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Markets Under Pressure

Jul 5, 2001 5:47 PM   By Martin Rapaport
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The diamond markets are under increasing pressure as the trade adjusts to lower levels of demand for rough and polished diamonds. Excess inventory and accumulation of polished diamonds at retail, wholesale and manufacturer levels of the distribution pipeline have drained the trade’s financial resources and severely reduced market liquidity. Retailers and wholesalers have delayed their purchase of new goods until they sell off existing inventory disrupting the regular flow of diamonds from manufacturers to retailers. While some select types and qualities of diamonds are in strong demand and short supply, large stocks of harder to sell goods have built up in the cutting centers.

As was to be expected, the downturn in polished demand has brought about a reduction in diamond manufacturing activity. This in turn has reduced demand for rough diamonds and put severe pressure on rough diamond prices. Discounts for De Beers Diamond Trading Company (DTC) rough boxes have increased significantly with some important categories of DTC rough selling at 5 percent to 15 percent below official DTC list prices. De Beers competitors have already lowered rough prices to reflect current market conditions. De Beers current pricing levels are not sustainable in the short-term and they will have to quickly adjust the pricing and/or assortments of rough in the boxes to significantly improve their profitability.

While the polished trade is adjusting to lower levels of demand from the retail sector by reducing production, extending credit and memo terms, promoting diamond sales programs and lowering prices, they have not yet confronted the significant changes now taking place in the rough markets. Given the unacceptably low level of profitability in the diamond manufacturing and distribution sectors it is unclear if and when lower rough prices will directly translate into lower polished prices to retailers. What is clear is that the rough markets are now being forced to adjust to the new realities of the polished markets and that rough pricing is now demand driven and much more volatile.

Trade concerns that the strong underpinnings of the rough markets are giving way to a new competitive market model are reasonable. A second front has now opened up. The polished markets will be under pressure from the rough supply side of the diamond equation as well as the consumer demand side. While the rationalization of the rough markets and pricing may create short-term price pressure on the polished markets the long-term implications are positive.

A fundamental problem of the diamond industry has been the irrational segregation, or disconnect, between the rough and polished markets. This disconnect resulted in many instances where rough prices were too high in relation to polished prices thereby assuring losses in the diamond manufacturing sector. The new demand driven reality of the rough markets is a very positive development because it promotes the integration of the rough and polished markets into a unified pricing and distribution model. The diamond industry should not fear the integration of the rough and polished markets for in the long term it is the key to assuring optimal competitive market profitability and

product distribution.

The Demand Side

Overall demand for polished diamonds is very weak. U.S. retail jewelry sales are off by about 5 percent due to the decline in the U.S. economy with reports indicating that diamond jewelry sales have fallen more sharply than overall jewelry store sales. In a recent talk with analysts, De Beers managing director Gray Ralfe estimated the decline in worldwide diamond jewelry sales at 5 percent to 7 percent. In the opinion of this writer the decline may be 10 percent or more.

A fundamental problem for the diamond manufacturing and wholesale distribution sector has been the excess inventory positions absorbed by jewelers in 2000. The combination of excess inventory and declining sales have created a situation whereby retailers are not reordering what they sell until they have significantly reduced their inventory positions. The decline in new orders from retailers to wholesalers and from wholesalers to cutters is therefore much greater than the decline in retail jewelry sales.

It is difficult to determine the level of sales decline by wholesalers. Statistics from Israel indicate a 15 percent drop in polished diamond exports for the first half 2001, but not all Israeli polished exports are sales as Israeli firms maintain inventory in the U.S. Furthermore, the return rate on Israeli polished exports jumped to 38 percent in 2001 verses 29 percent in 2000 and Israeli imports of rough declined 21 percent for the first half of 2001. We estimate that sales from the manufacturer and wholesaler sectors to retailers have declined by 20 percent to 30 percent so far this year.

Some analysts see a silver lining in the refusal of retail jewelers to buy diamonds until they have sold off excess inventory. They believe that there will be a surge of new orders when retailers restock. Many are, or were hoping that this reorder period would come about in the second half of 2001. While some large retailers have placed re-orders for loose diamonds and diamond jewelry, the overall trend among jewelers has been to wait and see. Retailers may do some buying closer to the season and at the upcoming NY July show but market demand is weak and new orders are almost non-existent. In the opinion of this writer, a huge surge in orders appears extremely unlikely before first quarter next year and that will only happen if, and only if, there is a strong holiday season.

We will probably see strong memo demand from jewelers as the holiday season approaches. The programs for large retailers by large wholesalers are already underway and several firms have begun to target broad selections of independent retail jewelers with specific memo marketing programs. While these memo programs do get goods out of the safe and onto the retail counters they are not sales and significantly increase the financial burden of the suppliers and the banks financing them. Woe to the diamond manufacturer that gambles on memo sales without the financial resources to take the returns.

Unfortunately, the current oversupply of polished and weak retail demand has created a situation where the diamond trade is often competing on the basis of credit and memo instead of price. Instead of selling diamonds, suppliers are lending them to retailers at high prices. In many instances the trade is not just financing the diamonds on the retail counter, but also absorbing the risk that the diamonds may not sell.

An interesting fallout of the diamond memo and long-term financing game is that so far we are seeing relatively light price competition. Prices at the large wholesaler level have come down a bit and are likely to come down further as rough prices decline. However, prices to retailers and from retailers to consumers have not fallen significantly. This is due to the fact that retailers are more interested in getting diamonds for free at higher prices than paying for them at lower prices. Furthermore, wholesalers and dealers need the extra margin created by lower prices to afford the credit, memo facilities and extra services they provide.

Given the current demand situation and lack of liquidity, the competitive cash market for diamonds has been significantly reduced. At some stage in the near future we expect strong price competition to develop. The diamond industry does not have the financial resources to continue to finance the retail sector while maintaining production inventory levels. A return to liquidity and the redevelopment of efficient price competitive cash markets is inevitable and a necessary prerequisite for the expansion and development of the diamond trade.

The Supply Side

The rough diamond markets are under increasing pressure due to declining polished demand. Cutters are unable to sell through their polished and many have stopped cutting and buying rough. The slowdown is evident everywhere. India laid off hundreds of thousands of workers at the end of last year. Small diamond cutters in Israel who rely on the cash markets for liquidity and sales have also been hard hit. The 21 percent decline of rough imports to Israel during the first half of 2001 is simply one indicator of a much

greater problem.

The key question facing the diamond industry is whether or not declining demand for rough diamonds and the resultant fall in rough prices will destabilize the polished markets. This depends on how much rough is sold and how sharp the decline in rough prices will be. The position of the outside (non-De Beers) rough producers that make up about 40 percent of the market is well established. Essentially these firms sell through their entire production at market prices. They do not stockpile or manage markets and have therefore been lowering prices steadily in the face of declining demand.

The decline in rough prices over the past months and weeks is welcome as it provides the diamond manufacturing sector with the opportunity for improved profit margins. Lower rough prices and indeed lower polished prices are not bad for the industry. They are a natural expression of market forces and very good for the trade if they support profitability in the distribution system and the expansion of markets.

De Beers Prices Too High

The big question is De Beers’ role. Historically De Beers has been the swing producer withholding goods during times of weak demand. But now there is a new De Beers. A De Beers that faces serious challenges as it transitions from a monopoly to a competitive market seller and from a public company with over $12 billion in assets to a private company $3.6 billion in debt.

One immediate problem is that De Beers’ rough prices are too high. Discounts on many of their boxes are running at 5 percent to 15 percent and the sightholders are losing money on them. Things have gotten so bad that the bankers are threatening to stop financing boxes unless De Beers makes them profitable. De Beers can improve the profitability of the boxes by either lowering prices or improving the assortment in the boxes. At this stage they intend to improve the quality of the diamonds in the boxes, provide sightholders with greater freedom in selecting the qualities of diamonds they buy and hold off supplies of hard-to-sell goods as they have done for larger heavy pique rough.

While we support any move that returns profitability to the boxes and brings De Beers rough prices in line with free market levels, this sophisticated “diamond quality inflation” approach is probably not too good an idea. It will unbalance De Beers’ inventory position putting them back into the stockpile game for select qualities of diamonds and create artificial shortages that will in the future be artificial surpluses.

Furthermore, if they release an oversupply of better quality goods to support the value of the boxes, then prices for better quality polished goods such as D-G’s may come under significant price pressure. Perhaps it is time for De Beers to simply bite the bullet and sell through its production without creating artificial shortages or surpluses that disturb the natural availability of diamonds in the pipeline.

De Beers Sales

A much greater problem confronting De Beers and the diamond industry is the level of DTC rough diamond sales for the second half of 2001. De Beers has set a target of $4.8 billion for 2001 (15 percent less than 2000) and has just announced first half 2001 sales at $2.6 billion (26 percent less than first half 2000). To reach its sales projections in the second half it will have to sell 1 percent more than it did in the second half last year (see table).

Given the current dismal level of diamond demand with diamond cutters reporting a 20 percent to 30 percent decline in sales it seems unlikely that De Beers can reach this target without significantly impacting the price of rough diamonds. Obviously, De Beers’ sales targets are not cast in stone and can be updated and revised. In fact we think it will be revised which is why we have lowered our estimate of what it will sell to $4.5 billion which is 13 percent less than second half 2000.

The big point here is that the diamond industry must come to the realization that at some stage, probably sooner than later, De Beers is going to sell through its production on a regular and timely basis. De Beers has $3.6 billion of debt to service and a new policy before the EC that says it will not control, manipulate or monopolize diamond pricing.

While De Beers will probably not take any action that causes a collapse of the diamond markets it is unreasonable to think that the game will go on as before and that De Beers will absorb excess inventory during times of weak demand. Clearly the trade should understand and accept that if De Beers sells through its inventory on a regular basis diamond prices will increase during times of strong demand and decrease during times of weak demand.

Regarding the current market situation, while we would like to see De Beers sell through its entire production on a regular basis so that no artificial shortages or surpluses develop, we must recognize that the difficulties we are now experiencing were partially caused by excess inventory accumulated due to De Beers one time sell off of its stockpile in 1999 and 2000.

Therefore it is reasonable to expect De Beers to hold off a bit on sales in 2001 so that the trade has a chance to dispose of the stockpile goods. Once the stockpile goods have been worked through the distribution system De Beers should no longer hold back goods to support diamond pricing unless extremely unusual circumstances require it to withhold diamonds from the market to protect its asset base. At the same time the trade must stop looking to De Beers to protect them from the natural forces of the marketplace. It is time for the diamond industry to free De Beers of its historic role as guardians of the diamond industry. By giving De Beers its freedom we will gain our own.
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Tags: Banks, Consumers, De Beers, DTC, Economy, India, Israel, Jewelry, Manufacturing, Production, Sightholders
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