Sarine Technologies Ltd and the rise of the Synthetic Diamond Industry

I have previously written posts about Sarine Technologies Ltd:

1. Sarine Technologies Ltd – Monday Surprise (read here)
2. Sarine Technologies Ltd – Clockwork buyback (read here)
3. Revisiting of trailing PEG and Intrinsic Value of Sarine Technologies Limited (read here)
4. Sarine Technologies Ltd – Shares Buy Back vs Grant of Employee Share Options (read here)

“The worst thing you can do is invest in companies you know nothing about. Unfortunately, buying stocks on ignorance is still a popular American pastime.” Peter Lynch

The stock price of Sarine has dropped significantly from a peak of $3.18 on 29 Sept 2014 to $1.98 on 31 July 2015.

This post will be about the outlook & narrative of its business, and specifically the impact of the rise of the synthetic diamond industry to its business.

Established in 1988, Sarine Technologies Ltd. is a worldwide leader in the development and manufacturing of advanced evaluation, planning, processing and finishing systems for diamond and gemstone production.

1) With regards to Outlook, on the company’s website, the Chairman stated the following:

Polished diamond prices: Polished prices ended 2014 down, as their erosion became more pronounced in the fourth quarter. A possible explanation for this trend may have been the need of Indian diamond manufacturers to sell at reduced prices in order to service their credit lines, as inventories increased and available credit decreased.

The credit squeeze in the diamond industry is a worldwide “revolution”  as stated by De Beers (read here). Tension it seems is coming from the change in the industry and felt by the so-called midstream segment — the companies in China, India, Belgium and elsewhere that buy diamonds from mine operators. Banks have either stopped lending or tightened their lending standards.

 

2) With regards to business moat:

Intellectual Property: The products they develop are proprietary in nature. Hence, their ability to remain competitive in the market is dependent, in part, on their ability to protect their proprietary intellectual property (IP), in general, and their software, in particular. To facilitate the protection of these proprietary intellectual rights, they have registered several patents and trademarks in countries key to their business worldwide, and several additional patent and trademark applications are pending in various registration phases.

 

3) The rise of the synthetic diamond industry.

Will this adversely affect Sarine Technologies? First, we must understand if it will be a threat to the real diamond industry. There are two schools of thought from what I have read (recently there are some discussions made in Value Buddies forum).

• Lab Grown Diamonds: Science over Nature? (read here)

 

1st school of thought (Pose no threat)

On the one hand, there is an argument that both real and synthetic diamonds are complementary, and natural fancy colour diamonds &  higher quality white diamonds’ prices (like natural pearls & top-tier natural emeralds) will only increase (read here):

• Natural diamonds are players in an economy of rarity, which synthetic diamonds could never be. The rarity of diamonds is the wind in the sales of the new trend of turning diamonds into an asset that may help us to preserve wealth.
• Many years of lab-made or enhanced rubies and sapphires made to perfection can prove that high-quality lab-grown gems have not decreased the demand for natural ones. The same goes with pearls, where natural pearls are high-priced because of their uniqueness and alongside them are cultured pearls. Prices of natural pearls have gone up since buyers have alternatives. Lab-grown emeralds are a fantastic product that has offered competition for the lower end goods by offering a better-looking alternative for the same money, but top-tier natural emeralds are more expensive now than ever before.

Unlike the rubies, emeralds, and sapphires market, whereby the synthetic market for these gems matured years ago and is now larger than the natural equivalent, in the case of diamonds, gem-quality synthetics currently represent only about 1-2% of the global diamond jewellery market. (read here)

• The technology to produce larger gem-quality diamonds has not yet advanced to the point where the industry can afford to significantly undercut the price of a natural equivalent.
• Even as prices come down and distribution improves, the synthetic diamond market share will be unlikely to get anywhere near that of the other aforementioned synthetic gems, as the market that is primarily driven by bridal; and when it comes to bridal, in particular, there seems to be a discriminatory desire for natural stones (thanks, De Beers).  As stated by De Beers: “It is not a symbol of eternal love if it is something that was created last week.”
• Lower-priced synthetics may actually have an adverse effect on a diamond’s appeal.

Accordingly to De Beers, the company has developed devices that can detect synthetic diamonds (read here). A quick search on the internet revealed that it is indeed difficult to differentiate lab made CVD diamonds from real natural diamonds. However, CVD synthetic diamonds currently on the market can be unambiguously identified only by the combination of two advanced test methods; UV-fluorescence microscopy and photoluminescence spectroscopy. (read here).

2nd school of thought (Threat to the natural diamond industry)

On the other hand, there is this argument that Synthetic diamonds are not exactly “fake” diamonds for their composition is actually no different from that of a real mined-diamond. (read here)

Weingarten shifts uncomfortably in his chair and stares at the glittering gems on his dining room table. “Unless they can be detected,” he says, “these stones will bankrupt the industry.  (read here)

• Man-made Diamonds Are Now Better Than Mined. Here’s Why. (read here)

As a result, the value of the diamond industry may be diluted if the producers of cheaper synthetic diamonds start selling their wares into the diamond supply chain. This can precipitate into a drastic fall in the global prices for diamonds.

• Diamonds are generally bought as jewellery because of its exclusivity. If too many diamonds in the market, the exclusivity factor may no longer be there, thus negatively affecting the demand for the stones.
• Profit margins for participants within the entire value chain of the diamond industry will likely see a sharp decrease, including that of Sarine Technologies.

The lack of full disclosure by manufacturers (that these are lab made diamonds) would threaten the real diamond industry (read here):

• A report released by Botswana Institute for Development and Policy Analysis (BIDPA) last year indicated that De Beers and its Russian rival Alrosa, are at risk.
• Synthetic diamonds, especially Chemical Vapour Deposition (CVD) diamonds, are difficult to segregate into a particular market.  CVD produces an extremely pure crystal. CVD diamond precipitates as nearly 100 per cent pure diamond and therefore may not be discernible from naturals, no matter how advanced the detection equipment.

• Manufacturers may be fully disclosing the nature of its stones, but wholesalers are not. So customers are not aware.
• Clever marketing may bring buyers around to manufactured diamonds. After all, there’s no chance that they are so-called blood diamonds – stones sold by African rebels to fund wars and revolutions, or under the thumb of an international cartel accused of buying off foreign governments, despoiling the environment, flouting antimonopoly laws, and exploiting mine workers.
• Diamonds that are smaller than a fifth of a carat are almost never sent to labs since the cost would eat up any profit made from them. These modest stones actually represent a significant portion of the market. So there is a lack of means to distinguish real and synthetic for smaller diamonds.

• Why would diamond producers have to form a group to “fight” synthetics if it poses no threats to them?

 

In recent quarters, the earnings of Sarine Technologies has decreased due to increased spending on research and development and marketing-related activities for new product launches (read here).

According to Sarine, the pessimistic outlook for the diamond manufacturing industry is due to the following:

• “…during the first quarter of 2015… [diamond] manufacturers had reduced output by some 20 – 30% accordingly”
• “…rough diamond prices had increased overall for most of 2014, out of sync with polished diamond prices market trends…”
• “.. the end-of-month March sight [held by DeBeers] saw an almost unprecedented refusal in excess of 30%, showing distinct sight-holder realization that at current rough (and polished) diamond price levels there is an inherent inability to create sustainable profitability. Purchases were limited to minimal quantities necessary.”

A recent article pointed that the company’s recurring issues consist of margin compression and credit crunch faced by the manufacturing midstream. (read here) Both manufacturing and the retail diamond trade were down in March and April.

Nevertheless, the JCK Las Vegas generated a high degree of interest for Sarine Products. And De Beers lowered prices (for selected rough diamond buyers) and buyers bought more stones.

Sarine is optimistic about its future prospect and stated that they are witnessing indications of a gradual return to normal in the industry (after JCK 2015 ), and they hope that this trend will continue.  (read here)

 

4) My take:

If there are ways to differentiate a lab-made diamond from a real natural diamond (which there are, using advanced test methods), there will always be a niche for natural diamonds. It is, after all, a symbol of eternal love.

Synthetic diamonds can never replace that role (especially in the jewellery industry). I believe that the price of the real diamond will probably not be affected much, but the price of synthetic diamonds (with increased availability) will drop.

The reasoning for this is that the real value of a diamond comes in the form of our perception of its value. Much in the same way that synthetic pearls and fake leather did not dampen the demand for the authentic, natural equivalents, so too natural diamonds will not be easily replaced.

Base on several consumer studies, including one performed by Bain & Company in 2012, found that consumers are reluctant to consider synthetic diamonds for important life occasions such as engagements and weddings. (read here)

There currently is no indication that consumer preferences are shifting from natural diamonds to synthetics, but synthetics can erode customer confidence if sold undisclosed.

It reminds me of the recent reports of the sale of high-quality fake watches in Singapore, that are very well made (so much so that it is near impossible to tell them apart). (read here)

However, the role of synthetic diamond in the semiconductor industry will be unprecedented (read here). Nevertheless, this poses little threat to natural diamonds (as a negligible percentage of natural diamonds are used in high tech industry application – see below and click here).

So it is the jewellery segment that we should focus on. The composition of the market for gem-quality diamonds is the reverse of that seen in the industrial market, with natural diamonds dominating commerce in gem-quality stones.

For now, diamond growing labs cannot even come close to the production of natural markets, cornering only 2% of current production.

Base on the Global Diamond Report 2014 (read here): The diamond market showed clear signs that its rollercoaster trajectory of recent years has moderated and that it is now on a path of steady, sustainable growth across every step of the value chain.

 

In view of synthetic diamonds threat to the natural diamond jewellery industry, the challenge comes from undisclosed attempts to pass off synthetic stones as natural.

A number of initiatives are underway to address this:

• Advanced detection technologies to filter out even high-quality synthetics (see Fig 2.3.5);
• Middle-market players increasingly request certification;
• World’s largest diamond producers had met recently to plan the creation of the industry’s first industry-association to fight off the threat of synthetic diamonds;

 

My take for the moment is that the public has been too affected by this rise of the synthetic diamond industry and fail to realize that every segment of the diamond industry value chain bucked the negative trends of 2012 and posted moderate growth of 2–4% in 2013.

Also, Prices of both rough and polished diamonds which have corrected since the peak of 2013, are beginning to trend moderately upward. With a better understanding and proper certification & disclosure of synthetic diamonds, the upward trend should continue.

Just as it has become easier to produce high-quality clear CVD synthetic diamonds, it has also been increasingly easier, cheaper and faster to detect CVD diamonds. Detection quality has risen. Not surprisingly, De Beers is one of the leaders in developing detection technology.

Nevertheless, I will track Sarine’s quarterly report tightly to see if earnings improve.

 

30 May 2018 entry:

The below post (dated Jan 2018) was made after this post (dated Aug 2015). I am including this as a continuation of the study in this post.

• Sarine Technology (Gemmological) Laboratory: Will this Tech Company be the Pick-axe to the Diamond Gold Rush? (read here)

I believe Sarine Technologies is taking the right steps in aligning itself with the development in the diamond industry. For instance, taking broad steps into the downstream sector of the industry (eg. polished diamonds), and more importantly, the setting up of Gemmological Laboratories. 

The services offered by the Sarine Technology (Gemmological) Laboratory will include authentication of the polished diamond (as per diamond or simulant, natural or synthetic, treated or not) and the grading of its 4Cs, all using the latest state-of-the-art technology.

With this, I can foresee that Sarine Technologies will be able to capitalise on the rise of synthetic diamond, in at least one way. Their technologies will be useful in an industry which in some parts still rely on human eyes verifications. However, verifications via the naked human eyes are rendered useless when differentiating synthetics from natural diamonds. 

Ultimately, the prices of synthetic diamonds will never be the same as natural diamonds (and many have mentioned that synthetic diamonds have no resale values). And demand for diamonds is there (if not increasing). The key is how to differentiate the natural from the synthetic.

With the recent announcement of the incumbent De Beers entering the Synthetic Diamond Industry, and its strategic pricing for synthetic diamonds appear to create a further disparity among the two.

“De Beers, on the other hand, is pricing 1-carat stones in jewelry at $800, while quarter-carat diamonds in accessories will cost $200. The intention here, clearly, is to upend the synthetic diamond industry by completely devaluing the current market…..

Essentially, it’s looking to flood the lab-grown diamond market, essentially sticking to the message it’s been promoting aggressively for a while now: Real is rare, especially if De Beers has something to do with it.”

• De Beers Is Coming for the Synthetic Diamond Industry (read here)