Monday, August 10, 2009

Diamonds: An Investor's Best Friend?

Lazare Kaplan (LKI) acquires, cuts, polishes and sells diamonds to wholesalers and retail jewellers. What makes this company an intriguing value play is the discount at which it sells to its liquid assets. Current assets are $225 million (including $125 million worth of diamonds) versus total liabilities of $169 million, for a difference of $56 million. Meanwhile, the company's market cap is just $19 million. While this may make the company look like a buy on the surface, the power of this company's supplier is a major risk to the future of this stock.

De Beers controls most of the world's diamond supply, and exerts pressure on its customers (cutters like LKI) by only selling diamonds to companies called "sightholders", of which there are approximately 80 companies including LKI. The sightholder contract is only three years long, however, and so it is vital to these 80 companies that they stay in De Beers' good books. As such, their gross margins are low. Perhaps more importantly, however, "In order to maintain their purchasing relationship, [De Beers'] clients have traditionally been expected to purchase substantially all of the diamonds offered to them by the [De Beers]."

During recessions, demand for some items tends to stay relatively stable. Diamonds do not fall in this category, however, as customers downgrade their selections, resulting in lower sales. In the latest quarter, LKI has seen its sales drop by almost 50% year-over-year. Usually, a company with a large inventory can stop making purchases and convert that inventory to cash, thus rewarding shareholders who purchased at a discount to the net current assets. If the excerpt from LKI's annual report in the previous paragraph is correct, however, LKI's actions may be governed by De Beers' best interests, not those of LKI's shareholders. Indeed, despite the major dropoff in sales, LKI's inventory last quarter remained flat, and is 15% above year-ago levels!

While De Beers may in fact stop forcing inventory on its clients considering the drop in demand, banking on this may not be a risk worth taking. Furthermore, if De Beers decides that LKI no longer meets its short list of 80 companies, LKI will have a difficult time sourcing its supply of diamonds. While this stock may be cheap and will likely reward shareholders, there is a risk that things could go south, as De Beers, rather than management, controls the future viability of this business.

Disclosure: None

1 comment:

Beri said...

I agree with you Saj.

Beyond its poor positioning in the value chain, I would add that their pitiful historical cashflow generation probably partly explains the low market cap to net working capital ratio.

They could be bleeding cash for a while.

I also dislike the characteristics of the product they sell. Diamonds' value rests primarily in people's perception that it retains value, i.e. it doesn't generate any cashflow. This circular feedback loop can fundamentally collapse.

It would be interesting to look at how much diamonds are added to the world inventory every year and the minimal portion that is destroyed.

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