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Between Rough & Retail ‎

Editorial

Nov 16, 2012 6:00 AM   By Avi Krawitz
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RAPAPORT... For news junkies in the diamond industry, this past week was a relatively exciting one. ‎And for once it wasn’t De Beers making the headlines. This time, BHP Billiton completed ‎its diamond exit by agreeing to sell the Ekati mine in Canada to Harry Winston for $500 ‎million, while further west, ALROSA signed a two-year deal to supply rough diamonds to ‎Chow Tai Fook. ‎

Significantly, it was two jewelry retailers which were the main beneficiaries, moving ‎further into the rough diamond space. While neither of the agreements came as a ‎surprise, both served to strengthen each of the parties involved. ‎

From a geopolitical perspective, a Russia-China tie-up in the industry is interesting and ‎one wonders why it took so long for ALROSA to find a foothold in the Far East. ALROSA ‎has been building its long-term client base over the past few years and this week’s deal ‎marks its first foray with a China-focused client – barring its sales on a spot deal basis. ‎The mining company now has 35 such clients, typically hailing from Russia, India, Israel ‎and Belgium, and, it seems, only one of which is now a retailer. ‎

Perhaps most important, however, is the strength of its new client given the weak market ‎conditions. Already, ALROSA has held back supply in the past six months, even selling to ‎Gokhran again, and must be on the lookout for willing and able buyers.‎

For its part, Chow Tai Fook appears to be on the hunt for rough diamonds and intent on ‎gaining a competitive edge over manufacturers as it seeks out the best goods. As a ‎result, the Hong Kong-based company, which is considered the world’s largest jewelry ‎retailer with more than 1,600 points of sale across greater China, has evolved to rank ‎among the largest buyers of rough diamonds in the market today. In addition to the new-‎found ALROSA supply, the company has three De Beers sights in London, Botswana ‎and South Africa and is also a Rio Tinto Select Diamantaire.  ‎

To illustrate its growth in this sphere, the value of Chow Tai Fook’s inventory of raw ‎materials for gem-set jewelry rose to $953 million (HKD 7.39 billion) as of March 31, ‎‎2012, from $384 million (HKD 2.97 billion) a year earlier. In fiscal 2012, about 46 percent ‎of polished diamonds used in its jewelry were manufactured in-house – either at its two ‎facilities in South Africa or at its factory in Shunde, China.  ‎

This column has noted in the past the growing trend among retailers to buy up rough (see ‎editorial: Retail Diamantaires, published on May 11, 2012). Today, Tiffany & Co., Graff ‎Diamonds, Gitanjali Gems and Chow Sang Sang rank among De Beers largest ‎sightholders and it seems Chow Tai Fook is taking the lead among them.‎

They’re able to gain better margins from the rough than their wholesale manufacturing ‎counterparts given the cost benefits from their spread across the pipeline and that their ‎brands garner better prices at the retail level. From a miner’s point of view, retailers are ‎probably a little less complaining than their other clients, and it could well be that retailers’ ‎ability to buy rough has helped buoy prices over the past year. ‎

It is therefore interesting when a retailer itself becomes a fully-fledged miner. ‎

If rankings count for something, Harry Winston’s Ekati purchase has lifted it to be the ‎world’s third largest diamond miner by value and fourth largest by volume. Combining ‎Ekati with Harry Winston’s 40 percent stake in the Diavik mine, the company would have ‎had combined production of about 4.7 million carats in 2011 whereas rough diamond ‎sales would have exceeded $1.2 billion. Not a small amount – unless we’re talking BHP ‎Billiton revenue standards – and Ekati adds significantly higher value production to the ‎Harry Winston mix.‎

Analysts at RBC Capital Markets noted that the price paid for the mine was at the very ‎low end of expectations. The current weak rough market probably gave Harry Winston ‎some bargaining power.  ‎

Still, there are risks involved. Whereas Diavik is operated by Rio Tinto, which owns the ‎other 60 percent share, Harry Winston will be the one to operate Ekati. In addition, Ekati ‎has a limited life and may require significant future capital investment to extend the ‎operation. RBC’s analysts conservatively give Ekati another five years but with some ‎‎“decent” options for extension. ‎

‎“From a mining perspective, we view the acquisition as a positive for Harry Winston, ‎which we believe will add decent operating, cash generative and likely [net present value ‎‎(NPV)] positive asset to its existing stake in the Diavik mine, although luxury brand-‎oriented investors are likely to be less enthused,” RBC wrote, adding that it was those ‎luxury-focused investors that probably caused the company’s share to lose 2.5 percent ‎value on Tuesday after the deal was announced. ‎

Indeed, all eyes now turn to Harry Winston’s luxury segment, especially after rumors ‎circulated less than a month ago that the company was in talks to divest from retail. ‎Harry Winston confirmed that it has received various indications of interest to purchase ‎the luxury business, but stressed it is not in active negotiations. It subsequently raised its ‎credit facility to $300 million for the luxury segment. ‎

However, the verdict is still out whether a jeweler can effectively coexist as a major ‎miner. While its roots are, in fact, in mining – having started off when Aber Resources ‎found Diavik back in the nineties – the company later bought the iconic Harry Winston ‎name as it sought a mechanism to understand the price of polished to better value its ‎rough. ‎

Philosophies aside, the luxury segment evolved to be a cash cow for the company, ‎accounting for about 55 percent of total sales and offering significantly better margins ‎than the mining business. RBC estimates the luxury business could sell at a substantial ‎premium, for well above $1 billion.  ‎

But Harry Winston offers a vastly different business model to the Chow Tai Fooks of the ‎world. Its rough supply is very much more of a pricing reference mechanism than a tool ‎to improve its retail margins. As a niche luxury retailer, it doesn’t require the scale of ‎rough supply that a mass market jeweler might. The two segments are therefore not as ‎intertwined as one might think.‎

Rather, it seems that the company simply sees greater upside potential in the rough ‎diamond space. If it has given itself a choice between the two, the decision has clearly ‎been made on mining – possibly with the other eye on Rio Tinto’s Diavik stake. Divesting ‎from the luxury segment may not make sense looking at the stand-alone business, but it ‎may be required to finance its mining ambitions. ‎

Such a move would further validate the prevalent positive long-term rough price ‎projections. And it would certainly encourage retailers to procure more rough supply at ‎prices perhaps only they can afford. This week’s deals marked a further consolidation of ‎the diamond industry, highlighting the strength of the two opposite ends of the market. ‎They were therefore a win-win for everyone involved, except, maybe, those caught ‎between the rough and retail. ‎

The writer can be contacted at avi@diamonds.net.

Follow Avi on Twitter: @AviKrawitz

This article is an excerpt from a market report that is sent to Rapaport members on a weekly basis. To subscribe, go to www.rapnet.com or contact your local Rapaport office.


Copyright © 2012 by Martin Rapaport. All rights reserved. Rapaport USA Inc., Suite 100 133 E. Warm Springs Rd., Las Vegas, Nevada, USA. +1.702.893.9400.

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Tags: Avi Krawitz, Harry Winston BHP Billiton Ekati Chow Tai Fook ALROSA Rio Tinto Rapaport Diamonds
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