The more we examine the facts, the clearer it becomes that the main problem faced by the diamond industry is that the midstream – the manufacturing sector – does not get its fair share of the pie.
The diamond sector is considered a lucrative one by the public, enticed by the allure and profitability that diamonds represent. However, the diamond industry midstream currently suffers from very low profitability, constantly verging on loss, while the upstream and downstream of the diamond pipeline maintain wide margins.
An industry pipeline based on a marginally profitable sector squeezed in between two profitable ends is not sustainable. What follows is a breakdown of the midstream cost structure. Upon examination, it will become clear why I think that demanding the midstream to “add value” is unreasonable, and that the investment in knowledge, stocks and financing does not pay off within the current structure.
Economy of the midstream
In basic terms, the midstream buys rough diamonds for cash. It then fully finances the manufacturing process and the polished diamond buyers by selling the polished product on relatively long payment terms.
The upstream and downstream are the biggest winners in the diamond pipeline, enjoying most of the profits. Meanwhile the midstream essentially works on a “cost plus” basis (the cost of rough and labor, plus profit). This is in spite of all the midstream’s financial obligations, the market fluctuation and financial risks, and the knowledge it has developed on how to turn rough diamonds into polished diamonds. Actually, each midstream diamond company works just like a salaried polisher, maybe even earning less than a polisher.
• The direct cost of mining diamonds in 2014 was $7 billion annually according to Chaim Even Zohar.
• In 2013, the mining sector extracted and sold about 130.5 million carats. For 2014, this number is believed to have declined a little, however official numbers are not yet available.
• Of the 130.5 million carats in rough diamonds, about 70 million carats are gem- and near gem-quality diamonds polished for jewelry.
• Miners value this production at $16.7 billion annually. This is what firsthand buyers in the midstream pay for the rough diamonds.
• Global annual sales of polished diamonds were $22.3 billion in 2014. The difference between $22.3 billion in sales of polished diamonds and the $16.7 billion rough diamonds purchased is $5.6 billion, or 33.5%.
• There are estimated to be 5,000 midstream companies. Dividing $16.7 billion of annual rough diamond purchases among 5,000 midstream companies means that each midstream company has an average expenditure of $3.34 million on rough diamond purchases. Dividing $22.3 billion of annual polished sales among 5,000 midstream companies means an average revenue of $4.46 million per company, and therefore an annual gross margin of $1.12 million per company. That may seem more than adequate, however there is more to account for.
• Finally, each company in the midstream has a long list of expenses. This varies from company to company, but they are well worth listing:
o Cost of labor
o Cost of machinery
o Machinery upkeep and maintenance
o Rental fees
o Head-office and administration expenses
o Research and development
o Shipping costs
o High insurance costs
o Certifying costs
o Travel costs
o Association dues (RJC, for example)
o Trading platform costs
o Website costs
o Bank charges
o Legal and accounting fees
o Interest payments
o Payments to local diamond authorities (diamond office, diamond institutes, etc.)
o Income tax
o Import taxes
o Kimberly certification and reporting expenses
o Marketing expenses
o IT expenses
Putting it together
On a per carat basis, dividing the $5.6 billion difference between cost of rough and polished sales, by 70 million carats of gem and near-gem diamonds, the added value is $80 per carat. This is the midstream’s gross “wage” for polishing diamonds, market fluctuation and financial risks, and its payment for all the great knowledge they hold on turning rough into polished diamonds at a considerable cost. From the $80 per carat, we still have to deduct the long list of expenses mentioned above.
At this point, I want to pause and return to a previous article I published about the true volume of sales. There, I indicated that while a $22-$23 billion in global diamond consumption by consumers is accurate for normal times, today I estimate these sales at around $17-18 billion (at polished wholesale prices), a decline of approximately 25% over the last 10 months.
Assuming the more generous $18 billion, this is an added value of $1.3 billion to the initial $16.7 billion of annual rough purchases. Dividing $1.3 billion of added value by 70 million carats of gem and near-gem amounts to just $18.6 per carat. In prosperous times, the Midstream’s typical profitability is about 5%, or $280 million of the $5.6 billion. In today’s market, with an added value of $1.3 billion – and even with a presumed profitability of 5% – this number plummets to $65 million for all 5,000 midstream companies – an average of only $13,000 in gross profit per company!
A much needed wakeup call
This is very poor profit for such a large investment in capital and knowledge. In terms of return on capital employed (ROCE), a standard business measurement, this is an average of less than 1.1%. To put this in perspective, publicly reported statements put the ROCE for the main suppliers at around 15% in 2014. On the retail side, first tier jewelers' ROCE was around 19.5%, according to their 2015 annual reports.
It is not only that margins are narrow or that financing costs are high – the whole economic structure of the diamond pipeline is skewed against the manufacturing sector. How can a profit be made under these conditions? Where is the return on investment, let alone increasing capital? Why would banks finance a sector that cannot demonstrate growth? Of course, under these circumstances, there is no room for expenditures on advertising, it is difficult to hold a stock of goods to provide better service to clients, or even protect the price of polished diamonds. Manufacturers are in a weak position and therefore their bargaining position is unfavorable.
This raises other important questions. With all the essential knowledge locked in the hands of manufacturers, aren’t they selling their expertise for too little? I think that is one of the problems in the market. Can’t we balance the scale of profitability so that the midstream gets a bigger share of the diamond pipeline’s profitability? Why should two equally important parts of the industry earn well and a third not at all?
The automatic calls (if not demands) for manufacturers to add more value to diamonds seem inappropriate in light of the above. After all, how much more can this lemon be squeezed? The instructions to add more value are especially daunting considering that it is often the response from miners to complaint about loss of profitability: “add more value and you will be more profitable.”
Upon examining the above, and with the realization that the midstream is left with a ridiculous margin (if at all), it becomes clear that there is something very unbalanced in the diamond pipeline. Some sectors make handsome profits even during times of declining demand such as today, while the midstream must consistently battle for the tiniest of profits (if that) – even in the best of times.
It is time to wake up. It is essential for all sectors of the diamond industry that the midstream makes money and justifies its huge investment of capital, knowledge, market fluctuation and financial risks, and unlimited devotion of time.
For the sake of a long lasting and healthy industry for all its participants, we have a responsibility to adjust the current model so that the indispensable manufacturing sector receives its fair share of the profitability pie. This is a crucial step in creating a strong industry that will be stable for years to come.
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.