My thoughts on Sarine Technologies Ltd (SGX: U77)

The thing about Sarine Technologies is that there isn’t really a consistent trend in its revenue (well, at least in recent years). Its recent report on the expected revenue and profit for the nine months ended September 30, 2017, has triggered a sell-off in its shares.

I have previously written a few blog posts on Sarine Technologies Ltd (see below).

• Sarine Technologies Ltd and the rise of the Synthetic Diamond Industry (read here)

9 Month Revenue and Profit History

If we trace back the nine months ended September 30 results from 2010 to 2017… we can see why.

There appears to be an uptrend from 2010 to 2014 until it was ‘disrupted’ in 2015. 2015 was a particularly bad year with a net profit of only US 2.1 mil.

As reported in 2015:

• Business conditions in the diamond manufacturing industry deteriorated as various market challenges persisted;
• Unsustainable disparity between rough and polished diamond prices, coupled
  with existing polished inventory resulting in significantly reduced quantities of new rough diamonds entering the midstream, resulted in lower GalaxyTM processing revenues and reduced demand for the Group’s capital equipment.

Things appear to be turning better in 2016 (in comparison to 2015).

Sarine Tech reported a record 60 GalaxyTM family systems delivered in the first nine months of 2016.

On 10 November 2016, the Group announced its new and groundbreaking technology to provide automated, objective and consistent Clarity measurement and grading for the diamond industry. In addition, the Group has also developed a new advanced computerized Colour evaluation technology. According to Sarine Tech, the combination of these two new capabilities will broaden the Group’s existing offerings for polished diamonds with revolutionary new products and services for Clarity and Colour grading.

That is until their recent 2017 Profitability Guidance and Industry Conditions Update:

• Build-up of surplus inventories of polished diamonds in the mid-stream, which, in fact, worsened built up further in the third quarter, causing manufacturers to slow additional production;
• Ongoing illicit operations of parties infringing on their intellectual properties, and uncertainties stemming from litigations pertaining to these issues.

2 points on a chart do not make a trend. The uptick in 2016 was undone in 2017. Investors, in general, do not like unpredictability. This is also not a stock covered by many analysts.

• Rough Supply Up, Polished Sales Down, and Stockpiles Created (read here)

From a business point of view, Sarine Tech has to deal with external issues such as the build-up of surplus inventories (which they clarified is typical of 3rd quarters – read here). Previously it was the unsustainable disparity between rough and polished diamond prices. However, they seem to somewhat come to terms with it by catering new technology that is applicable for both rough and polished diamond (in 2016).

Only to have the subsequent double whammy issue of external parties infringing on their intellectual properties.

Cost wise, Sarine Tech also had ramped up on the marketing expenses to promote their new capabilities. The stronger US dollar also did not help.

From another angle, the profitability of Sarine Tech has also gone down in recent years. If you compare 9M2015 and 9M2010 revenues and net profits, you would notice that although revenues for both periods are somewhat similar, the net profits for 9M2015 is however much lower as compared to that in 9M2015. Innovations, marketing, and expansion do not come cheap. Read an article stating that it costs Sarine Tech approx. USD 10 million per year for R&D.

The Diamond Market

Diamond / Jewellery, in essence, is not a necessity, and the demand fluctuates. Moreover, there have been reports that the diamond market is no longer monopolized by De Beers (read the article below). So hence, there is this variable factor when it comes to Sarine Tech income.

• A Diamond Market No Longer Controlled By De Beers (read here)

Sales in diamond jewelry have been clobbered by a perfect storm of wilting demand from China, as well as falling oil prices which have hurt sales in big luxury markets like the Persian Gulf and Russia.

Then there are factors pertaining to the recent rise of synthetic diamond and a public market for the trading of diamond (there has been mention of valuing diamonds like gold).

• Diamonds can now be new gold for investors, says Singapore diamond exchange (read here)

The effect and demand of synthetic diamond are not widely reported. However, ultimately there will still be a demand for natural diamond. Yes.. in today’s ‘synthetic perfect’ world, a premium is allocated for natural imperfect “perfection”, as in the case of cultivated vs natural pearls.

Synthetic diamonds have no resale value. So the market for natural diamond will still be there, but a new equilibrium in market demand is still forming.

“Lab-created synthetic diamonds have no resale value. No jeweler will buy them back and if you try to sell them on eBay, you’ll get pennies on the dollar for it. So, from a value perspective, you would need to buy the lab-created diamond at a massive discount to justify giving up the value retention of natural diamonds……

So for identical diamonds, the lab created choice was 25% more expensive than the natural diamond. That’s right: the claims that lab-created diamonds are 30-40% cheaper are WAYoff-base. In fact, synthetic diamonds are actually about 20% more expensive on average than comparable natural diamonds…….

Given the fact that you are losing all the resale/investment value from your purchase, it seems that lab created diamonds offer very poor value indeed.” Read here.

 

“Undisclosed lab-grown diamonds are a major threat to our industry. Grading laboratories are essential to ensure the natural pipeline is free of undisclosed lab-grown diamonds and consumers worldwide can be confident of their purchases”, concluded Ms. Azar. (read here)

The trading of diamonds will also place a premium on a natural certified diamond. The creation of an investable market for the gem, might affect the demand for diamonds, especially natural diamonds sealed with certificates of authenticity.

This is where Sarine Tech groundbreaking technology comes in handy (as compared to relying on human’s valuation). Wholly computerized, the clarity grading process need no longer be vulnerable to subjective, human perception.

• New Israeli machine to standardize diamond grading (read here)

Oh BTW, the world’s first electronic trading platform for the precious gems was launched in Singapore. The Singapore Diamond Investment Exchange has been live since the start of May 2016 and total trading volumes as reported in June 2016 are well on their way to $1 million. Not much, but growing.

• Singapore Just Made Trading Diamonds Easier (read here)
• Diamonds may be the next big thing in the futures market (read here)
• Investing in Diamonds: Should They Be Traded Like Gold? (read here)

Nevertheless, I view the above two developments as positive for Sarine Tech, and they will boost the demand for Sarine Tech technology.

Others with Grading Technology

Other companies involved in the grading technology include De Beers’ International Institute of Diamond Grading & Research (IIDGR), Ogi Systems, GIA and HRD Antwerp.

• De Beers Grading Firm Makes Asian Debut (read here)

In the case of the Singapore Diamond Investment Exchange (SDIX), the mark on the Diamond Bullion is developed by the International Institute of Diamond Grading and Research.

While the technologies applied by these institutions are constantly improving, we still have not gotten to an industry-wide standard that consumers can feel 100 percent confident to use when making a purchase decision.

Ogi Systems: It has developed a suite of tools, including FireTrace, which measures a diamond’s brightness, fire, and scintillation objectively, along with SimCut, which measures a stone’s symmetry and asymmetry features.

GIA: It has created a product called Facetware available to the diamond market, free of charge. It can be downloaded onto a computer, tablet, or mobile phone. Facetware references a GIA database of more than 40 million diamonds, to determine the cut grade of a diamond after being scanned and compared to references in the database.

GIA’s DiamondDock is perhaps the industry standard tool in human color grading.

HRD Antwerp: It has developed a tool to measure the smoothness of a diamond’s faceting, which a polisher can measure without removing the stone from the polishing tang. 

International Institute of Diamond Grading and Research (IIDGR), a member of the De Beers group of companies: Introduced a new Synthetic Diamond Detection course, to complement some of its newly released detection equipment.

• Technology in Diamonds – Grading Technology (read here)

In some cases, these companies use the technologies of others for their in-house grading process.

For instance, in the case of IIDGR, each diamond passes through roughly 37 steps before it’s declared a Forevermark stone. The first task involves weighing the diamond: Forevermark measures the carat weight down to six decimal points, as opposed to the industry standard of two. The next step relies on a Sarine machine to determine polish proportions and build a 3-D model of the diamond. (read here)

The Volatility of the Stock

Personally, for me, I first bought Sarine Tech shares in April 2015 and have held on to them until today. However, these shares only account for a small percentage of my portfolio as I was initially doubtful about the sustainability of their high ROE and EPS growth.

I have recently bought a few shares due to the sudden drop in their share price (still a small percentage of my portfolio).

I believe Sarine Tech is able to overcome the issue on the illicit operations of parties infringing on their intellectual properties. I do hope they learn from this and tighten their own ‘security’. It has happened to Steve Jobs (before he created the iPhone). They can’t really prevent it, but they can get smarter about it. It’s a constant battle.

• What Steve Jobs really meant when he said ‘Good artists copy; great artists steal’ (read here)

As for the external issues of the business conditions in the diamond manufacturing industry and build-up of surplus inventories and the stronger US dollar, nobody can predict and Sarine Tech can’t really do much about it (although they did expand their product range to cover the ‘upstream and downstream‘ markets).  Through new products and services, the company has entered the higher value-add downstream retail segment of the industry, which is more than twice the size of its traditional midstream
market and commands higher valuations.

And as a bottom-up investor, I am not really concerned about the external factors.

Fundamentally, within Sarine Tech itself, I do not see any major issues. Sarine Technologies continues to have a strong balance sheet that has US$37.1 million in cash and equivalents and zero borrowings. And they have been actively upgrading their technologies and marketing them in India and China (not the best place to protect intellectual properties though).

It is not a stock for the faint-hearted. Kind of a roller coaster type of stock (as you can see below). Not one of the better stock in my portfolio – but I have this penchant for down beaten up shares that everyone ignores (I am weird like that I guess).

Its business does not have a strong moat, but they do have an edge over their competitors (which kind of explains the copycat threat). Sarine is the market leader in precision equipment for the midstream segment of the diamond industry. And I see most of their issues as external rather than internal.

On the plus side, once there is an announcement of better market conditions and improvement in revenues and profit, the stock will rally strongly.

And in recent years there has been fewer share repurchase by the company. Which I reckon is due to cost needed for the new technology and marketing.