Is De Beers in financial trouble? Will DTC box discounting become a permanent feature? Will it now resort to tendering and selling rough to Arab sheikhs? These are but a few of the wide range of questions posed in an exclusive interview with the Managing Director of De Beers Group of Companies, Gareth Penny, earlier this week at the company’s London offices.

 

In the current profoundly uncertain business environment, Penny needed to slash budgets, implement massive staff dismissals, curtail output and close mines. However, in the more than two-hour interview with Chaim Even-Zohar, the industry leader constantly tried to steer away from crisis-related issues and, instead, focus on strategies shaping the corporate and industry future. As if there is no today – only tomorrow.

 

As a private company accountable to its shareholders rather than to the public at large, and as a player in fierce competition with other mining companies, we expected that some commercially sensitive issues (such as 2009 sales targets) would be side-stepped – and they were.

 

Nevertheless, Penny’s genuine effort to be forthcoming, candid and detailed was well above our expectations. While we persistently sought answers to specific current concerns, Penny was clearly thinking about seizing the extraordinary opportunities that have arisen – thinking about the long-term macroeconomic outcomes of the company’s actions. The preoccupation with “tomorrow” is somehow evident in every reply to whatever question.

 

Will Penny relinquish the helm of the company rather soon and move to other things? Forget it. There is going to be a new post-crisis global order and Penny will be there to make sure that De Beers and its partners will be the founding fathers of diamond business of the future. Extracts of an extraordinary interview follow:

 

On De Beers Corporate Issues:

Even-Zohar: Recently, there have been newspaper articles and analyst reports that suggest that De Beers has financial issues, and will not be able to renew a $1.5 billion credit facility that is due in March 2010. Can you shed some light on these reports?

 

Penny: Newspapers are full of speculative and inaccurate reports of companies all around the world, and De Beers is no exception. The fact is, we have taken significant steps to realign our cost base and reduce production, so we can remain profitable at significantly lower levels of sales. We are confident that we will service our debt in 2009 and beyond, have the full support of our shareholders and our bankers and, most importantly, world class mines that will generate strong future cash flows for decades to come.

 

CEZ: The De Beers London staff has in recent years been downsized from some 1,500 to only 300 people. This excludes redundancies on the mining side, and in South African offices. Can you actually manage the business effectively with so few people?

 

GP: De Beers’ UK staff has been in the process of downsizing over a number of years, long before this current financial crisis. London is one of the world’s most expensive cities and it doesn’t make commercial sense to be undertaking activities there which could be done more cost effectively elsewhere, principally in southern Africa. The current complement in the UK of 380 people is appropriate for our new decentralized business model, where most sorting activities are carried out in the producing markets and where technology has reduced manpower requirements significantly. While it has allowed us to significantly reduce costs at the centre (by some 50 percent), it will not impact on our ability to deliver on our Supplier of Choice and marketing commitments.

 

CEZ: You have not only reduced operational costs, but also slashed capital expenditures and exploration budgets. What will be the long term implications of these policies? How long will it take you to “go back to normal” after this crisis is over? Are the southern African governments supportive of these output cutbacks?

 

GP: Given the challenging trading conditions in Q4 2008 and Q1 2009 it was essential that De Beers, like many companies, quickly reduced our cost base to bring it in line with reduced turnover. The men and women of De Beers have responded with great determination and professionalism to this challenge. We have reduced capital and operating expenditure, but not in a way that will harm the long-term fabric of our business. In fact, to the contrary, we believe that the new cost base that we have achieved in 2009 will stand De Beers in good stead in the years ahead when we revert back to more normal market conditions. In effect, it will make us a more profitable business in future. Southern African governments have fully understood the need for these actions in the short-term to sustain the business through the global economic crisis.

 

CEZ: Just a follow-up: So much has been speculated about the indebtedness of De Beers, ranging between $3.5 to $4 billion. What caused these debts? How comfortable are you that they can be reduced significantly?

 

GP: De Beers’ external debt of $3.5 billion (down from $4 billion at the end of 2007), has principally arisen because of the range of major new capital projects that have been undertaken over the last five years. These projects have included Snap Lake and Victor mines in Canada, Voorspoed and the "Peace In Africa" vessel in South Africa, and our share of a range of capital projects in Botswana, Namibia and elsewhere. All of these decisions were taken many years ago, given the length of time mining projects generally require but they provide us with mines that are an important part of De Beers’ future. Fortunately, unlike some other companies, we had largely completed our capital projects enabling us to reduce capital expenditure sharply in 2009 without jeopardizing projects under construction. When the recovery comes, and it will, with our lower cost base and excellent diamond assets we will be in a good position to generate strong cash flows to reduce our debt.

 

CEZ: Do you expect major changes in De Beers corporate or shareholding structures? Is there likelihood that the government of Botswana may acquire a greater stake in either Debswana or De Beers? (In DBI for that matter.) Related to changes, when can we expect Element Six to start marketing gem quality synthetics? Would you be willing to say “we will never do so?”

 

GP: While the shareholding in De Beers is a shareholder matter, there has been no decision, that we are aware of, to change the current shareholding.

 

With regard to synthetics, we have made it clear over the years that De Beers (through Element Six) is the leader in synthetic industrial diamonds and that we have no plans to be in the business of manufacturing synthetic gem qualities.

 

Rough Marketing and Beneficiation Issues

CEZ: You have projected a reduction of some 40 percent of 2009 mining output and 2009 rough sales are expected to come to around $3 billion. If we take into account the price reductions, your 2009 revenue might well be 50 percent below 2008, while your profit margin also may dip well below the normal 19-20 percent margin (in your diamond account). Can you comment on this?

 

GP: We have and will continue to reduce mining output in line with client demand for new rough diamonds, but have the flexibility to adjust this level up or down as we proceed through 2009. Importantly, we are not saying that we expect sales to be half of what they were in 2008, but rather that if they are, we should still be in positive profit territory as a result of our determined and rapid effort to lower our on-mine and off-mine costs by 50 percent.

 

CEZ: Do you believe that rough prices have bottomed?

 

GP: It does seem that rough prices have bottomed, and we may well see some shortages in certain categories as the year progresses.

 

CEZ: As recently as 2004, you passionately argued that beneficiation in Southern Africa did not make any economic sense. Soon thereafter, you made a commitment to Botswana with binding contracts that even penalize you for factories not reaching certain thresholds in employment or rough purchase levels. Some of the 16 factories there have closed, while others are struggling. Were you right in 2004, or do you now feel that beneficiation makes good economic sense, and that these factories can compete effectively in the world markets? Aren’t there “too many” factories and would you encourage consolidation?

 

GP: I have never argued "passionately," as you say, that beneficiation in southern Africa did not make sense. Rather I have always been aligned with southern African governments in understanding their desire to encourage local added-value, but fully aware of the competitive challenges in doing so. However, with technology and innovation in sorting and manufacturing, and improvements in global communications allowing for immediate market to factory feedback, the timing was right for Botswana. We have worked tirelessly over the past few years to try to ensure the success of this strategy and good progress has been made. Clearly, this is a long term plan and cannot be evaluated under current market conditions, where every cutting centre in the world is struggling. I would not say there are too many factories but would say to those that have made commitments there that this is likely to be, in the long run, a good strategic decision.

 

CEZ: With the steep reduction in sales, which leads to a reduction of the critical mass that may be needed to manage a factory in the beneficiation countries, does it make sense to keep factories open during a period of crisis? You yourself managed the Teemane factory in Botswana for many years, so you probably understand the situation better than anyone else.

 

GP: It is ultimately a decision for each individual factory as to how it deals with the current crisis. Some will feel that they should reduce production, and others will find alternative ways to see through the period we are in. Our belief is that there is a good long-term future for diamond manufacturing diamond in Botswana.

 

CEZ: You haven’t yet moved the Sight aggregation function from London to Botswana. This brings me to three different questions: We have reported that the delay is due to De Beers tax (Income and VAT) problems in London. Can you explain what these are and give a timeline on when they will be resolved? And finally, how important is aggregation? Would it not be better for each of the production companies to sell its own output?

 

GP: We remain committed to aggregation as part of an agreed overall way of doing business for one simple reason. Our customers have consistently given us feedback that they appreciate the scale and consistency that aggregation allows, and they see this as a core benefit of DTC’s product offering. At the end of the day, it is the needs of our customers that matter most, as any business knows.

 

While there has been a delay in moving aggregation from London to Botswana, it is not due to tax problems in London. There are a few issues that still need to be sorted – both operationally and of a more general business nature – to ensure when aggregation does move, which it will, that it happens successfully and Botswana can be proud of it..

 

CEZ: Related to the foregoing, pressures are exerted on the government of Botswana to change its marketing regime and optimize revenues through tender sales, at least for those parts of the output which are not sold locally to beneficiation partners. Why are you so opposed to tendering, and will you drop your opposition if your partners insist?

 

GP: De Beers believes that the vast majority of its own production and that where we are in partnership with others, should be sold on a long-term contractual basis. We believe this is economically efficient, that it is of benefit to our customers, allows them to build sustainable businesses, maximize long-term returns for major producers and it is reflective of the very product we sell, namely, a unique “treasure of nature.” This is not to say that an element of this production could not be tendered and indeed, we have already done so through our subsidiary, Diamdel. In the current climate, we feel that tendering may be less effective, but it nevertheless remains an option within the parameters described above. For producer governments it is even more important that factories in those countries are given consistent supply. Diamantaires are having to make multi-million dollar investments in infrastructure, technology and training and they need confidence in terms of supply. Otherwise, all incentive to establish such factories is likely to be removed. Interestingly this seems also to be the view of most other major producers.

 

Diamond Markets

CEZ: De Beers has actively been promoting the “lasting value” aspect of diamond purchases, and you yourself have made efforts to draw outside investors into the diamond market, not just for purchasing polished, but also for rough. Traditionally De Beers has always apposed “diamond for investment” schemes. This has obviously changed. What are your views, your aspirations and your expectations of diamonds for investments? Have you been able to attract outside investors?

 

GP: De Beers believes implicitly in the lasting value of diamonds and indeed we have no investments or interests outside of the diamond business. The fact that we have invested billions of new capital in this business is a testament to our shareholders’ faith in it. Recently we have had a number of approaches from investors who understand and agree with our view of the extraordinary product we sell. In these uncertain times, they are looking for new asset classes that will provide a greater long term store of value than has been the case with a number of other investment categories. Given the changing world in which we live, De Beers has been keen to understand the opportunity to encourage new players (such as Sovereign Wealth Funds), who might be interested in diamonds as an asset class. We have not made any final decisions, but there are some interesting and prospective opportunities that are being looked at, but importantly, it will always be a niche opportunity for long-term investors and must not negatively impact the core diamond jewelry business.

 

CEZ: You can only in good faith support the rise of an investment market if you are convinced that long term rough and polished diamond prices will increase. Why do you think so? Can you put a figure to the expected rate of growth? Any time table? Do you expect greater price volatility in the future, and how will this impact your policy of only increasing prices if you believe that prices are sustainable on a higher level?

 

GP: We do believe that in the long term rough and polished prices will increase. If you look at historical data, it is clear that, immediately following a recession, the bounce back in rough diamond prices has been dramatic, and we would expect to see a similar situation soon after the current recession is behind us. This was even the case in the Great Depression where prices largely recovered within a year. We are also very aware that there is little new supply coming on to the market and indeed, overall supply of rough diamonds is projected to decrease as existing mines begin to tail off. On the demand side, there has been significant demand growth over the past years and with new and emerging consumer markets, like India and China, we see a significant supply and demand gap developing in the years ahead. Our pricing strategy has always been to look at a considerable number of inputs and to try to provide long-term sustainable prices to our customers.

 

CEZ: The performance of most large jewelry chains are public record. The De Beers jewelry venture is somewhat clouded in terms of performance. How many stores do you have? What are their turnovers? What are the profits? What are the prospects? Will De Beers and LVMH have to inject more funds beyond the amounts agreed when the venture was launched (I think $400 million altogether)?

 

GP: As a private company, we have the good fortune of not having to disclose what is competitively sensitive information. However, I would like to say that De Beers Diamond Jewellers has, over the last few years, been making excellent progress in building a network of over 40 stores in most of the major world markets, and rapidly increasing turnover to well over $100 million per annum. Like most all high end retailers, the economic crisis has impacted DBDJ from the fourth quarter of 2008. In 2009, again, like most jewelry retailers, DBDJ has scaled back expansion plans, focused on inventory and cost management and targeted the more robust areas of business like engagement rings, until such a time as the trading environment improves. In the medium and longer-term, we believe, we will re-establish the strong growth of the previous four years and succeed in building De Beers Diamond Jewellers into one of the leading international jewelry brands.

 

CEZ: Related to De Beers JV, there have been complaints in the market about excessive delays in payments to suppliers, suggesting an infringement of Best Practice Principles. One Sightholder was believed to contemplate legal steps. Are these issues of concern to you?

 

GP: I understand that an unexpected and rapid change in trading conditions over Christmas impacted most all retailers’ cash flow forecasts, but De Beers Diamond Jewellers is, to my knowledge, up to date with all its payments to suppliers and has certainly not infringed Best Practice Principles.

 

CEZ: De Beers has lately resorted to a two-tier system of selling prices, affording discounts to large volume purchasers. The DTC asserts that these goods don’t reflect standard Sight assortments, but the market has a different view. How do you reconcile these discount sales with the De Beers undertakings to the EC on fair competition among all the Sightholders? Will this become a permanent feature of DTC sales, thus enormously strengthening the so-called “supertanker” clients? Will those who made large purchases be further rewarded in the future?

 

GP: Firstly, let me say that the industry rumor mill has been working overtime on this and is largely inaccurate with regard to both the scale of discounts and the goods involved. DTC communicated openly and clearly its strategy with regard to large volume transactions. With the end of an ITO period, this program applied only to goods which were slow, or not moving at all, and where our stocks were getting significantly out of balance. Discounts were not applied to fast moving goods, and we do not envisage it being a permanent factor, but something designed for the particular and extraordinary market circumstances of the time.

 

Financial Issues

CEZ: As the global economic crisis is foremost a “credit crunch,” we would like to have your take on the depth and width of the equity and debt issues in the downstream industry. SoC has led many diamantaires to reduce equity and rely more on borrowings; the industry debt has doubled since the onset of Supplier of Choice. What has this crisis taught you? If you look at major industry defaults in the last few years, these were all either Sightholders or companies tied to a Sightholder’s group. Have Sightholders become the weaker links in the value chain?

 

GP: Contrary to your suggestion, Supplier of Choice criteria has sought to improve the equity to debt ratio with the objective of ensuring the financial soundness of all its customers. However, we all know that the story of the last decade, across many industries and consumers has been the availability of cheap credit and the resultant increase in leverage, an issue the entire corporate and financial world is now wrestling with. The fact that diamond industry debt has increased is not unusual.

 

Nonetheless, it has reminded us all of the need for prudence and to ensure that there is alignment between debt and equity in every business. Your comment that major industry defaults have been tied to Sightholder groups, I feel, is misleading, in that Sightholders represent the largest, and most significant diamond manufacturing and dealing companies in the world, with contacts and relationships with most, if not all, of the major retailers. It would be surprising if it were any other way. I certainly do not believe they are the weakest link in the value chain.

 

CEZ: Questions have arisen lately about the continued attractiveness of the diamond industry to the specialized lending banks. Though one or two banks have been joining industry financing, they are outnumbered by those who are dramatically decreasing their exposure and reassessing their commitments. What can and should be done to instill the confidence of the banking community? Bankers (and credit rating agencies) lament the low profitability of the downstream sector. Are you concerned about that, and, as leader of the industry, what can you do to change that situation?

 

GP: The diamond industry remains an attractive opportunity for lending banks which over many years have experienced good returns on the loans that they have made to the industry and with a relatively low level of default. Clearly, we are in unusual times, but I believe that as the market returns to normal, banks will be pleased to be involved in our sector. This is not to say any of us must be complacent or that our industry can return to the practices of the recent past. The banks must continue to demand that their clients’ businesses are run efficiently, effectively and soundly.

 

Closing Questions

CEZ: We all look for silver linings. We all hope that someone has the magic words for what we, the industry, need to do in order to come out of the crisis stronger, better, more resilient, with a bright future. If I would ask you to summarize what you think should be done, what would they be?

 

GP: I am pleased you asked the question about silver linings. While no business leader would wish for the current environment, it is always important in dealing with the challenges of today to consider if there are opportunities that could only be achieved in this environment that will improve the business, but for De Beers some of the things include:

 

·        Permanently change the corporate culture and ensuring all we do is simple, fast and effective.

·        Working more closely with our producer partners and Sightholder customers.

·        Ensuring all our mines move permanently down the cost curve.

·        Reducing the size of the corporate centre and driving accountability to the operating units.

·        Developing new marketing approaches (for example: the industry marketing association).

·        Consolidating operations to reduce duplication.

 

CEZ: And a personal question: You always intimated that you looked at the managing directorship of De Beers as something you might do for a year or five, and then you will move on. Are you nearing the end of your De Beers career, or have you still targets that you are determined to achieve before considering a change?

 

GP: Your final question is a personal one, and I am pleased to respond accordingly. I have been in De Beers and the diamond business now for over 20 years and cannot conceive of a more exciting company, nor a more interesting industry in which to work. I am also tremendously proud of this positive role De Beers is playing in the development of countries in which it operates. I am motivated and challenged by the current circumstances and the opportunities that they will generate and am looking forward to working in the months and years ahead with all the stakeholders in our business, to build on the successes and lessons of the past and to find new and innovative ways to create value in the future.

 

CEZ: Gareth, thank you very, very much.