Sarine Technologies provides machinery and software to the midstream diamond processing industry. The midstream sector is placed between the producers of rough stones (upstream) and the retailers of polished diamonds (downstream). There are about 5,000 manufacturers most of them located in India (1).
Sarine has played a major role in transforming the industry with the help of their automated solutions for every stage in the manufacturing process from the rough stone to the polished diamond. Sarine is mostly selling to the larger manufacturers providing them with a cost advantage over the smaller players in a very low margin business.
Sarine has a 70%+ market share and a monopoly position in some product segments. Their leading position in this relatively small market results in high returns on capital with profits reinvested in product development to strengthen the company’s competitive position.
But that’s not all: their growing installed base of machinery delivers recurring revenue streams that currently account for roughly half of revenue. In addition, Sarine recently started to market products for the downstream retail sector (2) and diamond grading. So far, contribution to total revenue from products targeting new sectors has been small. Management is targeting a 5% revenue contribution from these new products in 2018.
Currently, a number of risks and uncertainties weigh on the stock price:
Since its peak in September 2014 when the company was valued at SGD 1 bn, the share price has lost about 60%. This is partially due to two years (2015 and 2017) where industry headwinds weighted heavily on operating results. In the latest annual report, the company’s Chairman Mr. Glinert provides a good summary of the headwinds Sarine has been facing.
1) There has been substantial oversupply of polished diamonds due to the following reason:
“The normal production cycle of the diamond industry is driven by the fact that half of the annual retail sales worldwide are concentrated from November — China’s Singles’ Day, India’s Diwali and Black Friday in the U.S., through February — Chinese New Year and Valentine’s Day. Polishing is catalysed by the sell-off of inventories throughout the industry value-chain during this four-month period. As downstream wholesalers and retailers replenish their inventories, midstream manufacturers adjust their output accordingly and typically slow polishing activities when the downstream demand cools. However, as the industry is fragmented, and little, if any, information is shared, and as the cycle time from buying rough diamonds to finishing polished diamonds is at least three months, the midstream usually overshoots with production. There is a consistent cycle wherein in Q3 there evolves an oversupply of polished diamonds in the midstream. The degree of overstocking varies from year to year and is dependent on many factors – actual consumer demand, how aggressive the producers are at offering rough diamonds, how aggressive the manufacturers are at competing for said rough, at what point the manufacturers realise the demand for polished has slowed, relative prices of rough and polished stones, etc. This year, primarily due to the aggressive sale of rough by producers still working down their excessive inventories from 2015 (they sold more carats in 2017 than they mined), and correspondingly aggressive buying by the manufacturers, the build-up of inventory was significantly higher than the norm. This is evidenced by the very significant drop in rough stone sales by the producers in the second half of the year (e.g., the DeBeers sights from July onwards), after the manufacturers realised their situation. Consequently, the corresponding slowing of manufacturing activities in the second half of the year is the primary reason for our weaker results in the second half of the year.”
In summary, the midstream sector’s margins are squeezed by their suppliers (rough stone producers) and their customers (retailers and wholesalers). From time to time, supply of polished stones exceeds demand by a wide margin. This leads to an even weaker position of the midstream sector and therefore lower demand for Sarine’s products and services.
However, in February 2018, management reported that diamond sights have come down in 2018 and that retail sales were better than last year. In the annual report released at the beginning of April management confirmed this positive trend pointing out that they are expecting a relatively strong year for the industry (3).
Moreover, besides the up and downs of the midstream sector there seems to be a structural shift going on in the diamond cutting and manufacturing industry. A number of banks have reduced their borrowing activity to the midstream sector. And recently one of the biggest bank scams in Indian history was uncovered directly related the Nirav Modi who owns diamond manufacturing and retailing. Ultimately, I expect midstream segment consolidation to speed up as small manufacturers have to leave the market due to tight margins and more stringent regulation. A more transparent midstream sector consisting of fewer but larger players should benefit Sarine’s business activity in the future.
2) The other headwind results from Sarine’s technological leadership as intellectual property infringement saw a sharp increase in 2017. This is mostly the case in India, by far Sarine’s most important market. As Mr. Glinert explains in the annual report, management is taking all judicial measures to protect their intellectual property and is trying to increase awareness of these infringements with retailers and wholesalers of polished diamonds.
Moreover, they are also relying on technology to protect their property:
“The newest Advisor® 7.0, protected by proprietary home-grown cloud-based cyber protection, has many enhanced features. Comparative testing between Advisor® 7.0 and the older version hacked by the illicit competition shows the polished stones planned using the newer software have a significant tangible added value in actual dollar terms. Advisor® 7.0 also has functionality specifically aimed at enabling the manufacturer to better meet today’s retail trends for branding — optimising modified cuts, light performance enhancement, etc. These valuable add-ons, along with other commercial incentives noted below, motivate manufacturers to migrate upwards to the latest version…”
According to the company, out of twenty thousand systems sold, eleven thousand have so far transferred to the protected Advisor® 7.0 Software.
In addition, infringements can now be uncovered by various software control tools that have been implemented in Sarine software systems to prevent misuse.
Going forward, I expect that it will become more difficult to copy Sarine’s product and that the impact of patent infringements has reached its peak in 2017/2018. Encouragingly, management believes that Sarine managed to retain its market share in the midstream manufacturing segment of the diamond industry in 2017. Although the number of stones processed declined and product piracy took business away, Sarine was able to set a new record of 10 million scanned stones (4).
3) There are a number of additional risks that could affect Sarine’s operations including:
First, the technological advancement of man made diamonds has progressed over the last years. Consequently, there is a risk that synthetic diamonds substitute demand for natural diamonds at some point in the future (5).
Apart from that, the current geopolitical situation will affect the diamond industry, if US/EU lawmakers impose sanctions on Russian diamonds. With Russian state run Alrosa controlling 30% of annual diamond output any export restrictions would have a severe impact on market supply.
A brief look at management/shareholders and valuation:
The company’s directors have significant insider ownership holding about 12% of the company. David Block was appointed CEO in May 2017 after joining the company in 2001. Most managers have been working at the company for at least a decade. Mr. Block is currently holding 0.8 m shares and he will shortly be granted 1.2 m options at market price vesting over four years.
In December 2017, Mondrian Investment Partners and Shareholder Value Management exchanged their position, with Shareholder Value now being the largest outside shareholder holding 9.2% of the company.
Like many of my other investments, the company has a pristine balance sheet with USD 29 m of net cash. The current enterprise value is USD 277 m. I think that the company should be able to achieve normalized net profit of USD 20 m going forward valuing the company at a 13.8 times cash adjusted multiple.
Given the company’s
- high earnings quality,
- strong ROICs,
- leading product development capacity in its industry,
- recent product launches targeting new markets,
- high recurring revenue stream,
- a history of returning excess cash to shareholders,
- and a low financial leverage,
I think shares of Sarine should trade at a significantly higher multiple.
After building an entry 2.5% portfolio position in September 2017, I have been increasing the position to 3.5% after the release of the annual report at an average price of SGD1.14 per share.
The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!
(1) India is the largest diamond cutting and manufacturing centre with total rough diamond imports pegged at $17 billion per annum. Hence, India, especially Surat, processes around 90 per cent of diamonds mined around the world.
(2) A number of Asian retail chains including Soo Kee Group in Singapore, Shining House in China, Golden Dew in South Korea, K-Uno in Japan and Aurora in Thailand have already adopted Sarine’s retail solutions in 2016 and 2017.
(3) See also: http://www.paulzimnisky.com/global-diamond-supply-expected-to-decrease-3-4-to-147m-carats-in-2018
(4) Since its release into the market in 2009, the inclusion mapping technology / Galaxy® family of systems has provided inclusion mapping data for rough diamonds in major diamond processing centres wordwide. The company states that the system has “revolutionised planning and production processes by maximising polished diamond yield, while expediting the manufacturing cycle and reducing human error.” Over 30 million stones cumulatively have been scanned since the technology’s launch.
(5) See also: http://www.paulzimnisky.com/the-price-of-lab-created-diamonds-relative-to-natural-continues-to-fall