Interview with a Chinese diamond trader – Tough trading conditions

Bling in China: Like everywhere else in the world, all of China wants a big rock on its finger.  For a nation hell bent on status, bling is the thing for China’s up-and-comers.  According to some analysts, China’s gems and jewellery market could be worth USD 200bn by 2015 and is attracting a fair share of new entrants, with Brazilian jeweller H. Stern recently opening its first Shanghai store.

The Chinese diamond market provides a useful window into Chinese consumption patterns, so as part of my monthly on-the-ground China survey, I rang up one of my mates, a Beijing diamond trader, to find out what’s going on.

He had some very interesting insights into Chinese diamond demand, the rough / polished stone price squeeze, an increase in late payments, diamond bosses going AWOL, higher retailer inventory, diamonds as an investment and the carat size favoured by his customers.

He currently has a downbeat view of of the Chinese diamond industry, which reflects the negative flow-on effect from China’s current corruption crackdown.  His insights are very useful in trying to understand the businesses of listed jewellery companies like Chow Tai Fook, Luk Fook, Emperor Watch and Jewellery and Chow Sang Sang.

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Diamond prices and demand have fallen vs 1 year ago: The trader said diamond prices have fallen around 8-10% vs 1 year ago.

Bad environment for a diamond trader: He is unsure how the next 6 months will be and guesses that there might be a small increase in diamond prices.  The diamond trading environment hasn’t been good due to:

  1. Lower consumer confidence in China and India: The 2 main drivers of diamond demand over the last 4 years.
  2. Diamond cartel maintaining high prices: Rough diamond prices have remained high as De Beers and other suppliers try to maintain profits through reducing supply.

Rough and polished stone price squeeze: Indian and Israeli companies are really getting squeezed as they have to buy expensive rough stones, while polished prices are also falling.  In response manufacturers have been trying to reduce both capacity and inventory to try and stabilise polished prices.

Retailer inventory still quite high…polished diamond prices falling: The trader sells his diamonds to retailers and notes that retailer inventory levels are still high (not good signs for Chow Tai Fook and the rest of the retailers).  Also, despite manufacturers cutting production, retailers are not making big inventory purchases as polished diamond prices have been falling and according to the trader, “still feel fragile”.

What the trader is hoping for: The trader is hoping for either 1) improving consumer confidence or 2) the market finding a price level that can sustain a gradual increase in prices over a period of time.  This will lead to stronger retail sales, which will “eventually straighten things out.”

Some incremental improvement signs: “Recently (last month or so), we’ve seen some improvement in polished prices, especially in the lower quality stones, as well as smaller sized stones.  If the price level truly finds its bottom and starts to improve, I think sales will also improve, as people see diamonds as an investment product and are more willing to buy in a rising price environment.”

Rising payment problems a concern: Echos of Wenzhou and Erdos with bankrupt CEOs going AWOL.

“There has been at least 1 instance per month of a big diamond or jewellery company going bankrupt and the CEO running away with the goods.  Almost all of the cases have been in Shenzhen and Hong Kong, but we’ve also experienced delays in payment from our customers.”

2011 saw bigger rock size: The trader noted that carat size differs greatly between cities.  Interestingly, his sales (in Beijing) track the roll-out of China’s massive 4 trn fiscal stimulus.

  • 2010: Half carats were popular.
  • 2011 – Boom time! He sold a lot of 1 carat stones (ie. carat size doubled in 1 year!) and also a lot of very large stones (largest being 8 carat).
  • 2012: First half of the year, 1 carat still popular, but towards the end of the year he was selling a lot of low quality, low value, promotional 1 carat stones.

Fancy coloured stones also boomed in 2011: Fancy coloured demand started at the beginning of 2011, peaked around the end of 2011 and now is very low again.  Fancy stones are probably a good indicator of peak market demand – when it’s high, it’s probably the top of the market.

natural-fancy-pink-diamonds

Gold demand has increased and expected to increase: For all the gold bugs out there, the trader noted that Chinese gold demand has been stronger than 1 year ago.  He expects gold prices to increase over the next 6 months.

Read-through for listed jewellery companies.  The diamond trader’s views are not surprising given the recent dismal 1HFY13 results of Chow Tai Fook (CTF).  CTF’s earnings fell 32% YoY, with same-store-sales falling from +4% in 1Q to -7% in 2Q.

Weak wholesale revenue in China, down 23%, was the chief culprit, as was negative China retail sales growth in Q2.

Interestingly, gold products, which were 56% of CTF’s revenue, were up 11% YoY and reflect the trader’s positive view of gold.

Since the bottoming of the Chinese economy in Q3 2012, CTF has rallied 23% and has outperformed the Hang Seng Index, but is still down 10% from a year ago (and -28% vs the Hang Seng).

Unsurprisingly, valuation is still rich, with a PE of 22x 2013 earnings and a PEG ratio of 1.14x.  I wouldn’t be a buyer at this price.

In the medium term, I’m positive on Chinese luxury goods demand.  While the short-term will continue to be clouded by the corruption crackdown, luxury goods will continue to benefit from growing Chinese middle class demand.

Having said that, I’m not convinced that buying the jewellery companies is the way to play this medium term trend.  Apart from their expensive valuation, a few of the retailers have corporate governance concerns (for eg. Hengdeli Chairman’s personal debt, and Hengdeli providing loans to wholesale customers).  They’re punting stocks on your view of precious metal prices and are not buy and hold companies.

The Western luxury goods companies, like Prada, are better companies, though as previously noted, valuation is a key issue.

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