Strong retail demand offsets challenging rough diamond market

Despite difficult trading conditions in the rough diamond market during the first half of 2006, demand for diamond jewelry at the retail consumer level has remained vibrant, with an estimated growth of 3-4% on the record levels of 2005.

Sales in the United States and Japan — the first and second most important markets in the world — are reasonably strong, reports De Beers in its recent half-year review. Asia-Arabia is a slightly mixed picture, with good growth in China but slower growth in India.

“As we look out into the balance of the year in terms of consumer demand, there are obviously a number of risk factors with regards to growth and confidence, such as rising fuel prices and higher interest rates, general market instability and of course some of the challenges that we see in the Middle East and their implications,” said Gareth Penny, managing director of the De Beers group of companies. “We do, however, believe that growth in terms of consumer demand should remain at least the sort of levels it is now, if not a little higher in the second half of the year.”

Rough diamond sales by De Beers’ marketing arm, the Diamond Trading Company (DTC), for the first six months of the year are marginally ahead 1% of the same period last year, at US$3.25 billion. DTC diamond prices in the first half of the year are 3.3% higher over the same period a year ago.

“The second half is going to be challenging,” Penny acknowledged. “There is a lack of liquidity in the cutting centres with rising interest rates. High gold and platinum prices, of course, have a knock-on effect on the diamond component within a piece of finished diamond jewelry. All of this is contributing to lower margins.”

Penny said the company still sees rising demand, as measured in consumer levels, and a positive medium-term outlook. It doesn’t appear that there will be much new supply over the next 5-10 years, he added.

“The short-term outlook is a more challenging one in terms of the rough end of the business,” he noted. “Clearly, interest rates have continued to rise.”

The rough diamond segment of the business is capital intensive and sensitive to rising interest rates, both in terms of the level of capital that’s employed in the pipeline and the impact it has on the levels of stock being held. The customer base of the DTC comprises 93 sightholders (or clients) who are “world-leading diamantaires” and carefully chosen for their diamond and marketing expertise. There has been some speculation in the press that at least one or two of the sightholders are facing bankruptcy threats.

“The current events in the Middle East are not helpful and, clearly, Israel is a major trading centre and an important part of the diamond pipeline,” Penny explained. “All of that contributes to a cautious outlook for the second half, but this is against the backdrop of the more positive medium- to long-term picture.”

Alrosa deal

Rough diamonds are sourced by the DTC through 15 mines De Beers owns and operates across southern Africa. Many of these mines are in joint-venture partnerships with the governments of Botswana, Namibia and Tanzania. In addition, De Beers continued to purchase rough stones from Russian diamond producer Alrosa on a willing-buyer/willing-seller basis while it awaited approval from the European Commission on an outstanding contract signed with Alrosa in 1992. After scrutinizing the relationship, the European Union ruled earlier this year that the DTC can continue to buy rough diamonds from Alrosa until the end of 2008, at which time the trading relationship will end. The 3-year agreement covers US$1.5 billion worth of stones.

The DTC continues to invest heavily in major marketing programs, spending US$180 million annually, with teams in 15 major markets concentrating on driving demand for diamonds and diamond jewelry. A new program launched in the U.S., called Journey Diamond Jewellery, introduces a new piece of jewelry that incorporates six diamonds of ascending size to represent “a growing love on our journey of life.”

In Japan, the Trilogy program is continuing through 2006.

“(Trilogy) has been very successful for us and it has been one of the main reasons for the turnaround and the growth that we’ve seen in the Japanese market,” Penny said.

The DTC is currently undertaking a review of the market in China, with the launch of its Eternal Girl program celebrating eternal spirit and radiance.

On the retail side, De Beers’ recent joint venture with Moet Hennessy-Louis Vuitton (LVMH) has brought the De Beers brand to the street in a wave of new store openings in the U.S., Japan, U.K., France and Dubai. It’s expected there will be something like 20 odd stores by the end of the year. De Beers won’t provide sales figures for the joint venture, but Penny says it had a strong performance in the first half of 2006.

“We are very pleased with the progress that we are making,” Penny stressed. “Things are going very much in the right direction. We are well ahead of last year and we’re pretty positive about that joint venture.”

Group Production

Carat production for the De Beers group in the first half was some 24.7 million carats, up 4% over same period last year.

“For the year as a whole, we expect to be up in the low single-digit figures,” Penny predicted.

Debswana, the leading mining company in the De Beers group, produced 16.3 million carats from its four operations in Botswana, a 6% increase over the first half of 2005. The Debswana Diamond Co., a 50/50 partnership with the government of Botswana, accounted for 65% of the De Beers group’s output in 2005.

This year at the Orapa mine, Debswana is investing in a new kimberlite processing plant to replace the aging Orapa 1 plant, which has reached the end of its working life. The Orapa 1 plant currently produces about 6 million carats per year. The new Orapa 3 treatment plant is expected to recover 10 million carats annually.

In May, De Beers signed a defining deal with the government of Botswana covering the renewal of the Jwaneng mining lease, and the harmonization of the Orapa, Letlhakane and Damtshaa licences, for the next 25 years.

“This is of great importance to De Beers,” Penny said. “It removes an uncertainty.”

An agreement was also reached on the sale of Debswana’s production to the DTC for a further five years. As part of the negotiations, the DTC is establishing a joint marketing venture with the Botswana government.

“We’re also planning to move our aggregating or mixing activities from London to Gaborone, which we think is a win-win; it is a more cost-effective environment,” Penny explained.

The South African operations of De Beers Consolidated Mines (DBCM) took in 7.4 million carats in the first half, relatively unchanged from last year’s period. In 2005, DBCM made the difficult decision to close down the Koffiefontein and Kimberley underground mines, which had been losing money for years. Of the six operating mines in South Africa, two are currently profitable and the others are very close to profitability, Penny said. He emphasized that on a cash-flow basis, “a lot of them” are cash-flow positive.

In April, De Beers completed the R3.7-billion (US$517 million) sale of a 26% interest in DBCM to Ponahalo, a broad-based black economic empowerment (BEE) company.

“I think this was particularly exciting because in the past there have been comments about De Beers being slow to come to the BEE world,” said Nicky Oppenheimer, chairman of De Beers.

Oppenheimer said the company aimed to put together an innovative deal that would be good for its partners and South Africa, as well as De Beers.

“I am very encouraged by everything we have seen since this deal has been done,” he said. “The partners we found in Ponahalo are just the people one would want to be in business with. One of the key factors is that fifty per cent of the shareholders in Ponahalo are employees and, most importantly, are pensioners
because those are the people who’ve made De Beers Consolidated Mines great and that it’s only right that in the context of a BEE transaction they should be rewarded.”

Ownership of Ponahalo, a company formed specifically for this transaction, includes a 35% stake owned by the Equal Allocation Trust, under which some 18,000 current employees and pensioners of DBCM will be entitled to a specified beneficial interest in the trust on an equal basis. Another 15% of Ponahalo will be owned by the Key Employee Trust, whereby nominated current and future key employees will be allocated an interest in the trust as an incentive. About 72% of the employees and pensioners, and a majority of the key employee group, qualify as “historically disadvantaged” South Africans.

Led by chairman Manne Dipico, former premier of the Northern Cape Province, Ponahalo Investment Holdings’ 50% ownership is held by a consortium of seven prominent individuals and three trusts. The beneficiaries of the trusts, which will collectively own an indirect 22.5% in Ponahalo, are disadvantaged women, disabled people and the local mining communities centred around the DBCM mines.

“We have already seen the Ponahalo shareholders contributing to De Beers Consolidated Mines, particularly in our relationships with the government with regards to the renewal of licences — which is obviously the conversion of licences, which is of particular importance,” Oppenheimer said. The board has committed over R1 billion (US$139.3 million) for construction at the Voorspoed mine.

De Beer’s board has approved capital spending on two important projects in South Africa. About US$177 million is being committed to reopening Voorspoed (595,000 carats per year), pending the approval of a mining licence. Voorspoed is a historic producer that closed in 1909. The new mine is expected to employ 2,000 people during construction and create some 600 permanent jobs.

De Beers is also spending US$115 million on equipping a vessel to begin mining for the first time off the coast of South Africa, based on positive feasibility work. Offshore mining is expected to begin towards the second quarter of 2007, and the mining vessel should yield up to 240,000 carats per year, once fully commissioned.

Production from the Namdeb joint venture in Namibia was up roughly 5% over the first half of 2005 at around 1 million carats, while the aging 75%-owned Williamson mine in Tanzania produced roughly 80,000 carats for the first six months.

Canadian operations

Faced with ballooning capital costs for two new mines being built in Canada — the Snap Lake underground project in the Northwest Territories, and the Victor open-pit operation in northern Ontario — De Beers remains undeterred and excited by the projects’ potential and opportunities in Canada in general.

Originally estimated to cost $1.6 billion in all, De Beers’ board has now approved total spending of $2 billion to bring the two projects into production on schedule. De Beers blames the increase in project costs on higher energy and material costs in the highly competitive, booming Canadian natural resource industry, technological and construction challenges, and the impact of the early closure of the winter ice road in the Arctic.

A proposed 3,150-tonne-per-day (1.1 million tonnes annually) underground operation at Snap Lake is expected to produce 1.5 million carats annually over a life of at least 22 years. Minable ore reserves are estimated at 18.3 million tonnes grading 1.46 carats per tonne, equal to 26.7 million recoverable carats at a revised value of US$144 per carat. Snap Lake remains on track for commissioning, as planned, in late 2007.

The Victor project in the James Bay Lowlands of northern Ontario calls for the development of a 7,000-tonne-per-day (2.5 million tonnes per year) open-pit mine and on-site kimberlite processing plant. Minable reserves are estimated at 27.4 million tonnes averaging 0.23 carat per tonne, or about 6.3 million carats. The operation will produce as much as 630,000 carats annually over a 12- to 13-year life. It’s on track for startup in late 2008.

De Beers’ net earnings of US$336 million for the first six months of 2006 exclude a class action payment and the sale of a 26% interest in the South African subsidiary De Beers Consolidated Mines, and are down 1% reflecting tighter margins and increased exploration spending. Underlying earnings, which are adjusted for the impact of currency and interest rate hedging, are US$308 million, down 14% over the first half of 2005.

“Life has not been as easy during this first six months as it has been previously,” said Oppenheimer. “Those difficult (rough) trading conditions are reflected in the first half figures.”

Cash flow from operations jumped to US$353 million, compared with US$158 million in the same period last year. The increase in cash flow is attributed to sell-off of inventory. There had been a small buildup since early 2005.

Diamond inventories are now lower than they were this time last year. Capital expansion, at US$394 million, is up 338%.

“This is an indication of the exciting future that De Beers has ahead of itself,” Oppenheimer said. “We’re building two new mines in Canada and the board has committed money to two new projects in South Africa . . . and we have spent considerably more money during the six months on prospecting — most importantly in Angola and the Democratic Republic of the Congo, where we’re very encouraged by the early results we’re seeing.”

There has been talk in the market that De Beers may be looking to create a new listing for its Canadian assets. Penny dispelled these rumours.

“We have no plans to list in Canada,” he said. We obviously continue to look at all ways of financing our business, but we’ve got plenty of available financing capacity.”