The De Beers Bailout

RAPAPORT…

The De Beers 2009 financial results offered few surprises when they were released mid-February. The company’s annual report highlighted the improvement in the diamond market during the second half of last year and, at the same time, showed the vulnerability of the industry. It also indicated that the company’s influence on the market still extends well beyond the 40 percent global production share it holds.

Indeed, as Chairman Nicky Oppenheimer reflected that De Beers tries to “never waste a good crisis,” many of the trends that evolved in the diamond market were evident at the mining giant, if not prompted by it.

Looking back, De Beers was the first to mothball its mines to prevent an oversupply of diamonds coming onto the market during the downturn. The company responded quickly to the recession by implementing its action plan policy of “lowering production levels in line with client demand, cost savings and operating efficiencies, and stimulation of consumer demand.” An analysis of De Beers results indicates that to a large extent, the company achieved these goals. It can be assumed, or at least hoped, that any prudent business would have done the same in light of the global economic meltdown.

From a Bank’s Viewpoint

While, in many ways, the global diamond market mirrored the trends seen at De Beers, one development set the mining giant apart from the rest: a $1 billion bailout from its shareholders.

De Beers shareholders — Anglo American, the Oppenheimer family and the Botswana government — agreed to invest $1 billion in new equity to boost the company’s balance sheet by reducing its overall debt levels. The pledge enabled De Beers to finalize the financing terms with its lenders, which in turn will enable it to renew a $3 billion credit facility, $1.5 billion of which was due to expire this month. These negotiations were clearly not easy and as RDR predicted in August, the banks have agreed to restructure the loan, but with more stringent conditions, whereby “De Beers will have to provide better collateral to guarantee the loan.”

The very need for such a guarantee illustrates the tough nature of the negotiations and indicates that the banks were less than impressed with the De Beers balance sheet as it currently stands. They clearly viewed the company as a risky investment during the recession, and even as it moves into the postrecession period. In all likelihood, banks view the industry as a whole in the same way.

The Results

Nevertheless, the results contained in De Beers year-end report showed that the market vastly improved in the second six months of the year, from the first six. As pledged, De Beers cut production 49 percent to 24.6 million carats during 2009. This was the result of major shutdowns in the first half, when output fell 73 percent to 6.6 million carats. In the second half, production ramped up to 18 million carats, down a more reasonable 25 percent from a year earlier.

Rough sales through the Diamond Trading Company (DTC) dropped 45 percent to $3.23 billion for the year. First-half sales were down 57 percent to $1.4 billion, year-on-year, while second-half sales fell 32 percent to $1.83 billion. The steep drop in the second half was likely due to the lack of first-half production coming to market.

Also in accordance with its action plan, cost of sales fell 36 percent to $3.51 billion, while De Beers was able to significantly cut operating costs — including spending on exploration, research and development, sorting and marketing, and technical services — by 51 percent to $402 million.

Net earnings fell to a loss of $37 million in 2009, from a gain of $294 million in the previous year, and the company posted a net loss after once-off items of $743 million, due to an impairment of its Canadian assets.

Finally, the company’s cash available from operating activities fell 68 percent for the year, but after a negative cash flow of $31 million in the first half, the operations yielded $257 million in cash in the final six months, representing an increase of 5 percent from the same period in 2008.

Calls for More Rough

Indeed, while the numbers showed a significant improvement in nearly all aspects of the business in the second half of 2009, compared with the first, they also indicated that the company is far from operating at “normal” levels. The company acknowledged this in its outlook for 2010, stating, “Whilst production is planned to increase over 2009 levels, it is not expected to return to historic highs for the foreseeable future.”

De Beers also noted that, historically, “demand generally rebounds strongly in postrecessionary periods as manufacturers and retailers look to rebuild their inventories.”

While De Beers Managing Director Gareth Penny would probably be hesitant to acknowledge that we are at that stage yet, management said it is encouraged by the stronger levels of demand witnessed at the start of 2010. With a January DTC sight valued at an estimated $550 million, it appeared that sightholders, at least, were in some process of rebuilding inventories. There were similar reports of a large February sight — at which prices were 7 percent to 9 percent higher — and strong demand for rough, lending some credence to the belief that we are in the postrecession mini-boom.

While De Beers remains “cautious” about the recovery, market players further along the pipeline seem baffled by the buoyancy of the market at present. Some have heralded an “unknown factor” that is enabling Indian manufacturers to profit on such high rough prices. Others blame De Beers and its mining peers for keeping goods off the market in order to stimulate strong demand for their product, allowing them to get more dollars for their carats.

“Price increases at the moment are a product of shortages in rough and polished, rather than real demand,” one Israeli manufacturer insisted. “We need more rough on the market so that there will be a better balance between supply and demand.”

As a result, while Penny was quoted as saying that output could rise above 30 million carats in 2010, and above 40 million in 2011, it seems that many would like to see a faster ramp-up of production.

Bubble Trouble

Just as De Beers performance improved from the first half of 2009 to the second half, and continues to do so in the first quarter of 2010, so rough prices have risen — in fact, many believe, as we do, at a faster-than-desired pace (see graph below).

Polished price increases have been more modest but gained momentum in February (see graph below).

In all likelihood, the upbeat rough market and, to an extent, the polished, are being stimulated as much by the Indian industry’s aggressive trade, as they are by the mining sector’s supply policies. Add to those increased speculation in the market, and these developments have caused a rising concern for the same bubble mentality that brought the industry to its knees just over a year ago.

The concern is born out of the relative lag in retail sales — even after Christmas bore better-than-expected results — and sluggish economic data that suggest that consumers are wary about the recovery.

With U.S. unemployment at 9.7 percent and the housing market still in the doldrums, U.S. consumers have not yet returned to aggressive spending (see Consumer Confidence graph).

January retail spending rose 0.5 percent, according to the U.S. Commerce Department and, while the economy grew 5.7 percent in the last quarter of 2009, the rebound was led by higher business spending and a sharp drawdown in inventories, rather than consumer spending.

In addition, as the diamond industry pushes toward the Far East, there have been some mixed signals coming from that market that have given additional cause for concern. One such signal was the People’s Bank of China move in February to curb bank lending by limiting the share of deposits that banks must hold as reserves. The decision, the second of its kind within a month, marked Beijing’s latest attempt to rein in 2009’s stimulus program. When introduced, the program generated a spree of lending in the country, fueling economic growth, but it now threatens to inflate dangerous asset bubbles.

The Wary and the Cautious

It is therefore understandable that De Beers, like diversified miners BHP Billiton and Rio Tinto, stresses that caution should be the order of the present day. “De Beers will continue to take a cautious approach to production, sales and cost management in 2010, whilst anticipating a steady recovery of the industry,” the company stated. Its results highlighted this approach, and should well be mirrored by the industry.

But it must be emphasized that the De Beers 2009 financials would look a lot bleaker were the company not able to renew its loan facilities with the banks. Its shareholders had to provide one billion reasons to prevent that from happening, and with it, bolster the prospects for the industry. That was one aspect of its action plan that others in the diamond industry could not emulate.