Retail Economics: Why consolidation could be helping the entire diamond retail industry

Profit margins for the diamond industry’s midstream manufacturers have been continually eroding. Over the past few years, rough diamond prices have climbed steadily, while polished diamond prices have declined. Ultimately, the consumer determines the price at which the cutters can sell their polished output. The consumer’s decisions at the retail level reverberate back through the pipeline and should affect the decision making of all those involved in our industry.

However, there is more to this story. According to Tacy’s Diamond Pipeline, the value of polished production actually fell 4% between 2011 and 2014, from $22.6 billion to $21.8 billion. During the same period, the retail sales value of diamond jewelry rose nearly 11%, from $70.8 billion to $78.5 billion. Consumer resistance to increased prices for diamonds is commonly used to justify the lackluster performance of polished diamond prices in recent years. So why has the retail value of diamond jewelry increased? Are retailers earning higher profits at the expense of the midstream?

For the next article in our ongoing look at the diamond jewelry industry, I will look at the profitability and economics of diamond retailing. Are jewelry retailers making large profits while others in the pipeline languish?

Among consumers there is a pervasive myth that jewelry, especially diamond jewelry, is heavily marked up by the retailer. People often refer to ‘keystone’ pricing when talking about diamonds, which suggests a 100% mark-up at the retail level (i.e. double the wholesale cost). Many supposedly factual articles can be found suggesting mark-ups in excess of 300% on diamonds. 

In truth, retail mark-ups are far more complex than that and often each jewelry piece is priced individually. In addition, each retailer will employ his or her own specific pricing strategy based on factors such as brand value, marketing costs, product costs, and a wealth of other variables. Retailing in any industry is complex, and consumers are often unaware of the many hidden costs in bringing a product to market beyond simply the input cost of the raw materials. 

We have talked at length about consolidation in the retail jewelry industry, and have seen how chain stores are capturing more and more consumer spending on diamond jewelry, sometimes using fewer retail locations. It stands to reason that these stores should have the highest margins in the industry. 

In its most recent full fiscal year (2015), Signet Corporation, the world’s largest specialty jeweler by market capitalization, reported a net income of $381.3 million on sales of over $5.7 billion, for a 6.6% net profit margin. This is down slightly from the five-year average profit margin of 7.8%. A large company like Signet would necessarily have significant advertising and marketing budgets, as well as head office costs that a small independent jeweler would not. However, Signet’s gross profit margin has been fairly consistent for the last five years, at between 36.2% and 38.6%. 

Put another way, the cost of getting the products that Signet sells into their display cases is around 63% of the final retail sales value. Therefore, if an item costs $0.63 and it is sold for $1.00, it was marked up by 56%. Not bad, but far from the 100-300% markups that so many consumers seem to take for granted. 

Signet is one of the most vertically integrated specialty jewelry retailers in the world. They have agreements in place to purchase rough diamonds directly from various rough diamond producers, as well as their own diamond manufacturing facilities. Signet can achieve retail margins that are among the highest in the industry, yet their margins look very much like a host of other retail firms from other industries.

Chow Tai Fook, the largest specialty jewelry retailer in Asia and among the largest in the world, reported a gross profit margin of 29.2% for their last full year of operations, which was an improvement over 27.7% posted in 2014. This implies a retail markup of around 41%-42% above the cost of the jewelry. Like Signet, Chow Tai Fook should have some of the lowest product costs in the industry given their downstream integration. Despite its generally lower retail markup, Chow Tai Fook is even more profitable than Signet, with an average profit margin of nearly 10% over the last 5 years, owing mostly to their lower sales costs.

On the opposite end of the spectrum, Blue Nile, the world’s largest online jewelry retailer, achieves far lower gross margins than their bricks-and mortar-competitors. Due to their significantly reduced overhead costs, Blue Nile’s gross profit has averaged just 18.6% over the past three full operating years. Blue Nile uses their unique business model to offer consumers some of the lowest prices available to the general public. Not surprisingly, Blue Nile’s profit margins are also quite low compared to many of their peers, averaging 2.2% of sales over the past three years. 

However, Blue Nile’s business model makes it a member of an elite list of companies with negative working capital. To the best of our knowledge, Blue Nile doesn’t actually own any of the diamonds available for purchase on its site. This means it never has any money tied up in inventory. Instead, Blue Nile’s suppliers give it access to diamonds in the suppliers’ inventory, and Blue Nile makes those stones available for its customers to buy. When the customer makes a purchase, Blue Nile receives payment immediately, but usually does not have to pay its suppliers for the diamond for 90-120 days. 

This negative investment in inventory appears to be the opposite of what most typical diamond jewelry retailers are doing (appears to be the opposite because retailers, in addition to buying goods, also have diamonds on memo). Investing in inventory is often seen as a good thing as it means full display cases, and ultimately more selection for customers.

The problem is that inventory tends to turn over slowly in a retail jewelry store because of the high price points. Although the gross margin may be quite high when a sale is made, making so few sales hampers the store’s overall profitability and ties up its capital for longer. This often means that the retailer must obtain working capital financing, which adds to their costs and requires even higher markups to balance out.

According to a 2007 study by IDEX Online, most jewelry retailers are turning over inventory between 1 to 1.5 times per year. That means significant amounts of capital sitting on store shelves. Larger chain stores are addressing the problem by closing less profitable stores with lower customer traffic. But as I have mentioned before, specialty jewelry retailers are highly fragmented around the world, and the industry has a significant number of small independent stores, often family-owned and operated. 

These smaller stores typically cannot invest in large quantities of slow-moving inventory and have only a minimal advertising and marketing budget reserved for local distribution. They must buy their raw materials from wholesalers and lack the leverage to negotiate the best possible prices. The diamond wholesale sector is not always a level playing field, and the supply and demand characteristics in a certain location may put some independents at a disadvantage over others. But independents have not given up the fight just yet. In many places, small retailers are joining forces with each other to form buying syndicates, leveraging higher purchasing power and driving down their wholesale diamond costs. 

Perhaps research from Jewelers of America (JA) sums up the current situation the best. According to their 2014 Cost of Doing Business Report, gross margins in the US specialty jewelry industry averaged 47% in 2013. The ‘most profitable 25% of the companies in the sample achieved margins of 50%. It would seem that consumers were correct after all, and that ‘keystone’ markups are actually commonplace. 

However, according to the same study, the average operating expenses of a US jewelry business is about 43% of sales. This results in a median profit margin of less than 4%. The story is rather different for the top 25% of firms who have managed to keep their operating costs well below the average. These firms achieved profits of about 12% on average, a good result by almost any retail industry standard. One bright spot for independent retailers is that the volume of sales per store seems to be increasing quickly, according to JA. This should, in theory at least, help to lift margins, as many of the jeweler’s costs are fixed and can be spread out across high sales volumes. It isn’t clear, however, how much of the increase is being captured by the independent stores.

This situation isn’t isolated to the US. This is the norm in our industry, and indeed in retailing globally. That’s how capitalism works. But I would argue that this is a good thing. Ultimately the growing dominance of larger groups should help to bring retail costs down, increase the jewelry selection for consumers and continue to drive diamond sales upward. Smaller stores that can find ways to compete through better service, better designs, or a better customer experience, will always be able to find a niche in any market. If the consolidation that is underway leads to a better customer experience and ultimately to more diamond demand, then the entire industry stands to benefit.

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.