"Diamond War" May Mean Lower Profits For Jewelers

Implications: As DeBeers grows weaker, producing countries are demanding a bigger piece of the profits from rough diamond sales.  South Africa's recent demands may drive diamond price up sharply this fall and limit the supply of certain key sizes and qualities. This means jewelers may not get some product in time for the Christmas or pay higher prices in the 4th quarter for the replenishment of stock and best selling items. Here is why investors should be concerned. 

Analysis: The eighth year in the new millennium is shaping up to be one of ambiguities for jewelry companies.  During the year company executives have tried to cope with declining demand and still remain profitable despite increasing gold prices and operating costs too.  In February, both Signet and Zale signaled to the industry that they were increasing prices.  That gave competitors some room to adjust their prices in the hope that higher average sales prices would offset declining demand.  

Since then, the retail sector has continued to weaken and gold has remained relatively stable until August when China intervened with the Feds blessing to strengthen the US dollar.  Since then, the dollar’s appreciation in combination with the government scrutiny of commodity speculation practices has reduced commodity prices.  Now gold is trading at about $750/toz., a 26% decline from its previous 2008 high.  In the interim between product repricing and gold’s decline, rough diamond prices have also increased.  

High single digit price increases for large better quality diamonds has been common place for the last half decade.  However, small size, commercial quality diamond prices have been about flat over the last five years; that is until now.  This year, both commercial and better quality rough has increased by as much as 16%.  Some sources say the actual number is closer to 25%.  Regardless, mid market jewelry companies like Zale and Kay will have had to factor higher diamond prices into their pricing calculations this year to maintain margins; unless they intentionally lowered the size and quality specifications for the fall.  

Now, with product chosen and pricing set for pre-Christmas advertising, diamond prices may spike again as a “diamond war” breaks out between DeBeers DTC and South African government.  Apparently, the South African government is dissatisfied with its current price agreement with DeBeers and is demanding a 15% duty on the DTC’s diamond exports.  DeBeers has refused and canceled its South African DTC sight scheduled for September 22nd.  Diamond sights are the venue through which the DTC sells rough diamonds to a select number of cutters and diamond dealers.  The polished diamond product is what manufacturers buy to make jewelry.  Tentatively, the sight has been rescheduled for September 29th, but it remains to be seen whether DeBeers and the South African government can work out their difference in so short a time.   

DeBeers relinquished its dominance of the rough diamond market in 2001.  Then the company controlled more than 80% of the world’s production of rough diamonds.  Now the number is between 40% and 50%, probably more if you only include gem quality rough in the calculation.  So, any interruption of the sale of DTC controlled rough diamonds will mean both late deliveries and higher prices for retailers, especially in the critical fourth quarter.  

Just how this war will play out is anyone’s guess.  The South African government needs DeBeers to market its most valuable export.  But the government also wants a piece of the recent price increases in rough too.  From DeBeers’ point of view, changing its price structure with South Africa means new deals with other producing countries.  That could materially shrink the gold and diamond company’s profits not only this year, but in the future too.  

Unfortunately, the dispute is more complicated than a debate about an export duty.  DeBeers’ distribution of cuttable rough and its practice of selecting the type and amount of rough to be sold to its various customers have always been clouded in mystery.  South African officials are also questioning that methodology which may be of greater concern to DeBeers than the imposition of a tariff.  

Investors and jewelry company executives alike should be concerned about how this dispute will affect the cost and available of diamond product this fall.  Almost all jewelers depend on diamond jewelry product for a substantial portion of their revenue and profits.  That’s especially true of companies like Kay and Zale where diamond products comprise for 60% to 70% of sales.  

Longer term, the dispute is more problematic.  Until 2001, DeBeers acted as a cartel manipulating the supply of rough diamonds in such a way to keep prices increasing, while growing the market at the same time.  Everyone benefited more or less equally.  Since 2001, both rough and polished diamond price have often fluctuated wildly without DeBeers’ stabilizing influence.  Now, a smaller DeBeers means producing countries have more leverage to demand higher fees from DeBeers.  But as inequities crepe into the selling process, the whole structure may collapse as one producing nation tries to market more of its product directly, cutting out DeBeers.  

While producing counties may benefit short term from higher prices, the dispute will only serve to weaken the underlying diamond price structure that was already weak.  Further weakening of the DTC will certainly lead to falling prices in the future.   The fact is there’s every sign that what is known as the diamond pipeline is fragmenting.  Today the middle of the pipeline, that is the cutting, polishing, wholesale diamond part, is under severe margin and liquidity pressure.  Only the mining companies and retailers are making good margins and that could be changing too.  Mine operators are looking to even out the distribution process and are willing to pay for it.  More and more non-DTC controlled production may be available at lower prices in exchange for guarantees to buy minimum quantities and a range of qualities.  Polished dealers are also willing to deal on price to ease their liquidity problems if buyers guarantee continuity of purchases for a fixed price.  That can only lead lower prices for retailers and lower margins too in a free market.  

If diamonds are commoditized as many think will happen, the mid market diamond jewelry business located in malls will be a thing of the past and large companies like Signet and Zale need to think about diversifying now.  Medium sized chains will have too high a cost structure to make a profit.  That leaves the largest segment of the industry, small local chains and single store operations, that can differentiate them selves by value added services, design, and craftsmanship, more or less intact.