Between rough & retail ?

Avi Krawitz

For news junkies in the diamond industry, this past week was a relatively exciting one. And for once it wasn’t De Beers making the headlines. This time, BHP Billiton completed its diamond exit by agreeing to sell the Ekati mine in Canada to Harry Winston for $500 million, while further west, ALROSA signed a two-year deal to supply rough diamonds to Chow Tai Fook.

Significantly, it was two jewelry retailers which were the main beneficiaries, moving further into the rough diamond space. While neither of the agreements came as a surprise, both served to strengthen each of the parties involved.


From a geopolitical perspective, a Russia-China tie-up in the industry is interesting and one wonders why it took so long for ALROSA to find a foothold in the Far East. ALROSA has been building its long-term client base over the past few years and this week’s deal marks its first foray with a China-focused client – barring its sales on a spot deal basis. The mining company now has 35 such clients, typically hailing from Russia, India, Israel and Belgium, and, it seems, only one of which is now a retailer.

Perhaps most important, however, is the strength of its new client given the weak market conditions. Already, ALROSA has held back supply in the past six months, even selling to Gokhran again, and must be on the lookout for willing and able buyers.

For its part, Chow Tai Fook appears to be on the hunt for rough diamonds and intent on gaining a competitive edge over manufacturers as it seeks out the best goods. As a result, the Hong Kong-based company, which is considered the world’s largest jewelry retailer with more than 1,600 points of sale across greater China, has evolved to rank among the largest buyers of rough diamonds in the market today. In addition to the new-found ALROSA supply, the company has three De Beers sights in London, Botswana and South Africa and is also a Rio Tinto Select Diamantaire.

To illustrate its growth in this sphere, the value of Chow Tai Fook’s inventory of raw materials for gem-set jewelry rose to $953 million (HKD 7.39 billion) as of March 31, 2012, from $384 million (HKD 2.97 billion) a year earlier. In fiscal 2012, about 46 percent of polished diamonds used in its jewelry were manufactured in-house – either at its two facilities in South Africa or at its factory in Shunde, China.

This column has noted in the past the growing trend among retailers to buy up rough. Today, Tiffany & Co., Graff Diamonds, Gitanjali Gems and Chow Sang Sang rank among De Beers largest sightholders and it seems Chow Tai Fook is taking the lead among them.

They’re able to gain better margins from the rough than their wholesale manufacturing counterparts given the cost benefits from their spread across the pipeline and that their brands garner better prices at the retail level. From a miner’s point of view, retailers are probably a little less complaining than their other clients, and it could well be that retailers’ ability to buy rough has helped buoy prices over the past year.

It is therefore interesting when a retailer itself becomes a fully-fledged miner.

If rankings count for something, Harry Winston’s Ekati purchase has lifted it to be the world’s third largest diamond miner by value and fourth largest by volume. Combining Ekati with Harry Winston’s 40 percent stake in the Diavik mine, the company would have had combined production of about 4.7 million carats in 2011 whereas rough diamond sales would have exceeded $1.2 billion. Not a small amount – unless we’re talking BHP Billiton revenue standards – and Ekati adds significantly higher value production to the Harry Winston mix.

Analysts at RBC Capital Markets noted that the price paid for the mine was at the very low end of expectations. The current weak rough market probably gave Harry Winston some bargaining power.



Still, there are risks involved. Whereas Diavik is operated by Rio Tinto, which owns the other 60 percent share, Harry Winston will be the one to operate Ekati. In addition, Ekati has a limited life and may require significant future capital investment to extend the operation. RBC’s analysts conservatively give Ekati another five years but with some “decent” options for extension.

From a mining perspective, we view the acquisition as a positive for Harry Winston, which we believe will add decent operating, cash generative and likely [net present value (NPV)] positive asset to its existing stake in the Diavik mine, although luxury brand-oriented investors are likely to be less enthused,” RBC wrote, adding that it was those luxury-focused investors that probably caused the company’s share to lose 2.5 percent value on Tuesday after the deal was announced.

Indeed, all eyes now turn to Harry Winston’s luxury segment, especially after rumors circulated less than a month ago that the company was in talks to divest from retail. Harry Winston confirmed that it has received various indications of interest to purchase the luxury business, but stressed it is not in active negotiations. It subsequently raised its credit facility to $300 million for the luxury segment.

However, the verdict is still out whether a jeweler can effectively coexist as a major miner. While its roots are, in fact, in mining – having started off when Aber Resources found Diavik back in the nineties – the company later bought the iconic Harry Winston name as it sought a mechanism to understand the price of polished to better value its rough.

Philosophies aside, the luxury segment evolved to be a cash cow for the company, accounting for about 55 percent of total sales and offering significantly better margins than the mining business. RBC estimates the luxury business could sell at a substantial premium, for well above $1 billion.

But Harry Winston offers a vastly different business model to the Chow Tai Fooks of the world. Its rough supply is very much more of a pricing reference mechanism than a tool to improve its retail margins. As a niche luxury retailer, it doesn’t require the scale of rough supply that a mass market jeweler might. The two segments are therefore not as intertwined as one might think.

Rather, it seems that the company simply sees greater upside potential in the rough diamond space. If it has given itself a choice between the two, the decision has clearly been made on mining – possibly with the other eye on Rio Tinto’s Diavik stake. Divesting from the luxury segment may not make sense looking at the stand-alone business, but it may be required to finance its mining ambitions.

Such a move would further validate the prevalent positive long-term rough price projections. And it would certainly encourage retailers to procure more rough supply at prices perhaps only they can afford. This week’s deals marked a further consolidation of the diamond industry, highlighting the strength of the two opposite ends of the market. They were therefore a win-win for everyone involved, except, maybe, those caught between the rough and retail.

Source Rapaport