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Is De Beers Achieving its Goals?

Aug 5, 2009 9:00 AM   By Avi Krawitz
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RAPAPORT... The De Beers interim report for the first half of 2009 indicated some strong financial trends for the diamond major. The report, however, was geared toward stressing that the company is achieving its goal of weathering the economic storm that hit the diamond industry during the past nine months.

At the start of 2009, the diamond mining company set out a five-step program to: 

   1. Lower production levels in line with customer demand 
   2. Save costs 
   3. Increase operating efficiencies 
   4. Manage debt 
   5. Stimulate consumer demand

De Beers hinted that the worst was behind them, now that production has resumed and demand at its sights has risen from the historic lows early in the year. De Beers emphasized this by providing separate data for the first and second quarters. The comparison between the two periods was indeed telling (see table 1):

De Beers Table 1.JPG












The company is confident that the current growth trend will continue for the remainder of the year, led by improved sightholder demand, and, more importantly, by an increase in consumer demand. While De Beers has done much to improve its position, and has been effectively proactive in managing the crisis — in certain aspects of its five-point plan — Rapaport News has identified a number of areas of concern that need to be addressed before its true financial position and prospects moving forward can be assessed.

Summary

• De Beers high level of debt stands as its greatest challenge. The banks will likely restructure its $1.5 billion loan facility, but with more stringent conditions.

• De Beers ability to further cut costs is limited.

• While cost savings are filtered through to paying off debt, De Beers investment in new projects will take a back seat in the medium-to-long term.

• The recent surge in demand should be seen as a correction in the rough market, rather than a result of higher demand for diamonds from the consumer. Diamond Trading Company (DTC) sales should peak in August and then soften in the fourth quarter, as rough sales fall back in line with low retail demand.

• DTC sales are expected to decline to approxiumately $3.5 billion for the full year, from $5.93 billion in 2008. To achieve this, the final four sights of the year should yield an average of $400 million to $500 million in sales.

• De Beers full-year production is expected to fall approximately 49 percent to 24.7 million carats. Second-half production is therefore forecast to decrease 24 percent to 18.1 million carats.

• Further increases in rough prices will have a negative impact on sightholder demand and could have dire consequences for the market.



1. Debt Management and Cash Position

De Beers debt position poses the greatest challenge to the company moving forward. Net debt increased to $4.1 billion at the end of June, from $3.8 billion at the end of 2008. (See table 2).

De Beers Table 2.JPG

Of greatest concern is the $1.5 billion loan, payable in the next nine months. De Beers is in negotiations to extend the loan and we believe that it will succeed, particularly as financial markets have been bullish of late. However, based upon the company’s first-half results, which showed a very small profit and a negative cash flow, the matter is not so clear-cut. Should it fail to secure the loan, the alternative would be to go back to its shareholders. It is most likely that the banks will restructure the loan, but with more stringent conditions, e.g. at a higher interest rate, and that De Beers will have to provide better collateral to guarantee the loan.

Directly tied to De Beers' ability to pay its debt is its cash position. Net cash was reported at $622 million as of June 2009, compared with $147 million six months earlier. The majority of this balance was made up of a $500 million loan from shareholders, while De Beers had a net cash outflow of $277 million during the first six months of the year. It is also worth noting that cash consumed by operations was $31 million during the period, compared with $455 million made available from operations a year earlier.

2. Cost Savings and Operating Efficiencies

De Beers changed its strategy well before the economic downturn to focus on profitability rather than controlling the diamond market. In line with this, it disposed of unprofitable assets — most notably the Cullinan and the Williamson operations.

With the temporary closure of most of its operations during the downturn, De Beers said it succeeded in saving $612 million in operating and production costs in the first half of 2009. Of this amount, operating costs consisted of $153 million, down 63 percent from 2008, or a decline of $257 million (see table 3). The company did not provide a separate breakdown of its production costs.

De Beers Table 3.JPG










While much of the savings, particularly in sorting and marketing, were the result of lower business levels, the company’s cost of sales, as a ratio of sales, in fact grew during the period (See table 4).

De Beers Table 4.JPG








Table 4 shows that De Beers output was more expensive to produce in the first half of 2009 than a year earlier. While sales fell 54 percent, and production decreased 73 percent, cost of sales declined by only 47 percent. It therefore appears that the company’s ability to reduce costs is limited given that much of its costs are fixed.

De Beers was able to cut labor costs by downsizing by 23 percent, slashing 4,700 jobs for a total workforce of approximately 15,000 people across its global operations. In addition, capital expenditure was reduced by $241 million during the period, and these savings are being filtered through to paying off debt. The numbers indicate that De Beers has chosen to service its debt rather than invest in future projects or income generation. It appears that it will be some time after the markets recover until De Beers is able to reevaluate its asset portfolio with an eye toward expansion.

3. Dilemma with the Sales Numbers

De Beers total sales — including those from DTC, Diamdel, and its share in De Beers Diamond Jewellers and Element 6 — fell 54 percent to $1.7 billion in the first half of 2009. The majority of the revenues came from rough diamond sales at DTC, where sales decreased 57 percent to $1.4 billion during the period. The DTC numbers indicate that the first and second quarters were not as bad as they, and sightholders, reported.

A few points to note about these figures:

• Production, i.e. goods made available to sell, dropped 73 percent in the first half, while sales included some inventory from the fourth quarter of 2008 — when production was also low.

• While the first six months of 2008 were characterized by strong demand and high prices, the corresponding period this year saw extremely low demand and lower prices.

Given these points, it appears that sales were out of sync with production for the period and that some fourth quarter inventory was probably used up (see section 5). DTC sales were higher than forecasted by Rapaport News during the period.     

The recent increase in demand should be seen as a correction from the lack of production on the market and the lack of manufacturing in the first quarter, rather than a result of higher demand for diamonds at retail. It is not clear that De Beers agrees with this assessment. Gareth Penny, De Beers managing director, has stated that the company believes diamond retail sales in the first quarter were down between 5 and 10 percent and by less in the second quarter. Rapaport News estimates that these numbers are underestimated, and that retail sales fell by closer to 15 to 20 percent. De Beers did note in its report that demand at the retail level remains “subdued” in the U.S., adding that the rate of decline has slowed. Rapaport News believes that the higher rough diamond sales seen in May and June are therefore not a reflection of improved retail demand, and the two markets will level off by the year's end.

Reports from the July sight indicated strong demand for DTC goods, which the company could not fully supply, leaving it with an estimated sight value of $350 million. Rapaport News believes that demand will peak at the August sight as sightholders prepare for Christmas, and will progressively lessen, or at least stabilize at a lower level, at the subsequent sights in October, November and December.

DTC year-end sales are expected to fall to approximately $3.5 billion, compared with $5.9 billion in 2008. Assuming DTC sales so far of $1.75 billion — including Rapaport News estimates for the July sight — sales of approximately $1.75 billion spread between the remaining four sights of the year is therefore a reasonable assumption.

4. Rough Prices

The sales decline in the first half of 2009 was also influenced by the drop in rough prices as compared with the peak period of January through July 2008. Prices are estimated to have decreased between 50 and 65 percent in January, before starting to recover around April. Prices achieved at tender from Gem Diamonds’ Letseng mine rose 47 percent in the second quarter, compared with the first quarter, while Petra Diamonds, Rockwell Diamonds, Trans Hex and BRC Diamondfields all reported a steady and significant month-to-month rise in rough prices through July.

While De Beers is less forthcoming about its sight results, the company’s rough prices were less volatile than the market's. Its prices did not decline by as much in the downturn, and have not increased to the same extent in the past few months as have diamonds on tender, even while reports indicate that DTC raised prices between 3 and 15 percent at its July sight. DTC prices have reached the levels of the first quarter of 2008 but are still about 15 percent below the high point they attained in the third quarter of 2008.

As demand is expected to slow again toward the end of the year to fall in line with the new levels of consumer spending on diamonds, and as sightholder inventories level off, prices should not continue their climb. Further increases will have a negative impact on sightholder willingness to satisfy their hunger for diamonds, and will ultimately harm De Beers’ sales growth. Since demand for rough is ultimately a function of consumer demand, as long as retail sales remain low, higher rough prices will prove unsustainable.

5. Use of Inventory

Given its low sales at the beginning of the year, De Beers had excess inventory from the fourth quarter of 2008, and perhaps before then, since sales were also low at the end of 2008. With production of just 1.1 million carats in the first quarter (see table 1 above), it seems that second-quarter sales depleted that inventory, and that the company is up-to-date with its stock turnover. This is encouraging, and will enable the company to plan ahead more effectively.

6. Production

De Beers has succeeded in lowering production in response to the economic downturn. The aim was to level off supply with the low demand for its diamonds, rather than stockpiling production and dumping inventory on the market when conditions improve. Production fell 73 percent in the first half of the year to an output of 6.591 million carats (see table 5). 

De Beers Table 5.JPG


   











6.1 Debswana (Botswana)

Debswana placed all its mines on care and maintenance for three months, resuming work at the flagship Jwaneng mine, the Lethakane mine and part of the Orapa mine in mid-April. The company kept the Orapa 2 plant closed, but is readying to resume operations in early August. It plans to keep the Damtshaa mine shut until the end of the year. The mines are currently operating at about 80 percent capacity, which would bring Debswana's production to approximately 16 million carats for the year. 


6.2 De Beers Consolidated Mines (DBCM) — South Africa

DBCM took an extended Christmas vacation and subsequently kept mining at extremely low levels, drastically reducing production by 74 percent to just 1.655 million carats in the first half of the year. DBCM’s divestment from the Cullinan mine and its closure of the Oaks mine also contributed to the decline in production.

DBCM’s main focus continues to be on the Venetia mine, which yields about 40 percent of South Africa’s diamonds, on the Finsch mine, which recently underwent a major treatment plant upgrade, and on the recently opened Voorspoed mine. It is likely that the South Africa mines will not ramp up to full production this year and that total year-end production will stand at around 6.5 million carats. 


6.3 Namdeb (Namibia)


Namdeb implemented a three-month production holiday from April to mid-July at its land and sea operations. Currently, just two of its five marine vessels are docked at port. The company has stated it expects 2009 production to fall around 62 percent to 800,000 carats. Depending on demand, this may edge up to 1 million carats for the year. 


6.4 De Beers Canada

De Beers Canada was the only one of the group’s mining units to see a rise in production during the six months, for the simple reason that these are new operations. The company currently has its Snap Lake and Victor Mines on a six-week summer break, and depending on demand, will implement another six-week shutdown in the winter. Production is expected to reach between 1 million and 1.2 million carats by the year's end. 


6.5 Production Forecast


Since most of its production breaks are now complete, De Beers will ramp up its output during the remainder of the year. Production in the second half will be at approximately 80 percent of what it was in 2008, which will allow De Beers to achieve its stated goal of closing the year with half the volumes mined in 2008. Rapaport estimates that production will be spread across its operations as follows:

De Beers Table 6.JPG


7. Stimulating Demand


De Beers continues to lead the way in marketing diamonds to “maximize demand opportunities.” It invested several million dollars in its U.S. Christmas marketing campaign in 2008 and intends to do the same again this year. The company is also a founding member of The International Diamond Board (IDB), the new industry generic marketing initiative, which plans to launch its first campaign around the third quarter of 2010. The onus is therefore once again on De Beers to bring the diamond message to consumers this Christmas. This is vitally important to the industry for the remainder of this challenging 2009. That it has adopted a new approach by partnering with retailers and sightholders is encouraging.

De Beers marketing will focus on two areas. One is expanding the Forevermark brand in the Far East — where, it is clear, De Beers sees future market growth. The company has the brand at 245 locations across Hong Kong, Macau, China and Japan, and is currently expanding into six more cities in China. Secondly, De Beers is developing its “Big Idea” concept with sightholders and retailers, which will be unveiled in time for Christmas, and will focus on the U.S. market.


8. Conclusion

De Beers stated that it will “continue to take a cautious approach in terms of production, sales and cost management, while anticipating the continued steady recovery of the industry.” It needs to. Beyond questions revolving around its profitability for the year, the next two quarters will prove vital in determining whether the company enters 2010 in a position of strength or continued vulnerability. The company will need to better manage its debt and significantly boost cash generation through higher sales. The most effective way to do so is through the stimulation of consumer interest in diamonds. What is true for De Beers is ultimately true for the diamond industry as a whole: Neither can afford another weak quarter.


Reference Tables:

De Beers Table 7.JPG














De Beers Company Structure.JPG
Company Structure Image Courtesy of De Beers

Disclaimer

 

Nothing published by The Rapaport Group of Companies and contained in this report should be deemed to be considered personalized industry or market advice. Any investment or purchase decisions should only be made after obtaining expert advice. All opinions and estimates contained in this report constitute Rapaport`s considered judgment as of the date of this report , are subject to change without notice and are provided in good faith but without legal responsibility.

 

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Tags: Banks, China, Consumers, De Beers, De Beers Canada, Debswana, Diamdel, DTC, Gareth Penny, Gem Diamonds, GIA, Hong Kong, International Diamond Board, Japan, Letseng, Manufacturing, Namdeb, Namibia, Petra Diamonds, Production, Rockwell, Sightholders, Sights, South Africa
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