The current article aims to highlight the critical aspects of the business of companies involved in cutting and polishing diamonds. After reading this article, an investor would understand the factors that impact the business of cut and polished diamonds and the characteristics that differentiate a fundamentally strong diamond processing company from a weak one.
Key factors influencing the business of “cut and polished diamond” companies
1) Low pricing power of cut & polished diamond companies due to intense competition:
Cut & polished diamond (CPD) players face intense competition in their business. There are many reasons for this.
First, the industry has low entry barriers, which results in the prevalence of numerous unorganized players making the sector very fragmented leading to intense competition.
Rating methodology – gems & jewellery (cut & polished diamonds) by ICRA, September 2021, pages 3-4:
The diamond industry is fragmented…The entities face intense competition from the unorganised players as well as from a few established organised players…Furthermore, the industry has low entry barriers, leading to high competitive intensity
Second, diamond cutting and polishing is a low-value adding work where companies buy rough diamonds from miners/traders, polish and sell them to traders or jewellery manufacturers.
Diamonds, even though they are very precious, still, are commodities. Unless a jewellery manufacturer wants unique very large-sized diamonds, it can easily replace smaller diamonds polished by one company from another. Due to this low supplier-switching cost, jewellers enjoy strong negotiating power over cut & polished diamond players.
As there are many players competing fiercely to get business of customers. Therefore, cut-and-polished diamond players do not have bargaining power over their customers.
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The entities face intense competition…which limits their pricing power…the industry has low entry barriers…and consequently lower pricing flexibility
Also read: How to do Business Analysis of a Company
2) Very high bargaining power of diamond miners/suppliers:
Even though, India is the world’s largest player in diamond cutting and polishing; however, it does not produce diamonds.
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the country contributes 60% of the world’s supply in terms of value, 85% in terms of volume, and 92% in terms of pieces.
As India’s domestic diamond production is very small; therefore, the cut & polished diamond industry imports almost its entire rough diamond requirement.
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Rough diamonds are largely imported from key diamond producing countries such as Russia, Botswana, South Africa, Canada, Angola and Namibia, who account for almost 95% of the rough diamond production by value.
Moreover, the supply of rough diamonds in the world is concentrated in the hands of a few large companies. Four largest mining companies: De Beers, Alrosa, Rio Tinto and Dominion Diamond Corporation control about 75% of the world’s diamond production.
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Also, production remains concentrated across key mining companies such as Alrosa, De Beers, Rio Tinto and Dominion Diamond Corporation, who drive almost 75% of the world’s diamond production by value.
These large diamond mining companies keep strong control of the supply of diamonds in the world. As a result, they enjoy a very high bargaining power over diamond-cutting and polishing companies.
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the final supply in the market remains limited, given the high bargaining power of the suppliers in this industry.
Diamond miners exert their influence on cut & polished diamond players in multiple ways. Let us understand some of them.
2.1) Sight-holder status of cut & polished diamond players:
Diamond miners sell diamonds only to the players who are registered with them as “sight-holders”. If a cut & polished diamond player is not a sight-holder, then she cannot buy diamonds from the miners directly and has to buy them from traders in the secondary market, which increases her costs.
Therefore, cut & polished diamond players who are sight-holders have a competitive advantage over their peers due to a lower raw material cost as well as a direct continuous supply from the mines.
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The CPD players who are also sight-holders usually enjoy uninterrupted supply of roughs at a relatively attractive pricing as the miners sell the roughs through the auction route only to its sight-holders, providing the latter with a competitive edge.
Out of the four main diamond mining companies, De Beers has been the most prominent player who had previously almost monopolized diamond mining in the world. Therefore, a sight-holder status with De Beers is very important for cut & polished diamond players.
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Traditionally, De Beers was the primary source of rough diamonds for the industry and hence the De Beers sight-holder status of a CPD player assumed significant importance.
2.2) “Supplier of choice” status of cut and polished diamond players:
Another barrier created by diamond miners is the “supplier of choice” status for diamond processing companies.
Only those cut and polished diamond players who have a “supplier of choice” status can refuse/return the rough diamonds to the miner, which exceeds its requirements. Otherwise, a cut and polished diamond (CPD) player must accept its supply of rough diamonds as per the contract whether the CPD player sees demand from its customers or not.
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CPD player enjoying ‘Supplier of Choice’ status from its main rough supplier may have the right to reject the rough parcels which do not meet its own requirements as against other CPD players who may have to necessarily buy the contracted rough parcels in a given year.
This increases the cost of inventory for those CPD players who are not “suppliers of choice” because a large amount of money might get stuck in the excess purchase of rough diamonds.
Also read: How to analyse New Companies in Unknown Industries?
3) Low-profit margins of cut and polished diamond players:
The business of CPD players faces immense pressure from both, customers as well as suppliers’ side.
Customers exert a strong negotiating power over them because cutting and polishing of diamonds is a low-value adding activity and customers can easily switch from one CPD player to another creating strong pricing pressure on them.
On the other hand, suppliers (diamond miners) have created an oligopoly and keep tight control on the supply as well as prices of rough diamonds.
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While prices of rough diamonds are determined by miners due to the oligopolistic nature of the segment, CPD prices are largely market-driven, based on demand-supply dynamics. As a result, CPD manufacturers have low bargaining power and are often the price takers at both ends of the spectrum
As a result, CPD players face intense pressure from both fronts and their profit margins are squeezed leading to very low profitability in the business.
Also read: How to do Financial Analysis of a Company
4) Cyclicity in the demand for diamond jewellery:
Purchase of diamond jewellery is a discretionary activity i.e. is not an essential purchase. During the times of economic boom when customers have surplus money to spend, then demand for diamond jewellery increases. However, during periods of economic downturn, when there are job losses and salary cuts, then customers cancel or postpone diamond jewellery purchases.
Therefore, the demand and sale of diamond jewellery are highly linked to economic boom and bust cycles.
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Since jewellery buying is highly discretionary, the economic health of the consuming market remains a direct reflection of the demand conditions and, thus, demand for diamonds exhibits cyclicality.
The demand for diamond jewellery has a direct impact on the demand for cut & polished diamonds by jewellers leading to cyclicity in the business performance of CPD players.
5) Working capital-intensive operations of CPD players:
The business of cut and polished diamond players is highly working capital intensive. Due to a lack of negotiating power over both, their customers as well as suppliers, CPD players have to offer liberal terms to almost each counterparty.
Diamond mining is an oligopoly, which keeps tight controls over the supply and pricing of rough diamonds. Therefore, diamond mining players usually sell diamonds only on advance payments.
Once the rough diamonds are received, then CPD players have to spend a long time processing them including cutting, polishing, grading and getting them certified. This long processing time increases the inventory holding cost for CPD players.
Thereafter, when CPD players sell polished diamonds to traders or jewellers, then, due to intense competition, to gain their business, they have to offer a long credit period to customers.
All these aspects make the business of cut and polished diamond players very working capital intensive.
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Upfront payment to miners for procuring rough diamonds, longer turnaround time in processing (including grading and certification of CPD), high inventory levels, and extension of long credit periods to its customers are inherent operating characteristics of entities in the CPD industry. All these factors cumulatively result in high working capital requirements.
High working capital brings in risks in the business of CPD players. As these companies must keep a large inventory, it exposes them to the risk of inventory write-down if the prices of diamonds fall.
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High inventory levels, however, increase holding cost and also poses pricing risks.
Due to high inventory levels, CPD players must manage their inventory efficiently to control their costs and maintain profitability. Otherwise, the consumption of money in working capital may hurt their business operations.
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efficient inventory management and tight controls on other overheads are the keys to maintaining healthy profitability levels.
Declining inventory efficiency may indicate deterioration in the business position of a CPD player because an unsold inventory of diamonds will affect its operating efficiency.
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Deterioration in market position of a CPD player often leads to inventory pile up, significantly increasing price risks and liquidity concerns.
Also read: Inventory Turnover Ratio: A Complete Guide
Long credit period to customers exposes these companies to the risk of bad debts i.e. customers defaulting on making payment for their purchases. This is especially true during economic downturns because, during economic downcycles, diamond sales decline and the customers face a liquidity crunch.
In the past, during economic downturns, failure by customers to make timely payments has led to default by CPD players to their lenders.
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In the event of a demand slowdown, these collection cycles may get stretched further…In a few cases, stretched/bad receivables have led to delays/defaults by CPD players on their debt obligations.
Also read: Receivable Days: A Complete Guide
Therefore, any CPD player has to manage its working capital very efficiently. Otherwise, it might hurt its business significantly.
6) Funding risk faced by cut and polished diamond players due to poor corporate governance issues:
The diamond industry has seen numerous cases of poor corporate governance including fraud. For example, in the recent past, two diamond celebrities, Nirav Modi and his uncle Mehul Choksi defrauded the Punjab National Bank.
Explained: How Nirav Modi Cheated Punjab National Bank Of ₹ 14,000 Crore – NDTV
Such cases damage the reputation of the entire diamond processing industry including cut and polished diamonds. No wonder banks are very cautious in giving out loans to CPD players.
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in the light of past and recent defaults, which have plagued the gems and jewellery industry, as well as the perception of relatively lower transparency, availability of bank finance has emerged as a key challenge for the CPD industry.
These funding challenges are not limited only to the Indian CPD industry. Globally too, banks like Antwerp Diamond Bank and Standard Chartered Bank have decided to completely stop lending to diamond processing players.
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Globally too, banks such as Antwerp Diamond Bank and Standard Chartered Bank exited the CPD sector in the past few years due to lack of transparency and associated risks.
Such exit of global banks from lending to the CPD industry has hurt the sector because it is difficult to convince new banks to give loans to diamond players due to instances of poor corporate governance in the sector.
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Globally too, a few banks exited the CPD sector in the past few years due to governance concerns of the industry participants…Once a bank moves out of the industry or reduces credit flow to a particular sector, the credit may not be easily replaceable.
Even now, credit rating agencies like CARE have found that CPD players do not follow stipulated valuation guidelines for valuing inventory, which is a big risk as their business is highly working capital intensive due to large diamond inventory requirements.
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Inventory valuation is another area of concern in the industry. Due to high diversity of diamonds, its technical nature and lack of homogeneity, inventory valuation method adopted by entities are generally not as per the Indian Accounting Standard -2 (IND AS-2).
As banks have to take the security of the inventory of diamonds for giving out loans to diamond processing companies; therefore, when the banks are not sure about the value of this inventory, they hesitate to give loans or increase exposure to this sector.
In the case of Neerav Modi and Mehul Choksi, the Punjab National Bank faced a lot of challenges in assessing the value of diamonds that it could secure against its loans and could not recover its money.
PNB hasn’t recovered any money from Nirav Modi, Mehul Choksi: RTI reply – The Hindu
Due to a lack of transparency, banks as well as public investors are not able to get information about overseas customers of CPD players. As a result, stakeholders are not able to assess any impending challenges a CPD player might face due to the deterioration in the financial health of its key customers. Due to such a lack of transparency, public market players become extra cautious while providing funds to CPD players.
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credentials of many export customers are not readily available in the public domain, sudden deterioration in the creditworthiness of overseas customers has adversely impacted the credit risk profile of CPD manufacturers.
In addition, allegations of involvement of a significant amount of cash transactions/unaccounted money in diamond trading also scare away formal financiers from organized sectors like banks and public markets.
As a result, the diamond industry including CPD players have to rely primarily on equity money or loans from friends and family to meet their requirement as the market in general is cautious about putting its money in the sector.
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The CPD industry is largely dependent on bank finance to meet its funding needs with no or limited access to capital markets
working capital debt constitutes a major share of CPD players’ debt followed by unsecured loans from promoters
Therefore, an investor should be careful while projecting the business growth of any CPD player because the company may face a funding crunch in its growth path.
Also read: 7 Signs to tell whether a Company is cooking its Books: “Financial Shenanigans”
7) Regulatory risks faced by cut and polished diamond players:
The CPD industry is very prone to govt. regulations due to multiple reasons. First, the industry is primarily export-dependent; therefore, any change in tariff structure impacts it significantly as it is a low-margin business.
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It is largely an export-oriented industry with only a small proportion of diamonds (6%) meant for domestic consumption.
Nonetheless, due to modest margins prevalent in the CPD industry, any change in the duty structure would bear a direct impact on the competitiveness and credit profile of the CPD entities.
Second, due to the export-oriented nature of the CPD industry, any issues impacting relationships with other key countries also directly impact Indian players. For example, the Indian CPD industry exports polished diamonds to Hong Kong and China (35% of its output) where they are put into jewellery, which is then sold in the USA. As a result, in the recent instances of the US-China trade war, the USA put restrictions on the import of diamond jewellery from China, which directly impacted the demand for Indian CPD players.
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CPD exports from India were also adversely impacted by the US-China trade war…India’s CPD exports to the Hong Kong–China region are significant, and these are re- exported to the US in the form of diamond-studded jewellery. As per industry estimates, China and Hong Kong currently account for approximately 35% of India’s overall CPD exports
Third, diamonds are usually sold as an embedded part of gold jewellery. Therefore, any change in govt. policies related to gold, which is highly sensitive to govt. regulations, also significantly impact the demand for diamonds.
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The Indian CPD industry is also impacted indirectly by regulations related to import of gold…change in the duty structure for gold imports has a direct impact on the final price and demand for studded jewellery.
An investor may read the following article to learn business analysis of companies involved in the gems and jewellery sector focusing on gold: How to do Business Analysis of Gems and Jewellery Retailers
Other than govt. regulations about trade and tariffs, the diamond industry is also impacted indirectly by mining regulations affecting diamond mines. This is because diamond mining impacts the environment due to soil and water pollution as well as accidents and other hazards.
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for the CPD segment, indirect exposure via the mining sector remains…soil and water pollution as a result of the processes used in diamond mining as well as manmade hazards like wall collapses at open-pit mines, flooding, collapse of tailing dams, underground fires and explosions, and cave-in or ground falls at underground mines.
Similarly, labour regulations also impact the CPD industry as diamond cutting as well as polishing is a labour-intensive activity and the sector faces labour disputes.
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heavily reliant on human capital. The labour force is unionised in geographies like Surat (Gujarat), which exposes the segment to risks of labour disputes and collective bargaining.
Therefore, an investor should closely track regulatory changes impacting the CPD industry.
8) Diversification in business brings a competitive advantage to CPD players:
Cut and polished diamonds business is a very low-profit margin business as CPD players have very low bargaining power over their customers as well as suppliers. Additionally, the business is cyclical. Therefore, during down cycles, CPD players face immense profitability and cash flow constraints that might risk the survival of the companies.
In order to improve profitability as well as reduce the impact of cyclicity, CPD players diversify along different business aspects. These diversification strategies smoothen the impact of external factors and strengthen their business model.
For example, CPD players with geographical diversification across different markets are not significantly impacted by an economic slowdown in any one market and continue to stay profitable on an overall basis.
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A CPD player with a well-diversified presence across multiple regions or geographies is more likely to perform consistently across demand cycles prevalent in different consuming markets.
Additionally, a presence across different countries protects the company from drastic changes in regulations or political unrest in any one country.
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Entities exhibiting diversified export sales are expected to be in a better position to mitigate the challenges arising from a decline in demand in a particular country, adverse changes in duty structure, imposition of trade restrictions or economic and political instability in a particular region.
A diverse mix of customers i.e. selling to diamond traders vs. directly selling to jewellery manufacturers also helps CPD players in mitigating adverse developments related to any one segment, especially during economic downturns where customers face liquidity crunch and delay payment of money to CPD players.
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For a CPD player, the customer mix mainly comprises wholesale traders and jewellery retailers who can come under liquidity pressures during periods of demand slowdown, exposing the CPD players to risks of bad debts...well-diversified customer base is relatively better positioned to protect its revenues and future cash flows
Diversification of business in this aspect is especially visible in the customer profile of CPD players. A CPD player might focus on wholesale diamond traders in Belgium (Antwerp), UAE etc. or it may focus on directly dealing with diamond jewellery manufacturers in end markets like the USA, Europe, China etc.
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most of the exports to West Asia and HK being finally resold to the US, China and Europe in the ready-made jewellery form. While Antwerp in Belgium and the UAE are key hubs for trading roughs as well as polished diamonds, a player’s direct presence in the key markets ensures distribution reach.
Similarly, CPD players who are able to use multiple sales channels like direct sales, online portals, affiliate members, brokers etc. enjoy relative stability in their business model.
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ability to adopt multiple sales channels (e.g., marketing affiliates, brokers, online platforms, among others, besides direct sales)
As the jewellery sector faces constantly changing consumer preferences; therefore, CPD players who are able to process a diverse range of diamonds in shapes, sizes, carats, colours etc. are able to better meet the changing demand from customers/jewellers. Such players can do profitable business across different phases of economic cycles.
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CPD players with a product portfolio of a wide range of shapes, colours, sizes and carats of diamonds are in a better position to cater to the demands of a larger customer base.
CPD player with high product diversity is also likely to have a diversified customer base and see lower volatility of earnings.
Among diversification of products, CPD players focus on certified diamonds i.e. those diamonds whose 4 Cs, viz. Carat, Cut, Colour and Clarity are graded by international agencies that are able to cater to the premium customer segment. Whereas non-certified diamonds cater to value-conscious customers. A CPD player who focuses on both these segments can enjoy relatively stable demand and profitability across economic cycles.
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a larger share of certified diamonds in the overall sales mix of a CPD manufacturer aids in a competitive market, where customers are becoming increasingly quality-conscious and are willing to pay a premium for third-party certification.
Apart from diversification in sales/customer level, CPD players who bring diversity in procurement by way of mixed sourcing of rough diamonds from miners (primary sources), as well as traders (secondary sources), are able to avoid supply disruptions and continue their business.
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Diversification of rough diamond procurement between primary and secondary sources.
Similarly, CPD players who are able to diversify their funding sources across different banks, capital markets etc., are in a better position to sustain economic downturns than those CPD players who rely on any single bank/source for funding.
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A diverse resource profile in terms of number of banking arrangements may help a company cushion the potential impact an exit of a bank
Also reading: Margin of Safety in Stock Investing: A Complete Guide
9) Large scale of operations (economies of scale) is a big competitive advantage for cut and polished diamond players:
As CPD players have no bargaining power over either their customers or their suppliers (diamond miners); therefore, they must minimize their cost of operations to improve their profitability as well as gain a competitive advantage over their peers.
One of the strategies that cut-and-polished diamond players follow to reduce their costs is an increase in the size of their business. A large scale of operations brings in benefits of economies of scale by spreading the fixed costs of business over a large volume of diamonds and in turn reduces the overall cost of processing per diamond.
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A larger scale of operations confers scale economies supporting better cost absorption and the ability to withstand competition.
Moreover, if any CPD player may have negotiating power over its customers and suppliers, then it is the one with large business size. This is because only a large CPD player can assure the supply of a variety of diamonds to jewellers at short notice. Similarly, only a large CPD player can buy so many rough diamonds from a miner that the miner would be willing to offer special concessions to it.
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an entity’s scale of operations is an important factor that drives its competitive position and supports its bargaining power with suppliers and customers
Additionally, large CPD players are able to integrate their business operations by starting jewellery making/retailing and are able to capture a higher share of value-addition leading to improved profitability. An integrated business allows CPD players to create a brand for their diamonds and earn a premium from customers.
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Further, several CPD players forward integrate into jewellery manufacturing by venturing into retail or wholesale jewellery. Under their retail operations, the companies sell branded diamonds under their own brand to retail clients.
Moreover, large CPD players are able to diversify their business across different geographies, product ranges, rough diamond procurement sources etc., which brings stability to their business model.
Large CPD players are able to obtain sight-holder as well as supplier-of-choice status with diamond miners, which helps them get a continuous supply of required quantities of rough diamonds.
In addition, large players also have the better financial strength to handle economic downturns.
Large CPD players are also able to invest in the latest technology, which improves the efficiency of their operations as it reduces the wastage of diamonds in processing.
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Higher technology adoption for certain higher carat product categories could also support profitability with lower wastage and more value per carat.
Therefore, large CPD players enjoy competitive advantages over their smaller peers.
Also read: Self Sustainable Growth Rate: Inherent Growth Potential of a Company
10) Foreign exchange (forex)/currency risk:
The business of cut and polished diamond players is highly dependent on the import of rough diamonds and the export of processed diamonds, which makes a large portion of their business transactions in foreign currencies exposing them to forex fluctuations risk.
However, CPD players benefit from a natural hedge if sales, as well as purchases, are denominated in a single foreign currency like USD or EUR. Still, such companies stay exposed to currency risk due to exposure to different currencies and a net import/export position.
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currency risk that an entity faces depends on its net imports/ exports position…while most rough diamond requirements are met through imports, a significant proportion of the polished diamonds get exported, thus providing a natural hedge.
Additionally, CPD players usually take working capital loans from banks in foreign currency to make payments to their overseas suppliers, which also helps them manage the overall currency risk in operations.
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Also, generally, the CPD players enjoy dollar-denominated export working capital facilities from banks, which further helps in mitigating foreign currency-related risks
Also read: Credit Rating Reports: A Complete Guide for Stock Investors
Summary
Cut and polished diamond (CPD) players face intense competition due to a fragmented market resulting from low entry barriers. Numerous small and unorganized players dominate the industry and compete based on price to gain customers’ business. Due to intense price-based competition along with the low value-adding nature of diamond cutting and polishing work, CPD players have low profit margins.
Customers of CPD players, and jewellery manufacturers can easily switch from one diamond processor to another; therefore, have a high bargaining power over CPD players. Whereas the rough diamond miners have consolidated the supply chain and have created an oligopoly. As a result, diamond miners control the quantity as well as the price of rough diamonds and have strong negotiating power over CPD players.
Diamond miners impose conditions like sight-holder status and “supplier of choice” status on CPD players to exert their negotiating power in the trade. Therefore, CPD players are squeezed from both sides, customers as well as suppliers and face significant challenges in maintaining their profitability.
The demand for diamonds is cyclical because jewellery purchase is a discretionary activity, which picks up during an economic upcycle and declines sharply during a downcycle. These cyclical phases in demand along with low profit margins put significant strain on their liquidity position and at times even risk their survival.
Diamond cutting and polishing business is highly working capital intensive because CPD players have to keep a large amount of diamond inventory, both rough and polished, to cater to customers’ demands quickly. Additionally, they have to give a long credit period to customers due to competitive pressures. Therefore, any growth of the business by CPD players demands significant investment in working capital.
Large working capital investments hurt CPD players during downturns because the diamond inventory consumes costly capital and customers delay payments leading to bad debts. As a result, during downturns, many CPD players default on their lenders.
Lenders face challenges in recovering their dues from CPD players by selling their diamond inventory because it is not easy to value diamonds. In addition, the CPD industry has many corporate governance-related issues where information about the correct value of diamond inventory as well as details of overseas customers is not easily available to outside stakeholders. Therefore, banks hesitate to take large exposures to CPD players creating funding challenges. As a result, players have to rely on promoters for raising capital either by equity contribution or unsecured loans.
The CPD industry is exposed to significant regulatory risk because its business depends a lot on the import of rough diamonds and the export of polished diamonds. Any change in trade policies and duty structure impacts their business significantly. Recently US-China trade war hurt CPD players in India.
To mitigate the impact of trade policies, political scenarios, and economic downturns in any one market, those CPD players who are present across multiple geographies have a competitive advantage. Diversification across multiple customers, direct sales as well as traders protects CPD players from liquidity crises in downturns.
CPD players who have well-diversified sources of rough diamonds across multiple mines and traders benefit from assured supply for business continuity. Diversified sources of funding across banks and capital markets help a CPD player in accessing funds for meeting growth requirements.
In all these diversification aspects, CPD players with a large size of business benefit a lot. The large size helps them with scale benefits and lower operating costs. In addition, large CPD players also enjoy better bargaining power over their customers as well as suppliers. They also benefit from better financial flexibility to tide over downturns. Therefore, the big size of CPD players helps them to grow even bigger.
Therefore, an investor should always keep in mind these multiple aspects of cut and polished diamond companies to understand their business position.
- Low pricing power due to intense competition
- Very high bargaining power of diamond miners/suppliers
- Low profit margin in the business
- Cyclicity in the demand for diamond jewellery.
- Working capital-intensive operations
- Funding risk due to poor corporate governance issues
- High regulatory risk due to trade policies, mining regulations, policies around gold etc.
- Diversification strengthens the business model
- A large scale of operations brings competitive advantages
We believe that if an investor analyses any cut-and-polished diamond company by keeping the above factors in mind, then she would be able to assess its business properly.
Regards,
Dr Vijay Malik
P.S.
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Disclaimer
Registration status with SEBI:
I am registered with SEBI as a research analyst.
Details of financial interest in the Subject Company:
I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.
1 thought on “How to do Business Analysis of Cut and Polished Diamond Companies”
Surat is a hub for diamond cutting-polishing. In Surat, you will find excellent work for diamond cutting-and-polishing because workers are highly skilled in this field.