we get
problems.
Moreover, diamond industry stakeholders need to thoroughly understand the factors that drive consumption of diamonds.
Stronger consumption of diamonds has to multiply from somewhere and so far it's been a struggle. Without it, the diamond
industry is stuck in long-term attrition.
Sincerely,
Tinashe Takafuma
Equity Communications.
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Equity Communications 2015
Dark clouds and silver linings
Economic Context
Global Economic Backdrop
Global Economy Risks
Sharp Observations and Keen Insights
6
14
Key Research Findings
Diamond Supply
Diamond Price Indices
Forecast Diamond Supply 2025
31
39
45
How to tackle high rough costs and low profit margins
Look to diamond banks for direction of diamond markets
The right and wrong way to look at diamond supply and demand
Speculation and informational gaps in diamond markets
Systemic risks in international diamond markets
59
72
87
102
119
Can diamond industry stakeholders now collaborate to save diamond markets
134
Road to survival and riches
How lab-created diamonds threaten dominance of natural diamonds
153
160
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of insights and analyses
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