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MIDSTREAM

Following a challenging year in 2015, more normal trading conditions have returned to the diamond industry’s midstream in the first half of 2016 as a result of the actions taken to address inventory indigestion.

Sustained success is likely to require ongoing efforts from midstream businesses to reduce their risk profiles, to enhance their use of technology, to strengthen their B2B brands and to develop their interactions with downstream customers.

2015 SNAPSHOT

While consumer demand for diamond jewellery remained relatively robust in 2015, the rough diamond trading environment was tougher, making it a much more difficult year for the diamond industry’s midstream businesses.

These traders, cutters, wholesalers, polishers and jewellery manufacturers saw a number of interconnected issues lead to severe inventory indigestion in the industry pipeline (Fig. 9).

In light of the challenges relating to supply, demand and profitability, a number of responses helped to normalise trading conditions.

Upstream, the major diamond producers responded to the reduced demand for new rough diamond supply by either reducing production or selling less production.

They also provided customers with greater supply flexibility, enabling them to defer purchases that had been set out in buying plans without any impact on future supply levels. Cutting centres also played a key role in rebalancing midstream inventories by sharply reducing their manufacturing output during this period.

Meanwhile, downward adjustments to rough diamond prices, coupled with reduced rough diamond production, helped with midstream participants’ profitability issues.

Click to enlarge.

On the demand side, De Beers invested heavily in additional category marketing activities in the US and China. It also launched a new Forevermark campaign. Combined with the investments in diamond marketing from other major brands and retailers, these actions stimulated consumer demand for diamond jewellery strongly enough to trigger a significant increase in footfall and sales over the all-important holiday selling season.

As a result of these actions, the first half of 2016 has seen rough diamond demand improve, with midstream businesses replenishing inventories that were depleted by holiday season sales.

FIG. 10: KEY DEVELOPMENTS IN MIDSTREAM FINANCING

ASSET SECURITISATIONS

In addition to some existing programmes, new securitisation vehicles have been launched by midstream businesses in 2016 with receivables acting as the underlying assets for the securitisation.

PACKAGED FINANCE PROGRAMMES

A leading insurance firm is brokering its own packaged finance solutions for midstream players, placing an insurance ‘wrapper’ around conventional midstream assets (ie stock, receivables) and offering these as commercial paper to capital market investors. Another financing entity is exploring a similar solution for rough purchase finance.

NOTES ISSUES TO THE CAPITAL MARKETS

A notes issue to finance inventory has proven to be successful in raising significant funding. Meanwhile, working capital assets have also been successfully packaged into commercial paper.

SYNDICATION DEALS

A leading lender to the industry co-ordinated the issuing of a syndicated loan in 2015 for a major midstream business, which in turn attracted several new lenders into diamond financing.

BOND ISSUES

A recently reissued bond placed by a financial institution for a midstream business was fully subscribed.

Increasingly, midstream players are likely to draw their funding from hybrid models, including elements of traditional bank finance as well as participation in other more progressive options.

LOAN GUARANTEES

The Overseas Private Investment Corporation (OPIC), the US Government’s development finance institution, signed a loan guarantee that will help Botswana develop its diamond manufacturing sector by making further financing available to businesses with cutting and polishing factories in the country.

FIG. 11: HOW TECHNOLOGY DEVELOPMENTS MAY BENEFIT MIDSTREAM BUSINESSES

AUTOMATED CUTTING AND SHAPING TECHNOLOGY

This has the potential to boost efficiency and consistency in the manufacturing process.

It also provides an opportunity to reduce the lag between the purchase of rough diamonds and the sale of the resultant polished stones.

It will likely be especially useful for businesses with factories in diamond producing countries where there is a focus on improving productivity.

This could become increasingly important as the momentum for cutting and polishing operations moving to producer countries appears set to continue in the coming years. De Beers’ recent Sales Agreement with the Government of the Republic of Namibia, as well as its Enterprise Development Project for Diamond Beneficiators (in partnership with the South African government and the South African diamond cutting industry), also highlights this trend.

SYSTEMS THAT ENABLE BETTER INTEGRATION BETWEEN SUPPLIERS’ AND RETAILERS’ INVENTORIES

These have the potential to deliver significant benefits to midstream players’ ability to forecast demand.

They could also enable more efficient inventory management, thereby reducing the risk of a repeat of the indigestion seen in 2015.

FIG. 12: HOW MIDSTREAM BUSINESSES MAY ENHANCE THEIR BRAND TO DOWNSTREAM PARTICIPANTS

Strong brand propositions will be especially important for midstream players when working with downstream operators to prevent the commoditisation of diamonds at retail. This has been a growing problem due to increased online price transparency, more focus on grading reports and a dearth of compelling brand stories.

Midstream businesses that can offer retailers the opportunity to purchase products that are accompanied by a narrative that makes them stand out for something other than price (such as design innovation, traceability of product through the pipeline, or extraordinary craftsmanship) will have a substantial advantage over those providing undifferentiated offerings.

Offering retailers support on co-brand building and global category trends may also make midstream players more valuable to downstream partners. Many smaller retailers value their midstream suppliers’ support with store design, explaining product stories and industry insights.

These kinds of collaborative approaches also offer midstream businesses the opportunity to establish more sustainable suppliercustomer relationships, which can be challenging to achieve due to midstream fragmentation and the highly competitive landscape.

FIG 13: INDUSTRY ANALYST INTERVIEW

Kieron Hodgson, Commodity and Mining Analyst, Panmure Gordon & Co

WHAT IS YOUR VIEW ON THE ACTIONS THE INDUSTRY TOOK IN 2015 TO ADDRESS THE INVENTORY ISSUE?

Our view on the actions taken by the major producers last year was a rare example of industry participants realising that something had to be done. At the time, inventory levels were too high, with fear and despondency dictating sentiment and transactions. Looking back, the actions were successful to a point; however, as inventory levels creep up again, should they reach the levels as before, would similar actions be taken? We hope so.

WHAT SHOULD MIDSTREAM BUSINESSES FOCUS ON IN THE NEAR FUTURE?

Without wanting to dictate to those who are perfectly able to manage their own businesses, we feel the risk to the availability of reasonable commercial lending facilities remains a major risk to growth. However, within this argument, manageable leverage ratios and higher equity investments tend to reduce the risks inherent to cyclical businesses. We also feel that increased consolidation throughout the midstream may in turn strengthen the negotiating hand when considering the relative margins at the midstream level, versus those at the industry’s bookends, producers and retail.

WHAT IS YOUR VIEW ON THE FUTURE OF INDUSTRY FINANCING?

While ADB and Standard Chartered reducing their exposure to the diamond industry is undeniably concerning for many, it does clearly point to one conclusion: returns are not high enough for the risks taken. For lenders to increase their willingness to provide capital, at least one of two outcomes will be required: higher returns or lower risk. We therefore believe the industry will need to reduce its risk profile and, while this can be done through a myriad of processes, most likely this would be delivered by increasing financial transparency, reducing long term average inventory levels, continuing to close non-economic enterprises and decreasing overall debt ratios, most probably through lower leverage ratios and higher equity contributions.

DO YOU THINK THERE HAS BEEN A FUNDAMENTAL CHANGE IN HOW INVENTORY IS MANAGED ACROSS THE VALUE CHAIN?

Inventory (and how it is managed) is likely to be a key determinant of the prosperity of the industry for the next generation. And, put simply, the midstream cannot be relied upon to warehouse the output from producers and be there to satisfy the needs and wants of the retailers who are in turn ensuring their balance sheets are as efficient as possible. The possible outcome of a lower, more just-in-time approach to inventory is a significant increase in price volatility and possibly speculation on future category shortages.

LOOKING AHEAD

The events of 2015 crystallised many of the risks and pressures that midstream diamond businesses can face. The issues of finance, technology, reputation and differentiation look set to continue being of paramount importance in shaping the future of midstream participants.

CHANGES IN THE FINANCE LANDSCAPE

A host of new compliance pressures (from banks, regulators and rough diamond suppliers) require midstream diamond businesses to adopt international standards of financial transparency to maintain their business activities. This brings with it a need for greater financial robustness, as banks and suppliers generally seek commercial relationships with the businesses that present them with the lowest risk.

Improved financial robustness would also position midstream operators more strongly in an environment where volatility is the new normal. Those with stronger balance sheets will be better able to ride out periods of depressed demand without the need to liquidate inventories cheaply, and will have greater ability to capture opportunities in a rising market.

The adoption of new forms of financing also appears set to change the way the midstream operates (Fig. 10). If bank lending remains restricted, then businesses that can find alternative and competitively priced sources of funding will gain a strong competitive advantage.

A sharper focus on financial efficiency could also play a significant role in shaping the future of the cutting centres. Over-generous credit terms have often been the norm in the middle of the diamond value chain, but, in an environment where funding is under pressure and ‘cash is king’, businesses may see that the benefit of a more efficient cash cycle can outweigh the perceived advantage of competing for custom on the basis of extended credit terms.

THE GROWING IMPORTANCE OF TECHNOLOGY

The wide range of technological developments in the diamond sector means there is a great degree of potential for midstream firms in this area: there could be increased commercial opportunity, for example, for businesses that focus on new technology in areas such as automated cutting and shaping and online inventory systems (Fig. 11).

Technologies focusing on the detection of synthetic diamond material, and on 3D printing in the diamond jewellery manufacturing process, are also likely to be significant areas of interest. Additionally, businesses that can effectively use technology to gather and analyse relevant data to gain insight on customer needs, consumer trends and business performance will be strongly placed.

REPUTATION AND DIFFERENTIATION: THE ROLE OF THE B2B BRAND

With growing pressure from industry stakeholders (including consumers, banks, rough diamond suppliers and retailers), midstream participants will increasingly need to consider their reputations as a vital element of their B2B brand.

Higher ethical and professional standards (and the ability to provide evidence of them) are becoming more of an expectation than a ‘nice-to-have’ extra. The increased attention on the risk of undisclosed synthetics is also likely to continue, so businesses that can demonstrate their brand’s focus on product integrity stand to benefit.

The development of strong B2B brand equity is also likely to be important in other ways: a firm’s ability to differentiate its offering will be increasingly important in a fragmented, competitive part of the value chain. Some midstream businesses are likely to have continued success by selling to other midstream players, and differentiating themselves on the basis of a technical offering (such as product specialisation or tailored assortment). Others will see more success by supporting the ability of their retailer customers to tell compelling brand stories (Fig. 12).