Thomas E. Scotti, Managing Director, Consensus Advisors
Thomas E. Scotti, Managing Director, Consensus Advisors

Since the financial meltdown of 2008, the diamond and jewelry industry has gone through a period of great turmoil. The midstream of the supply chain, which is comprised of some 15,000 diamond cutters and polishers, traders, wholesalers and jewelry manufacturers, has suffered in particular. The midstream is considered post-mining (not DeBeers, ALROSA or Rio Tinto) and pre-retail (not Kays, Zales, Helzberg or Tiffany).

There is a general lack of profitability and cash flow in the midstream due, in large part, to the leverage of the powerful parties at either end of this supply chain. The miners require cash for their rough stones and retailers require extended terms or consignment for what is a slow-turning asset. This disparity on cash flow punishes the highly fragmented midstream by putting even greater pressure on it to turn goods into cash as soon as possible.

This cash flow problem has been exacerbated by the periodic imbalances, which occur in the prices of rough stones, where they sometimes cost more than the equivalent polished diamonds. Since the miners are an oligopoly, they have tremendous power over supply and typically look after their own interests to the detriment of their customers vis-a-vis pricing.

This ongoing turmoil has hastened the exodus of commercial banks from these asset-rich but cash flowpoor borrowers. At the same time, the industry has been suffering financial woes. Changes in bank regulations have forced banks to take greater loan loss reserves on these poor-performing credits. These increased reserves, coupled with the occasional blowup where the borrower has perpetrated some kind of fraud (often missing or misrepresented collateral), have resulted in every bank reexamining how it deploys capital to this industry.

Lenders Exiting the Industry

Bank of America, RBS, Santander and JPMorgan Chase exited the midstream diamond industry some time ago. More recently, leading industry lenders Bank Leumi and Antwerp Diamond Bank (a subsidiary of KBC Group NV) have exited as well. Two top lenders to the industry, ABN AMRO and Standard Chartered, have both pulled back. Standard Chartered announced a few months ago that it will be getting out altogether. Standard Chartered’s lending to the industry is currently greater than $2 billion.

In 2013, some $16 billion was lent into the diamond midstream, according to a report published a few years ago by Bain & Company. Once Standard Chartered winds down its portfolio this amount will be around $11 billion.

So what has the midstream done to deal with this credit crunch?

In some cases, businesses have downsized or shut down due to reduced liquidity. In other cases, peer-to-peer lending has occurred, typically at usurious interest rates. These arrangements are typically short term and are not sustainable. For the most part, the majority of jewelry and diamond companies are living day-to-day. Those with lenders are trying to live with a pay-down plan, where their banks are not re-advancing as they control proceeds from the sale of collateral. This is often accomplished by capping inventory advances or excluding inventory altogether from the borrowing formula. Effectively, these companies are downsizing their balance sheets in order to satisfy the needs of their commercial banks.

So what can be done? How does a challenged industry get critical financing to conduct business? Equally important, what can be done to address the structural challenges which constrain the profitability within the jewelry and diamond industry?

While there is no single cure, one approach may provide a partial solution, which could provide both much needed credit and, possibly, enhanced marketing.

Collateral Fraud and Flight

First, let’s address credit. One of the major hurdles in the industry has been lenders’ concerns about inventory. Be it fraud or flight, this inventory is difficult to lend against. It is highly portable (millions of dollars of value can fit in your trouser pocket and walk out the door) and easily faked (swapping out real diamonds with hard-to-detect facsimiles does occur on occasion). Both these collateral attributes make validation and control on the asset critical. Industry experts who can both validate the product is real and also value it are a necessity. This is a highly specialized skill and only a handful of resources can do this with any scale. Fortunately, there is an entire ecosystem in and around the diamond and jewelry industry where these valuation resources are available.

More difficult is ongoing control of the asset. Historically, lenders have been reliant on the systems and reporting of borrowers on their inventory. While most companies today have a SKU perpetual inventory system, some systems are better than others, and every company maintains its system in its own way. Borrowers also control their own goods. This situation is fraught with peril. There have been cases where, after a thorough valuation has been completed, goods were swapped with facsimiles or went missing and a fraud perpetrated.

While the vast majority of borrowers are honest, the temptation to cheat is ever present, particularly with borrowers who are under duress. Borrower control of the asset has the potential to negate the care and diligence that went into valuation of the goods.

Lenders Can Take Control

An answer may be for the lender to control the asset in a highly secure facility and provide the systems and management tools to their clients who can conduct the business of selling the inventory to their customers. By providing both the front- and back-end tools, including receiving, put away and storage, order processing and picking, shipping and invoicing, the lender maintains control of the asset. The borrower could be free to focus energy on activities that differentiate them from their competition as opposed to engaging in low value-added activities like shipping, which offers no competitive advantage.

Taking this control environment one step further, consignment programs with select retailers may also be a possibility as the lender acts as the control agent on behalf of the borrower. The lender could handle all the logistics of shipments, returns, damages and customer service, which are critical to consignment programs. Borrowers would continue to do what they do well —designing, buying and manufacturing — while cultivating high value retail relationships. Borrowers could get the critical financing they need from a specialist who can lend with confidence, as they focus on value-added services unique to them.

Marketing the Product

The second desirable feature would be value-added marketing services. Given the relatively small size of each jewelry or diamond company and the limited number of relationships small companies can successfully cultivate, anything that can increase the number of sales channels and/or the sales velocity within a given channel is welcome. The way to do this is to leverage distribution resources a custody lender may be able to provide. While not something a generalist lender can do, a specialist lender to the diamond and jewelry industry may be able to provide solutions that improve the underlying business of its customer. This could be achieved through expense reduction and potential increases in turn and gross margin. If the borrower can leverage the infrastructure of its lender for storage, insurance and logistics, then there would be both headcount and rent reduction opportunities for the borrower. Access to increased distribution channels could result in improved margin dollar opportunities and even higher inventory turn. Therefore, in conjunction with the benefits of financial leverage on the inventory, the borrower’s sales and margin may well increase as well.

This one-two punch of both credit and marketing services could provide a holistic solution sorely needed in the midstream diamond and jewelry industry, at least to certain borrowers. Undoubtedly, after almost 10 years of doldrums, there is no going back to the good old days. Since business as usual is no longer an option, the industry must reinvent itself to prosper and grow. This novel lending and marketing solution could lead the way for those borrowers able to embrace it.