In the first half of 2006, the DTC sold some $3.252 billion worth of rough diamonds, which is barely one percent more than its sales in the first half of 2005; this is in spite of a 3.3 percent higher average level of prices over the comparable period last year. Diamdel failed to sell all the goods it “bought” from the DTC and is facing a build-up in stock (which is believed to equal some 15 percent of its sales targets). This reason, along with some other factors, has caused the overall sales of De Beers to decline by one percent in the first half of 2006.

            An estimated $150 million worth of boxes, which Sightholders “left on the table” during the year’s first five sights due to their high prices, had a severe impact on the DTC results. If clients would have acted as they did in “the good old days” when they grumbled and took the goods, the DTC would have recorded an increase in sales of 5.6 percent. (And, as some sources suggest that if the “goods left on the table” during the first half of 2006 would be closer to $200 million, the DTC might have recorded better sales of 7.2 percent.)

            In the “good old days,” at some point, management would have remembered those clients who had taken losses and would have found ways to compensate them later through “specials,” price discounts, etc. But these days are history.

First Cyclical Turndown in SOC Contract Period

For the first time since the privatization of De Beers and the formal Supplier of Choice (SoC) contractual agreements, the diamond industry faces a significant market downturn. Skeptics have always charged that SoC wouldn’t work during downturns in the business cycle. That is now being tested.

            In 2005, DTC sales at $6.539 billion were 15 percent above 2004. Will De Beers managing director Gareth Penny and DTC managing director Varda Shine (hereinafter: “the GPVS Team”) be willing to start their first year in their present positions with a “no sales growth,” or a mere one percent DTC sales growth? My gut feeling says: not in a hundred years! The GPVS Team will do everything to push sales in the second half.

            In 2005, the first seven sights (thus including the first two sights of the second half) totaled $4.77 billion. If the GPVS Team doesn’t want to run below last year’s levels, the first two sights (July and August) should come to at least $1.52 billion (thus an average of $760 million per sight, which is well over $100 million more per sight than in the first half when the average was $650 million). At the July sight in which some price ranges were lowered, again some goods were left on the table.

            There are four sights left to try to turn sales around. How will the GPVS Team do that? Let’s make some guesses: DTC brokers are likely to call clients and suggest that they expedite their purchases, they should move their ITO allocations forward, and they should take goods now – at the “expense” of the later allocations.

            However, you might argue, then there will be no goods left to take at the end of the year. After all, the GPVS Team has indicated that there will be no ex-plan sales (sales beyond the ITO commitment). This is both right and wrong. There will be ex-plan sales, but they will be named differently. In India this week, one DTC Sightholder used the word “substitute” allocations. “If I take my later allocations now, I’ll get a substitute for these goods later in the year,” stated this Sightholder, who is normally quite well informed.

            Does that signal a return to the “be loyal” and “be awarded” system of the past? We don’t know – at least, not yet.

            Can the market absorb more DTC goods (or, more precisely, expedited deliveries of the second-half ITO, supplemented by extra goods) without causing a further weakening or a decline in prices? My guess is no, the market cannot.

            Those DTC Sightholders who buy the later allocations now would probably be able to get a better (i.e. lower) price if they took the goods later in the year. There is a vicious circle here: if the DTC encourages its clients to take more goods now – rather than later – this action, in itself, may trigger lower prices later, making it worthwhile to wait. Unless, of course, the “substitute goods” that will be offered later will be the equivalent of the compensation of the “good old days.” This is possible, but not very likely.

            If I were a Sightholder, I would defer my ITO purchases. (However, I have been told that the DTC has a new policy against deferring for more than one sight. So that has become a limited option or a non-option.)

A Private Company in Adverse Times

What is basically being tested now is how De Beers will deal with a market downturn as a private company, while having clients under contract. Let’s get very specific: in the first half of 2006, De Beers mined some one million more carats (four percent more volume) than in the first half of 2005. Assuming at least a four percent carat growth for the full 2006 year, this will get De Beers to almost 51 million carats this year. (De Beers has said: "We expect full year production to be up in the low single digits in carats.”) Volume is only one issue. What we further have seen in the first half of 2006 is that the quality of the intake has deteriorated; as compared to the first half of 2005, De Beers is mining, and thus offering its clients, a less attractive mix.

            This has many reasons. When you mine deeper and deeper, the quality of the goods may decline. In Namibia, which is known for its high-quality marine (offshore) diamonds, the more one mines north of the Oranjemund River, the smaller the diamonds. Around the mouth of the Oranjemund, diamonds have an average size of one carat. By the time one gets to Elizabeth Bay, the average size has gone down to 0.3 carats; going even farther north, 0.25 carats is the best average one can get. Namdeb is mining more towards the north – and this also explains part of the deterioration.

            What does all of this mean? The GPVS Team will have some two million more carats available for sales – and most of the increased production will come from Debswana. I expect that increase will translate into some $250 million value. Of course, the DTC has agreed to take only $600 million from the Russians in 2006, but this is only slightly less than it took in 2005, so that will hardly impact the DTC’s maneuverability.

            Even with declining prices and a deterioration of the product mix, the DTC should have enough intake to make the whole of 2006 a “better year” for the PGVS Team than the first half. De Beers says that the diamond jewelry retail market is growing by some three-four percent (so far), and De Beers is forecasting “continued growth in consumer markets.” As a matter of policy and principle, De Beers (as a private company that will not artificially manage the market) is committed to selling its full output. Incidentally, other producers follow a similar policy – but that is not the issue now. De Beers, with 40-43 percent in value of world output remains the dominant producer and price-setter, and its decision not to stockpile has significant ramifications.

            Incidentally, while De Beers recorded a production growth, Rio Tinto’s production went down 25 percent in carat terms in the first half of 2006 compared with the same period last year. (This was mainly caused by a fall of 29 percent in Argyle production, offset by a six percent growth in Diavik output.)  It is certainly worrying that the cheaper goods “are in trouble,” while the supply to the markets have greatly been curtailed. Rio Tinto also reported higher diamond prices for its first half of 2006 compared with the same period last year.

            It is my expectation that the DTC will sell aggressively in the next four sights; it will not resume stockpiling; it will also sell its new production; and it will look for ways to assure that the company will gain back client loyalty. Moreover, Diamdel will more aggressively place its goods – which is a euphemism for price flexibility.

            The statement that clients are “allowed to leave goods on the table” has been taken seriously – too seriously – by many a Sightholder. Don’t expect a retraction, but expect that pressures will be exerted to make it clear to DTC Sightholders that this wasn’t to be taken too literally; loyalty is expected. That may prove to have been an unrealistic expectation.

            De Beers tries to assure the markets – nicely, but not convincingly. To quote Gareth Penny, “The rough diamond market will remain a challenge through the balance of 2006, which will constrain DTC sales growth.” How will the shareholders view a failure to sell all current output?

            De Beers reports diamond inventory figures together with “other assets,” so it is becoming quite difficult to estimate the diamond levels. For the record: inventory seems to be down, but this could mean anything.

            What remains a fact is that the DTC will have to sell some eight percent more in the second half of this year if it wants to have full 2006 sales just one percent above last year. That is not an easy feat – and, if it is accomplished, it is probably still well below the level management aspires or what shareholders would like to see.

            There should be no illusions: in a private company the interests of the shareholders come well before the best interests of the market. Nevertheless, the DTC’s marketing system and the resolve of De Beers to behave like a private company and not act as market custodian are now severely being tested. Clearly, De Beers doesn’t want to keep any stocks (beyond working stocks) and will try to maximize sales for all the reasons mentioned and many others (like company value creation for shareholders). The question remains whether the DTC clients want to hold rough in a market in which prices may still see further softening.

            Some may have to take a hard landing…

            Have a nice weekend.