Here is a summertime conundrum to contemplate: Which forces drive business activity besides the obvious: buying, adding value and selling at a profit? There are other forces at work in the diamond industry, and they have a potentially devastating effect.
The summer vacation is almost over, most diamond industry people are back to work, and we are hearing of steady demand for rough diamonds by diamond pipeline midstream players. A typical manufacturing business buys raw materials, manufactures a product, and sells downstream to wholesalers, retailers or consumers. The common approach is to sell at a price that covers the cost of materials and manufacturing, and leaves over a profit. That is how capitalism works: the main driver to doing business is the profit. Last week, Tiffany and Signet released their financial reports, which showed a decline in quarterly sales amid weakening consumer demand, and expectations for a less-than-spectacular holiday season in the US. Considering the times, as supply outstrips demand, it has become clear that the basic capitalistic driver is not at work here. So what is driving this demand? Part of it is the decline in supply. De Beers and ALROSA supplied less rough diamonds to the industry in recent months. Coupled with the recent fire at Dominion’s Ekati process plant, overall supply to the manufacturing sector has declined. Perhaps there is a psychological element serving as a driver, but supply is still higher than demand. Knowing that manufacturers are rational people, a supposed shortage is at best a minor contributor.
Rough buying drivers
At times, other economic factors drive manufacturer purchases, and they seem to be powerful drivers. One such driver is the ability to generate profit on the trade in rough diamonds. The main diamond miners directly supply a limited number of manufacturers. Almost everyone else depends on secondhand supply. The trade in rough diamonds between firsthand buyers and the secondary market can at times be lucrative, generating large premiums for the sellers. This driver is so powerful that most firsthand buyers often purchase goods from the miners with the intention of selling them on the secondary market. This practice has obvious financial rewards, not limited to a quick turnaround between purchase and sale, or to a good margin. At times, a seller will do the deal for the interest on the credit term. This credit usually carries an interest of 1% per month, a very profitable return on the money. The downside is that manufacturers find themselves acting as a bank, which is not their core business. This can become a distraction, especially in times such as these when businesses are not performing well, and the risk of non-payment rises.
The bank driver
Another force at play has to do with the banks. Many companies have deep credit lines and are highly leveraged. The need to service debts is important. The problem is that often companies are far more leveraged than is healthy, and the magnitude of it is such that it impacts the entire pipeline. I have discussed the dangers of over-leveraging, deep bank debts, and large credits at length in past articles here, here and here . Suffice to say that many of the business failures in the diamond industry over the past couple of years were exacerbated by this phenomenon, with a high number of companies shutting down because of heavy bank debt that could not be paid. Moreover, while you could argue that some of the other drivers mentioned here are reasonable supplements to the bottom line, or make sense in other ways, unusually large bank financing is not healthy. Because of this, the bank driver is potentially harmful.
The factory driver
Another force impacting rough diamond buying decisions is factory-driven. I have already discussed on many occasions the problem of manufacturing overcapacity. At times, the push comes from the need to keep employees busy. Due to the decline in demand, manufacturers cut back on factory staff work hours. The idea is that everyone comes to work every day, and everyone is busy, but by reducing work hours, manufacturers can still reduce output. With that comes another saving: many factory workers are paid based on work hours or volume, and therefore the reduction also results in a cut in expenses. The downside is a reduction in income for this workforce. As the important Diwali holiday approaches, and with it an extended vacation, many on the workforce want their employers to increase daily work hours so they can save up before going home for a month during the holiday. In some instances, the request is to extend daily work hours by several hours a day. With that in mind, and with a desire to enable their workers to generate this extra income, several manufacturers have extended work hours, and to make it happen, need to buy rough diamonds so there is enough work to be done. On one hand, this adds to pressure on businesses, but on the other hand, it is justly compensating loyal workers, at least partially, for the reduced income they suffered from over the past couple of years.
Impact of alternative reasons of buying rough diamonds
The outcome of these drivers being at play is that the capitalistic motivator is set aside and profitability is hurt. Worse, these drivers are not taking us as an industry to safe harbor. They are not pulling the industry out of its difficult situation, are not resolving the structural problems from which it suffers, and do not offer a long-term solution. This raises a number of important questions: Why don’t we resolve the problems? Is there anyone out there that feels that this is okay? How can we improve without battling what is not working well? Why do we allow manufacturing and financing to be concentrated in a single center? Won’t the distribution of manufacturing and financing allow for a pluralistic approach to doing business? And finally, which driver caused the increased demand for rough diamonds this past week, while demand for polished diamonds remained low? You be the judge.
The diamond polishing infrastructures that exist today, particularly in India, are so large that we must pause to ask ourselves if the monster hasn’t risen against its maker. One so large that it created all these uneconomic drivers, so large that even if global consumer demand rises to record levels, would barely sustain itself, and still have capacity to polish lab-grown goods. This may actually become a necessity even today. By doing so, lab-grown’s market share will only increase at the expense of natural diamonds. This will become a zero-sum game, and natural diamonds will only lose out, further exacerbating the problem. We are going down a very unhealthy path. We have been doing so for many years, and we are now paying the price for it. I charted a course ahead in the past and still strongly believe that it is the way to go. However, as long as we do not take the necessary steps, and continue to act as if nothing has changed, forgetting that it is the consumer who sets the demand, we will continue to watch our industry crumble. More companies will shut down, more facilities will succumb to the pressure to pay back their debts, and fewer consumers will buy our product, because we will be too busy with surviving and won’t have the ability to focus on creating marketing and increasing our capital. If we continue on this path, which abandons basic capitalistic principles as the guidance for our business, I fear for the long-term survival of the majority of companies in the diamond industry.
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.