The ‘Capping Mechanism’ in Name Only
June 14, 07Notwithstanding the prohibition of Sightholder applicants to talk about the confidential DTC sight-application processes, you can detect a rising sense of frustration as the contract proposal deadline nears. On many fundamental aspects of the new Supplier of Choice (SoC2), the perception of some Sightholders seems to run counter to the views of the DTC, which almost guarantees future clashes resulting from misunderstandings of the rules of the game.
The “capping mechanism”, the ceiling on an applicant’s sight allocation, is an example. The yardstick for entry into the new SoC2 is the applicant’s total rough purchases in 2006 from any source. Prima facie, Sightholders say, this rewards companies that were using
Accumulatively, these distortions amount to billions of dollars of rough invoices, which are really based on artificial bookkeeping.
Many Sightholders believe that the new scoring system is also going to reward companies that inflated their balance sheets by overstating the rough turnovers.
One should not ignore the fact that the Kimberley Process data shows that the industry seems to process almost double the amount of cuttable rough available in the world in any given year. Therefore, the fallacies of using the 2006 turnover seem self-evident. If for no other reason, this should be sufficient to eliminate or reduce the weight of these turnovers. They should never become the main factor in starting SoC2.
This not just a matter of creative-accounting exercises or Best Practice Principles or even a tax question. Now it is becoming an essential basis for the DTC's re-ranking of the Sightholders. The very confidential criteria states that the applicant must “convincingly substantiate” that he will “utilize the rough in a way that will sustainably create or capture value.”
The issue is “value creation.” Cynics, including myself in this instance, will argue that demonstrating added value in the rough distribution will again be greatly supported by the very same creative accounting that some Sightholders practiced in the last five to six years.
Trading in unopened (sealed) boxes has been exceedingly widespread in the last few years. As the DTC didn’t really tolerate that, deceptions were created. De Beers knows about such deceptions – as Sightholders complained – and forensic investigators were hired by De Beers to look into this.
The investigators found that some Sightholders had DTC-box sales agreements with a manufacturing company that purchased boxes on a regular basis. This “regularity” enabled a Sightholder to claim that the buyer was not an arm’s length buyer but a subcontractor or a joint-venture partner, and that they were selling the polished together. They were adding value. Some Sightholders would sell boxes and then have them presented to KAMs (key account managers) to substantiate claims of subcontracting or joint venture.
It is irrelevant how widespread this box trading was. We believe that the majority of Sightholders are respectable companies that don’t inflate their books. Among the rest are good people who are simply trying to understand how to survive in the system. Under the new “capping mechanism,” say Sightholders, the most decent companies will suffer and score below those who abused the SoC scoring system.
The Relevancy or Irrelevancy of the ‘Capping Mechanism’
Sightholders, who probably have considerable misperceptions about the new allocation system, argue that those who have worked with the DTC for many years who have developed a business that is grossly dependent on DTC rough are going to be penalized. Meanwhile, those who are really marginal Sightholders and are obtaining most of the goods from outside sources will be rewarded.
Look at the arithmetic: Assume a “hit rate” of 60 percent, (“hit rate” means the percentage of the application a Sightholder actually gets). Take a Sightholder that has a $40 million annual sight. If he applies for 120 percent of the previous year’s allocation, and has a 60 percent “hit rate” he would get an annual sight of $28.8 million.
Senior DTC sources dismiss the relevancy of the “capping mechanism” and the “hit rates”. They expect the selection process will focus on a number of companies that may be getting virtually 100 percent of what they asked for while others will get hardly anything – and the “capping mechanism,” for all practical purposes, is irrelevant. The DTC has cautioned me that it is highly misleading to look at the current Intention to Offer (ITO) planning system and to suppose that there will be a similar or comparable “capping mechanism” in the new contract period.
The “capping mechanism” will cease to have much real meaning in the future. This is why there has been so much talk about “hit rates” after the DTC announced its six month ITO. The term “hit rate” will assume a different meaning, after the DTC received many negative comments about some of the commercial and strategic implications of the “hit rate” system. The company decided to deal with “applications capping” from quite a different angle. It will focus on the concept of commercial competitiveness. This is the concept that will ultimately drive the DTC’s allocation decisions.
Until now, an applicant’s total business performance received a score, and the game was to earn the highest possible score. The DTC says that it will not assess anymore the relative merits of competing businesses, but rather it will assess the relative merits of competing Contract Proposals. This is an important distinction.
Very few applicants seem to understand why the “capping mechanism” has become largely irrelevant. A Contract Proposal is a proposal to purchase a specified value of a specified type of rough diamonds. Applicants requiring multiple categories of goods will need to submit a separate Contract Proposal for each category they require.
When the DTC will assess the Contract Proposals, the process will seek to identify the most commercially competitive Contract Proposals for each particular goods. The DTC will also evaluate them in terms of how well that specific Proposal satisfies the Sightholder Criteria – and the rest of the applicant’s business is really not relevant for the score.
The DTC says it plans to evaluate the Contract Proposal based entirely on the Proposal's performance against pre-specified performance measurements and assessed against pre-specified performance benchmarks.
The process will allow the DTC to determine which are the most commercially competitive Proposals.
Simulating the Consequences of the Proposal Scoring System
My sources at the DTC are adamant that “the evaluation process will have absolutely no regard to the value of rough supply that has been requested - it will be an entirely qualitative benchmarked performance assessment. Once the assessment has determined the degree to which each Proposal has satisfied the Sightholder Criteria, then, and only then, will the DTC start to think about how much supply it might be prepared to make available to each of the Contract Proposals it has received for the categories of rough it expects to have available to sell.”
It is expected that the DTC would be prepared to offer applicants whose Proposals demonstrate customer propositions and capabilities in tune with SoC objectives and backed with a well-financed and implementable plan that builds on confirmed excellence in utilizating these goods up to 100 percent of the applicant's current allocation. With exceptionally strong performance, even offer some headroom for growth up to 120 percent.
In reality, it is expected that very few applicants will be able to reach such an extremely high level of commercial competitiveness. Applicants will need to convincingly demonstrate in their Contract Proposals that the full value of the requested supply is already utilized in a way that is sustainable and profitably addressing the needs of their customers. It must be backed up by exceptionally strong corporate infrastructure, and that it will be able to retain and further develop the applicant's profitable competitive advantage.
If the full value of the requested supply cannot be substantiated by activities that satisfy this, then applicants will be offered less goods.
Though the DTC says it has precise “benchmarks” to judge the strengths of the Contract Proposals, a high degree of subjective judgments will underpin the decision-making process. The DTC makes it clear that, in fact, the less commercially competitive the Proposal, the lower the value of supply that will be offered.
So the “ranking” or the “first claim on available goods” will not be based on an overall business score, but rather, priority will be given to the requirements of the most commercially competitive Proposals, subject to the constraints of availability.
My assessment that the Sightholder list will be dramatically reduced is partly based on the fact that my sources at the DTC clearly expect that once the needs of the most competitive Proposals for every category have been satisfied, there will be no availability left for Proposals that are less competitive.
Applicant Creates his Own ‘Capping’ Level
The fact that the DTC stipulates that one cannot apply for more than the 2006 rough purchases from all sources is, in fact, quite irrelevant.
The real “capping” of applications refers to specific goods and not the entire rough intake of the type of goods for which Sightholders are submitting a Contract Proposal. It is that figure that will simply define an absolute ceiling for applications.
The DTC met with brokers this week to reiterate, explain and stress that the “ceilings” depend on the applicant himself: on his ability to construct a Contract Proposal to purchase a value of goods from the DTC for which he can put forward a current business case and a future business plan that covers the entire value of supply requested and that they believe is sufficiently commercially competitive to secure an offer of supply.
It is intimated that this system will make it almost impossible for the DTC to “reward” companies that have artificially inflated their turnovers. Due to the intense competition the DTC anticipates for each category of rough, an inflated Proposal that cannot demonstrate excellent current and future utilization of the entire request would risk securing minimal supply at best and no supply at worst.
Whether the DTC has the ability to detect false stories is still an unanswered question. I expect that the services of Kroll or other forensic accountants will also be obtained in the future as effective verification is absolutely fundamental to the success and the integrity of the new SoC2 process.
The DTC stresses that “every successful applicant should expect to have any of the claims they make in their Contract Proposals to be subjected to external third party verification at some stage of the coming contract period.”
The DTC expects that a focused Contract Proposal assessment methodology, which asks applicants to identify their utilization on the basis of which they’re substantiating their Proposals, should make responses much more difficult to falsify or exaggerate.
Creative Accounting Will Backfire
The DTC seems convinced that the incentive to exaggerate rough turnover has been removed, as it may lead to reduced supply – or even no supply at all. I strongly believe that even if a “storyteller” initially slips through the net and secures a new contract in 2008, he would fail to thrive in this new, more commercial environment of account planning and performance reviews, in which future supply would very much be dependent upon an ongoing record of strong current performance against the targets discussed and agreed upon with the KAMs.
It really comes down to two things: it was utterly confusing and probably unnecessary for the DTC to set a “capping” based on one’s overall 2006 rough purchases – as chances are zero that someone would demonstrate excellent value-creating business programs for each and every stone. And secondly, the arithmetic sounds nice to satisfy those who believe that computer programs are important.
The bottom line is that the allocation system is now “humanized” – and humans will assess the Contract Proposals. Whether that is positive or negative is a different question. In any event, the applications capping based on 2006 purchases is, for all practical purposes, irrelevant and confusing.
Have a nice weekend.