Thursday, February 13, 2014

Top 10 trends for 2014 - Trend # 4 - No capital, no business

All through the history of the jewelry business, and especially the diamond business, the support offered by banks to suppliers has been an essential part of the industry's growth and prosperity.  This has been particularly true in the decades after WWII, a period in which there was steady expansion of the US economy and a rapid recovery and industrialization in Europe and Japan.  People were making more money, the most since before the Great Depression, and the war years had built a backlog of consumer needs that were being satisfied.

De Beers played a key role in the expansion of appetite for diamonds and thereby the desire for people to own jewelry in general.  De Beers played a very important role in another way.  They acted as the market buffer, holding stocks when the economy suffered recessions, and releasing more when boom times returned.

This was an excellent environment for banks.  They could lend against inventories, with De Beers protecting their backs on diamonds; and gold hedging, or gold leasing, aiding in protecting the key metal.  There is no question that the leverage so afforded helped many companies reap profits over the years, even in soft years.

There was a strong reliance on long term personal relationships in all this, with banks often accepting that inventory values were being accumulated by manufacturers through careful manipulation of inventories.

No capital, no business.  We are now reaching a critical turn in this long history of bank financing.  The unraveling of these close relationships began in the late 1970's and early 1980's.  Too many companies were caught up in the diamond investment boom in that period.  When values peaked and then crashed, many companies ended up underwater.

That was further exacerbated by the Fed bumping interest rates to extraordinary levels in a push to stop the inflation that was ripping through the American economy.  Investors were fleeing cash and buying any kind of hard asset that made any sense, including gold and diamonds.  Lending rates reached 18-20%, and that was enough to wipe out many companies.  Banks were taking heavy losses.  Major lenders to the diamond and jewelry business, like European-American Bank, bailed out of the industry.  The bank itself was dissolved not long afterwards.

The road since then was a slow retreat by the banks from lending to the diamond and jewelry business.  That retreat was accelerated when the major diamond producers started to unload their inventories in the 1990's.  De Beers, BHP, Rio Tinto, Alrosa, and several African producers, in effect, stopped buffering diamond pricing, and we saw the beginning of price volatility, a problem that has become much worse in recent years, discouraging or stopping banks from lending on inventories.

Banks discovered that in too many bankruptcy cases the key asset, diamonds, disappeared.  Diamonds can pack great value into small packages, and desperate people took advantage of that.  Even worse, excess capacity and competition drove margins down in a business that already suffered from thin margins.  External forces, like Internet retailers selling diamonds (led by Blue Nile), resulted in reduced margins at both the wholesale and retail level.

Moreover, banks were finding that receivable banking, even at low percentages, had risk.  Merchandise might be invoiced, but that did not stop retailers from returning a great deal of what they had bought (and may not have paid for as yet) but not sold.  Many invoices had, as one industry person described it to me years ago, a "rubber band" on it.  One never knew what would actually stick.

Add to that, the increasing government regulations on diamonds and jewelry enacted to counter money laundering, terrorism and human abuse activity, placed banks in the position of being policemen and monitors.  That was something they were not good at, even if they ignored the costs.

So, today, banks financing this industry, on the supply side, are faced with thin margins, volatile prices, unreliable receivables, heavy and expensive compliance costs, and government oversight that could cost them huge penalties.

In the US, one could add, the market is over-supplied and over-stored largely because this is a very mature market.  So growth for banks would depend on whether their particular clients are smart enough to capture market share - kill the competition.

In just the last month or so, the last large lender to the industry in the US, Bank Leumi, has informed all their clients that they are getting out.  Unlike times in the past when banks left, only to return, this might truly be the end of major bank financing.  True, banking facilities continue in Antwerp, Ramat Gan, and Mumbai, but at much reduced levels from just a few years ago.  The outlook is not good.

Where does that leave manufacturers?  Some financing might be available with outside collateralization - assets easily controlled that are not part of the business.  Credit insurance will make some receivables bankable.  Properties could be mortgaged to raise cash.

One possibility is non-traditional money sources, e.g. hedge funds.  But that money will be at least twice as expensive, and will make today's thin deals that much more dangerous.

All these options, and others, raise the same question.  Are the risks reasonable? Many are starting to say no, and are looking to see what they can change in their business model.  

Of course, I speak mostly, but entirely, of the larger manufacturers.  Small companies, designers, and local private dealers have always found ways to finance their businesses through personal loans, mortgages, and even credit cards.

The drying up of bank financing is going to be another big step in the consolidation of the business.  Some owners will bow out, not wanting to take greater risks.  Others will merge.  Jewelry lines will get smaller (less inventory and development costs).  Jewelry will drift even more into basics, thereby reducing risk - but also becoming even more boring.  The supply side will get smaller.  We jsut do not know how far that will go.

Like I said, no capital, no business.


Please note:  If you are interested in seeing the subjects covered in these 10 days of trends, you might be interested in a full-day seminar being tentatively planned for later this year in New York.  We will expand the discussion, cover other issues, and include options for the future.  I would be happy to hear your thoughts.  Comment here or e-mail at benj@janosconsultants.com.  Thanks!

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