Credit is Not Forever
June 02, 05Banks provide the oxygen the diamond business needs to operate. The positions of the diamond bankers tend to be analyzed in a similar fashion as U.S. financial market players interpret every word uttered by Federal Reserve chairman Alan Greenspan. When new personalities are appointed at the top of the decision-making pyramid – something that occurs once a decade at the industry’s largest financing institution – the proverbial first message to customers is always one of reassurance, since stability and continuity are essential to bank and client alike. Then, inevitably, a policy transition commences. It is the resulting second message that really counts – when the banker decides to signal his approach and to share his philosophy thus indicating the direction in which bank money will be – or will not be -- flowing in the years ahead.
ABN Amro’s new Global Head of its International Diamond and Jewelry Division, Loet Kniphorst, who recently took charge of some $3.5 billion of credit facilities for the industry, made his maiden speech at the Mines to Market international diamond conference in Mumbai last week. Some may have found his multiple messages disturbing, others may have found them comforting – but nobody can ignore them. He is clearly unhappy about the $10 billion plus industry indebtedness to the banks. “Since the end of 2000 the estimated overall bank debt has increased by 60% or $3.8 billion dollars. If we compare this to the development of the estimated dollar values in the diamond pipeline over the same period, you can see that we are talking about significantly different developments in terms of growth,” says Kniphorst, looking in vain for a matching growth on consumer, retail or wholesale levels.
“One might argue that banks ought to be happy with an ever-increasing appetite for bank debt,” he says, adding that “in the short term that perhaps is true. However in the long term the question remains how much bank debt can the industry sustain and how much gross margin does a company need to make to be able to service its increasing debt. The changing environment puts a strain on the margins, pushes the costs up and lengthens the payment terms. One should also consider that the cost of borrowing has been relatively low in recent years. Nevertheless, the industry must be aware that every additional percentage point of interest rate increase will add another $100 million of costs to the industry. Moreover, every $1 billion of additional bank debt creates an additional annual cost of at least $60 to $75 million in interest, which once again adds to the cost of the industry,” says Kniphorst rhetorically asking whether “this means that banks should step out of this industry before the financial health deteriorates any further?”
Over the past few decades, this writer cannot recall any bank spokesman asking aloud whether the banks should reconsider their involvement in the industry. I am not sure whether the following quote comes from a newcomer’s naivety or whether it is carefully calculated: “Once again, fortunately this still is and has been for a long time a very profitable business and, as many players have retained a large part of their earnings over the years, there is no reason for panic yet. But, given the type of business we are in, stretched levels of leverage are not desirable in this industry and may dampen the interest of financial institutions to participate.”
Nonetheless, Kniphorst qualified his words and carefully issued an uncompromising warning: “The financial health of the diamond industry may well be at a still acceptable level in general terms, but various negative factors are threatening this health if they are allowed to persist. They must be properly countered. In order to remain a meaningful player, there is a need to structure the diamond company in a corporate fashion. This will also enable it to comply with the regulations, attract additional funding and allow the company to vertically integrate.”
The traditionally fragmented diamond industry consisted largely of a plethora of small family players. Without actually dismissing these, Kniphorst intimates that he wants clients to follow corporate approaches. He finances organizations, and finances corporate entities that behave and are managed like corporations – not families. “Taking a corporate approach” was part of the title of his presentation – and not without cause.
Looking at the overall diamond pipeline, the banker identified the downstream sector – especially the retailers – as the weaker or even weakest link. “Compared to other industries, the companies in the diamond business generally have considerable reserves, allowing them to absorb a negative impact over a longer period. The exception to the rule is perhaps the retail industry where, in order to improve their earnings, many players tend to maintain a much higher level of leverage and where measures taken to improve the cash flow, often in fact are to the detriment of the suppliers upstream in the pipeline. Consequently, over the past years we have seen a number of players in the retail market seeking protection from creditors to restructure their financial situation,” argues Kniphorst.
At the same, he hints that in the long term it may well be the retailers who will assume “control” over their diamonds and the destiny of the diamond industry, which is a most uncomforting view to most manufacturers and dealers. It is a view, however, that is privately shared by some influential players in London, though more whispered quietly than pronounced publicly. Kniphorst used the food industry as an example. “The number of independent grocery and butcher shops, as well as wholesale and retail distributors of foodstuffs in the EU has dropped drastically in the last decade, the reason being that large supermarket chains have been able to use their purchasing power to force suppliers into reducing their prices, to introduce their own branded products, to cut out the middlemen and to offer a large selection of goods to the consumer backed by a massive marketing budget.”
Kniphorst admits that it may have been rather rude to compare a loaf of bread and a jar of peanut butter to a beautiful natural diamond, yet, he says, “the economic forces at work are not fundamentally different. There are many other examples of vertical integration, whereby a few large players dominate the entire chain. There are, by the way, also examples where in the following phase the large players start concentrating on one particular stage again, and outsource the rest. In the diamond industry the trend of vertical integration along the pipeline is in my opinion a development that will continue.”
Throughout his presentation, the ABN AMRO banker underscored that he views vertical integration as a desirable, even necessary, trend within the diamond industry. At the same time he makes it clear that while such a policy may result in better profits, it will, at the same time, put considerable pressures on the diamantaire’s cash-flow.
“By participating in most of the stages of the pipeline, say from buying rough to manufacturing jewellery and selling diamond jewellery to retailers, it will enable the diamond company to maximise the overall margin. However, it also implies that more money is tied up in the whole process for a much longer period. Diamond jewellery may command an attractive margin, but it requires substantial inventory and tends to have a slow turnover. This puts a lot of strain on the company’s cash flow. Add to that the cost of marketing and possible investments in retail outlets, and it becomes clear that the overall costs will be almost insurmountable for the medium or small players to do it on their own,” says Kniphorst.
The banker didn’t say that small or medium players will become “toast” nor did he explicitly say that they are bound to disappear. But many diamantaires in his audience drew that conclusion. And so did I. It was also clear that Kniphorst supports the Supplier of Choice approach to verticalization. Not all banks have been so specific on this score.
Clearly the “newcomer” is not buying all the London rhetoric. Kniphorst doesn’t see a demand driven industry. He clearly views the operations as still monopolistic or oligopolistic. “Although there may be a trend for the market to become less controlled, at the supply side there still exists a high level of price coordination among the rough suppliers (I could use another word for price coordination but that may lead anti-trust supporters to jump up),” notes Kniphorst. “As we have all observed over the recent period the increases in the rough prices have generally not been followed by similar increases in the prices of polished nor in the prices of diamond jewellery. This obviously has a profound negative financial impact on the development of the industry,” warns the banker in a clear message on the eve of another rough diamond price increase.
Explains Kniphorst: “As an economist, I can perhaps make the general statement that a market, controlled by a dominant player, as has been the case in the diamond industry, usually has the advantage of creating a predictable environment. Most of the players will know what role they can play and, as long as they adhere to the rules stipulated by the dominant player, their place in the market is more or less secured. Moreover, the market also tends to be neatly controlled: when demand goes down, supply is decreased and vice versa. When moving to less control, their place in the market becomes less secure and next to the usual business acumen a company will depend much more on financial strength, strategic positioning, organisational structure and management skills.
The essence of the bank’s argument is that it witnesses shifts in the “power” within the pipeline – in a downstream direction. “This shift in power, the pressure on the margins and increase in the [marketing and operating] costs force the players in this industry to take a comprehensive corporate approach in order to become better focused, better equipped in a changing environment and more efficient in their activities,” says the banker, clearly expecting the structural changes in the business as a whole to be followed by the required organizational structures of the individual players, most notably the banks’ clients.
The banker offered the bank’s assistance in its customers’ efforts to restructure. He advised the corporate players to focus on five specific areas:
Have a clear strategy. It may be obvious that one needs to have a strategy and certainly the Sightholders have been forced to be explicit about it. As I have argued earlier, vertical integration may be a good strategy to benefit from the overall margin and improved efficiency, but requires a certain scale of business and financial strength. An alternative is to focus on a specific niche in the market. A clear strategy is an excellent way to focus the company and position itself, but a strategy alone is not enough. It is as important to analyse the resources needed to implement and maintain the strategy; to consider whether these resources are available now and in the future and closely monitor the progress.
Make a cost/benefit analysis. An integral part of the strategy needs to be the costs involved and the short and long-term benefit to be derived from it. For instance, for many players the cost of branding will be a cost that will not be earned back in the short term, if at all, and in a situation of scarce resources may prevent them from developing other, more profitable, activities.
Strengthen the capital base. Perhaps the first or the last part of the strategy should be to quantify the financial needs to implement it and to introduce asset and liability management. How much own means does one require to attract third party funding and, if the capital base is deemed to be insufficient, is it preferable to tune down the strategy rather than to over leverage the company? Or is it the right moment to consider looking for a partner or to merge with another player?
Develop an organisational structure. In order to comply with international regulations and the requirements for a high level of transparency, it becomes more and more necessary for worldwide operating diamond companies to set up a corporate structure using legal and tax efficient structures to channel the flow of goods. By having a transparent structure and audited financial statements it also becomes possible to attract third party funding.
Use financial markets and products. The diamond industry is still predominantly financed by short-term commercial loans, mainly provided by a limited number of specialised commercial banks. However, when the need for third party funding increases, the need to find alternative sources of funds also increases. The capital markets provide endless funding options through institutional investors like pension funds and insurance companies. In general, however, these players require transparent organisational structures, accurate/frequent and audited financial reporting, often as well as an acceptable rating from the rating agencies. Several of the large players in the industry have already set up receivables and inventory securitisation programs and I believe the appetite of institutional investors is growing to buy this kind of asset backed paper. An important advantage is that the actual borrowing costs tend to be substantially lower than those of commercial loans,” says Kniphorst.
It is clear that ABN AMRO seeks to reduce its risks and exposure without stating this specifically. Securitization, which this writer has always seen as replacing bank debt with public debt, basically doesn’t lower the industry’s debt – it only moves the risk from the banks to the public or the holders of the bonds.
The banker also suggested to the diamond industry’s corporate players to consider accessing the capital markets through private placements. “The marketable size actually ranges from $50 million to up to more than $1 billion. Maturity can go up to 15 years and usually it does not require a rating. A corporate structure allows the creation of a centralised treasury function, and it then becomes possible to efficiently manage the company’s international cash flow through cash management products. In a time of rising interest rates, it is also useful to lock in the current rates by using interest rate derivative products and to arrange umbrella-banking facilities to allocate the financing there where it is needed in the most efficient way,” concludes Kniphorst.
Most of these financial instruments have never been used by the diamond industry. ABN Amro’s great emphasis on these instruments, coupled with its call on companies to create “corporate structures” which allow access to alternative sources of capital or finance, should give the industry a clear indication of the direction in which the industry’s main financing institution is heading. The Kniphorst speech ought not to be ignored.
Have a nice weekend.