Financials: Q317 results review
Sarine reported weak Q317 numbers, with group revenues declining by 34.6% y-o-y to US$11.3m on the back of lower capital equipment sales. This was caused by the continued build-up of surplus inventories of polished diamonds in the midstream, which the company had not expected to continue into Q3.
It is important to note that Q3 is a low season for Sarine and sales are usually 20-40% lower sequentially, given that a great deal of annual polished diamond sales volumes occurs from late October/early November to February. For instance, in the US, sales during the 2.5 months of holiday season towards the year-end constitute more than 50% of full year sales. The time between buying rough diamonds and the moment when polished diamonds can be offered to the wholesale players is typically three to six months (depending on size), creating a delayed response from manufacturers to a slowdown in demand. This in turn results in temporary oversupply around late Q2/early Q3, which puts downward pressure on the price of polished diamonds.
Having said that, the extent of inventory build-up in Q317 seems to be above average, with sales declining sequentially by 37.8% (ie at the higher end of the normal range indicated by Sarine). Importantly, this comes after a 5% y-o-y sales decline in H117 to US$34.4m. Also, Q317 sales constitute only 25% of ytd revenues, compared with a five-year historical average of 28%. Current sentiment among Indian diamond manufacturers (which represent c 70-80% of Sarine group sales) remains weak, with some of the players reducing the number of production staff. Nevertheless, despite the difficulties midstream players are currently facing, management estimates that counterparty credit risk is low.
According to the management, three-quarters of the sequential decline (ie around 30pp) was due to weak market conditions. The balance was related to the ongoing illicit activities of Sarine’s competitors (in particular with respect to inclusion mapping systems) and this will continue to affect the company’s performance in Q4 as the countermeasures already initiated are yet to fully bear fruit. The company remains active in the pursuit of legal action but also believes that several features of the newest Advisor 7.0 version should incentivise brand loyalty (c 60% of key customers have already migrated from previous versions). Furthermore, Sarine is about to launch a new system (Meteorite), which is aimed at being the most cost-effective system in the market for scanning very small, rough diamonds and allowing Sarine to compete with the illicit competition in its main market.
On the positive side, recurring revenues related to Galaxy products, Quazer services, polished diamond-related services, annual maintenance costs, etc remained stable and contributed more than 46% to group revenue (9M16: 40%). Importantly, the number of stones processed by the installed base did not drop significantly, according to the company. Recurring revenues should continue to grow, driven by Galaxy and Sarine Profile products. However, as Sarine becomes more active in the smaller diamond sizes, the sales growth rate for Galaxy family systems will become more moderate compared to the historical average.
Sarine’s gross margin in Q317 declined slightly to 65.7% from 68.6% in Q316, with the 28.7% y-o-y decline in COGS being mostly volume-driven. The company booked a minor US$11,000 operating loss for the quarter (Q316: profit of US$4.5m), with overall operating expenses down just 11% in Q317 due to an increase in G&A costs (US$1.60m vs US$1.15m in Q316), largely on the back of IP litigation. According to management, the run rate for litigation costs in absolute terms should be maintained at a similar level until the end of the year. The bottom line was also negatively affected by currency headwinds, amid a c 10% depreciation of the Israeli shekel vs the US dollar, with most of Sarine’s R&D and personnel expenses denominated in the former.
Conversely, R&D costs dropped 14.3% y-o-y and 20.5% sequentially to US$2.4m, as the bulk of expenses associated with the Clarity and Colour grading technology, as well as Advisor 7.0 planning software, has already been incurred (although the company capitalised US$0.4m of costs associated with the former project in Q317). This is in line with management’s statement that R&D expenses reached a peak in H117, which should make it easier for Sarine to improve the bottom line next year.
Sarine’s balance sheet remains firm, with US$27.8m in net cash as at end-September 2017, and the decline versus end-2016 (US$38.0m) being mostly attributable to the 2016 final and 2017 interim dividend payments (US$15.8m in total), US$0.5m spent on share buyback and expenditures related to new facilities in Surat India.
Exhibit 1: Results highlights
US$000s |
Q317 |
Q316 |
Y-o-y (%) |
Revenues |
11,285 |
17,250 |
(34.6) |
Cost of sales |
(3,870) |
(5,424) |
(28.7) |
Gross profit |
7,415 |
11,826 |
(37.3) |
gross margin |
65.7% |
68.6% |
-285bp |
Research and development costs |
(2,430) |
(2,834) |
(14.3) |
Sales and marketing expenses |
(3,393) |
(3,341) |
1.6% |
General and administrative expenses |
(1,603) |
(1,149) |
39.5% |
Operating profit |
(11) |
4,502 |
N/M |
Net finance income (expense) |
53 |
403 |
(86.8) |
Income taxes |
(572) |
(918) |
(37.7) |
Post tax profit |
(530) |
3,987 |
N/M |
Net margin |
N/M |
23.1% |
N/M |
weighted average number of shares (‘000s) |
350,939 |
349,984 |
0.3% |
EPS (US$ cents) |
(0.15) |
1.14 |
N/M |
Source: Sarine Technologies accounts
Demand outlook remains robust ahead of the peak season
Sarine remains confident with respect to the end-market outlook for the upcoming high season and does not see any weakness in consumer demand (with the exception of the domestic market in India). The US market is performing consistently well and has already entered the holiday season covering Thanksgiving, Christmas and New Year. China (the second most important market for Sarine) exhibits strong consumer demand for luxury goods and diamond jewellery in particular. This represents a continuation of recovery seen over the last six months after more than two years of subdued activity in this country.
New products gradually gaining momentum
In line with earlier guidance, Sarine’s Clarity and Colour grading technology was formally launched in mid-September at a Hong Kong trade show. Management expects the initiation of grading reports and first revenue contribution in Q118. According to the company, this technology addresses a US$500m market with 7m diamond grading reports generated annually for stones from a quarter of a carat (or even from a fifth of a carat) and price per carat reaching US$50-100. Sarine expects that its proprietary technology will allow it to grade polished diamonds from a tenth of a carat and up, bringing the potential market size to US$750m.
The company’s polished diamond retail-sales supporting offerings, Sarine Profile (which was launched in 2015), seems to be gaining some traction also, with solid interest across Asia, including Japan (there is already a good customer base here, K-Uno recently added) and Australia, as well as South Korea (eg Golden Dew), Singapore (eg Soo Kee Group) and Thailand (Aurora). The company sees good momentum in North America, with increased interest from large regional and national chains and high-end independents in the US. Sarine highlighted that it remains on track to increase the number of stones scanned using Sarine Profile in 2017 vs 2016. However, the platform still represents a rather minor part of the business (around 2% of group sales in 9M17). The critical mass required to see new customers coming on their own is yet to come, although in Singapore the company has already experienced some spontaneous attraction of new clients.