Promises and Concerns over the Harry Winston Deals

The long and winding road from wrestling with deep losses and large debts to the highlights of profits, major acquisitions and large returns on a divestment, was as precarious as the ice road leading to Canada's diamond mines. How did Harry Winston Diamonds, soon to be renamed Dominion Diamonds, edge out De Beers to buy Ekati? What does this mean for the diamond industry? Why does $1 billion for the retail arm make sense? What will happen with the DAA diamond fund? Which upcoming player in the luxury market should we be paying more attention to?

Beating De Beers to Ekati
A number of companies entered the first round of bidding for BHP Billiton's 80-percent stake in Ekati, with only four – De Beers, KKR, Stornoway and Harry Winston – making it to the second round.

KKR and De Beers did not make it to the third and final round. At this stage, according to a market source, Stornoway bid $500-$600 million; we believe the figure was about $550 million. Harry Winston submitted a much higher bid of more than $700 million.

During the following weeks, as BHP and Harry Winston entered into final negotiations, the price was reduced, finally reaching $500 million – less than Stornoway's offer.

BHP had a couple of considerations when deciding on the bid, including its own good standing in Canada. The company is investing in its potash operation, and politics that went beyond the diamond business apparently took the lead. Eventually, BHP decided to favor the higher profile company with mine ownership (but not operation experience) over the lesser-known company with a seasoned mining team in place.

During the two final stages, we were sure that the heavily in debt Harry Winston would not win the bid. We were wrong. Yet, how will Harry Winston cough up $500 million?

The company sought financing wherever it could, with executives making stops in a number of countries, including in Asia, to find cash for the deal. Selling its luxury retail arm made sense because of its heavy debts. The downside is that high-end popular brands do well in the stock exchange and keeping share value high is a constant concern for any public company. Losing the brand means risking its trading position. In addition, market sources claim that most bids for Harry Winston's retail arm were at about $350 million, which means that an extra $150 million in financing was needed, something that banks did not want to foot.

Enter Swatch
Swatch has many high-end watch brands, but not one that is as diamond heavy as the Harry Winston watches. The $750 million price tag plus $250 million debt, (triple most other offers) makes sense for Swatch if you consider the following: First, Swatch wants a high-end diamond watch line. Next, Harry Winston has a plant in Geneva that is working below half capacity. Swatch can beef-up that operation and, with the power of its excellent marketing, propel revenues further, bringing it closer to the +20 percent that other higher-end Swatch brands enjoy. Finally, while Harry Winston, Inc. had an estimated 5.7 percent profit margin in 2012, removing the debt financing will add an extra few percentage points to its bottom line.

According to Barron's, Swatch CEO Nick Hayek told analysts that in four or five years, it can turn Harry Winston into a brand with 1 billion Swiss francs ($1.07 billion) a year in sales and profit margin of about 25 percent. That puts the price in perspective.

There is another benefit – high-end jewelry. Swatch has been selling jewelry for many years, but never on the scale that made Marilyn Monroe sing, "Diamonds are a girl's best friend." With a salon on 5th Avenue, this new and promising situation can beef up Swatch's bottom line.

What Does this Mean for DAA?
Harry Winston has been working for some time on its diamond fund, Diamond Assets Advisors (DAA). The basic idea is that the fund finances diamond purchases, and when the diamonds are sold at Harry Winston stores, some of the proceeds return to the fund, generating a profit.

This venture, as part of the retail side of the company, is going to the Swatch Group, which means that the watchmaker will not only be a very large diamond buyer and high-end diamond jeweler, but also will possibly be involved in a diamond fund.

The Problems Ahead
Chuck Fipke and Stewart Blusson each hold 10 percent of Ekati and the surrounding resource known as the “Buffer Zone.” They have a right of first refusal if BHP wants to sell the mine, giving them a chance to match the deal.

As just reported, Fipke claims that Harry Winston’s debt financing arrangements for the acquisition interfered with his ability to arrange his own financing.

Nevertheless, there are bigger issues here that concern the diamond industry. Taking control of Ekati, and with a war chest of $250 million making them the frontrunner for buying Rio Tinto's 60 percent of Diavik, the firm soon to be named Dominion could be a major rough diamond player selling more than 15 percent of the global supply, third only to De Beers and Alrosa.

Although part owners of a major mine, until now they never managed one hands on. This tough business requires trust, delegation and expertise. "They have a big learning curve" to run mines, one insider told us. "They lack a long-term view, the kind needed to run a mine and a major sales operation,” he added.

Selling the goods, something they do have experience with, is another issue. Most rough diamond traders that bought from Harry Winston in the past are not head-over heels in love with the company, to say it politely. The criticism ranges from their antics, lack of flexibility, and harsh dismissal of clients. Other claims, far worse, were also raised.

Underscoring this, at the bottom of the market, at times that everyone including Rio kept selling rough, clients turned Harry Winston down. This is a sign of a lack of trust and an issue they'll need to tackle head on. They'll also need to develop a long-term contract system, offering their goods through the BHP tender system (BHP's Antwerp team is part of the deal), or form a combination system. That could possibly be long-term contracts combined with tenders for price disclosure.

This requires a far more sophisticated marketing operation, with long-term analysis and plans and much deeper understanding of the diamond industry then demonstrated today. Squeezing clients is not how you do it, which is why clients leave when they have alternatives.

"I'm not sure a leopard can change its spots," the source told us. The good news is that the diamond industry has an excellent new player with great marketing abilities, in Swatch. I hope that Dominion will rise to the occasion and with its dominant force, help the industry at large rise and push forward too.

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