Time to Stop Bad Financial Practices in the Diamond Industry

An interesting opinion column published this week highlighted the legal aspects of some of the business closures in the Indian diamond sector. Prominent Indian industry member Sanjay Kothari, formerly chair of the GJEPC, advocated much stronger steps against those involved in shady dealings. I’m not an investigative journalist and so not in the position to opine as to whether the actions he writes about are criminal or not. But I am a seasoned businessman, and can speak to business practices.

I have spoken many times in the past against the heavy lending practices we see in many parts of the diamond pipeline. I think that an oversupply of exports favoring bank financing may lead some diamond manufacturers and dealers into a false sense of euphoria and may result in very unhealthy and unprofessional decision-making. Such practices could even lead to criminal thoughts.

Professionalism in diamond management

Sticking by a number of key principals will make falling into bankruptcy difficult. Last week I advocated that sticking to simple and sound principals is what will save us from an approaching disaster .

The true worth of a rough diamond is the worth of the polished diamonds we can extract from it. If you know what the transaction price of a polished diamond is (which is not the vague asking benchmark price minus a common discount) you can’t really go very wrong. You take the value of the polished diamond(s) that the rough stone will yield, subtract from it the cost of manufacturing and profit and then divide the total by the weight of the rough stone. Mercury’s recommendation is a 5% manufacturing cost and 10% profit. At worse, if polished prices fell by 15% after you purchased the rough, you will lose about 5% at most - the five percent cost of manufacturing.

Prices don’t often drop by 15%. This is very rare. Such a drop is not completely impossible, but it would require a major catastrophe that we know only happens once in many years. Because it is still a possibility, let’s examine this situation so I can show you that even in such a case, a business built on sound financial principals, knowledge of the market, and cold logic, should be able to survive this doomsday scenario.

Let’s imagine a company that is operating with 50% bank financing and another 50% is its own capital. This is a financially sound business with balanced credit and capital. For the sake of this example, let’s say that owned and borrowed capital are each $1 million, which means the company has $2 million on hand.

This company took the entire amount and bought $2 million worth of rough diamonds, assessing the polished outcome at $2.3 million ($2 million + 15%). This provides a margin of $300,000, of which about $100,000 is the cost of polishing, leaving the company with $200,000 in gross profit it expects to earn.

If our rare doomsday scenario takes place, and polished diamond prices fall 15%, what does our company’s financial situation look like? Subtracting 15% from the expected polished value of $2.3 million means a price decline of $345,000. The value of the polished diamonds will then be $1.955 million. This business has a loss of $45,000 on the cost of rough and another $100,000 on the cost of the production, a total of $145,000.

A company with a track record of years of doing business smartly and soundly, in a rare and extreme case of a sharp drop in prices, and an inventory of polished diamonds worth $1.955 million, won’t go bankrupt. They will sell the goods, pay back the bank the $1 million plus interest, and will still have plenty of capital in hand. They will easily survive.

Now, imagine a situation where a business is not managed carefully and banks are still willing to provide you with financing that is ten times your capital. This is not unheard of, especially in countries where banks may not be fully aware of borrowings their clients may have from other banks.

Let’s take a company that has $1 million in capital and borrows another $10 million from the banks. What will happen if it buys $11 million worth of rough diamonds, expecting to sell them for $12.65 million, but then the polished diamond market falls 15%? Now the value of the polished outcome is only $10.753 million. After selling the polished and returning the bank loan they will be left with less than $250,000 from which they need to subtract another $550,000, the cost of manufacturing.

This company is in a very precarious situation. They completely erased their own capital and are $300,000 in debt. Such a company is on the brink of collapse, leaving behind debts to the bank and maybe to the industry as well. A company of this nature, acting without prudence, may also have missed a few other fundamental components of the diamond business: for example, they may have wrongly assessed the value of the rough diamonds, or not known the transaction prices of polished diamonds, etc.

This is a dangerous situation for our industry, not because a company may find itself in this situation, but because there are many companies that are incredibly overleveraged! And if they fall, they will drag down with them the many other companies to whom they owe money, hurting the banks in the process. Banks hurt in such a way may choose to reduce their exposure to the diamond industry – not just by reducing financing to poorly-managed companies, but by cutting off prudently-managed companies as well.

Wrong messages

I often hear from different people in the market calls to the mining companies to reduce their supply of rough diamonds to the manufacturing sector. They are told to act responsibly. This is a little odd: why should they demand that the major producers be responsible while the manufacturers are not taking responsibility themselves by buying less rough? If the midstream across the board is willing to buy the goods, why should the producers assume that it’s not wise to sell?

Isn’t it the midstream’s responsibility to buy wisely? Shouldn’t manufacturers be first to know that they don’t need some of the rough – be it by type of good or quantity? Shouldn’t members of the midstream adjust their level of demand according to their own sales volume and prices? Doing so is a fundamental tenet of running a business carefully and thoughtfully.

Isn’t it the role of the banks to ensure that the companies to whom they lend know how to assess the value of rough diamonds, read the market direction and act according to the fundamentals? After all, it is the bank’s money that is at risk, as is the bank itself because it is the majority financier of the diamond market (contrary to Basel’s efforts to limit the risk) and stands to lose the most.

Blaming the suppliers – be it rough diamonds or low-cost financing suppliers – is the wrong message. Manufacturers should examine their own businesses, assess them honestly, and act according to what is right for their operations. They should internalize the message of prudence themselves.

Not a farfetched scenario

I called the 15% drop in polished diamond prices a doomsday scenario, but as a veteran of this industry I know, as should you, that economic disasters take place. Easily-available and low-cost bank financing in 2005-2007 brought a series of mistakes to the market. The feeling that making money is easy led to many wrong decisions, which resulted in the deep economic crisis of 2008, a crisis whose lingering consequences we still feel to this day.

An oversupply of financing and credit in the wrong hands might lead to wrong decisions in any industry, and especially in the diamond industry, which is by nature more abstract. Bad economic times have happened in the past, and we should count on them to happen again in the future.

Most banks that are subject to the Basel regulations pulled out or are in the process of exiting the diamond industry. The largest volume of financing is coming more and more from banks with lighter regulations and is being provided to manufacturers from a single geographic area with their own particular ideas of how to run a successful business. There is no doubt that these manufacturers are global experts in polishing 1-carat down to 0.005-carat diamonds, representing a big part of the diamond business by value.

An unforeseen outcome of this could be the entry of speculators who will thrive on wide fluctuations in the value of rough and polished diamonds, which will take place several times a year instead of once every few years.

An oversupply of financing could cause other harmful effects, and not necessarily to the speculative companies that enter quickly and exit quickly, leaving a series of bankruptcies in their wake. Good, established companies that act with caution may find themselves inadvertently caught up in the trail of mayhem irresponsible companies leave behind them, dragging them down into a financial whirlpool.

An oversupply of credit is harmful for the diamond pipeline, especially the thin-margined midstream. This is not only destructive when the actions are criminal in nature, but also when they are “only” financial and professional. I join Mr Kothari in his call to industry organization heads as well as to the banks to act swiftly and harshly in this situation.

The views expressed here are solely those of the author in his private capacity. No one should act upon any opinion or information in this website without consulting a professional qualified adviser.