How the Gatekeepers Can Turn Losses to Profits

If the diamond pipeline’s midstream is the gatekeeper of rough diamond prices for the entire diamond industry, than what tools should it use for evaluating prices and how should it use those tools? It is time to dig deeper into this issue.

As I explained last week, margins were very thin even before the current crisis in the diamond industry, because the price of rough diamonds was high compared to that of polished diamonds. Manufacturers buying rough diamonds from the major suppliers have succumbed to repeated price hikes which constantly increased their costs, while the prices of polished diamond prices have not increased accordingly, or not increased at all. 

One of the reasons this occurs is the apparent tendency on the part of quite a few manufacturers to buy rough at almost any cost. There are two versions of this, one involving first-hand buyers and another involving secondary market buyers. First-hand buyers buy rough diamonds from miners and find it impossible to resist the urge to buy rough, even if miners raise prices to a level they know will leave no margin. 

The rationale behind this decision is typically a preference for demonstrating financial ability and “loyalty” to a miner rather than refusing the goods. I believe that in many cases, this is not rational buying; it is emotional buying. Economic rationality would mean refraining from buying rough diamonds that are not economically worthwhile to polish.

The second version is when second-hand buyers, those who don’t buy directly from miners, clamor for rough and pay unreasonably high prices – to the point of not making a profit. This type of transaction usually means that the seller, often a first-hand buyer, sold the goods at a large premium. Ironically, it is often these type of transactions in the market that causes miners to increase prices…

The way to avoid both of these two trends is to buy based on only economic logic: Know the price of polished, the cost of manufacturing and your desired margin, and calculate the maximum cost of rough diamonds accordingly. In particular, it is probably wise to avoid buying rough diamonds speculatively. 

If the midstream chooses such a course of action and sticks by it, it will become the rough diamond gatekeepers that the diamond industry so desperately needs. Such gatekeepers would not allow for the annual supply of rough diamonds to reach a cost of $16.5 billion and for the entire pipeline operate without profitability.

A reality of losses vs. the prospect of profit

After weeks of talking about the macroeconomics of the industry, it is time to zoom in as closely as possible and break down the costs of very a specific and popular rough assortment with which many manufacturers are familiar. I want to go through the entire process, from buying the rough, through manufacturing, to wholesaling the polished diamonds – and break down the financials throughout every stage of this process. 

In June of this year, a primary supplier to the market, a miner, sold boxes of 2.5-4 carat fine goods for $2,402 per carat to its contracted clients. According to one of the manufacturers who bought this parcel, it cost him $146 per carat to manufacture the rough diamonds in this box. The cost of the rough and the cost of manufacturing brought manufacturer’s total cost to $2,548 per carat. This is the cost of the polished diamonds produced from this parcel of rough diamonds.

If the manufacturer sells the polished diamonds for $2,548 per carat, he will only break even. He will not increase his capital, he will not have the financial means for advertising or marketing of any kind, he will not make a profit. In practice, all he will have done was to work hard, while making a tremendous investment in technology and expertise. He won’t have anything to show for this financially. To benefit financially, he must sell these goods at more than $2,548 per carat.

Sadly, with all their efficiency, know-how and hard work, manufacturers of this rough diamonds box sold the resulting polished for only $2,375 per carat, based on tracked real price transactions. They lost $173 per carat on average.

b2ap3_thumbnail_Anatomy-of-loss.png

Let us examine this process step by step. The wholesale price of polished diamonds is fairly rigid from the perspective of a manufacturer. Consumers pay what they feel is a fair price, or choose to buy something else if they perceive the price as too high. The cost of manufacturing is relatively fixed as well; the costs of labor, energy, machinery, property taxes, etc. are all set by external forces which manufacturers have little ability to affect – these inputs are already as lean and efficient as possible. 

This leaves them with just two courses of action – either to accept the rough at the cost it is offered, or to turn it down. We know from the experience of the past few months that if manufacturers refuse goods, miners reduce prices. This is similar to the course of action that retailers and consumers choose: If the price is too high, they say no.

There is an alternative course of action, one that starts from the end and works its way backwards all the way to the cost of rough. It involves starting with the real wholesale price of polished. The real wholesale price is not a guess, an estimate, a belief or even a hope. It does not appear magically out of benchmark price lists that are based on high asking prices. Real prices are regularly collected, analyzed and measured. They are widely known. 

In our case, the wholesale price of polished is $2,375 per carat; that is where our starting point should be. From that price we must subtract 15%, which here means $356.25 per carat. This 15% includes the cost of manufacturing (in this case $146 per carat) and profit margin. The resulting figure is $2018.75. This should be the maximum sum the manufacturer will allow himself to pay per carat for this specific rough diamond parcel. 

b2ap3_thumbnail_Anatomy-of-profit.png

What a difference this approach makes! Now we are providing the polished diamonds at a cost the consumer can afford, the retailer is willing to pay this price because they know they can sell this polished, the manufacturer makes a reasonable gross margin, and the miners can still make the goods available at this cost because they did so in the past! This creates a win-win situation for all.

This box generates some very nice goods, mainly VVS1-VS1 clarity in E-I color, averaging about 1 carat in size. An analysis of sales of this box from the start of the year shows that manufacturers have lost money throughout the year. 

Based on the same analysis, and assuming for the sake of this exercise that box assortment was largely unchanged during this period, the following table shows the losses suffered by manufacturers: 

b2ap3_thumbnail_Fine-2.5-4-ct-Fine-losses-Jan-Aug-2015.png

According to my analysis, a manufacturer is likely to face double-digit losses from polishing and selling the resulting polished diamonds, even after recent price reductions, as I demonstrated in recent articles

Had manufacturers used the reverse engineering specified above, they could have seen a gross margin after every allocation week this year, instead of the losses from which they suffered in reality. 

b2ap3_thumbnail_Fine-2.5-4-ct-Fine-transaction-based-Jan-Aug-2015.png

The above proves the importance of having a gatekeeper, and proves that the midstream of the diamond pipeline must be this gatekeeper. The midstream is capable of transforming the situation for the whole diamond industry. 

It must be noted that the figures above are based on several assumptions: that the assortments are not changed, that output changes very little and that the cost of manufacturing is consistent. 

In addition, the real transaction prices in the table above are based on a wide sample of transaction data collected from the market. The prices are for wholesale transactions, based on multiple sales in each color/clarity category while taking all possible comments and/or other irregularities in consideration. They were collected as part of my own ongoing market research.  

Below is a sample grid for real transaction wholesale prices for perfect (no comments or irregularities) round stones, 1.00-1.49 carat diamonds in August. All values are in hundreds of US dollars and per carat.

b2ap3_thumbnail_analysis-of-real-transaction-prices-Round-1-1.49.png

There are a few other factors that we should take into account. In particular, there is a time delay between the purchase of the rough and the sale of the resulting polished. In the current market, this period is critical and increases the manufacturer’s uncertainty. A low volume of polished purchases results in rising inventory levels and lower polished diamond prices, which is a further destabilizing factor.

The importance and necessity of the role of the gatekeeper are no longer open to question. The current manner of pricing rough diamonds is out of touch with the product that this raw material is yielding. A change is needed now, before the market improves and the mining sector once again pushes $16.5 billion of rough that is not supported by real transaction prices on the wholesale level. Will they rise to the occasion?

The views expressed here are solely those of the author in his private capacity. None of the information made available here shall constitute in any manner an offer or invitation or promotion to buy or to sell diamonds. No one should act upon any opinion or information in this website (including with respect to diamonds values) without consulting a professional qualified adviser.