Sarine Technologies — Leader in diamond manufacturing equipment

Sarine Technologies is the leading provider of technology equipment and services for the diamond industry. Its business is mostly exposed to the midstream segment, which encompasses a broad range of activities starting with the purchase of rough stones through to the delivery of polished stones for jewellery retailing. More recently, it has developed technology and products relevant to wholesalers and retailers of polished diamonds, enabling Sarine to extend its addressable market to the larger and more profitable downstream segment of the diamond industry. The company’s headquarters are in Israel where it was established in 1988. It was listed in April 2005 on the Singapore Stock Exchange at S$0.272.

Almost all Q117 revenues are attributable to midstream customers (manufacturers). 80% of revenues came from India, reflecting the country’s dominance as a diamond manufacturing centre (accounting for 90% of all stones polished worldwide by volume). Non-recurrent revenues (58%) are generated from sales of capital equipment and recurrent revenues (42%) from per-usage charges of installed equipment (owned by the manufacturer or available for use in one of its service centres).

Sarine’s business model is to provide technology and automation solutions for the diamond industry and add economic value at each stage of the value chain. Historically, it has focused on the midstream manufacturing segment where its products now serve virtually all aspects of manufacturing. It is the dominant player with an estimated 70% global market share in midstream planning and grading equipment. More recently, Sarine has developed products and services that are also relevant to the wholesale and the retail value chain. Sarine believes these products will allow it to extend its addressable market to the downstream segment of the diamond industry, creating significant future growth opportunities (see Exhibit 3).

Sarine’s planning equipment and software optimise the utilisation of the rough diamond. High-precision geometrical modelling and mapping of internal inclusions enable the automatic prediction of the post-manufacturing value of a stone and its various options. This allows the manufacturer to choose how best to utilise the rough stone, for example to trade off carat (size) against clarity and cut to suit different end-market preferences. The relevant product families for planning and optimisation are Galaxy, DiaExpert and Advisor software. In addition to selling the equipment, Sarine applies a per-usage charge per carat. A pay-per-use service at a higher price is also available at its services centres in Mumbai, Surat, Ramat-Gan, Antwerp, Moscow, Johannesburg, Gaborone, Windhoek and New York.

Integrated with its planning equipment are its systems for cutting, shaping, polishing and finishing of rough diamonds (Quazer, Strategist, DiaMension and Instructor software). These services are also available as a per-carat service in multiple locations.

Using the combination of these technologies can raise the achievable yield of a polished stone’s weight from under 40% to over 50%, a 25% benefit to the manufacturer.

Sarine’s Profile family encompasses multiple products and services that enable a stone to be quantifiably viewed digitally. Sarine has developed technology that enables multi-faceted viewing of a stone (for example in three dimensions, from 360 degrees in all axes, up to 40x magnification). This allows a stone to be accurately assessed for characteristics including cut, clarity, brilliance and inclusions even without the stone being physically present. Profile also has the capability to inscribe polished diamonds, which can be used for a number of purposes including branding or identification. Profile helps improve buyer confidence at all stages from wholesaler to retailer to customer and helps improve inventory management throughout the chain (as the stone need not be physically present for viewing). Sarine charges US$35 per carat for the use of its Profile service and the company believes the immediate addressable market represents the brand name stones, which number around 500,000 pa (at an average of 0.7 carats), or over US$12m. The likely trend is for more stones to become marketed under a brand, each with its own ‘story’ and gemological profile. This trend should support significant growth given annual production of over 3m stones of over 0.5 carats.

Sarine Profile was launched in 2015 and accounted for 2% of revenues last year. It is being well received, particularly in Asia where it has been adopted by leading retailers in China, Japan, Singapore and Australia. The company expects Profile to account for 5% of revenues in 2017.

Sarine is currently testing new technology for automated and objective grading of a polished stone’s clarity and colour. If successful, this will give Sarine the capability to automate evaluation of diamonds against the 4Cs1(it is already established in cut grading where its technology has been adopted by virtually all of the gem labs including the Gemological Institute of America [GIA]).

The overall certification business generates revenues of over US$500m for around 7m reports a year of stones typically above 0.2 carats. Sarine believes the introduction of cost-effective, consistent and reliable automated grading could expand certification to stones of above 0.1 carats and increase the size of the addressable market value by 50% to US$750m. Certification is a highly profitable business as the capital cost of a laboratory is around US$1.5m, while prices for reports range from $50-100 per carat.

Potential customers in the certification business come from across the entire diamond industry value chain from manufacturers to gemological laboratories to retailers. The industry is growing as retailers and consumers are increasingly demanding reliable third-party verification to enhance confidence and achieved prices. Sarine has yet to finalise its business model and options include co-operation with existing gemological laboratories, supporting self-certification by major manufacturers or leading retailers, some of which already have independent laboratories, or setting up its own laboratories. Should Sarine decide to operate its own laboratories, it believes it can charge US$80-100 per carat for grading services and offer a package to include Profile services. The company targets commercial launch of this technology towards the end of 2017.

Sarine has traditionally operated within the midstream segment of the diamond industry’s value chain, depicted in the dark green box in Exhibit 4. New products enable the company to move into the significantly larger retail segment. Meanwhile, the company’s strength in technology and automation makes it well placed to benefit from many of the structural trends in the midstream and downstream segments of the industry.

Sarine’s products and services have traditionally focused on the midstream segment of the diamond industry. This segment of the value chain encompasses an extensive range of activities from the purchase of rough diamonds to the completed jewellery piece for retail, and generated revenues of around US$19bn in 2016. The key players in this segment are cutters and polishers, Sarine’s main customer base. Midstream is arguably the most structurally challenged of the three segments with low margins, high fragmentation and squeezed financing as banks have become increasingly reluctant to lend in this area. These characteristics have driven the following trends, which continue to prevail:

According to De Beers,2 in 2015 the US was the largest market for diamond retail sales at around 45% global market share. China and India were the second and third largest markets at 14% and 7% respectively, but represent the greatest growth potential given their more rapid economic growth, urbanisation and rising middle classes. While the US market is more stable and will continue to be the most important market for some time, changing trends present good opportunities in this market. In the US, the consumer is now younger, buying jewellery for themselves and showing preference for brands. These structural trends should drive:

Cyclically, the industry has recovered from the challenging 2015 environment, which was particularly acute for midstream players due to inventory overhang combined with unprecedented, ill-conceived and overly aggressive pricing of rough stones, which led to unsustainably poor margins. This was exacerbated by weak polished diamond demand, mainly due to China’s economic slowdown and anti-corruption policies. Market conditions started to improve in 2016 on the back of stronger economies globally, normalised inventory levels and margin recovery, particularly at the midstream. So far this year, there is some evidence to suggest that the recovery momentum for the industry has continued into 2017, in particular for China. Jewellery sales in China improved over the key Chinese New Year period (February) and Chow Tai Fook’s (China’s largest jewellery retailer) operational data for the first quarter of 2017 showed like-for-like growth of 12% and 4% respectively for China and Hong Kong. Meanwhile, Sarine observes upstream supply and inventories to be in equilibrium.

Sarine recently reported Q117 results, which showed an improvement in revenues (up 5.1% y-o-y) offset by higher expenses, resulting in a decline in net earnings of 17% y-o-y.

The increase in revenues was attributable to higher equipment sales and recurring revenues. During the quarter, Sarine delivered 17 Galaxy family systems, taking the installed base to 316 systems, which underpins prospects for recurrent income growth.

Growth in expenses, however, offset the improvement in revenues. These were mainly driven by the following during Q117:

Q117 results follow a strong 2016, which showed a significant recovery in revenues following a very challenging 2015. FY16 revenues rose nearly 50% to US$72.5m. This was primarily driven by much better equipment sales, which rose by c 77%, including record delivery of 84 Galaxy systems.

Recurring revenue at the end of Q117 accounted for around 42% of total revenue, of which revenues for its polished diamond products and services (Profile referred to by the company as Trade) were around 2%. The company expects this segment to increase revenue to around 5% of total sales this year.

A peaking of the current investment cycle gives scope for ROE to improve. Despite a significant recovery in 2016, Sarine’s profitability remained below its 2014 peak ROE of 34% (see Exhibits 6 and 7). Management believes that, following a multi-year investment cycle that included establishing new premises (New York and Surat), as well as development of new products and services (Profile and grading), capital expenditures can now start to moderate. At the same time, these investments should start to reap rewards in terms of revenues and the company is optimistic that these can become meaningful from 2018 which, in turn, could help restore ROEs towards previously achieved levels of over 30%.

Sarine has a strong balance sheet. As at end Q117, the company has no debt, cash and cash equivalents of US$19.7m, as well as short-term investments (bank term deposits) of US$21.2m.

Historically, the company has financed its development and expansion internally, without debt, and the current financial position should allow this to continue. Capital expenditure over the past three years was elevated at around US$3-7m per annum due to significant investment in a property in New York City (International Gem Tower) costing around US$6m and a new facility in Surat, India costing around US$6.5m. Surat completed this year and is likely to incur a further US$1.5m this year, but overall, the company expects capital expenditure to moderate this year. Potentially significant investments on the horizon could include the development of its own gem laboratories to support its new polished diamond grading business. Management has yet to determine whether this will be necessary. The required investment of around US$1.5m per laboratory would be well within the company’s capability.

Sarine’s dividend policy is to pay 2.5 US cents every six months and bonus dividends if appropriate. In 2016 the company paid 4.5 US cents reflecting its optimistic outlook.

Sarine trades on a trailing 12-month P/E of 24.3x. Consensus shows 2017 and 2018 forecast P/E of 20.3x and 14.6x respectively, and expected EPS growth of 19% and 40%. We note there are only two broker estimates for the forecast period.

Sarine’s valuation and upside is mainly dependent on its expansion in the downstream segment, which should further support earnings growth and improvements in profitability and returns. Some premium can be expected given Sarine’s industry position and leadership in technology.

ROE has scope to improve towards 2014 levels (34%) as the company believes it has passed the peak of its current investment cycle and that 2017 represents a transition year where expenditures peak while revenues from investments can become meaningful from 2018.

Success in the downstream polished diamond businesses could support earnings growth and a valuation re-rating. We have not identified comparable listed peers against which to evaluate Sarine. In the peer comparison table (Exhibit 9) we show two Indian companies, primarily engaged in midstream manufacturing. On historic P/E, these companies are modestly valued compared to Sarine, which is reasonable in view of the low margins, market fragmentation and volatile earnings that characterise this segment of the market. Low historic dividend yields indicate possible pressures on financing and the need to preserve cash. Given Sarine’s focus on expanding into the downstream market, it is instructive to look at players in this area with strong brands and balance sheets. Chow Tai Fook (the largest jewellery retailer in China and Hong Kong) and Tiffany & Co both trade at significant premiums to Sarine on forward P/E, but at similar EV/EBITDA levels. The P/E premiums are likely a reflection of their very strong brands and market positions in jewellery retailing. Chow Tai Fook also stands out because of its yield of nearly 6%.

Sarine is listed in Singapore and incorporated in Israel, and follows the corporate governance requirements of these jurisdictions. The important principles, which are aligned with the UK Corporate Governance Code, are as follows:

Sarine has seven members on its board of directors including four independent directors.

At the recent AGM on 25 April, three longstanding directors retired and a new director, Ms Varda Shine, was appointed. Ms Shine has over 30 years’ experience in the diamond industry and was CEO of De Beers’ Diamond Trading Company (DTC) between 2006 and 2014. The company is considering seeking additional directors to the board to add experience and diversity, in particular in the area of polished diamond retailing.

On 1 May 2017, longstanding CEO Uzi Levami retired and was replaced by David Block, previously the group’s deputy CEO and chief operating officer.

Key members of management and board: