From the bottom up

by jacquie_dealmeida | February 1, 2016 9:00 am

How managing risk could help turn the diamond industry around

By Isaac Mimar

[1]Much has been written and debated among the trade about the current troubles facing the diamond industry. Not a day goes by we are not bombarded with headlines about the high price of rough or theories on how to make selling diamonds profitable again.

Members at all levels of the pipeline have offered various opinions regarding a solution. Most have merit to some extent or another. Without a doubt, unravelling the issue is complex and coming up with viable solutions is equally challenging, to say the least. Expert opinions range from the importance of creating a generic marketing campaign to increase consumer demand to changing how goods are sold (i.e. auction versus sight).

I propose, however, that the industry remains in its current state of crisis because no one is investing in diamonds. What do I mean by this? Well, for the past decade, retailers and wholesalers have been divesting from diamonds by buying and holding inventory for which there is consumer demand. Their thinking is reasonable. By diverting capital that was once used to buy diamonds and investing it in branded products consumers are actually purchasing, they are able to enjoy better margins and bigger profits. Capital is mobile, but this practice is at the centre of the challenges the diamond industry is currently facing. If a retailer or wholesaler cannot make money on diamonds, they have no reason to invest in them. In other words, why buy and hold product that ties up much-needed capital?

Assuming liability

[2]

Diversion of capital forces private, non-borrowed money to exit the industry only to be replaced by borrowed funds, which brings further financial strain. This trend of moving away from an inventory-on-hand business model really gained momentum when online vendors began offering diamonds on a ‘just-in-time’ basis. Rather than holding inventory, diamond e-tailers simply ordered a diamond once the customer clicked the purchase button.

Selling diamonds direct to consumers is a strategy loosely based on ‘vertical integration.’ The classic definition of this strategy refers to a company owning different parts of its own supply chain. In the case of the diamond industry, the scenario is one in which several levels of the diamond pipeline are consolidated to direct more and more profit to sightholders and then eventually to mining companies. One example is De Beers, which looked to the Internet to create a B2C business model. In doing so, it cut out several levels of the supply chain by encouraging sightholders to find more direct routes to dispose of their polished diamonds. The rush of sightholders to supply one online vendor in particular allowed it to reach $450 million in sales in just a few short years.

There are two major flaws with this way of doing business: the assumption polished diamonds are highly liquid and the belief there is infinite demand for them. Most of us in the trade know neither is the case. Rough sights take place like clockwork every six weeks; beyond that, however, the process is much more time-involved. Once rough is acquired, manufacturers must plan the yield and polish the diamonds. Sending polished stones to laboratories for grading can take up to six weeks, while listing them and converting them into cash can take anywhere from four to 12 months. This is clearly demonstrated by the swelling polished inventory of sightholders who are unable to sell their goods to wholesalers to hold as stock. The problem is, financing a business that is constantly acquiring product and churning out inventory no one is buying is a hardship on the entire supply chain.

Previously, the traditional diamond distribution channel allowed sightholders to pass on risk (e.g. price fluctuations on RapNet, weak demand, or currency instability, etc.) to wholesalers in exchange for their cash (i.e. liquidity). However, without sufficient profit, ownership of polished diamonds becomes a risky and unattractive proposition. Risk mitigation is the most important factor in the survival of any industry; not recognizing or managing risk leads to complete industry failure.

If a wholesaler or a retailer cannot make money, they will not buy and hold diamonds as inventory, as doing so involves too much risk. Without reasonable margins, there is no financial incentive for retailers and wholesalers to stock diamonds, leaving the entire burden of risk on sightholders. The result is a pipeline clogged with polished diamonds, which is where we find ourselves today. This is the reason for the current liquidity crisis in the industry—no one below sightholders wants to assume risk of polished diamonds due to small margins and poor return on investment.

‘Shooting themselves in the foot’

[3]

No doubt, the problems we are experiencing today have been building for several years. By the late 2000s, sightholders decided the most profitable way to dispose of polished diamonds was to upload their inventory to several large online diamond retailers. As wholesalers began holding less inventory, sightholders became less and less liquid and more dependent on online vendor sales, which were destroying margins for the entire industry. In essence, sightholders were shooting themselves in the foot without knowing it. Severe competition began to emerge amongst sightholders, which caused them to fight tooth and nail to earn a spot among the first three lines on the results grid of RapNet and other trading networks. They dropped their prices (and consequently shrunk their margins), effectively adopting a just-in-time model themselves and selling at bargain basement prices, an unprofitable way of doing business.

This war to get the top spots is like King Kong fighting a mouse with a toothpick and winning—the result was minuscule, though the consequent damage was significant, as it decimated margins across the board. Of course, not all consumers were buying diamonds online, but many were using online prices as leverage to negotiate better deals in brick-and-mortar stores. While this fight to the bottom was taking place at the counter, retailers and wholesalers were being offered little financial incentive (e.g. better prices or better terms) to buy and hold diamonds, making the just-in-time model of acquiring product more attractive, since you only bought what you needed when you needed it, and, more importantly, for the same price.

Margin destruction is taking place regardless of the size of the last sight or what Rapaport tells us diamonds should be worth. This malady is chronic and ongoing. Consider the example of Blue Nile. If you analyze this publicly traded company’s 2014 financial statements (the most recent available at this article’s writing), you will note it has been running average gross margins of 18 per cent. Keep in mind Blue Nile sells on demand with no initial outlay of capital (i.e. liquidity) and by assuming no inventory-related risk. Conversely, retailers who put out money to acquire polished diamonds assume significantly higher risk, and if given the choice, would likely prefer to not buy and hold diamonds, and by extension, tie up much-needed capital.

Historical tolerances for assuming polished risk for wholesalers is 10 per cent, while for retailers it is 30 per cent. These minimum values need to be restored to inject capital from the trade back into the polished pipeline.

We can rebuild margins from the bottom up rather than top down, but this starts with sightholders offering wholesalers and retailers better margins to assume the risk of owning diamonds. Top-down solutions, such as reduced sights and lower list prices, are just benchmarks; they will not stop margin destruction, improve consumption, or increase sales as long as there is no incentive for capital to re-enter the pipeline. Sightholders have to move away from relying on online vendors and instead build relationships among the various levels of the pipeline. Investing capital needs to be rewarded. Without consideration for this fundamental economic theory, sightholders will be forced to sell diamonds one stone at a time at the lowest possible price with the lowest possible margin. A business model such as this does little to solve anything.

Rewarding investment

[4]

The trade has to re-embrace the old, though functional, selling model of efficiently passing down risk by rewarding investment in polished inventory. Selling online or just in time is not proper risk mitigation. Sightholders either have to raise prices to extract better margins from online vendors for just-in-time purchases or offer bigger discounts to volume buyers to reward them for acquiring polished risk. I suspect they would be more open to the first solution, as they have smaller margins to work with after dealing with online vendors.

As long as margins are non-existent, the model cannot be fixed by reducing prices, output, or sight allotments. This is the equivalent of a soldier bleeding from the head while pressure is applied to his abdomen. Prices have to be raised on players who do not want to assume the risk of owning goods and financially rewarding those who inject capital or liquidity. This can allow the trade sufficient capital to operate as it once did. De Beers and sightholders have to re-evaluate their vertical integration model as a potential failure and figure out how they can pass on diamond ownership risk successfully to allow a healthy flow of capital to re-enter the industry.

Isaac Mimar is CEO of MDL Diamond Merchants, a diamond house based in Toronto. A second-generation diamantaire, he has an economics and finance degree from the University of Toronto, holds a gemmology degree from Gemological Institute of America (GIA), and currently serves as treasurer of the Ontario chapter of the GIA alumni association. Mimar is also an active member of the Diamond Bourse of Canada (DBC) which is now affiliated with the World Federation of Diamond Bourses (WFDB). He can be contacted via e-mail at issac@mdldiamonds.com.

Source URL: https://www.jewellerybusiness.com/features/from-the-bottom-up/

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