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Diamond Industry 2004
Nov 4, 2004 1:20 PM
By Martin Rapaport
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The following article is based on Martin Rapaport’s presentation at the Rapaport International Diamond Conference 2004.
Our goal is to try to understand the changes taking place in the diamond industry and how these changes will affect our business. Over the past few years the diamond industry has grown increasingly complex and difficult to understand because so much is happening at the same time. Diamantaires and retailers know that the diamond business is changing in ways that threaten their very existence, but they do not know what to do about it. For many it’s not just that they do not know where the market is going, they do not know where they are going.
Rough shortages combined with the implementation of De Beers Supplier of Choice (SOC) initiative have tightened rough distribution to intolerable levels. Cutters unable to source rough diamonds, yet desperate to remain in business, have bid up rough prices to unsustainable levels. The extreme price surges in the rough markets have impacted polished prices for expensive large diamonds and inexpensive small stones. Diamond prices have become much more volatile as the irrational exuberance and speculative fever of the rough markets confront the hard realities and cold cash requirements of the polished markets.
While a reduction in rough supplies due to the sell-off of De Beers inventory has been mitigated by an increase in supply from Canada’s new Diavik diamond mine, a 50 percent drop in diamond production from Australia’s Argyle mine has severely reduced the availability of inexpensive small diamonds. With significant increases in global diamond demand expected from China, India, Arabia and the Far East, tighter supplies of rough are expected to result in shortages of polished. As demand exceeds supply for select diamond qualities, prices will increase. Large retailers will have to come to terms with the fact that diamonds are a natural product with inherent supply limitations dictated by natural availability. You can’t order Mother Nature to supply thousands of identical diamonds with highly selective quality and price-point characteristics. As the natural availability of supply declines relative to demand, the premiums that retailers will have to pay for large quantities of very selective identical product will increase. Retailers wishing to protect their profit margins will have to learn how to sell broader ranges of diamond products that are in line with market availability.
Distribution
The challenges presented by real shortages of rough diamonds are minor when compared to what is going on in the distribution system. De Beers SOC initiatives coupled with downstream marketing and branding initiatives by other mining houses have created a situation where suppliers have become obsessed with the need to shorten the distribution system so as to maximize profits. This is accomplished by cutting out middlemen and their polished diamond bourse markets. Everyone’s supplier’s supplier is trying to sell their customer’s customer. Not only are rough suppliers and polished manufacturers aggressively venturing downstream, but retailers are also doing everything they can to cut out middlemen by sourcing direct from rough suppliers or their proxy manufacturers. If you are “just” a diamond dealer, everyone is trying to get rid of you.
BHP’s Canadmark®, De Beers Forevermark®, De Beers retail stores, Aber’s purchase of Harry Winston, Tiffany’s partnership in Canada’s Diavik diamond mine, Zale’s and Wal-Mart’s visits to India to buy direct from suppliers are not isolated events. They are all part of the same story — the consistent tightening of the distribution system so as to increase profit margins. Marketing and branding warfare are not the root cause of the changes we are seeing, they are merely the symptoms and by-products of a huge shakeout that is taking place in the diamond trade.
Retailer’s should not be complacent and believe that the distribution revolution is limited to diamond-market players. What is going on in the diamond trade is nothing compared to what will happen at retail. Wal-Mart is the largest jeweler in the world. It is growing larger, becoming more efficient and will take huge marketshare from small independent jewelers. Costco with its 14 percent gross margin, I to VS1 plus strict quality control and certificate business is selling product at prices retailers cannot compete against. Sure, the shopping experience Costco provides is no competition to a serious jeweler, but it and others like it are selling increasing amounts of diamonds and diamond jewelry to consumers. Questions need to be asked. What is the shopping experience worth to a consumer and how much does he want to pay for it? If consumers’ know exactly what the shopping experience costs them would they want it or would they expect the shopping experience for free? Can retailers with high overhead and expensive distribution justify their higher prices in a market with highly transparent competitive prices? Is an educated consumer the best customer for a traditional high-end retailer?
The internet is not only pushing detailed price information to consumers and helping to commoditize diamonds, it is also selling diamonds. While internet jewelry sales are currently only 2 percent to 3 percent of the U.S. market, they grew by 50 percent last year — how many retailers are growing at that rate? And look at their profitability. In 2003, internet retailer Blue Nile sold $129 million, generating a net profit of $27 million or 21 percent net profit margin. (Tiffany’s net profit margin is 11 percent.) Blue Nile went public this year and its current market cap is about $450 million. How many retailers are doing that well?
The issue is not just the internet, commoditization, Costco or Wal-Mart, it is the impact that all of them individually and collectively have and will have on distribution. The great wave of change revolutionizing the diamond trade from rough mining to polished wholesaling will not stop at the retailer’s door. The distribution revolution will continue all the way down to the consumer level. Everyone will be affected as competition drives global market integration and disintermediation, product quality and pricing transparency, and hyper-efficient alternative product delivery systems that will revolutionize the distribution system.
Regulatory and Economic Environment
Government regulations, credit considerations and a changing economic environment will also have great impact on the diamond industry in the near future. The Kimberley Process (KP) has implemented strict controls over sourcing and shipping of rough diamonds to protect our trade’s integrity. The new, soon-to-be-released USA Patriot Act with its strict cash reporting and “know your customer” guidelines will have a much greater impact on the polished diamond and jewelry business. The old way of selling diamonds — no questions asked — will have to change. This will undoubtedly have implications for the use of diamonds as a store of value for unofficial money. We must resist the temptation to trade diamonds without invoices so as to protect our integrity and the integrity of the international diamond trade.
Diamond industry credit practices are expected to come under pressure over the next year. The current global debt level of $9.2 billion is unsustainable. Not only is the use of extensive credit to sell product taking industry risk to unacceptably high levels, but interest rates, which are currently very low, are sure to rise. Once interest rates rise, industry credit practices will no longer be an issue of self-discipline. We simply will not be able to afford to sell diamonds with expensive credit terms. As the cost of money increases, there will be pressure throughout the diamond pipeline to reduce inventories. If interest rates move significantly higher and the industry remains as undercapitalized and over-inventoried as it is now, we would expect diamond prices to fall.
While the changing economic environment will have definite impact on diamond prices and markets, a discussion of these complex factors is beyond the scope of this article. We do note that the global economy is highly unsettled and this will significantly increase uncertainty and volatility in the diamond markets. Over the medium term, we expect significantly higher interest and inflation rates. The very weak dollar, record high oil prices at over $50 per barrel and very high gold prices at $425 per ounce are all indications that we are entering into an insecure global economic environment.
Additional important factors include the changing role of governments in Africa, with increasing control over their diamond resources to insure black empowerment and local beneficiation; huge increases in demand from China, India and the Far East; treated and synthetic diamonds; changes in laboratory grading reports; and a host of additional issues to numerous to detail in this article.
What Is Happening
By now it should be clear. The diamond industry is undergoing fundamental, unprecedented great changes that are creating complex interactions throughout the entire diamond distribution system.
By fundamental we mean that some of the changes are irrevocable and long term and that they will alter or even uproot the very foundations of how the diamond business works. This is particularly true of the diamond distribution system.
By unprecedented and great we mean that we are seeing changes that have never happened before and that some changes are big enough to shake out even the largest and best companies if these companies do not adapt to the new realities.
The ways that the changes are impacting the diamond industry are complicated due to the fact that they are happening simultaneously at different levels of the distribution system. Furthermore, the distribution system itself is forcing new interactions that cannot be easily generalized or predicted across the system. While the results of specific actions taken by individual players can be analyzed, overall system uncertainty is at a very high level.
Simply put, it looks like too much is happening at the same time — too many people at too many levels. We may be heading into the perfect storm as numerous systems interact to create an “exciting” environment. Exciting does not necessarily mean negative, particularly for those firms that know how to optimize opportunities in changing environments.
Another message should also be clear: Everyone is affected; diamond miners, cutters, wholesalers, jewelry manufacturers, retailers, bankers and governments are all subject to a rapidly changing and uncertain environment.
The point here is that no one should think that they will evade the consequences of the changing environment. It does not matter who you are, where you are, what you do or how big you are. If you have anything to do with the diamond business you should recognize the need to understand the changes taking place in your environment and what you should do about them.
What To Do
The key factor to success is to identify and implement activities that lead to sustainable real added value. Most often this is an area of activity where your unique strategic market position, skills, human resources, capacity and/or capability provide an opportunity for us to add value. It is important that our added-value profits be sustainable, meaning that they generate a net profit appropriate for their level of investment and risk assumption. Due to the competitive nature of markets, the profitability and sustainability of an added-value proposition will often be directly proportional to the benefit provided by its unique selling proposition.
We must recognize that there are many ways to add value that are not sustainable. For example, a diamond cutter who charges $100 per carat cutting the same types of diamonds in the same way that they can be cut in China for $15 per carat is adding value, but this added value is not economically sustainable because it is not priced competitively. Adding value in and of itself does not assure success unless it generates sustainable profits.
The same holds true for retailers. An extremely upscale retailer who provides an incredible shopping experience at a 400 percent markup may find that customers prefer a slightly lesser shopping experience at a 120 percent markup. This added-value proposition may fail because it is not competitive in terms of the cost-benefit proposition being offered the customer.
Marketing and Branding
De Beers SOC has done a great job waking up the trade to the need for marketing and now many in the industry believe that marketing and branding is their best opportunity to add value to diamonds. This may be true. However, diamond marketers should be careful not to provide added value propositions that fail because the cost-benefit proposition to the customer is not justified.
Just because you have something good or better does not mean it is worth what you are asking for it. Often the problem is not the cost of the item, but the perceived value of the product to the consumer. For example, you may have a great cost-benefit proposition with inferior distribution. The problem then is not the price or the product, but rather how the product is distributed. To succeed, you must get everything right.
We must recognize that developing, maintaining and marketing brands is a sophisticated venture that requires independent management. Just because you mine, cut, process or trade diamonds does not mean that you have a better chance of branding them than anyone else. In fact, your knowledge of diamonds and desire to sell what you own may be a disadvantage as it creates conflicts of interest that limit your branding perspective. While the idea of going downstream and creating diamond brands is intuitive, the fact is that there is negligible downstream advantage for diamond firms. If you want to create a diamond brand you are probably better off buying the diamonds from someone else rather than cutting them. That is what De Beers is doing with their brand.
Commoditization
Commoditization is often seen as the enemy of branding. If an item is traded at a known quality and price then some say it cannot be branded. Frankly, this is not true. The value of a brand is directly tied to its added value and unique selling propositions. The question that every brand must face is what is the extra price or sales margin that can be obtained from the added-value proposition? If consumers buy into your added value, they will buy your brand and pay what they think it is worth.
The question for branders and anyone else trying to make a living in the diamond trade is what are you doing to, or with, the product that makes it more valuable? If you are not doing very much then you are not entitled to much of a profit margin.
Commoditization, with its standardization of product quality and pricing, is the driving force behind the development and maintenance of efficient markets. Efficient competitive markets are the only optimal way to allocate scarce resources. Commoditization and the free, fair and competitive markets it creates are the best way to get the right diamonds to the right people at the right prices.
This writer strongly supports the development of commoditized diamond markets and does not believe that such markets unfairly limit or restrain the development of added-value marketing initiatives, including brands. Commoditization creates a level playing field as it establishes a base price for a commodity. Then it is up to the marketers and branders to add value and get compensated based on the amount of value they add.
Let us accept the notion that the optimal way for the diamond business to operate is that all added-value players should be fairly compensated based on the amount of value they add. Furthermore, the amount of “fair compensation” should be set by free, fair, efficient and competitive market forces.
The reason that commoditization terrifies many diamond retailers is that they do not believe their added-value propositions can stand up to the transparency provided by fair markets. They do not believe they can sell their products at the profit margin they need if the buyers are educated and knowledgeable about price. Their added-value propositions cannot stand in the light of day and so they want to make sure that no one turns on the lights. They seek a dark world where buyers know less about price and value so that they can make money due to the fact that their customers do not really know what is going on. In the view of this writer, these people are free riders trying to make more money than they deserve from the diamond business.
Another free-rider problem is the manipulation of the diamond distribution system so that suppliers can steal some of the added value that retailers add to the diamonds they sell. Say a retailer has a great added-value proposition, but he can only source his diamonds from limited suppliers. Since the retailer is doing well and has limited sourcing options, his suppliers will seek to increase prices so that they can capture some of his added value.
One of the problems of De Beers SOC is that it pushes sightholders downstream so that De Beers and their sightholders can capture downstream profits. If in fact the sightholders create these profits through their added-value propositions then they deserve the profits, but if the retailer creates the profits and the only reason the sightholder is raising prices is because the retailer cannot get the diamonds elsewhere then the sightholder is a free rider.
The development of commoditized competitive diamond markets is very important, essential and positive for the diamond industry because it creates a barrier and a free zone separating suppliers and resellers. Suppliers who do not add marketing value to their diamonds get a fair free-commodity market price. Buyers who do add value also get the same fair free market price, but they can then make money based on the amount of added value they can generate — no more and no less.
Consider and compare this with the gold markets. If someone needs gold, there is a market price. If they simply flip bullion, then their profits are miniscule. But if they make very fine gold jewelry, they often make large profits. Buyers — be they jewelry wholesalers or consumers — all know the price of gold, yet this has not destroyed the gold jewelry business. On the contrary, the availability of fair gold markets has supported and greatly enhanced the development of the gold jewelry sector.
The bottom line is that we must recognize the need to develop, maintain and promote free, fair, open and competitive markets that assure equal opportunity for all.
Way to the Future
We must recognize the demand for diamonds is emotional and not utilitarian. The need for love and its symbols is far greater and more important than desire for mere physical products. While commoditization sets the price for a base product, the base product is not what the diamond jewelry business is all about.
There are unlimited opportunities for creating excellent, extremely profitable added-value propositions once we understand that we are not selling a diamond product, we are selling the idea behind diamonds. The idea is that men and women desire a symbol of their love commitment. They are willing to pay for that symbol — not because they need it — but because they want it.
Satisfying that want is what the diamond business is all about.
The type of love symbols that we create and how we position them in the mind-set of our customers is the key to the diamond business. Let us make it crystal clear that the commoditized price of a diamond has very little to do with the value to the consumer of the love symbols we create. How well we create love symbols and the values that we support them with is what the future of the diamond industry is all about.
Let us now close this article with two quotes:
“I don’t think there is anything higher than love. I mean I’m not sure what could possibly come after love because love is so expansive. I had such a difficult time coming up with a definition for Love in my book, but the way I define Love as the selfless promotion of the growth of other. So to me, if you selflessly promote the growth of your customers and your colleagues, that’s true Love. I don’t know what more you could do for someone.”… Tim Sanders, chief solutions officer, Yahoo!
“The idealism of love is the new realism of business. By building respect and inspiring love, business can move the world.”… Kevin Roberts, CEO worldwide, Saatchi & Saatchi in his book Lovemarks: The Future Beyond Brands.
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Tags:
Argyle, Australia, China, Consumers, De Beers, Diavik, Economy, Government, Harry Winston, India, Jewelry, Kimberley Process, Production, Sightholders, Tiffany, Zale
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